The Direct Route

More hospitals turning to banks for direct-placement borrowing
Modern Healthcare  |  March 5, 2012
By Melanie Evans

Borrowing by hospitals directly from banks got a boost after the credit crisis but ballooned last year as hospitals look to reduce exposure to potentially volatile debt.

Banks loaned $1.7 billion directly to healthcare borrowers last year in bond deals that might have otherwise been sold publicly, according to data from Thomson Reuters. That volume of deals does not include another $1.2 billion borrowed in other privately negotiated deals. The combined $2.9 billion in private healthcare lending is an increase from $503 million in the prior year, the Thomson Reuters data show.

More hospitals have embraced such deals, in which bonds are sold privately, as an alternative to financing vehicles that have proved riskier after the credit crisis, according to healthcare finance chiefs.

That was the case for the Cleveland Clinic, which borrowed $42 million from a bank last year. The deals was the system’s first direct bank placement in roughly eight years, says Chief Financial Officer Steve Glass. Officials with the Ohio system sought to limit exposure to more volatile debt deals, known as variable-rate demand bonds, by financing with a more stable alternative.

And banks appear eager to lend. RBC Capital Markets conducted its first direct placement deal in 2008 and has since purchased $1.5 billion in healthcare bonds, says Kathleen Costine, managing director of RBC Capital Markets’ healthcare finance group. Wells Fargo began to increase its direct lending roughly 2 ½ years ago, says Adam Joseph, a Wells Fargo Securities managing director in public finance capital strategies.

A large appetite

“I’ve never seen this much bank appetite” for direct loans to borrowers, says Mark Melio, founder of healthcare financial advisory firm Melio & Co., based in Northfield, Illinois. Multiple banks compete for deals and have agreed to lend $100 million to $150 million directly to borrowers with strong credit ratings, Melio says. He says that such capacity appears to have tightened somewhat in recent months, but demand from borrowers and banks for deals continues so far this year.

Johns Hopkins Health System borrowed directly from a bank for the first time last month.

The $53 million deal diversified the system’s dept portfolio without adding a risk common to variable-rate demand bonds, says Stuart Erdman, senior director of finance for Baltimore-based Johns Hopkins.

Variable-rate demand bonds are often backed by bank letters of credit, which act as a credit guarantee for investors. But when banks’ credit strength falters, as it has in recent years, investors grow more wary of such guarantees and interest rates might climb. Hospitals must also renew letters of credit with banks frequently—which creates the risk banks may not renew or may charge more to do so.

Erdman says Johns Hopkins, which owns six hospitals, is seeking to reduce its exposure to letters of credit.

“That’s our goal now,” he says. So when officials considered how best to refinance a loan, they looked for other options, which include fixed-rate bonds and private placement with other investors.

Banks competed aggressively for the system’s business as they made their first direct placement, he says. John Hopkins pursued such a deal for the first time because direct bank deals were not previously as available or as cheap.

“If they were available, they weren’t available at a good price,” Erdman says.

Three of eight banks offered bids that were less costly than letter of credit deals. Johns Hopkins ultimately closed the direct bank deal for less than a letter of credit, he says.

The direct deals aren’t without risk. Banks typically agree to deals of three, five or seven years and hospitals may be forced to refinance. “Markets change,” Erdman says. Demand from borrowers or bank appetite for direct deals could disappear in coming years.

Banks too may be looking to move away from letters of credit.

Joseph of Wells Fargo says experience during the nation’s recent financial upheaval made the direct bank deals more attractive.

Banks and borrowers developed a “shared fear” the letters of credit could change borrowing costs and demand on balance sheets overnight, he says. When investors no longer want hospital bonds, banks must honor letters of credit by buying up the debt—as was the case during the nation’s recent financial upheaval in 2008 and 2009. Banks must abruptly tak debt on the balance sheet. Hospitals and borrowers must refinance or quickly pay back the bank.

Anxiety prompted banks and borrowers to look at direct bank loans as an alternative. Meanwhile, direct deals got a boost from Congress as a part of federal efforts to open credit markets and shore up the economy. The American Recovery and Reinvestment Act offered banks a tax incentive to buy bonds from tax-exempt organizations and state and local governments. Congress approved the measure, but only temporarily. The incentive expired at the end of 2010, but lending continued. Healthcare finance experts credit the volume of healthcare bonds in the tax-exempt market last year (Oct. 31, p. 6).

Joseph says banks also face regulatory changes in 2015 that would erase one benefit of letters of credit by requiring banks to set aside cash to cover potential payouts to investors. Banks are not currently required to do so.

Wells Fargo has loaned $14 billion directly to borrowers since 2009 and healthcare accounts for $4 billion of the volume, says Jeff Ruehle, executive vice president of Wells Fargo’s healthcare financial services group in government and institutional banking.

Ruehle says banks saw demand increase for direct deals as letters of credit taken out during the credit crisis expired last year. Borrowers faced renewal or refinancing for debt with an expiring letter of credit.

Will demand endure?

Ruehle says healthcare’s appetite for capital has weathered the economic downturn. Finance chiefs consider direct-placement deals one option with less risk from market volatility, he says.

RBC Capital Markets’ Costine says banks’ continued appetite for direct deals will depend on borrowers’ credit. Regulations and interest rates could also affect bank lending to hospitals. Banks may choose to invest elsewhere should regulatory changes increase banks’ funding costs or if the federal funds rate increases, Costine says. The Federal Reserve Board has said rates will remain low through 2014, but that could change if inflation picks up, she says.

Melio says it is unlikely hospitals will find the same demand when looking to refinance Bank appetite “’hasn’t been seen in the past,” he says. “I think it’s prudent not to expect it to be there” in coming years.

Still, some banks see the healthcare industry’s size and ability to withstand an economic downturn as an attractive market for growth even outside of financing deals.

“It’s a very stable part of our economy … and a large part of the economy as well,” says Stuart Hanson, a vice president and head of the healthcare business line for Fifth Third Bank.

Fifth Third Bank expanded its 4-year-old healthcare revenue-cycle arm last year by contracting with a large billing and collection technology company.

The industry’s growing use of electronic health records and new payment models mean opportunities for Fifth Third’s financeial expertise outside of lending, he says. Hospitals are investing heavily to upgrade financial and clinical software, which creates an opening for new revenue-cycle products, Hanson says.

“It’s an industry in a major state of change,” he says.