Coming on the heels of a record year, the health care sector will remain stable but vulnerable in 2008. Capital needs remain high, investment returns are steady, and reimbursement rates are still adequate, analysts and market sources say.

However, some add that the sector’s credit quality has reached its peak, and that a return to historical trends is probable, led by a number of factors beginning to undercut some of the sector’s more vulnerable issuers. Adding to concerns, a shifting landscape in the overall market could mean tougher decisions for issuers looking to access the capital markets.

“On the credit quality side, it remains as complicated as ever,” said Martin Arrick, health care analyst at Standard & Poor’s. “There is a credit quality split between the haves and the have-nots. It’s not new, but it is a re-intensification and reemergence.”

In spite of these concerns, health care organizations continue to demand capital at historical levels. Health care remains a competitive business and as patients demand private beds and accessible outpatient services, health care organizations find they must expand or renovate to keep pace.

Many hospitals still have facilities that need updating, and information technology remains an ongoing and expensive concern. In addition, Arrick said construction costs are so high that an additional tower or extension could cost as much as $500 million for an urban hospital.

“Many organizations have facilities that are not consistent with the kind of care that needs to be delivered or the way that their communities want to receive that care,” said Ken Kaufman, managing partner at Kaufman Hall & Associates, a leading financial adviser for health care credits. “That’s what’s been driving the tremendous amount of capital in the last four or five years and I don’t see that changing at all.”


The credit analysts, for their part, said that issuers both big and small continue to approach them about rating deals. This despite the widening gulf between large systems and stand-alone hospitals that are doing well and those medium- to small-sized facilities that are starting to struggle.REIMBURSEMENT RATES

Lower-rated credits are suffering from health insurer reimbursement rates that are coming down from historically high levels, as well as increased debt loads driven by capital needs, a changing insurance environment, and physician recruitment issues.

“There were a couple of years where we had exceptionally strong reimbursement rate increases and now that is coming back to what is more normal,” Arrick said. “Underlying cost pressures are beginning to poke through the growth of insurance and we are seeing weaker performance.”

He said he expects more downgrades than upgrades this year.

The insurance environment and reimbursement policies for hospitals are complicated. Health care organizations receive reimbursements both from commercial health insurers and from the federal and state governments, through Medicare and Medicaid. While managed care payers often paid reimbursement rates in the double digits earlier this decade, those rates are likely to fall back down to the single digits.

“We see [managed care reimbursement] tempering and coming in line at between 3% and 7% on the commercial payer side,” said Anthony Houston, a health care analyst at Fitch Ratings. On the public side, Medicaid is likely to be maintained at best, he said. In late December, President Bush signed the Medicare, Medicaid, and S-Chip Extension Act of 2007, which increased reimbursement for physicians by 0.5% through June 30, and keeps the state children’s health insurance program at current levels.

Many hospital administrators and governors had hoped for an extension to S-Chip. The extra money was sought to help states pay for benefits expanded beyond the original mandate. Federal regulations allow states to provide health insurance through S-Chip to children, and in some cases adults, in families with income under 250% of the federal poverty level. Some states have also received waivers to provide aid beyond that threshold.

In its absence, many states will have to cover fewer people than they did in 2007, or find other ways of funding the benefits. This could mean an increase in the number of uninsured who are hospitalized, potentially cutting into their bottom line.

Congress also approved Medicare market basket rate increases of 3.3% for fiscal 2008 after increases of 3.7% in fiscal 2006 and 3.5% in fiscal 2007. However, the increases still fall short of the rise in health care costs.

“The cost of medical inflation continues to outpace the reimbursement increases that are coming from the government, and we think overall that disconnect could rear its ugly head in the industry over the medium term,” Houston said.

In addition, health care organizations will be required to do a number of added things to secure reimbursement funds. Coding these changes will require a steep learning curve for health care workers and may result in decreased reimbursements while they get up to speed, Houston said.

While these uncertainties will affect all health care credits, those coming to market in the next year will encounter added difficulties. Many issuers are at a loss about how to access the capital markets since serious disruptions in the bond insurance industry and auction-rate markets — both financing techniques employed by health care organizations — roiled the market in the last few months. In some cases, deals are being postponed or tabled until the market settles down.

“In the very near term, there is a lot of uncertainty,” Arrick said. “There are a certain number of deals getting postponed and pushed back as people sit down with their financial advisers and bankers and try to pick their path through the current market.”


