BETTING ON RISK
By Melvin J. Howard
Derivatives has been a huge
part of hospital's financial problems in the past and as evidence suggest translated into
a lack of hospital beds. Since the 1980's innovative bankers have entered
into the health care industry with an array of financial products. But what
the financial crisis brought to the surface was that some CEOs or so
called "sophisticated" investors participated in all sorts of
transactions they simply could not understand.
Hospital managers should
concentrate on the hospital at hand not their financial
complex portfolios. The job as the CEO of a hospital is to be a healthcare
expert not Warren Buffet but egos prevailed. Even though health care
organizations have long used floating-rate debt in finance with great success.
I myself have deployed this technique many times but it is not for the un-sophisticated.
For some health
care administrators, derivatives seemed like a safe bet and why not. The
potential rewards were too great to resist, for years and years it was a smart
strategy. Hospitals made money on these for a long time. What changed? the
financial crisis and they lost money. When times were good it worked for a
while but when times went bad it went very bad. Boom you took a hit on your
swaps.
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. Conventional thinking was the wisdom about swaps is that they can
be a good way for hospitals to guard against a sudden change in rates.
This was true in some cases but the key word is "some." Just not
always. Just what are Derivatives they are bets, pure and simple,
predictions about the future.
The concept of derivative is
to create a contract that derives from an original contract or asset. For
example, stock market derivatives are contracts that are settled based on
movements in prices of stocks, without transferring the underlying stock.
Similarly, a credit derivative is a contract that involves a contract between
parties in relation to the returns from a credit asset, without transferring
the asset as such. As you may notice this is a financial instrument that is
used by financial institutions. It has now been expanded to a number of
industries. In order to properly serve as a hospital administrator or CEO. It
is important that one has some information on the different methods of
financing and mitigating risks of their health care facility but I often find
that this roll is often conflicted with the CEO and CFO of the facility and the
fund that owns it.
What is a credit derivative?
A credit asset is the extension of credit in some form: normally a loan,
installment credit or financial lease contract. Every credit asset is a
bundle of risks and returns: every credit asset is acquired to make certain
returns on the asset, and the probability of not making the expected return is
the risk inherent in a credit asset. There are several reasons due to which a
credit asset may not end up giving the expected return to the holder: delinquency,
default, losses, foreclosure, prepayment, interest rate movements, exchange
rate movements, etc. A credit derivative contract intends to transfer the risk
of the total return in a credit transaction falling below a stipulated rate,
without transferring the underlying asset. For example, if bank A enters into a
credit derivative with bank B relating to the former's portfolio, bank B bears
the risk, of course for a fee, inherent in the portfolio held by bank A, while
bank A continues to hold the portfolio.
The motivation to enter into credit derivatives transactions are well appreciable. The above example has depicted credit derivatives being a bilateral transaction - as a sort of a bartering of risks. As a matter of fact, credit derivatives can be completely marketable contracts the credit risk inherent in a portfolio can be securitized and sold in the capital market just like any other capital market security. So, anyone who buys such a security is inherently buying a fragment of the risk inherent in the portfolio, and the buyers of such securities are buying a fraction of the risks and returns of a portfolio held by the originating bank. Thus, the concept of derivatives and securitization have joined together to make risk a tradable commodity of which we participate in.
A definition of
credit derivatives: Credit
derivatives can be defined as arrangements that allow one party (protection
buyer or originator) to transfer credit risk of a reference asset, which it may
or may not own, to one or more other parties (the protection sellers). Types of
credit derivatives: The easiest and the most traditional form of a credit
derivative is a guarantee. Financial guarantees have existed for thousands of
years. However, the present day concept of credit derivatives has traveled much
farther than a simple bank guarantee. The credit derivatives being currently
used in the market can be broadly classified into the following:
Total return swap: As the name implies, a total return swap
is a swap of the total return out of a credit asset against a contracted
prefixed return. The total return out of a credit asset can be affected by
various factors, some of which may be quite extraneous to the asset in
question, such as interest rate movements, exchange rate fluctuations etc.
Nevertheless, the protection seller here guarantees a prefixed return to the
originator, who in turn, agrees to pass on the entire collections from the
credit asset to the protection seller. That is to say, the protection buyer
swaps the total return from a credit asset for a predetermined, prefixed
return.
Credit default swap: Credit default swap
is a refined form of a traditional financial guarantee, with the difference
that a credit swap need not be limited to compensation upon an actual default
but might even cover events such as downgrading, apprehended default etc. In a
credit default swap, the protection seller agrees, for an upfront or continuing
premium or fee, to compensate the protection buyer upon the happening of a
specified event, such as a default, downgrading of the obligor, apprehended
default etc. Credit default swap covers only the credit risk inherent in the
asset, while risks on account of other factors such as interest rate movements
remains with the originator.
Credit linked notes: Credit linked notes are a securitized
form of credit derivatives. The technology of securitization here has been
borrowed from the catastrophe bonds or risk securitization instruments. Here,
the protection buyer issues notes. The investor who buys the notes has to
suffer either a delay in repayment or has to forego interest, if a specified
credit event, say, default or bankruptcy, takes place. This device also
transfers merely the credit risk and not other risks involved with the credit
asset. Now that you know the different methods it doesn't get
hospital administrators off the hook. You should not use financial instruments
you don't understand. The point I am making is this hospitals 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 return on capital so you should be aware of all scenarios.
