Centra reworks its debt as mortgage crisis snarls markets

By Cynthia Pegram
Lynchburg News & Advance
Published: April 15, 2008

The long-term financial structure that Centra used to cover the cost of the new East Tower was hit by aftershocks from the subprime mortgage crisis — briefly almost tripling interest rates for the local health care system.

From mid-February to the end of March, Centra paid out an extra $1.8 million in interest as a result of what’s been called a meltdown of the auction rate securities market — a $300 billion nationwide market.

Centra, like many other health care systems in the nation, used the Auction Rate Securities market as an option to finance long-term debt, using a system of investor bidding and buying of bonds for the short term and a quick return.

“Until the fourth quarter in 2007 it was working beautifully,” said Lewis Addison, Centra chief financial officer.

Now hospitals and municipalities that used the Auction Rate Securities market have begun reworking their investments.

Last week, Centra began buying back its $171.4 million in bonds, and by last Friday had purchased $93 million. That effort is continuing.

“We now have an interim solution in place that does away with the punitive interest rates,” said Addison. “And that enables us the time to work out the permanent solution so our debt structure will be again providing the lowest cost of borrowing that’s possible.”

Two banks, BB&T and SunTrust have extended a $171.4 million credit line to Centra, making the strategy possible.

However, it is not a long-term fix, said Addison.

Centra began monitoring the situation with heightened concern last fall and has been working to find a solution for most of this year.

In January 2008, the tide of defaulted loans from the housing market led the Federal Reserve to take action by lowering the prime interest rate.

“Looking from afar, it’s kind of hard to connect the two, but it is really the genesis of the problems that led to the collapse of the auction rate security market,” said Addison.

Bond insurers that had been covering the defaulted housing loans faced huge losses. Investors and “broker-dealers” became concerned and the auction rate securities market began to slow.

Many hospital systems used the auction rate securities format, so Centra’s not alone in re-working its plans.

At Roanoke-based Carilion Clinic, about half the system’s debt is in auction rate securities, said Eric Earnhart, Carilion spokesman. The multi-hospital system also has huge building projects using long-term financing.

Carilion is in the process of converting to other options, “and expects to have that completed in two weeks,” Earnhart said. “We are fortunate in that the insurer we’ve been using has not been severely affected by the subprime so we’re able to make the conversion in an easy fashion — that, is an AA rating.”

Auction rate securities were attractive to hospitals with large debt financed over decades.

The auction rate securities market involves about $300 billion, said Michael McCue, a professor at Virginia Common-wealth University in Richmond.

The auction rate securities are a form of variable rate bond, but for very short periods — a few days, a week or a month.

The system’s rapid buying and selling of bonds keeps investments almost as liquid as cash, he said, but right now, there are few buyers, “and there’s essentially a freeze.”

The connection to the subprime mortgage crisis comes through the bond insurance, said McCue.

McCue does not see the situation as a meltdown. “I think that’s a strong word … I don’t think we’re at a crisis of that magnitude.”

In normal economic times there’s not much risk and very little fluctuation. And the bond ratings were high.

That made them attractive to investors who wanted “a shorter term investment, high quality, high credit grade, and the rates reflected that. That’s why Centra was able to keep its borrowing costs very low because the mechanism worked very well,” said Addison.

Centra has an A credit rating from Standard & Poor.

But, as concern rose about a subprime mortgage crisis, investors began to doubt the stability of the bond insurers.

“Investment bankers had packaged the mortgages together, and then gotten insurance for those packages of mortgages which were then sold,” said Addison. “There were questions about the bond insurers — that they could have all these billions of dollars worth of losses out there that they’d have to pay for, because they insured those instruments.”

The auction rate security market began to struggle. Investment bankers stopped supporting it. “When that happened,” Addison said, “there were not enough buyers to cover the sell orders.”

Centra’s use of Auction Rate Securities included a default rate of 15 percent if bondholders wanted to sell, but there wasn’t a buyer.

“In an instant our borrowing costs went from 3.5 percent to 15 percent,” he said, noting that bidding has since brought the price down to 8 to 9 percent.

The system that was worked out also means Centra can continue to keep its bond insurer, MBIA.

In buying back the bonds, Centra becomes both the issuer of the debt and the holder of the debt and has set the rate at 2.5 percent.

“The real cost now becomes the cost of the bank loan,” said Addison. That’s in the 4.5 percent range; around 1 percent above what Centra usually pays.

Centra is negotiating for a permanent solution to the debt structure, he said.

The solution most attractive to Centra is to convert the auction rate securities to Variable Rate Demand Bonds (VRDBs), which would reset every seven days like the old system. Centra would have the credit backing from the banks that would make it possible to issue VRDBs.

Addison said the banks have committed to provide Centra letters of credit “when we put in place the permanent solution, if we use variable rate demand bonds.”

A second option would be to refund the bonds and issue new debt, he said, but that would lose the bond insurance now available through MBIA.

The third option is fixed-rate debt and the issuing of long-term tax-exempt bonds. “The rates we have to pay for a fixed rate issue would be higher,” he said.

The financial issues are under study by the Centra board’s finance committee, which will determine which option is used, Addison said.

Centra continues to be “very stable, very credit worthy. Our finance committee is on top of this situation.”

“It is never good to incur another $1.8 million in costs that you weren’t expecting, but is it catastrophic to us? No. We expect our total operating revenues this year to be in the $580 million range. So does $1.8 million hurt? Yes. Is it something we can’t deal with? No.”