Financial Reform: How Supposedly Safe Derivatives Make Hospitals Sick

Under a last-minute change to the financial reform bill, Wall Street banks can keep selling interest-rate swaps directly, rather than isolating these derivatives in separate units. Beyond simply getting the measure passed, the thinking is that IR securities are benign, or at least less dangerous than credit default swaps, which the legislation requires banks to detach from their main operations.

Question is, less dangerous for whom? The WSJ has a fascinating story today on how a number of not-for-profit hospitals got scorched on their purchase of IR swaps and auction-rate securities, or ARS. IR swaps are derivatives that let buyers exchange a variable debt payment for a fixed one (and vice versa), among other permutations. For instance, a hospital that issues bonds to fund construction of a new wing might use IR swaps to guard against a future rate-hike when the unit is being built.

In this case, hospitals paid banks a fee to get a fixed rate that was lower than what was available in the municipal bond market at the time. The buyers lost out when rates plunged from more than 5 percent, where they had locked in, to near zero. Some of the hospitals claim they were led astray by the banks that arranged the IR swaps. Now the lawsuits are starting to fly.

"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.

Yet that doesn't get hospital administrators off the hook. First (and sorry to note the patently obvious), people shouldn't use financial instruments they don't understand. Did all the health care companies that lost out manage their derivative portfolios with care, or did some simply sign on the dotted line and pray? Hard to say. But recent precedent suggests that some hospital executives made mistakes.

A common theme in the financial crisis -- and this is true of everyone from homeowners and county treasurers to financial company CEOs and ostensibly "sophisticated" investors -- is that people participated in all sorts of transactions they simply couldn't fathom. Stop that.

But don't listen to me -- just cup your ear to the market. Here's what Michael Griffin, head of municipal credit research at Vanguard, which invests in health care firms, recently told ModernHealthcare about what he looks for:

We expect our hospital managers to be hospital experts, and we don't want to find out that they have too complex a financial portfolio. They're meant to be healthcare experts, not financial wizards.

Another thing. As the story notes, many hospitals have for years used IR swaps to refinance debt and boost their profits, largely without complaint. Indeed, it's a fair bet that some hospitals dove into swaps not because they were unclear on the risks, but because they knew them -- and the potential rewards -- all too well. Said the head of the Healthcare Financial Management Association, a trade group:

For years and years it was a smart strategy. Hospitals made money on these for a long time.

The bigger point is this -- hospitals' taste for interest rate swaps didn't come out of nowhere. The health care industry, like companies in other sectors, relies increasingly on the securities market to drive profits. Over the years they've developed an ever greater appetite for all sorts of risk, particularly hedge funds, as investors push health care companies to boost returns:

Alternative investments made up 18 percent of not-for-profit hospital and health system portfolios for the year ended in December 2008 compared with only 8 percent in 2003, according to the most recent yearly survey of portfolios by investment manager Commonfund, Wilton, Conn.

Many hospitals committed cash to alternative investments as they took on additional risk by borrowing in short-term markets debt that could be unloaded by investors for quick repayment, assuming bonds could be sold to new investors... Some used derivatives known as "swaps" as an interest-rate hedge for bonds in short-term markets.

True enough. But the operative word is "can." Just not always. Derivatives are bets, pure and simple -- predictions, to use a less loaded word, about the future. If you place your chips on black and the little spinning ball lands on red, you're done for. Case in point: Long-Term Capital Management. When the hedge fund blew up in 1998, most of its exposure came from IR swaps. More recently, municipalities nationwide have gotten murdered on these swaps and auction-rate securities.

A familiar pattern: Reckless execs, greedy bankers, risky financial instruments. Financial reform can't do much about the first two offenders, so it makes sense to crack down on the last.

Image from Flickr user Brykmantra
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