Wall Street in the ER

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Hospitals' Wall Street Wounds Wrong-Way 'Swaps' and Auction-Rate Bets Hit Hard; Brokers Defend Sales

By IANTHE JEANNE DUGAN

Hospitals nationwide are tangling with Wall Street to get out of disastrous wagers that have complicated their financial problems.

Tri-City Medical Center in Oceanside, Calif., bought auction-rate securities and interest-rate swaps from Smith Barney. It is suing Citigroup and Smith Barney.

Some hospitals are paying millions of dollars in penalties to get out of derivatives contracts, after betting incorrectly that interest rates would rise. Other hospitals are paying higher interest rates. At many, these ill-fated financial bets have contributed to layoffs and scuttled projects.

More than 500 nonprofit hospitals—at least one in six—bought interest-rate "swaps" in a bid to lower their borrowing costs, estimates Municipal Market Advisors, a Concord, Mass., consulting firm. The swaps allowed hospitals to act much like homeowners switching from a floating-rate mortgage to fixed-rate one, betting on rising interest rates.

For a fee, the hospitals received a fixed rate to sell bonds, lower than the municipal-bond market at the time. These bets backfired when the Federal Reserve cut interest rates to nearly zero from more than 5% in 2007.

Hospitals also issued auction-rate securities—which reset bond prices weekly or monthly through auctions—that represented about a third of the $330 billion market for these derivatives. Hospitals paid Wall Street firms more than $120 million in fees for the securities between 2005 and 2007, said data firm Thomson Reuters. That market dried in the 2008 financial panic, leaving hospitals with higher interest rates.

Sarasota Memorial Hospital System says it lost $5 million.

Wall Street firms and many hospital executives say interest-rate swaps were a plain-vanilla product that they have sold for years and say no one could have foreseen the crisis that cratered the auction-rate securities market. "For years and years it was a smart strategy," said Richard Clarke, president of Healthcare Financial Management Association, a trade group. "Hospitals made money on these for a long time."

The hospital deals were part of a larger stampede into swaps contracts by cities, schools and other taxing districts seeking to lower their payments on bonds they sold. Some strapped hospitals only now are beginning to break the contracts and pay a financial penalty for it.

Swaps were "the Edsel of the time," said John Hackbarth Jr., chief financial officer of Owensboro Medical Health System of Kentucky, which recently paid about $14 million to end an interest-rate swap with Merrill Lynch, now part of Bank of America Corp.

Mr. Hackbarth, like many other hospital executives, says his hospital was aware of the risks going in and initially benefited from the deals. But they never predicted the storm that turned markets upside down.

Wall Street firms say that hospitals, like other municipalities, had reaped millions of dollars in savings before the market turned sour and that their reaction stems from bets that turned against them.

That said, no one disputes the impact on the hospitals. "Financial engineering by Wall Street has been a huge part of hospital's financial problems and has even translated into a lack of hospital beds," said Brian McGough, a managing director of health-care investments at Bank of Montreal Capital Markets in Chicago.

Some hospitals allege that banks misled them. In April 2007, Smith Barney brokers pitched Tri-City Medical Center in Oceanside, Calif., on ways to save money on interest rates. In a presentation, the brokers argued that the hospital could save tens of millions of dollars by refinancing its debt with derivatives from parent Citigroup, according to a lawsuit filed in April 2010 against Citigroup and Smith Barney, now co-owned by Morgan Stanley.

"Historically low" interest rates created an "optimal environment," according to Citigroup documents reviewed by The Wall Street Journal. "Citigroup can mitigate the primary risks," according to a slide presentation.

Persuaded that it could cut its interest rate—5.7% at the time—on $67 million in outstanding bonds, the hospital issued auction-rate securities and added interest-rate swaps, according to the lawsuit and Daniel Callahan, an attorney for the hospital.

Soon, the auction-rate market collapsed. Investors stopped bidding on these securities and the banks that sold them stopped acting as a buyer of last resort as they had in the past. This forced many hospitals and other issuers to pay a maximum penalty rate—sometimes up to 20%—that kicks in if there aren't buyers.

As a result, rates shot up to 17%, costing Tri-City some $16 million more than it would have paid under its old rates, according to the lawsuit, filed in California Superior Court in Orange County.

The hospital board replaced many top officials and paid Citigroup more than $6 million to get out of the auction-rate securities and the interest-rate swaps, Mr. Callahan said.

The loss "continues to impact Tri-City's ability to meet the needs of the entire community," Mr. Callahan said, delaying the expansion of services and capital improvements.

Auction-rate securities "were an engineered, artificial market supported by the activities of the investment bankers designed to postpone a collapse," the hospital alleges in the lawsuit.

A spokesman for Citi, Alexander Samuelson, said: "We believe the suit is without merit and will defend ourselves against it." A spokesman for Morgan Stanley Smith Barney said that the deals occurred well before the joint venture was created on June 1, 2009, so there is no potential liability for the joint entity.

The collapse of the auction-rate securities market caused chaos at other hospitals. The rates at Rogue Valley Medical Center in Ashland, Ore., shot from about 5% to about 18%.

At the same time, the number of paying customers at Rogue Valley was declining rapidly, as people lost jobs and health insurance. The hospital in 2008 paid nearly $5 million interest that it hadn't anticipated, wiping out its operating margin for the first time. It suddenly wasn't bringing in enough money to pay its liabilities, a dire situation that can put a hospital out of business.

Last year, it set a hiring freeze on dozens of jobs, reduced its staff and suspended managers' raises. Numbers-crunchers ran spread sheets trying to figure out which was worse—the amount the hospital would pay in exorbitant interest rates over time, or the $30 million that Merrill Lynch sought to let it out of the contracts. In three years, the hospital determined, it would pay that amount in higher interest rates.

"We finally said, 'let's just get out of it,' " recalled Marvin Haas, the medical center's chief financial officer. "It was not an easy decision but it was the best choice."

Mr. Haas said the hospital knew the risks going in, hired a consultant and made a calculated decision. A spokesman for Merrill parent Bank of America declined to comment.

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Sarasota Memorial Hospital System in Florida figures it lost more than $5 million on auction-rate securities and interest rate swaps and now-voided insurance contracts to protect them.

"We had a lot of people, including attorneys and advisers, and we all agreed that it was a good thing to do," said David Verinder, Sarasota's chief financial officer.

Between the downturn in that market and the nation's economic woes, the hospital pulled the plug on plans to build a new hospital in nearby North Port, Fla., one of the fastest cities in the country.

"We were going to build a 300-bed hospital there, but I don't see that happening for a long time partly because of this Wall Street mess," Mr. Verinder said. "Now, 50,000 people are without a hospital."