The tax-exempt market has been going through considerable soul-searching to determine what federally guaranteed hospital issues are worth, according to analysts and investors.

In the wake of a series of downgrades on tax-exempt issues backed by Federal Housing Administration mortgage insurance and the extraordinary call of a $54 million deal, market participants are reassessing the impact of FHA insurance upon specific tax-exempt issues and finding it prudent to examine "the skull beneath the skin."

"Buyers are no longer content to look at just one line of security." said William deSante, managing director at Moody's Investors Service. "There's a real move to looking through the FHA mortgage insurance to the underlying hospital.

"We just started a new approach to this stuff in the last six to eight months," he continued. "People have placed their faith in a lot of things which have failed them. They are concerned about the health-care market, and they're concerned about guarantors across the board."

With FHA-backed deals getting this closer scrutiny, analysts are finding nettlesome "holes" in the structure of the issue that could mean a missed coupon payment. Debt service reserves and bank-issued letters of credit are two primary examples of non-federal government exposure.

In fact, it is not whether the U.S. Department of Housing and Urban Development -- which encompasses FHA -- will pay, but when it will pay, according to market participants. In the meantime, these "holes" are of crucial importance to bondholders.

14 Surprising Downgrades

Last fall, Standard & Poor's Corp. downgraded 14 FHA-backed New York Medical Care Facilities deals totaling almost $1 billion because of deteriorating credit quality in the banks that provided letters of credit. One issue even went from the standard AA rating to BBB.

The action, published belatedly, caught the market off guard, but since then a gradual reassessment of such bonds has been under way. Clifford Griep, managing director at Standard & Poor's, said the emphasis in such deals is placed on the "materiality" of the exposure, or the degree to which the specific accounts factor in to payment streams.

"We look at the 'materiality' of the exposure, the size, relative credit deterioration of who's providing the reserve funds, and the duration of the exposure relative to the impact on a [mortgage] default," he said. "If we think there is some exposure to the reserve fund or investment account, bondholders should be informed about the quality of those accounts.

A current example of this heightened focus is the market's treatment of a $53.98 million hospital deal sold in 1983 by the Puerto Rico Industrial, Medical, and Environmental Facilities Financing Authority.

The deal was in trouble by last October, according to Eugenio Prado, executive vice president of the Government Development Bank for Puerto Rico, because the 300-bed Centro Medico del Turabo took so long to build that its working capital fell short of the amounts needed for the mortgage loan.

Wall Street was quickly on top of it. "When I looked at it in January, the price had already declined to the possible redemption price," said Nancy Utterback, high-yield analyst at Kidder, Peabody & Co. "The coupon was so high [11 1/8%] that it brought the deal up a bit; the price assumed another six months of life."

In hindsight, that was exactly what the bonds were worth. On July 3, HUD paid the development bank $39.5 million, or 90% of the hospital's underlying mortgage. The payment enabled the July 15 coupon payment, but it also triggered a par call of the issue: On Thursday, more than $37 million of the bonds were called, according to Mr. Prado.

The sequence of events left investors bereft of at least three years of precious double-digit coupons. "With a cash payout, everybody loses all the way along," said an investor who held a large block of the bonds. "But this is the worst case. At least you are not losing your par," as hospital investors might without FHA insurance.

At the same time, the federal government's $39.5 million subsidy is in keeping with its mission of undertaking liabilities that private markets will not touch.

"The fund is for social or public purposes," said William Glavin, spokesman for the FHA. "It would be nice if they didn't lose money, but the purpose is to take an underwriting risk where others fear to tread." He noted that the Section 242 hospital fund was in far better shape than the Section 8 housing guarantee fund.

Bond Market Irrelevant

Furthermore, the U.S. Department of Health and Human Services, which approves the mortgage insurance for HUD, considers only the hospitals being serviced, not the impact on tax-exempt investors. "We look at specific criteria pursuant to our interagency agreement with HUD," said Timothy Miller, chief of load origination at HHS. "We don't look at the underlying bond market at all."

Centro Medico del Turabo is obviously an essential institution, Mr. Prado of the development bank said. "Caguas is one of the largest municipalities in Puerto Rico," he said. "It is the only private hospital in the region, and it serves all kinds of citizens, including people from rural municipalities."

