CHICAGO -Capital spending is expected to remain heavy across the nonprofit health care sector amid mounting financial pressures and the fallout from the collapsed auction-rate securities market, according to a pair of reports released this week by Moody's Investors Service and Standard & Poor's.

Downgrades are likely to outpace upgrades through 2009, said Standard & Poor's in its report "Tough Times Take a Toll on Credit Quality of U.S. Not-for-Profit Health Care Sector." Many of those downgrades will be aimed at stand-alone, lower-rated credits, but higher-rated systems are not immune from the sector's problems, analysts said.

In Moody's report looking at medians in fiscal 2007, analysts noted that for the second straight year, median spending exceeded median revenue rates, in spite of a 7.4% decline in spending last year. Analysts predicted that operating margins would continue to soften through 2009 - particularly if the U.S. economy stays weak - and that cutting costs would likely not be enough to halt the trend.

Among the tough times facing the sector is the fallout, both short- and long-term, from this year's turmoil among monoline bond insurers and the auction-rate market, a debt market long favored by health care issuers.

"Since the start of 2008, the broad issues facing the health care sector have been, in our opinion, surpassed by a series of financial events that have hurt providers' non-operating income," Standard & Poor's analyst Martin Arrick wrote in the report.

Beyond the unexpectedly high interest rate costs stemming from failed auctions, health care issuers have since been forced to restructure that debt, often into variable-rate demand bonds. The wave of restructuring that swept the sector has proved costly, according to analysts.

Interest rates on the newly restructured debt are often higher than rates on the original auction-rate debt, and providers face the additional costs from terminating swaps or writing off bond insurance. Finally, the market turmoil and efforts to restructure have been time-consuming for senior finance officials.

While most providers' balance sheets are strong enough to absorb short-term costs of the collapsed debt market, the widespread use of variable-rate demand bonds could pose a long-term risk to issuers, said Standard & Poor's. The put features in VRDBs add risk, largely in that banks could become reluctant to provide short-term financing to health care issuers, Arrick said.

"If that were to occur, many providers could have higher costs for renewing letters of credit or three- to five-year liquidity facility, and weaker credits may even find gaining access to the bond market difficult," he wrote.

A bright spot has been the recent increase in underlying ratings, which has brought some transparency into the market, Arrick added.

Despite fiscal woes, most providers are expected to increase capital spending through the debt markets. The median total debt outstanding continues to increase and totaled $148 million in fiscal 2007, up from $146 million in 2006 and $130 million in 2005, Moody's said.

Capital spending remained strong throughout 2007. The trend is driven in part by good cash flow generation in recent years, relatively low interest rates, the competitive nature of the health care industry, and information technology investments, Moody's said.

Median operating margins declined to 2.1% in fiscal 2007 from 2.3% in 2006, according to the rating agency. The median operating revenue growth rate declined to 7.2% last year from 7.3% in 2006. Liquidity ratios grew stronger in 2007, though the pace of growth slowed, in part due to the use of cash flow to fund capital spending. Liquidity ratios are likely to be weaker this year due to "turbulent" equity markets and continued heavy capital spending, Moody's analyst Mark Pascaris wrote in the report.

Standard & Poor's rates 138 health care systems and 470 stand-alone hospitals. For its median report, Moody's looked at 410 hospitals and systems and 16 multi-state systems.

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