Rate jump on bonds hurts

Memorial Health System is scrambling to refinance $272 million in bonds, more than 90 percent of its debt, to curb sharply higher interest payments triggered by the national subprime mortgage meltdown.

The rates Memorial pays on so-called auction-rate bonds have more than doubled in recent weeks in the wake of the credit trouble, but it’s unclear what the fallout from higher payments will be for the cityowned hospital, said Chief Financial Officer Gary Flansburg.

“It’s definitely increasing our expenses and will impact our net operating income (profit) this year,” he said.

Memorial sold auction-rate bonds in 2002 and 2004 to pay for expanding its main hospital campus, building a hospital in Briargate and remodeling projects. The interest rate on those bonds has jumped from an average of 3 percent to 6.5 percent Thursday, Flansburg said. That has increased Memorial’s monthly payment on the bonds by $800,000 to $1.5 million, he said.

“Interest rates started to trend up a little in January and got acute in the last two to three weeks of February,” Flansburg said.

Auction-rate bonds became a popular financing tool for governments and nonprofit organizations such as hospitals and universities and now account for more than $300 billion in outstanding debt, according to The Bond Buyer, a New York-based publication specializing in public finance.

Locally, no other city or county agency or enterprise has used such financing, nor has Colorado College, officials said. But other issuers around the state and nation are scrambling to refinance. They include the city of Aurora, Denver International Airport, Philadelphia public schools, the College of New Jersey, the city of Portland, Ore., and the agency that owns a football stadium and convention center in Indianapolis.

Auction-rate bonds are longterm securities that pay bondholders interest rates that fluctuate every week or month. Such bonds are typically less expensive for the borrower because they take advantage of low, short-term interest rates.

Memorial Health System had been saving about $2 million a year using auction-rate bonds instead of more traditional fixed-rate financing, Flansburg said.

“We made the decision to get into this financing structure because it made sense, but no one had any idea that the bond insurers could be down-rated and turmoil in the auction-rate market was a possibility,” he said.

The problem is that auctionrate bonds are insured against default by companies that also guarantee securities largely made up of risky subprime mortgages. As defaults on subprime loans have grown, so has investor concern about the bond insurers.

Auction-rate bonds are resold daily, weekly or monthly at auctions. But in recent weeks, there haven’t been enough buyers for the bonds because they have been downgraded, which has pushed up interest rates at a time when most interest rates have declined.

The nation’s bond insurers had guaranteed little or no subprime mortgage debt in 2002 and 2004, when Memorial issued its auction-rate bonds, said Terry Casey, managing director for RBC Capital Markets in Denver, Memorial’s previous financial adviser. Bond insurers didn’t start backing subprime mortgages in a major way until late 2005 and 2006, he said.

“No one anticipated what has happened to the auctionrate market would happen,” Casey said. “If you could have predicted the problems in the subprime mortgage market and the effect that would have on the auction-rate bond market, you would have done it differently.”

The situation, Flansburg said, is “very serious” for public agencies and nonprofit organizations that use the bond market for debt financing.

Memorial board members at a meeting on Feb 20 agreed to hire a new financial adviser, Kaufman Hall of Skokie, Ill., to help figure out how to refinance the bonds.

The impact on Memorial’s balance sheet will depend on the new financing structure and how long the process takes, said Flansburg, the chief financial officer.

In its annual budget approved by the City Council in December, the hospital system projected $12.6 million in profit from operations this year.

Memorial doesn’t have enough cash to buy back the bonds directly, Flansburg said.

He expects to have a debtrestructuring plan completed in three to six months, depending on which option Memorial uses. One solution would be to convert the auction-rate bonds to a type of bond called a variable-rate demand bond, which banks stand behind by giving a line of credit. Flansburg said he did not know how much that route would cost. Another option would be to issue shortterm, fixed-rate bonds at a cost of up to $1.1 million.

“This particular investment instrument is tainted and never going to recover because investors have moved away from it,” Flansburg said of auction-rate bonds. “Investment bankers are saying we need to move away from it regardless of whether the interest rates go down because it’ll never be the same.”

Reissuing bonds would require City Council approval; transferring bonds to a different financing structure would not, he said.

“We’re taking every step we can to quickly remedy this to reduce our interest expense,” Flansburg said. “We feel like we’ve saved more than we’ve spent to date by using the auction-rate bonds.”

THE SITUATION

Auction-rate bonds are long-term securities that public entities and nonprofit organizations issue to raise money, often for such projects as buildings, public improvements and even student loans.

The bonds are rebid to investors such as corporate cash managers and wealthy individuals at auctions every seven, 28 or 35 days. Hundreds of auctions have failed to attract bidders in recent weeks because investors are worried about the financial health of the bond insurers who guarantee the debt. That has sent interest rates that borrowers pay soaring.