FRANKFORT — University of Kentucky officials were reprimanded Thursday by lawmakers concerned about a complex and potentially risky funding arrangement the university used to buy Good Samaritan Hospital for $35 million.
The deal to take over the hospital, which filed for Chapter 11 bankruptcy protection in April 2007, uses a 20-year lease-to-own arrangement financed through the Kentucky Association of Counties. UK will make its first payment on the hospital at the end of the month.
Several legislators now say they're uncomfortable with the deal after reading the fine print that says UK could be on the hook to pay millions of dollars more than it agreed to if certain financial conditions worsen.
"You may have made a big mistake. This may not have been thoroughly vetted," Rep. Jim Wayne, D-Louisville, told UK administrators who updated the Capital Projects and Bond Oversight Committee on the purchase Thursday. "You may be getting yourself in deep water if the rates change."
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The deal involves what are known in financial parlance as "swaps," and other states are moving away from them. President Barack Obama's administration has called for tighter regulations on swaps.
This week, Obama asked Congress to consider a measure to tighten regulation on swaps and the trading of derivatives — which are essentially bets on what a financial contract is worth.
UK chose to finance Samaritan through KACo, which offered what appeared to be the lowest interest rate — 4.39 percent over 20 years, compared to 6.1 percent over 10 years offered by the only other bidder. That choice would save the university about $1.5 million a year in interest, said Bob Wiseman, UK's vice president of facilities management.
UK officials handled the deal without consulting an outside financial expert and thought they had a fixed-rate deal, Wiseman told the committee.
But it's not that simple, according to the fine print of the agreement.
KACo, which has brokered $700 million worth of financing for local governments, generally offers counties financing with variable interest rates, KACo executive director Bob Arnold said.
In order to give UK the fixed interest rate that university officials wanted, KACo engaged in what's called a "swap" with U.S. Bank. That trade gave UK an interest rate that still could go up under certain conditions.
For example, if financial rating agencies on Wall Street downgrades U.S. Bank's standing, that could cause the rate to go up, said Rep. Bob Damron, D-Nicholasville.
Frank Butler, UK's executive vice president for finance and administrations, told the committee that KACo officials assured the university that KACo would absorb any increase.
Lawmakers urged UK to get that promise in writing.
Arnold told the Herald-Leader that KACo would have to take that request to the board that handles lease financing.
"I don't know that I'd have a problem with that," Arnold said of signing such an agreement.
Arnold also said his organization has a record of protecting its clients from any increases in fees or rates.
"We have never passed any increases on," Arnold said. "What we tell them it's going to be on the date of close is what it is."
He said that other Kentucky universities have expressed interest in using the funding arrangement.
But Damron said UK might have unnecessarily put its stellar bond rating at risk by engaging in such a complicated swap, especially one tying its fate to a risky deal at a time when "all banks are under stress."
In Tennessee, where several towns have seen their bond interest payments leap because of similar swaps, the state's comptroller proposed a temporary ban on those deals.
KACo finances a variety of municipal projects through its KACo Leasing Trust Program (CoLT), using lease-purchase agreements that are frequently traded in swaps. They range in size from small loans, such as $3.5 million to help build a new health department in Mason County, to larger loans for as much as $30 million for a new hospital in Marshall County.
Damron said swaps can be useful for cheaper, short-term deals, but they are inappropriate in big deals for municipal groups that might not be aware of how complicated and risky they are.
"A long-term, large bond issue is inappropriate, especially in local governments that have no experience in these kinds of deals, as Tennessee has found," said Damron, who works for a large municipal bond company, Ross Sinclaire & Associates, which arranges financing for many new school and courthouse projects. "I'm concerned about any project funded with a derivative-based fund."
Even in a worst-case scenario in which KACo would have to pass on higher interest rates to UK, university officials say they would be able to cover the cost. The $35 million deal would represent just 3 percent of its total debt, Wiseman said.