Panelists Urge Smart Swaps for Hospitals

LAS VEGAS — Issuers must devise coherent and well-thought-out strategies to capitalize on the benefits that derivatives, credit enhancement, and other options provide in the fast-changing world of nonprofit health care, according to participants at The Bond Buyer Nonprofit Hospital Finance Conference here Monday. In recent years, health care issuers have turned to derivatives and hedging strategies to help them manage market risk. As they have done so, many have proceeded without a firm understanding of the varying strategies, while others have shown reluctance to use them, according to conference speakers. As the use of derivatives increases, it behooves people to educate themselves and create a forward-looking plan, said attorney Renee Friedman of Katten Muchin Rosenman LLP. “It’s in everyone’s interest to have a derivative policy,” she said. The policy should be a reflection of the specific needs of the hospital or health care system and should not be boilerplate, according to Friedman. “You need to come up with an individual policy that speaks to what you care about and what kind of risk tolerance you have,” she said. In examining the risks it is helpful to look at them in terms of both the market risks that hedging, derivatives, and credit enhancement guard against — such as interest rate risk, credit risk, and existing debt risk — as well as the added risk that comes with using derivative products and credit enhancement. “You have to make choices,” said Debra Sloan, the director of capital markets at Partners Healthcare System Inc. in Massachusetts, who manages about $1 billion in derivatives. “Be conscious of what [risks] you want to accept and what you will offset.” Issuers often live with the risk that the market gives them, but by being proactive and making a plan, hedges and derivative swaps can be useful tools, said Peter Shapiro, managing director of Swap Financial Group. However, in using those tools it is imperative that issuers understand the risks that various products and strategies bring, he said. By way of explanation, Shapiro said he would concentrate on forward hedging, which seeks to guard against future market conditions. In Shapiro’s view, forward hedging brings with it four main risks: basis risk, or the risk that a swap tied to the Securities Industry and Financial Markets Association index or a percentage of the London Interbank Offered Rate does not perform in line with the municipal market; the risk that the project is not built on time or costs more than anticipated, meaning that the hedge is not timed or calculated properly; interest rate risk, where rates fall in the short term, making the hedge look extremely expensive; and the risk associated with the counterparty involved in the derivative.Shapiro said all of these risks can be mitigated by hedging only part of an issuer’s debt, keeping a long-term view of why you are employing the hedge, and by using diversification to employ multiple highly rated counterparties. “When hedging, people think of it as making a bet,” Shapiro said. “But by not hedging, you are also making a bet.” “When we started looking at derivatives, we came up with a game plan,” Sloan said. “We wanted to use derivatives to lower the cost of capital and to manage existing debt risk or hedge against forward interest rate risk.” In doing so, she decided to employ a synthetic fixed-rate swap, a transaction in which an issuer sells variable-rate debt and swaps that variable-rate payment with a swap provider to get a fixed rate in return. When she started, Partners had about 18% of variable-rate debt on their books, and now they have decided to carry about 40% . “We had to ask, 'How much variable-rate debt is good for us?’ ” Sloan said. “We settled on 40% for net variable-rate exposure.” This shows, said Mark McIntire, vice president at Kaufman Hall & Associates Inc., that it is important for management and their boards to properly understand the role that derivatives can play in an overall debt strategy. “You need to have the financial wherewithal to enter into these swaps,” McIntire said. “And you might have the knowledge to take risk, but you also have to have the ability to take the risk. This is important in evaluating whether these risks are appropriate.” Many times when looking to employ a hedge, issuers grow skeptical after seeing short-term mark-to-market losses, according to Shapiro said. Sloan said keeping perspective and the long-term goal in mind can help with peace of mind. “Again, it is not about where it is today, but it is about the long term. That is why we keep doing them,” she said. Also, the knowledge that mark-to-market losses on, for example, a 30-year trade, may get as bad as 20% to 25% of the total value without cause for concern may help issuers steel themselves and assure their board in the face of short-term market volatility, Shapiro said. “If you keep that total in your head you won’t be far off,” he said. As much as the use of derivatives, credit enhancement, such as bond insurance or a letter of credit, must be evaluated for its value in specific situations. “The risk you take to a credit enhancer is much like a marriage,” said Michael Quinn, director at Assured Guaranty Corp. “Sometimes it leads to a long and healthy relationship and sometimes it doesn’t work out the way you intended it to.” Issuers should take a measured look at the firms providing the credit enhancement, Quinn said. This can include the cost of the enhancement, the covenants involved in the transaction, and the capacity, he said. But it should also be expanded to look at the balance sheet and claims-paying resources, ratings history, and reinsurance practices of the insurer, he added. “In the event that there is negative news [relating to the credit enhancer] the issuer could pay substantially higher interest rate costs on the debt,” Quinn said. “This could lead to a weaker credit profile.” All in all, issuers need to work hard to evaluate all of the risks associated with a deal. Ultimately, Sloan said, issuers must “know where they are taking risks and monitor those risks on an ongoing basis.” “I think issuers need to go into this with their eyes wide open,” McIntire said. “The bottom line is there is no free lunch.”