Primarily, financial advisers and bankers are fretting over the state of bond insurance. As insurers have suffered write-downs based on the falling mark-to-market values of the collateralized debt obligations they wrap, the rating agencies have taken notice. And the triple-A ratings of several of the market’s largest insurers — such as Ambac Assurance Corp., MBIA Insurance Corp., and Financial Guaranty Insurance Corp. — are under review.

These insurers were the first, third, and fourth most active insurers, respectively, of health care credits in 2007, according to Thomson Financial. In the primary market, credit spreads have widened and bond insurance is no longer a path to lower borrowing costs. For lower rated credits that depend on the insurance to make their bonds attractive to investors, this makes it difficult to structure deals.

“If you are a low-rated or unrated hospital, this is a really difficult time,” said Alan Richmond of InnoVative Capital, a financial advisory firm that specializes in health care credits. “Credit spreads are widening and there is no bond insurance out there.”

The spread between triple-A rated, 30-year munis and single-A rated hospital bonds was 95 basis points on Tuesday, compared to 53 basis points on Oc. 2, according to Municipal Market Data. George Friedlander, managing director and fixed-income strategist at Citi, also cited MMD in a recent report, quoting the spread of high-grade munis to triple-B hospitals as having widened from about 80 basis points to about 160 basis points now.

Not all bond insurers are in such dire straits. Financial Security Assurance Inc., which has remained relatively free of any write-downs, was the second most-used insurer among hospital credits. More hospitals will likely turn to FSA this year.

“Basically, the only game in town is FSA and that will last probably six or seven months into [this] year,” said Edward Merrigan, director of research at B.C. Ziegler & Co.

However, the insurance quandary could lead issuers to go without insurance in 2008, and the uninsured fixed-rate deals may be more popular than they has been in a while, analysts said.


Adding to the ongoing ambiguity for health care deals in 2008 is the breakdown in the auction-rate market. In many cases, yields in the auction-rate market — in which the rates on auction-rate bonds are reset weekly through an auction process of bids and orders — have reset higher as banks shy away from providing the liquidity that the market needs to keep rates low. Health care organizations prefer auction-rate securities because they have offered a relatively low cost of capital in the past.

“We’ve got auction-rate programs that are not working right now and we don’t know whether they are permanently disabled or whether this is something that they can get over,” Kaufman said. “We’ve got some interesting liquidity issues around banking liquidity providers. They seem to be less interested in providing letters and lines of credit [for hospitals] than we saw eight, 12, or even 16 weeks ago.”

In the place of auction rates, variable-rate demand bonds will become the next best thing, market sources said. For many years, yields on auction-rate securities and VRDBs were similar. However, as the auction rate market has dried up, the spread between the two has widened. The Securities Industry and Financial Markets Association municipal swap index, which serves as a proxy for seven-day variable-rate demand instruments, reset at 3.02% on Jan. 9 while the corresponding SIFMA index for auction rates reset at 3.80%, a spread of 78 basis points.

However, VRDBs are vulnerable to renewal risk if banks elect not to renew the letter of credit. This is just one more risk that must be taken into account when structuring a deal.

“Nothing is easy right now,” Kaufman said.

Lack of faith in the insurers and questions about the variable-rate market could also derail one of health care’s more popular transactions: the synthetic swap. These deals require an issuer to sell variable rate debt, while then swapping it with a counterparty to get a fixed rate in return. The difficulty is that these transactions still require credit enhancement, Kaufman said.

However, hospitals recognize the importance of getting a deal done this year; it might be their last chance in some time.

“I think people are trying to get projects accomplished now, while the overall financial picture in the sector is still good,” Arrick said. “Many of the astute players recognize this is their last opportunity to set themselves up for the next decade.”


In spite of the many risks facing the health care sector, it does remain fairly healthy overall, analysts said. Large systems continue to show their dominance, and continuing care retirement communities are gaining in popularity.

In contrast to general hospital credits, the market is thriving for these non-acute, retirement community credits, as banks’ appetite for letter-of-credit enhanced and variable-rate demand debt remains strong despite the credit crunch, Merrigan said. As people grow accustomed to the idea of CCRCs, banks have come to see them as a relatively safe bet. Though unrated, with a history of just a few spectacular defaults, CCRCs are far less volatile than many hospitals, Merrigan said.

“There will probably be about 15 startups done [this] year, which is a little above average,” Merrigan said. “I know of many incubation seed capital deals that are coming along, getting their presales, and will be ready for prime time with their bond issue come July or August.”

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