SAN FRANCISCO - The auction-rate market meltdown came at the worst possible moment for Cascade Community Healthcare of Bend, Ore.

The chief financial officer of the hospital system, the biggest in Central Oregon, had just left. Chief executive officer James Diegel was a little more than a year into the job as the top administrator. In his first full year, Cascade posted its worst financial results in two decades - a 90% drop in operating income in 2007. A computer virus breached a database with the personal information and credit card numbers of some donors.

Then, the credit crunch started. A third of Cascade's debt was in auction-rate bonds that faced penalty rates as high as 15% when auctions failed. Moody's Investors Service last week downgraded Cascade's underlying rating to A2 from A1.

"The downgrade reflects a significant deterioration of performance, in fiscal year 2007, instability among senior management, an increase in debt costs due to disruptions in the auction-rate markets and the incurrence of a significant amount of short-term debt," Moody's said in a report.

The downgrade hit as the hospital system prepared to restructure $50 million of ARS. The rating affects $131 million of tax-exempt bonds issued through the Deschutes County Hospital Facilities Authority. Cascade plans to convert the ARS to fixed-rate mode on May 1. It's also working to renegotiate the standby bond purchase agreement on $72 million of outstanding variable-rate demand obligations.

"Whenever you get news like this, you're disappointed," Diegel said. "Regardless of whether Moody's downgraded us or kept us at A1, we were still moving forward with the plan of corrections that we need to do to shore up operations and deal with our other issues."

Diegel's time as CEO has been marked by the discovery of new problems at seemingly every turn. He took the top job in June 2006, inheriting a staff revolt that was being aired in the local papers and an expensive new computer system that wasn't meeting the hospitals needs. His predecessor lasted just 18 months in the job.

Nine months into the 2007 fiscal year, Cascade's preliminary operating results showed a sharp drop in operating income from 2006. Three months later, the drop turned out to be twice as much as forecast. Operating income fell to $1.5 million in 2007 from $17.2 million in 2006. Moody's blamed the results in large part on an "alarming" jump in expenses and on reduced Medicaid and Medicare reimbursements.

The hospital's CFO, Thomas E. Safley, a long-time colleague of Diegel's, departed a few weeks into the new fiscal year, replaced within 10 days by interim CFO Michael McGinnis, an outside consultant. Diegel said he didn't fire the CFO. He said they "parted ways very amicably."

Moody's "concerns are realistic, and we take their comments very seriously," McGinnis said. As he and Diegel work to right the system's operations, they have to simultaneously address the impact of the national credit crunch on the hospital's.

Cascade's ARS auction failed shortly after Fitch Ratings downgraded the deal's insurer, Ambac Assurance Corp., triggering a 15% penalty rate for one week, McGinnis said. Subsequent auctions have cleared, but the system is still paying rates over 6%. At the end of March, the rate was 7.8%, up from about the 3.5% in December. The system plans to convert to the bonds to fixed-rate next month.

"That still leaves us with exposure to the variable-rate market, but it takes a part of our outstanding long-term debt and fixes the rate," he said. "It's certainly going to be higher than what we experienced over much of the lifespan of the auction-rate notes, but it's going to provide us with a little more stability and predictability."

The cost of issuance - technically conversion costs - will be about $500,000. With the earlier failures and a higher fixed rate, McGinnis expects to pay about $1 million in unanticipated interest this year. Together, those two extra expenses equal all of last year's diminished operating income.

Diegel has ordered the system's new director of nursing to slash staff costs, especially overtime. He is also raising prices and delaying new capital spending, according to Moody's. Still, Cascade expects an operating margin of just 2% this year, down from its 5% average over the past decade.

Meanwhile, Diegel and McGinnis continue to watch Cascade's outstanding debt cautiously.

In addition to the ARS, the system has about $72 million of variable-rate demand obligations that are also backed by Ambac, with standby bond purchase agreement from Morgan Stanley, which also underwrote the bonds.

The liquidity support for the VRDOs terminates if Ambac's rating falls below investment grade. That makes it tougher to remarket any notes that get put back to the remarketing agent. The health system is negotiating to amend a provision of the standby bond purchase agreement with Morgan Stanley to ensure that the termination would only be triggered if both Cascade and the insurer lose their investment-grade ratings.

"This amendment would bring a little stability to our issue because it does give the bondholder a little bit more security," McGinnis said.

He would prefer to stay in the VRDOs to avoid a $4.5 million swap termination fee that the system would need to pay to Morgan Stanley if it had to refund the VRDOs with fixed-rate bonds. The swap - under which Cascade pays Morgan Stanley a fixed rate of 3.5% in exchange for 68% of the London Interbank Offered Rate - "performed well" before the credit crunch, he said.

"This will come back," he concluded. "The thing we need to do here is to make sure the variable rate remains reasonable while we wait for the value of the swap to stabilize."

That would let the administrators get back to their main job: running hospitals.

Despite the health system's recent operating woes, that might not be quite as hard as it sounds. The system - anchored by St. Charles Bend Medical Center - has an 86% market share in a growing region that hasn't been particularly hard hit by the economic downturn and housing market crisis.

"The outlook is stable," McGinnis said, echoing Moody's assessment. "From a market perspective, all of the elements for success are here."


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