Swap Liabilities Boost Downgrade Risks for Hospitals, Higher Ed

WASHINGTON - Growing mark-to-market liabilities for interest rate swaps are posing credit risks that could result in downgrades for some not-for-profit hospitals, higher education institutions, and other nonprofit borrowers, Moody's Investors Service warned in a report issued yesterday.

Over the last few months, most borrowers have seen the fair value of their swap agreements decline significantly, which in some cases has required them to post significant amounts of collateral, Moody's said. The collateral postings, combined with poor investment returns over the last year and deteriorating operating results, has left some borrowers unprepared for a sudden drain on liquidity that swap liabilities can cause.

Large mark-to-market swap liabilities and swap collateral posting requirements mean that "rating downgrades are possible, especially for lower-rated borrowers, who have additional balance sheet or operating stress at the time that they are required to post collateral under their swap agreements," said Daniel Steingart, associate analyst and author of the report.

He said current conditions are a striking contrast from the mild fluctuations in the fair value of most swap agreements that occurred over the past decade, when the majority of borrowers met collateral calls with little difficulty.

The current low-interest rate environment poses two primary risks to borrowers with floating-to-fixed interest rate swaps, Moody's said. The first is that collateral calls or termination payments could significantly reduce the borrower's liquidity. The second is that swap liabilities, especially in combination with investment losses, could lead a borrower to violate its financial covenants, such as liquidity covenants under the bond indenture or related documents like bank liquidity agreements, the report said.

For borrowers affected by both of these risks, rating downgrades are especially possible.

All three major rating agencies have posted a negative outlook for the nonprofit hospital sector, which also has been experiencing weak operating trends, such as slowed growth and revenue declines.

Recent large declines in the market valuation of swap agreements are primarily related to London Interbank Offered Rate-based fixed-payer swaps, which have been entered by a lot of hospitals, universities, and other nonprofit borrowers in recent years. The issuer sells variable-rate debt paired with a fixed payer interest rate swap with a similar maturity.

Under a fixed-payer Libor swap, a hospital or university issues variable-rate debt and then enters into an agreement with an unrelated third party whereby the issuer pays a fixed rate to a counterparty and, in return, receives a variable-rate payment from the counterparty that is tied to a percentage of Libor.

The counterparty floating-rate payment is intended to be approximately equal to the variable-rate debt service the issuer pays on its variable-rate debt. Changes in the present value of the fixed and floating streams of payments will cause the market value of the swap to fluctuate. Increases in negative swap valuations have grown significantly in the past few months because long-dated Libor rates have fallen, Moody's said.

Although swap liabilities have eased from lows in recent weeks, the valuations can change rapidly and therefore collateral posting requirements could increase quickly, the report said.

Collateral postings reduce the borrower's financial flexibility and may require it to issue more debt or liquidate long-term investments at unfavorable valuations to raise the cash to meet the collateral calls, the report said.

Because of the immediate effect on balance sheets, collateral posting is of "significant concern" to all public finance borrowers, even if they are not subject to a strict liquidity covenant in related bond or bank documents, the report said.

Further, borrowers experiencing operating difficulties face the risk that a downgrade could spark additional posting of collateral. A collateral posting that consumes a significant portion of a borrower's unrestricted liquidity, or that triggers accelerated repayment under reimbursement agreements, could result in rapid rating transitions, Moody's said.

The effect on unrestricted liquidity is often more severe for hospitals than for higher education borrowers because of hospitals' more variable liquidity needs on a daily basis, the report said.

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