Interest rate swaps: financial tool of the '90s - includes related article

Healthcare Financial Management, Nov, 1993 by Mark A. Woodard

The three most common indices are the Public Securities Association (PSA) municipal index, the JJ Kenny municipal index, and the London InterBank Offered Rate (LIBOR). Each has its advantages. By far the greatest number of swaps overall are based on LIBOR and the fewest based on the PSA index. This fact increases liquidity and lowers costs for LIBOR-based swaps. The PSA index is thought to have the closest correlation to true short-term municipal interest rates, with LIBOR having the least. To choose the appropriate index, hospital financial managers must decide how important it is to have variable rates based on a tax-exempt index.

The two parties to the swap agree on a principal amount of the swap (called the "notional" amount), but principal does not change hands. On an agreed upon set of dates, the parties calculate the amount that has accrued on the variable rate part of the swap and compare that to the amount that has accrued on the fixed rate part. To simplify the payment process, the payments are netted against each other, with only the party owing more to the other making a net payment.

Swaps have been executed with widely varying maturities. The most common maturity period is between three and 10 years. Some swaps have been executed over 30 years, though swaps with a long final maturity frequently require additional security provisions or credit enhancement.

Risks inherent in swaps

There are three risks in the swap structure: counterparty default, early cancellation fees in event of hospital default, and unanticipated interest rate exposure in the event of early termination. In addition, there are different risks in floating-to-fixed swaps than from fixed-to-floating swaps.

Counterparty default. The counterparty is generally a financial institution, and there is no guarantee that it will not default. Despite the obligation of the counterparty to make swap payments in certain circumstances, the requirement of the hospital to make debt service payments is not discharged. As a result, default of the counterparty effectively voids the swap but has no impact on the hospital's obligation to pay debt service on any outstanding debt regardless of whether the outstanding debt is fixed or variable.

One factor in assessing counterparty risk is the rating of the counterparty assigned by the rating agencies. Most financial institutions (with some notable exceptions) are currently rated in the "A" range. To decrease counterparty risk, some investment banks have established new subsidiaries rated substantially higher than the investment banks themselves, even as high as AAA/Aaa. In addition, some bond insurance companies have offered to insure counterparties, which has the effect of raising the counterparty's ratings to AAA/Aaa, though the practice is not yet widespread. In any event, it is not enough to execute a swap with a well-known financial institution. The ratings and the specific subsidiary of the counterparty are important.

Hospital default. The swap may terminate before its maturity in the event of hospital default, even in a technical default while payments are still current. The party that defaults under the swap must compensate the nondefaulting party for the cost of procuring a substitute swap, which is called a cancellation fee. Depending on how interest rates have moved since the execution of the swap, the cancellation fee may be substantial. From the hospital's point of view, this feature is unattractive; at precisely the time the hospital is having difficulties, it may have to pay a large fee in order to cancel the swap and then expose itself to unanticipated interest rate risk. However, some hospitals believe that the likelihood of a default over the term of the swap is so small that this risk is worth bearing.