May 26, 2008

Hospitals and the Next Debt Crisis
By Kevin A. Schulman, MD
For The Record
Vol. 20 No. 11 P. 6

Widespread access to debt has been one secret to U.S. economic success. Debt allows us to make a purchase today (eg, a house) and pay for that purchase over time. When debt is used prudently, it’s a powerful tool for businesses and consumers. However, proper debt management requires timely payments on a loan plus the interest on the debt.

In the subprime mortgage market, as interest rates and monthly payments have climbed, borrowers have not been able to uphold their end of the equation. This has led to the loan defaults and foreclosures that are so widespread today. One problem was the “creditworthiness”—or perhaps the uncreditworthiness—of the borrowers.

Just as the subprime mortgage chickens are now coming home to roost, the hospital industry appears to be headed for a similar crisis as plans for large amounts of debt for the construction of new medical facilities are being developed. Fortunately, we can see this crisis looming. Unfortunately, our nation has a spotty record with addressing problems before they reach a state of urgency.

Right now, hospitals are doing a robust business, and capital construction is back after several years of a soft market. Medical facilities with price tags approaching $1 billion are planned or under construction in many areas. Healthcare spending makes up 16% of the gross domestic product, and that figure will approach 20% by 2015. As baby boomers become eligible for Medicare, the number of beneficiaries covered by the program will swell from 44 million in 2005 to 70 million by 2030. On the surface, the business model for hospitals appears rosy. However, a closer look at the numbers raises serious concerns about the future ability to pay off all this debt.

A recent Congressional Budget Office report highlights the gap between future federal obligations for entitlement programs and expected program resources. In 2030, the federal government is expected to be underfunded by $2 trillion per year for Medicare and Social Security, and the shortfall will only increase beyond that point. More immediately, U.S. firms, including Ford, General Motors, and Delta Air Lines, are desperately restructuring their retiree healthcare obligations. DaimlerChrysler recently paid a private equity firm to take Chrysler and its $20 billion in healthcare obligations off the Daimler books, and GM has pledged $35 billion in new payments to a voluntary employee benefits association to get out of the healthcare business. The government doesn’t appear to have the same sense of urgency that industry has shown in preparing for the gathering storm surrounding healthcare costs.

One may ask a particularly relevant question of the $200 billion hospital bond market: How are hospitals going to pay off new 30-year mortgage notes on the medical palaces being planned and built today? There are almost 600,000 licensed beds in U.S. nonprofit hospitals. According to Standard & Poor’s, at a replacement cost of $1 million per bed, there is the potential for $600 billion in new debt to replace aging facilities. Meanwhile, it’s not clear that the funds will exist to support this activity as the bonds mature. It’s a complicated issue, but the math is simple: Hospitals earn money by treating patients. Once baby boomers begin dealing with age-related health problems, those bills will be paid by the same Medicare program that will be underfunded by trillions of dollars.

Without an overhaul, the Medicare system will run out of money just when the largest number of Americans are relying on it as a source of health insurance. If the money source—currently, Medicare—cannot be trusted to pay the bills (at least at the current rates), hospitals will not be able to pay off their new loans. This substantial uncertainty is clearly recognizable, but will the market ignore these projections as it did with the subprime market? Is this truly high-grade debt if the money cannot be identified to support the debt payments over the life of the projects?

The typical hospital project can take years from the initiation of the planning process to the completion of construction, and a cycle time of one decade is not unheard of. So if planning starts today, a new facility will open in 2018, just in time to see the Medicare hospital insurance trust fund depleted in 2019, according to the Medicare Trustees’ latest estimates.

Healthcare providers, insurers, government, and citizens need to have a realistic conversation about this market and where it’s going. A prudent prescription would be to assume that there will need to be some reconciliation between the expectations and the resources in healthcare. Hospitals’ robust business projections will also need reevaluation. It’s necessary to build a capital infrastructure that will be profitable at lower reimbursement rates that may result over time (with lower costs today). The resulting facilities must also be flexible enough to handle changes in medical technologies.

If we must gamble on the future, we should place small bets on modular development rather than large bets on integrated projects. Maybe the hospital of tomorrow needs to have 200 rather than 800 beds, with greater consumer access and more rapid development times. Finally, we should not build facilities that are incapable of being upgraded as quickly as technology advances.

It’s no surprise that government is not sounding the alarm on these important issues. No one wins elections by urging America to address future problems right now. But right now is the time to start the process of heading off what could prove to be a healthcare calamity.

As interest rates on hospital debt reflect the true underlying uncertainty in the market, these costs will change the behavior of managers and planners and help us develop more efficient building models for the hospitals of tomorrow.

— Kevin A. Schulman, MD, is a professor of medicine and business administration and the director of the Health Sector Management Program at Duke University’s Fuqua School of Business.