The effect of interest rate derivative transactions on debt savings for not-for-profit health systems.(Report)

The utilization of interest rate derivative instruments in US for-profit companies has grown exponentially since the early 1980s. International Swaps and Derivatives Association, Inc. (ISDA), reported that the amount of outstanding standard swaps grew by 25 percent during the first six months of 2003. The growth rate of all interest rate derivatives, which includes single-currency interest rate swaps, cross-currency interest rate swaps, and interest rate options, grew by 24 percent during the same period. The total outstanding amount of interest rate derivatives now totals $123.9 trillion compared to $99.9 trillion at the end of 2002 (Dodd, 2003). This explosion in usage is a testament to the efficacy and flexibility of the instruments and the increased appreciation by financial managers of the importance of financial risk management in a volatile interest rate environment. Key words: interest rate derivative instruments, for-profit companies, interest rate swaps, not-for-profit health care systems, debt savings.

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A derivative instrument is a security, such as an interest rate swap, whose value depends on the performance of an underlying security or asset (Kuprianov, 1994). Generically, interest rate derivative transactions, or interest rate swaps, are the exchange of interest differentials, meaning there is no exchange of the underlying debt. The basic interest rate derivative transaction involves two counterparties (parties to the agreement). In a fixed for floating (i.e., variable) interest rate derivative transaction, for example, one counterparty pays a fixed interest rate and the other pays a floating rate. The counterparty stands ready to enter a transaction as either a fixed-rate payor (floating rate receiver) or as a floating rate payor (fixed-rate receiver) (Figure 1). Two basic types of interest rate derivative transactions exist. There is the fixed for fixed rate transaction, in which the counterparties exchange interest payments of mismatched payment dates. Mismatched payment dates can be defined by having the dates of interest payment occur on different days for each counterparty. This is sometimes called a currency interest rate swap, because many times the counterparties are dealing in two or more currencies. The second type of derivative transaction is called a "plain vanilla swap," in which counterparties exchange fixed for floating rate, as discussed. A variation of this second type is to exchange floating for fixed rate debt.

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Not-for-profit hospitals have experienced decreasing operating margins and difficulties in accessing capital in recent years, which has generated an environment in which these borrowers of taxable and tax-exempt debt use interest rate swaps and other derivative products to optimize their debt management and lower interest rate cost. A greater dependence on debt financing, the complexity of the mechanics of the interest rate derivative transactions, and stringent accounting regulations have increased the significance of well-planned debt policies and a full comprehension of risk profiles. A lack of current data concerning the predictive value of the yield curve and variable rate indices on short-term and long-term debt service savings is needed.

Not-for-profit hospitals and health systems utilize long-term debt to fund the development and growth of service lines, augment infrastructure, increase technology, and purchase property/plant/equipment. Volatility in the bond interest rate market can expose these institutions to interest rate risk (i.e., the risk to earnings or capital because of movement of interest rates) and cash flow risk (i.e., the risk associated with decreased liquidity in a rising interest rate market). Interest rate derivatives are useful hedges against the risk of issuing long-term financing instruments. They have the potential to decrease the financial leverage/cost of financing, increase liquidity, and allow for a flexible debt service. Health care systems spend an estimated $17 billion to $42 billion per year on information technology. Relative to education, government, insurance, and financial industries, health care lags far behind and only spends 2 percent of revenues on information technology (Mills 2000). This need to increase expenditures is reflective of the increase in demand for an electronic medical record system and will exaggerate the need for increased capital. Interest rate derivatives can improve the likelihood health care institutions will survive in a reimbursement-restricted environment and help organizations attain their strategic goals of serving a larger community through growth, access niche markets through service line development, or increase their efficiency via information technology initiatives.

Interest Rate Derivatives and Health Care

The not-for-profit health care industry consistently uses debt to fund various infrastructure, technology, and expansion projects. A for-profit entity can access capital by issuing both debt and equity (stock). Because of its not-for-profit status, a health care system cannot issue stock, as it is owned by the community. Instead it must rely on profit generation, debt, voluntary contributions, and philanthropy (Wareham, 2004). In 2002, the US hospital industry's growth rate of debt outpaced the growth rate of assets (Cleverley, 2005). This means that the hospital industry as a whole is leveraged, not experiencing sustainable growth, and therefore must manage its debt carefully. Generally when an institution is carrying too much debt based on its assets, it does not have the collateral to support its existing debt, resulting in a poor financial condition. Because the hospital industry is carrying a significant amount of debt, however, it has an opportunity to utilize derivative transactions to its advantage. The inclusion of interest rate derivatives in the management of debt can affect a health care system in a number of different ways.

Not-for-profit health care organizations that raise capital and invest in equities or debt expose themselves to the risk that the market will move in a direction that will adversely affect their investments. In the past, health care systems would commonly issue long-term fixed-rate tax exempt debt to match the long-term assets it financed or issue variable rate demand bonds (Woodard, 1993). These variable rate debt issuances are normally at a lower interest rate than the fixed issuances, although they are more risky. This is because the variable rate is reset periodically and generally rises when treasury rates rise. Furthermore, when issuing fixed rate debt the health care organization exposes itself to the risk that interest rates may fall.

Derivative instruments were created partially to mitigate interest rate risk. For example, a health care system wants to fund a construction project by issuing a bond. If interest rates rise during the planning stages, the institution runs the risk of increased financing costs when the project is ready to be financed (Aderholdt, 1996). Instead the system could enter into a floating for fixed interest rate swap by which it will prevent the increased financing cost by fixing its interest rate at a lower level. Inherent in this transaction is a "bet" that over the course of the planning, interest rates will increase. In the opposite case, if the organization believes that interest rates will fall, the system could execute a fixed for floating rate transaction that will decrease the risk of holding a higher fixed rate when interest rates are declining. The speed with which a transaction can take place is an advantage of interest rate derivative transactions (as opposed to buying back debt early and reissuing new debt) and allows for the reduction in risk or for lower interest expense (Woodard, 1993). The time needed to buy back an institution's existing debt and reissue new debt is longer than the time needed to swap existing debt. As for any new issuance of debt, the executives of the health care institution need to present to government and to the board the reasons for …