Auction-rate endgame

Hospitals caught in one of the year’s earliest credit crises have emerged after months of further turmoil with fewer options for borrowing and little expectation that debt markets will resume lending as freely and cheaply as they did a year ago.

Not-for-profit hospitals and health systems were among the borrowers caught in February’s collapse of the $330 billion auction market for tax-exempt bonds. Its demise abruptly ended nearly two decades of stable, low-yield deals between the market’s short-term investors and not-for-profit borrowers.

The meltdown unleashed a flood of debt restructuring as hospitals, universities and other not-for-profits rushed to abandon auctions for less-volatile debt. Nearly nine months later, many healthcare borrowers have successfully exited the market, but at a hefty price. Just how much the market’s collapse cost healthcare borrowers is unknown, but financial statements show health systems lost millions pulling out of auctions. Not-for-profit giants Ascension Health, St. Louis, and Trinity Health, Novi, Mich., reported restructuring losses through June of $23 million and $14.3 million, respectively.

And many moved debt into more-conservative, and more-expensive, deals after the unrest added millions to their borrowing costs. For those that did not escape quickly or cleanly, the apparent recession and shaky financial markets have delivered fresh disappointments and more rounds of interest-rate spikes. “As time has passed, it has not been anybody’s friend,” says Andrew Majka, partner and chief operating officer for financial consulting firm Kaufman, Hall & Associates.

Municipal bond markets emerged from February’s investor panic only to undergo further disruption in the fall as nation’s financial system teetered on failure. Capital markets froze in mid-September as major banks stumbled into bankruptcy court or buyouts. Short- and long-term bond markets froze as investors fled money market funds—a major buyer of municipal bonds—for highly liquid alternatives.

Short-term markets reopened gradually, though access to such debt requires a pledge from borrowers to buy back bonds, either with their own cash or a bank guarantee, but the latter is an increasingly expensive and hard-to-come-by option. Still, one measure of interest rates for short-term variable-rate bonds dropped to 1.14% in mid-November from 7.96%, according to the Securities Industry and Financial Markets Association.

Investors were less willing to return to long-term bonds, and poor demand has forced some borrowers to scale back bond issues and accept interest rates significantly higher than what had been available just months ago.

Investors favored auctions because the market appeared to offer minimal risk, ready access to their cash and a modest return. Borrowers appreciated the market’s low interest and the low risk to liquidity, since investors could not demand payment, as is the case with variable-rate demand bonds.

But unlike an alternative debt market that allows investors to demand repayment at any point, auction-rate investors must rely on a bank or the next bidder to step up.

Buyers fled the market in a credit panic, and anyone holding auction-rate investments was stuck. Aptly named “failed auctions,” the impasse left investors unable to get access to their cash and forced borrowers to pay a default interest rate, which in most cases sent rates skyrocketing as high as 15% from the typical 2% to 3% range.

In the months that followed, billions of borrowed dollars moved into long-term bonds or an alternative short-term debt market known as variable-rate demand bonds. Between April and June, healthcare borrowers issued $24.7 billion in municipal debt, more than any three-month period since 1990, according to figures from Thomson Reuters.

Many borrowers stung by spiking interest rates moved rapidly to restructure debt.

St. Joseph Health System, based in Orange, Calif., entered February’s auction-rate implosion with all of its debt, roughly $1.1 billion, trading each week, says Darrin Montalvo, the nine-hospital system’s senior vice president and chief financial officer.

Within four months, St. Joseph orchestrated three deals to exit the auction market.

Montalvo says the system long relied on the auction market because it provided the lowest cost of capital without the liquidity demand required by the alternative short-term debt market, known as variable-rate demand bonds. For St. Joseph, auctions offered “the best of both worlds.”

But St. Joseph’s interest rates spiked as the market caved along with investor confidence. Interest rates that averaged 3.5% rose to as high as 15% for the system. “We reacted to that increase” with speed that, in hindsight, was fortunate, he says. “We were ahead of the curve.”

By June, St. Joseph managed to switch its debt to a combination of long-term bonds and the seemingly less-volatile market for variable-rate demand bonds.

The system’s $671 million fixed-rate debt secured an interest rate of roughly 5.4%. St. Joseph agreed to use its own cash as a guarantee for another $300 million of short-term, variable-rate demand bonds and a bank backed the remaining $140 million in variable-rate bonds.

Montalvo says officials sought to minimize risk and interest rates by mixing the stability of long-term bonds that typically carry higher interest rates with short-term bonds, which traditionally cost less.

But the past year has been anything but traditional. Interest on variable-rate demand bonds skyrocketed in September when shaky financial markets prompted the failure or takeover of major banks and spurred global government intervention.

St. Joseph saw interest rates on its newly restructured debt jump as well. The variable-rate demand bonds that had carried rates of less than 1% to 2% hit 6% to 10% after September’s chaos, he says.

Amid the turmoil, investors holding $40 million in bonds notified the system it had one week to find new buyers, or pay up. Fortunately, the bonds sold, he says, but St. Joseph’s bank was forced to temporarily buy back $70 million in debt before finding a new buyer in mid-October. “It’s been unprecedented,” he says. “We’re a double-A rated credit, and for periods of time our debt was going at 8% to 10%,” he says. “There’s no rationale for that.”

