Historical perspective on hospital financing practices, 1998-2018

In the two-decade period of 1998-2018, fixed-rate debt was the norm for hospital borrowers. But there was greater reliance on variable-rate debt 1998-2008 because hospitals were comfortable accepting variable-rate risk and hedging it. Taking on variable-rate risk, whether in the form of an auction rate security or a variable-rate demand bond, had long been an acceptable strategy dating back to the 1980s, and although fixed rates declined during the decade, variable rate remained an attractive alternative. It reached a peak in 2008, with 60% of total healthcare issuance dedicated to variable-rate financing modes. Contributing to the substantial use of variable-rate alternatives in 2008 was the conversion/refinancing of almost all the auction rate market

One major difference in the 1998-2008 decade was the use of municipal bond insurance by about 40% of healthcare issuers. What was striking was the ready acceptance of bond insurance by hospital credits fully capable of financing on their own. Insurance premiums were sufficiently attractive to attract A and A+ credits to use insurance to backstop their fixed- and variable-rate issues. The abrupt collapse of the municipal bond insurance business was one of the major events of the 2008 crash and undoubtedly led to an alternative form of credit readily provided by the commercial banks. Although bank direct purchases have not yet reached the scale of the bond insurers in terms of healthcare lending, they did extend the practice of relying on external credit for capital funding purposes.

This is not to say that the banks were not active in the period prior to 2008. On the contrary, they were quite active in writing letters of credit and standby bond purchase agreements. Insurance coupled with a bank liquidity facility was frequently used to access the burgeoning auction-rate securities market. The insurers helped expand the auction-rate market by broadening their credit criteria to take in a wider range of credits. The auction-rate risk was frequently managed through use of a derivative, most typically in the form of a long-dated interest rate swap. These swaps could lock in fixed rates at levels well below what conventional fixed-rate bond pricing would command and became a preferred financing approach. For the more aggressive, the swap could be coupled with other derivatives that could further enhance the results by introducing an additional element of risk. The introduction of derivatives was a landmark change that would later come to an abrupt halt when auctions began to fail.

The marriage of variable-rate debt and derivatives was certainly the biggest new development of the 1998-2008 decade and the one most likely to be carried forward over the next 10 years. Hospitals had long been comfortable with variable-rate risk, and the higher-rated ones typically would devote a portion of their debt structure to variable-rate securities. A blend of fixed and variable rates helped average down the cost of capital and could be reasonably managed.

The appearance of derivatives added a new dimension to the debt structure. Although it had been long recognized that a bond was a financial instrument that needed to be valued on a regular basis, the practical effect of its periodic valuation was not particularly noteworthy. Derivatives were also financial instruments requiring routine valuation. As long as interest rates remained more or less stable, the impact of the derivative valuations was typically either modest gains or losses. In the 1998-2008 period rates remained relatively stable for much of the decade. Consequently, so did derivative values. That begin to change in 2008 as the 30-year U.S. Treasury dropped from 4.35% on January 2 to 2.67% on December 31. The effect on balance sheets was immediate and depending upon when the swap was entered into and its duration, the change in valuation could be significant. Starting in 2009 and continuing to the present, the use of derivatives has fallen sharply from the heydays of the prior decade.