02/01/2012 01:44 pm ET | Updated Mar 31, 2012

Medical Care Bubble 2.0

A not-for-profit hospital in North Carolina that historically served an underserved population salvaged it's precarious fiscal situation in the 1970s by going into the cardiac surgery business big time. It was a successful strategy and millions of dollars from government and private insurers were added to their bottom line. A group of cardiologists who practiced in the area provided the patients for cardiac bypass surgery and in the process generated a very attractive revenue stream for themselves. These surgical procedures resulted in hospital stays in many cases of more than a week with what were, at the time, more than ample allowable medical and hospital charges paid for by insurance. As one of the cardiologists said, "We needed the hospital and they needed us." It was a significant money maker for everyone involved.

There were potential fiscal hazards which were discounted as highly unlikely. It is widely accepted that to stay healthy, even non profit hospitals need at least a 3 percent profit margin. The millions the hospital was collecting put them comfortably above that threshold. They were used to pay their increasing multimillion operating expenses. There was some risk since this revenue stream would dry up if there was any significant decrease in their heart surgery business. If that happened, they would be hard pressed to cover these increasing costs.

The unthinkable happened. First, Medicare reduced their allowable charges and the private insurance carriers followed suit. Then the in-hospital length of stay fell and many open heart bypass procedures were replaced by cardiac catheterizations with markedly reduced reimbursement schedules. The hospital experienced a sharp fall in their revenues that was inadequate to meet their inflated needs. In an attempt to preserve their incomes, the doctors who previously had previously been well compensated found themselves forced to reduce their practice overhead by reducing the size of their staff and/or moving to less costly office space.

The hospitals knew their ability to negotiate reimbursement rates with the insurance carriers was dependent on expanding their market share. In order to increase their patient load, they recruited more cardiac surgeons and cardiologists to fill their operating rooms and hospital beds. Doctors were offered salaried positions where their pay was determined by the revenue stream they generated. New young physicians were guaranteed an income while they built their practices.

These strategies failed to remedy the situation and led to increased competition among hospitals serving the same catchment area. Like the board game Monopoly, it was predictable that in time it would be winner take all.

The board of, let's call it, hospital A decided to embark on a $750 million dollar deal to buy hospital B. This would eliminate the concern that their business model could be threatened by hospital B. Another potential competitor, hospital C, would also be neutralized. The boards of both institutions proceeded to lawyer up and retain consultants to advise them on their best strategy.

A summary of the proposed financing puts things in the perspective. Hospital A had $150 million in cash on hand and would float a $600 million dollar 30 year bond for the rest. This was an expensive deal that by any objective measure was risky. The logical question is if hospital A was going to turn over $750 million to hospital B and own them since both were not for profit institutions what were the plans for three quarters of a billion dollars. While the assumptions underpinning the deal are clear, the answer is not obvious.

Suppose an asset is assumed have a stable value and can be used as a source of funds which, as a result, encourages additional spending. Then consider a situation where the imputed value of the asset starts to fall but you have been using borrowed money to cover operating expenses and paying interest predicated on the assets original assumed value. And there comes a point were you can't afford the interest or meet the obligation to reduce the principle of your loan. Sound familiar? I don't think I need to connect any more dots.

This class of fiscal folly is being replicated in many parts of the increasingly complicated and complex health care industry and will continue to inflate the medical care bubble. If we don't take the appropriate action soon, there is a very small chance any of the new proposed schemes to reduce the nation's bill for health care will achieve their projected goals.