St. Joseph spent an additional $10 million on interest for the year ended June 30 because of the disruptions. Montalvo calculated that the system’s restructured debt would boost interest costs by $4 million for 2009, but to date, the estimate has proved to be too conservative, he says. Between June and September, interest expenses exceeded budget by $2 million.

Some borrowers relied on temporary fixes as they considered their options. In Painesville, Ohio, Lake Hospital System hastily pulled more than half of its auction-rate debt from the market in April using bridge loans as executives crafted a more permanent solution.

The two-campus hospital relied almost entirely on the auction market to finance its capital projects, including a replacement hospital under construction for its 168-bed LakeEast Hospital campus in Painesville. The building, four miles from the existing campus, is expected to improve access to physicians and patients in a moderate-growth community, credit analyst note. The $155 million replacement is still scheduled to open in the fall of 2009.

Until February’s collapse, the strategy appeared relatively low risk, says Robert Tracz, senior vice president of finance and CFO of Lake Hospital System, but then “the worst thing happened.” Not only did the market collapse, but the market’s extreme volatility upended side deals that Lake Hospital and many others entered as insurance.

The system hedged the risk of fluctuating interest rates with deals known as swaps. In such a deal, the borrower and a bank trade payments. The “swap” involves a borrower exchanging the variable rate it owes on its debt—often based on a fluctuating major market index—for a fixed payment from the bank. The hedge may fail to protect borrowers under certain market conditions, as has happened amid the current credit crisis. Backing out of the deals would have cost Lake Hospital System $15.4 million in April, ratings analysts noted in June.

Tracz says the swaps were one factor in the system’s strategy for restructuring its debt.

Lake Hospital System returned to debt markets in June with a more permanent solution that refinanced nearly $190 million in auction-rate debt to about $115 million in the alternative short-term market for variable-rate bonds with bank backing and another $74 million as fixed-rate debt. Swaps already in place now hedge against the variable-rate debt.

Not all systems moved to exit auctions quickly. Some issuers had little incentive to flee the auction-rate market thanks to bond deals that set a low cap for interest rates. And in March, the Securities and Exchange Commission said borrowers may bid in their own auctions, under certain conditions (March 24, p. 8).

As panicked investors fled and auctions ground to a halt, the University of Pennsylvania Health System opted for a short-term fix to keep rates steady—and relatively low—as executives considered long-term options.

Before the auction market crashed, the three-hospital Philadelphia system paid rates between 1.9% and 3% on bonds worth $196 million that traded hands each week. After the auction market toppled, rates spiked to as high as 11%; the higher interest, before officials engineered a fix, cost the system $750,000, says Keith Kasper, senior vice president and CFO for the University of Pennsylvania Health System.

To temporarily prevent rates from fluctuating every seven days, the system extended the period between auctions from one week to nine months.

Trinity Health similarly extended its auction period and guaranteed investors the Roman Catholic system would buy back bonds as necessary between November and January. The move successfully pushed the interest rate on Trinity’s $599 million in auction-rate debt to an average of 2.58%. In late October, Trinity issued $492 million in fixed-rate bonds and roughly two weeks later sold another $793 million of variable-rate demand bonds to restructure its debt and free up cash.

To attract investors and soothe anxiety that bondholders would be unable to unload the debt after nine months, the system promised to be a buyer of last resort. “We were buying time,” says the University of Pennsylvania’s Kasper.

Such a pledge put the system on the hook to spend $104 million on Nov. 14 and another $92 million four days later. To avoid hemorrhaging so much cash, the system had to successfully restructure the debt before the deadlines.

September’s near collapse of U.S. financial markets threatened to derail the system’s plans to exit the auction market by mid-November. Buyers in municipal bonds fled to safer investments after reports that one well-established money market fund saw its assets plummet with the bankruptcy filing earlier this fall of major Wall Street bank Lehman Bros. Holdings. Municipal markets seized. Few investors wanted short-term bonds, and the market for long-term bonds was worse.

Kasper planned to replace the system’s auction debt with long-term, fixed-rate bonds. Market uncertainty prompted the system to consider commercial paper as an alternative, if necessary, which must be backed by its own cash, ratings analysts said in an October report.

With days before its auction debt was set to return to market, the Aa3-rated system successfully closed on $200 million in fixed-rate debt at just under 6%, he says. That left the system with $100 million in outstanding variable-rate demand bonds.

Fixed-rate bonds mean borrowing at higher interest rates, he acknowledges. But the rates won’t fluctuate and there’s no risk that volatility will force the system to buy back bonds from investors or a bank, as is the case with short-term, variable-rate demand bonds. “We’re obviously willing to sacrifice some cost for some certainty and to preserve our liquidity,” Kasper says. “Everybody wants to be in cash until they find out where it’s going. And it’s not over.”

The system’s restructured fixed-rate debt is expected to add roughly $5 million to interest expenses.

Kasper says he’s uncertain if the future will include an auction-rate market. Without auctions, healthcare borrowers have one less route to curb interest expense on the billions borrowed each year to finance construction, renovation and technology.

“That loss of liquidity has a cost to it,” he says. “People are going to price it in.”

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