The hospital bond market and the AHERF bankruptcy.

An analysis of hospital, tax-exempt bonds issued before and after the Allegheny Health, Education, and Research Foundation (AHERF) bankruptcy demonstrated that despite the decline in market rates for taxexempt securities in the post period, bonds issued by hospitals and systems carried higher coupon rates than they did in the pre period. There was a significant decline in the proportion of hospital/system bonds that were insured from the pre to the post period. Bond insurance firms tightened their credit criteria after the bankruptcy, which may explain, in part, why the proportion of insured bonds declined. We conclude that hospital bonds are now viewed as riskier instruments than they were prior to the AHERF bankruptcy. This is reflected in higher coupon rates for both insured and uninsured bonds and fewer insured bond issues. This decline in hospital creditworthiness comes at a time when many hospitals need to replace aging assets and acquire new technologies in response to increased inpatient utilization. Key words: AHERF bankruptcy, hospital bonds, bond insurance.

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FOR MORE THAN three decades, tax-exempt debt has been the primary source of long-term capital for nonprofit hospitals and health systems. Before Medicare enacted its prospective payment system and before the substantial growth in managed care enrollment, hospital, tax-exempt debt was considered a relatively low-risk investment. The credit standing of hospital, tax-exempt bonds typically has varied with the reimbursement policies of third-party payers, both public and private.

To secure a better credit rating and, therefore, a lower interest rate, many hospitals and health systems purchase bond insurance. Bond insurance guarantees that bondholders will continue to receive interest and principal payments for the life of the bond should the hospital default on the issue. The use of bond insurance increased dramatically in the 1980s and 1990s. In the first quarter of 1998, 66 percent of new health care bond issues carried bond insurance. By the first quarter of 1999, only 40 percent of new issues were insured. (1)

Credit analysts have asserted that one of the major reasons for this decrease in insured hospital debt was the bankruptcy filing, in July of 1998, of the Allegheny Health, Education, and Research Foundation (AHERF), a multi-institutional health system in Pennsylvania. (2) The AHERF bankruptcy was the largest not-for-profit, health care bankruptcy in US history. At the time of the filing, AHERF's estimated liabilities totaled $1.3 billion, of which $353 million was in tax-exempt debt insured by MBIA, a leading guarantor of health care bond issues. AHERF also defaulted on another $161 million of uninsured, tax-exempt debt. (3) A recent court settlement left most of AHERF's creditors (not including the holders of the insured debt) with about 4 cents on the dollar. (4)

It is clear that factors other than the AHERF bankruptcy contributed to the decline in hospital creditworthiness in the late 1990s. Hospital profitability declined due to changes in Medicare and commercial insurer payments. The effect of the Balanced Budget Act of 1997 (BBA) was first felt in 1998. (5) In 1997, Medicare inpatient margins were 17 percent, but total Medicare margins were only 3.4 percent. By 1999, total margins for Medicare were approaching zero. (6) In the late 1990s, commercial health plans also started to gain financial leverage over hospitals and reduced payments accordingly. The proportion of hospitals with negative margins grew to 34 percent by 1998. (7)

Some unsuccessful strategies initiated by hospitals in the mid 1990s started to affect hospital earnings, as well. Hospitals incurred major financial losses from business investments unrelated to their core line of operations, specifically in the areas of physician practice acquisition and health plan development. (8)

Although all of these factors contributed to a negative credit assessment of the hospital industry, the AHERF bankruptcy was likely the major factor that resulted in significant changes in the tax-exempt market in the period immediately following the AHERF default. Bond insurers became more selective in who they insured and raised premiums to offset the increased risk associated with health care bond issues. (9) One investment banking firm estimated that the insurance premium on a AAA-rated bond with a $50 million par value increased from $450,000 before the bankruptcy to $900,000 after it. (10) In addition, the spread of yields between investment grade BBB-rated bonds and insured bonds was only 38 basis points in the period from January to August of 1998. (11) However, after the AHERF default, from August 1998 to March 1999, the spread between insured bonds and investment grade BBB-rated bonds rose to 59 basis points. (12)

From a health policy standpoint, the fallout from the AHERF bankruptcy may have reduced access to capital for some hospitals and health systems. If the anecdotal evidence is correct, many hospitals and health systems are now facing higher costs of issuance (bond insurance premiums) and higher interest rates on their debt. Access to capital is critical to the financial performance of a hospital. Hospitals need capital to finance new services and to maintain and upgrade the buildings and equipment needed to meet the demands of patients, physicians, and payers. Lack of capital has led some hospitals, especially rural hospitals, to be acquired by investor-owned hospital systems, while others seek out relationships with nonprofit systems. Unfortunately, some nonprofit systems have experienced their own capital woes because of their inability to integrate their facilities and their unprofitable investments in physician practices and managed care plans.

The purpose of this study is to profile the market, operational, and financial characteristics of insured and uninsured hospital, tax-exempt bonds issued immediately before and after the AHERF bankruptcy. We will attempt to validate empirically what heretofore has been anecdotal evidence of a significant change in the market for hospital and health system debt instruments.

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