Hospitals and health systems are finding that it’s not easy to unload interest-rate derivatives that backfired with the credit-market collapse.
Volatile swaps complicate exiting credit deals
Demand from investors since January has lowered interest costs for tax-exempt bonds that lock in rates over many years—a market largely frozen during last fall’s credit crisis. That’s prompted a recent push by not-for-profit healthcare to borrow and refinance debt.
Among those providers are some with debt in an alternative market for short-term investors where bank distress has continued to cause interest-rate volatility. Some hospitals unwilling to stomach the uncertainty have seen the drop in interest for fixed-rate bonds as an opportunity to exit.
But not all borrowers that have unloaded the variable-rate demand bonds, whose rates vary with the bonds’ frequent sales, have dumped side deals that hedge against the debt’s floating interest rates. Under the deals, borrowers trade a fixed payment for a variable payment from a bank. The fixed payment is often pegged to the swap curve of the Libor, the London Interbank Offered Rate, and sets the value for the so-called swaps.
As the Libor swap curve has declined, so has the value of swaps, said Bart Plank, a senior vice president for healthcare investment bank Cain Bros. & Co. That has left borrowers liable to make up the lost value if they terminate the agreements.
Swaps quickly emerged as a potentially expensive complication for healthcare borrowers in faltering credit markets. Health systems and hospitals with bonds sold at frequent auctions were forced to exit the $330 billion short-term market after it collapsed in February 2008. Investors fled the auction market as bond insurers with exposure to risky mortgages began to falter.
Interest rates on bonds in the auction market also reset with each sale. Some borrowers hedged auction bonds and discovered, as they rushed to refinance the debt in the spring of 2008, that the swaps had soured (March 3, 2008, p. 8). The hedges grew increasingly skewed as the year continued. As swap values fell, some hospitals and health systems were required to post collateral on the deals.
Swap values have climbed this year after falling to a 10-year low in mid-December of 1.79%, according to an analysis of Bloomberg data by Cain Bros. As of Oct. 29, the fixed price for borrowers in a swap deal was 2.94%.
Intermountain Healthcare, which owns 19 hospitals and manages one more, has seen collateral required for its swaps drop to $36.7 million at the end of August from $158.3 million nine months earlier, the system said in documents released as Intermountain went to investors in October to borrow $250 million.
The hefty collateral demands of last December have not shaken the system’s confidence in derivatives, however. “During the past few months, Intermountain has experienced significant reductions in the amount of these collateral postings,” said a spokesman for the Salt Lake City-based system, in a written statement. “Intermountain continues to consider the underlying fixed-rate derivative instruments valuable financial tools that reduce the risk of higher interest rates.”
For Gwinnett Hospital System, a two-campus hospital based in Lawrenceville, Ga., terms have not moved far enough to unwind four swaps on roughly $154 million the hospital is expected to refinance to fixed-rate bonds from the variable- rate-demand market. Thomas McBride III, Gwinnett’s chief financial officer and executive vice president, said financial market turmoil “that we’ve all seen and experienced is one of the main driving forces” behind the exit of variable-rate bonds. However, the 435-bed hospital won’t unload its interest-rate hedges until conditions prove more favorable. As of June 30, the hospital’s swaps had a negative value of $23.1 million, according to financial statements.
McBride said the hospital never used swaps before 2007, when the system refinanced its debt and borrowed $100 million to renovate and add 155 beds at its Lawrenceville hospital. The 2007 bond deal left Gwinnett Hospital with roughly half of its bonds in the auction market and the rest as variable-rate-demand bonds covered by swaps, ostensibly to smooth out interest payments similar to a fixed rate-bond.
McBride said volatility since the credit crisis erupted has prompted the hospital to abandon the strategy of using a combination of variable-rate bonds and derivatives for the security of actual fixed interest rates.
Andrew Pines, a managing director for Citigroup’s healthcare finance group, said healthcare borrowers’ strategies for swaps have varied. Some find the cost of terminating the contracts remains too high. Some have adopted strategies to offset negative hedges, including options that pay borrowers to agree to exit when swap values reach certain targets, such as a break-even position. Borrowers agree to forgo the chance that hedges may eventually swing in their favor. Other borrowers have decided the cost of exiting the deal is worth it, Pines said.
Blaine O’Connell, senior vice president of finance and CFO for Froedtert & Community Health, said market disruptions and uncertainty have soured the Milwaukee hospital’s directors on variable-rate debt and swaps. Froedtert had no variable-rate debt until 2007, and the hospital likely will not return to the short-term market for its next financing deal, he said.
Froedtert closed a $187.4 million bond deal in late October that replaced roughly $90 million of variable-rate bonds with fixed-rate debt. The hospital paid roughly $5 million to cancel a swap on the bonds. O’Connell said the cost to exit the swap—which had climbed as high as $7 million—did not factor into the decision to refinance. The desire to reduce risk outweighed swap costs, he said.
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