Interest Rate Swaps Create Financial Nightmare For Hospitals, Tax Exempt Groups
They’ve been called everything from weapons of mass destruction to a company’s worst investment nightmare. Now hospitals and nonprofits from California to Indiana are getting an unwelcome lesson on the financial consequences of what can go wrong when interest rate rate swaps meet an economic downturn.
South County Hospital in Wakefield, Rhode Island is a prime example. As reported March 18 by Bloomberg, in just one year the interest rate on the hospital’s $52 million of debt has doubled to 12%. On top of that, the facility has turned over nearly $13 million in “collateral postings” to Merrill Lynch, money that could have been used to make up for a reduction in state aid for treating uninsured patients or buy four years’ worth of orthopedic supplies, according to the Bloomberg article.
Interest rate swaps have become an increasingly popular mechanism with hospitals, nonprofits and other tax exempt entities to hedge against changes in interest rates. There is a downside, however. The value of the swaps is tied to the contract’s underlying assets, as well as larger trends in the lending markets.
In the case of South County Hospital, fallout from the credit crunch and the collapse of the auction rate securities market caused its interest rate swaps to backfire, which in turn contributed to a $1.5 million operating loss for the hospital and a need to lay off employees and reduce pay for others.
South County is far from alone. Countless other hospitals and nonprofits face a similar plight after having entered into these complex derivative deals with Wall Street. Instead of the savings they were promised by bankers, the instruments have become a big liability.
And the news couldn’t come at a more inappropriate time. According to the Bloomberg article, the investment income that nonprofits use to support their operations fell more than $830 million in the third quarter of 2008, while unemployment rose and more patients without insurance sought medical care.
When South County initially entered into its interest rate swap arrangement with Merrill Lynch, it agreed to pay an annual fixed rate of 3.5% for 30 years after selling $52 million in auction-rate securities. At the time, the average rate for a comparable fixed rate hospital bond was 4.5%, according to Bloomberg data.
In February 2008, however, everything changed for the $330 billion auction-rate securities market. Wall Street banks suddenly stopped serving as buyers of last resort, which led to the market’s collapse. As a result, investors had no buyers for their investments, while issuers like South County faced penalties of double digit interest rates on their auction bonds.
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