From a buyer's perspective, the bonds sold for it turned out to be just as essential. After a six-month introductory rate of 6 7/8%, investors were awarded an 11 1/8% coupon until at least 1994, barring default. And because theyw ere Puerto Rico bonds, the interest was exempt from state and local taxes in most high-tax states.

In addition, the FHA mortgage insurance led Standard & Poor's to confer an AA rating, making the deal very low risk. The bonds were downgraded to AA-minus in May 1990.

Yet eight years after the issue was sold, troubles loomed at Centro Medico del Turabo. The owners, Mr. prado said, sank $8 million of their own capital into the hospital due to building delays. In January, the debt service reserve fund was used to make a $2.86 million coupon payment, and bondholders had only the Government Development Bank's expertise is dealing with HUD standing between them and a missed coupon.

It is precisely this expertise that analysts should focus on when picking apart an FHA hospital, according to Mr. deSante of Moody's. There are three "lines of defense," he said, in these issues: the hospital itself; the FHA; and the issuer.

"Our approach is that we're starting to place more emphasis on the issuing authority and look at their ability to manage the situation," Mr. deSante said. "They have to deal with HUD properly. The approach in the past had been that FHA plugged the holes -- bang it's a double-A.

"But we are now focusing more on the FHA processing and the authority -- whether there's anybody home -- less than the deal as a stand-alone structured financing," he added. "The Government Development Bank is definitely at home."

'Deus ex Machina'

"The GDB is deus ex machina," said another investor who held the bonds. "Without them, we'd all be in trouble."

Mr. prado described a give-and-take process that allowed the extraordinary call to take place with little suffering all around. Last October, he informed HUD that the bonds were in technical default and that a loan assignment -- the equivalent of a policy claim -- appeared inevitable. For whatever reason, HUD officials asked for a postponement of assignment, and Mr. Prado complied.

"We postponed the assignment of the loan, with their consent, because we had sufficient funds for the payment on January 15," he said. "In May, I told them I couldn't wait any longer. And then they moved very happily."

Usually, when it comes to paying FHA claims, the pace is rather slow in Washington. HUD is not overbrimming with staff, and officials must be sure the federal taxpayers' money is legitimately spent. With Centro Medico, the FHA came through with a cash payment only 12 days before the coupons were due.

A cash payment differs significantly from HUD's other option in these circumstances, a debenture payment. The debenture route keeps both the bonds and the mortgage outstanding, and the federal government would foot the bill for the roughly 12% loan. "HUD elected to pay in cash because the mortgage would be very expensive for the U.S. Treasury," Mr. Prado said.

Mr. Griep of Standard & Poor's said issuer expertise was a tangible contribution in such mortgage defaults. "I certainly agree that some parties bring more to transaction than others do," he said. "The capability to manage the process... may add relative value."

According to FHA documents, the Centro Medico cash paydown is the largest hospital reimbursement by HUD since 1967. There were no loan assignments from 1979 until 1986, but over the past four years, FHA policies have paid out a total of $72.22 million. In 1987, one deal totaling $4.65 million was paid down; in 1989, three deals totaling $17.56 million were assigned and paid; and already this year, two assignments totaling almost $50 million -- including Centro Medico's eventual $43.88 million payment -- are scheduled for payment.

FHA Deals Considered Oddity

The market itself considers FHA hospitals as an oddity, but as yet no blanket discounting of the bonds has occurred, according to several Wall Street researchers. John Clark, director of research at Morristown, N.J.-based William E. Simon & Sons, characterized the FHA hospital market as "segmented," with troubled deals trading well below the rest of the bonds.

"It's unusual. The generic FHA bond is trading stronger than ever," Mr. Clark said. "But individual issues are trading cheaper. It's on a name-by-name basis."

He added that a wide array of these bonds are trading actively, yet buyers did not seem to be taking the time to look closely. "People are taking the easy way out," Mr. Clark said.

Ms. Utterback of Kidder Peabody said the stronger-than-expected pricing is "because supply is so thin."

"There's not a lot of float," she said. "So in this time frame a lot of questions are being overlooked. Call features have tended to affect price more than credit quality."

David Johnson, portfolio manager of the Van Kampen Merritt Tax Free High Yield Fund, said the double-A FHA hospital bonds trade at yields of 30 to 40 basis points cheaper than the privately insured market. He estimated 10-year deals would fetch 7.45% to 7.50%.

The issues themselves, at the same time, present an inherent quandary: "On one side you get a hospital," Mr. Johnson said, "and on the other side you don't get paid for it."

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