CHICAGO - Following a sharp spike in downgrades among not-for-profit hospitals over the last two months, Moody's Investors Service warned that the sector is increasingly struggling with a number of internal and market-related pressures.

The warning, prompted by the unusual number of downgrades during October and November, comes less than a month after the ratings agency revised its outlook to negative from stable on the sector. Since October, Moody's has downgraded 18 hospitals while only upgrading one. In contrast, most recent quarters have seen an equal number of upgrades to downgrades.

"The rather quick change in the number of downgrades relative to upgrades prompted the report," said Lisa Martin, a Moody's analyst who helped write the recent report, Diagnosing Not-for-Profit Hospital Downgrades. "To some extent, after we put the negative outlook revision you might expect more downgrades, but there have been many more, so we felt it was necessary to comment."

The downgrades are due to a range of economic and market pressures facing the industry amid a quickly weakening economy. They include a rise in market risks for many hospitals that have issued variable-rate debt; declines in liquidity due to investment losses; and in some cases, an increase or planned increase in debt. At the same time, hospitals are grappling with rises in uncompensated care and competition aggravated by drops in volume as patients defer elective procedures.

The downgrade trend is expected to continue next year, Moody's warned.

"We expect there to be a heightened number of downgrades over the next year as virtually all rated health care credits are facing some degree of credit stress due to the weakening economy, restricted access to capital, and the growing risks associated with variable-rate debt," analysts wrote. "Proactive management and engaged board members may be able to mollify some of these risks."

On the debt side, hospitals are increasingly facing problems - and potential downgrades - due to their outstanding variable-rate debt, a structure long favored by the sector. Declines in liquidity coupled with the recent credit crunch mean that many providers are at risk of defaulting on credit covenants that were considered harmless a few years ago.

For example, Moody's said it downgraded one hospital that suffered a decline in liquidity stemming from high capital spending as well as investment losses. The liquidity loss has brought the hospital "dangerously close" to defaulting on a covenant with its letter of credit provider, which requires that the hospital maintain a certain level of days-cash-on-hand. The hospital does not currently have the cash it needs to pay back the LOC provider if the bank demands payment, Moodys noted.

Interest rate swaps associated with variable-rate debt are another potential headache in the current market, analysts said. Many swaps have reached their threshold of losses where collateral postings are required, a measure that could become increasingly important to credit quality.

"Similarly, if a hospital has been unable to remarket a large amount of bonds that are held by the bank providing the LOC and the payments under the accelerated term-loan requirements are quickly approaching, we may take rating action," analysts said.

A large chunk of the recent downgrades affected lower-rated credits, according to Moody'ssaid. Though only 10% of the 538 providers rated by the agency are below investment grade, 44% of the downgrades in the last two months have been to below-investment grade or deeper into below-investment grade category. That reflects the "heightened vulnerability" and "thinner cushions" available to lower-rated, smaller providers.

As of last week, Moody's had nine additional hospital ratings on watch list for downgrade.

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