Revisions to the Hospital Mortgage Insurance Program, 67524-67560 [E7-22406]

Agencies

• DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

[Federal Register Volume 72, Number 228 (Wednesday, November 28, 2007)]
[Rules and Regulations]
[Pages 67524-67560]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-22406]



[[Page 67523]]

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Part IV





Department of Housing and Urban Development





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24 CFR Parts 200 and 242



Revisions to the Hospital Mortgage Insurance Program; Final Rule

Federal Register / Vol. 72, No. 228 / Wednesday, November 28, 2007 / 
Rules and Regulations

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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

24 CFR Parts 200 and 242

[Docket No. FR-4927-F-02]
RIN 2502-AI22


Revisions to the Hospital Mortgage Insurance Program

AGENCY: Office of the Assistant Secretary for Housing--Federal Housing 
Commissioner.

ACTION: Final rule.

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SUMMARY: This final rule revises the regulations governing HUD's 
mortgage insurance program for hospitals. The rule updates and 
incorporates some earlier provisions that currently are not published 
as part of the Federal Housing Administration (FHA) regulations. 
Further, the rule adds new provisions to make them consistent with 
current industry practices. The rule also codifies the relevant 
regulations that address hospital mortgage insurance in one part, 
thereby making the regulations more user-friendly.

DATES: Effective Date: January 28, 2008.

FOR FURTHER INFORMATION CONTACT: Roger E. Miller, Director, Office of 
Insured Health Care Facilities, Department of Housing and Urban 
Development, 451 Seventh Street, SW., Room 9224, Washington, DC 20410-
8000; telephone (202) 708-0599 (this is not a toll-free number). 
Hearing- and speech-impaired persons may access this number through TTY 
by calling the Federal Information Relay Service at (800) 877-8339 
(this is a toll-free number).

SUPPLEMENTARY INFORMATION:

I. The January 10, 2005, Proposed Rule

    On January 10, 2005, HUD published a proposed rule intended to 
revise HUD's hospital mortgage insurance regulations. The proposed rule 
(70 FR 1750 et seq.) describes in detail the background and purpose of 
the hospital mortgage insurance regulation.
    The January publication proposed eliminating references to hospital 
mortgage insurance in 24 CFR part 200, and proposed codifying the 
entire program in 24 CFR part 242. As a result, users of the regulation 
would be able to find everything they need in one location, and the 
rule would avoid unnecessary repetition.
    The number of applications for hospital mortgage insurance has 
increased recently, and one purpose of this new rule is to respond to 
this increase with more detailed and complete regulatory guidance. The 
new details in the proposed regulation reflect HUD's actual experience 
with the hospital mortgage insurance industry, as well as statutory 
developments that have taken place in the last few years. The result is 
a new proposed comprehensive program of mortgage insurance for 
hospitals to replace the current, much less detailed regulations.

II. This Final Rule

    This final rule follows publication of the January 10, 2005, 
proposed rule, and takes into consideration the public comments 
received. The public comment period for this proposed rule closed on 
March 11, 2005. HUD received comments from four commenters on a wide 
variety of issues related to the proposed rule. Commenters included a 
hospital industry trade association, a financing company, and two 
individuals. The final rule makes a number of changes to the proposed 
rule based on the comments received. The following pages present a 
short, section-by-section description of the changes HUD made in the 
final rule to clarify terminology, conform to a statutory change, and 
address public comments.

Section 242.1 Definitions

    The final rule adds new definitions for the following terms: 
``AMPO'' (Allowance for Making Project Operational); ``applicant''; 
``construction''; ``days of cash on hand,'' in order to clarify 
terminology used in the definition of ``surplus cash''; ``most recent 
audited financial statement''; ``net income''; ``Secretary''; ``service 
area''; and ``substantial rehabilitation.''
    The final rule deletes the definitions of ``Commissioner'' and 
``working capital'' because they are no longer needed. ``Commissioner'' 
is not used in the final rule. ``Working capital'' has been replaced by 
the more commonly understood phrase, ``initial operating capital.''
    The final rule clarifies terminology that was in the proposed rule. 
Commenters found the term ``credit instrument'' confusing, so this 
final rule uses the term ``mortgage note'' instead. For ``Debt service 
coverage ratio,'' the formula has been adjusted to include excess of 
revenues over expenses as an option for net income, and to take into 
account amortization expense. The definition of ``identity of 
interest'' has been revised to include examples in order to provide 
improved guidance. The term ``mortgagee'' has been clarified. The term 
``operating revenue'' has been revised to state that, at HUD's 
discretion, additional items beyond those specifically mentioned, and 
that have been historically and reliably received, may be considered 
operating revenue for underwriting purposes. ``Preapplication meeting'' 
has been revised to clarify that the meeting includes HUD, the 
potential mortgagee, and the potential mortgagor. The definition of 
``project'' has been clarified by using another defined term, 
``substantial rehabilitation,'' and by specifying that construction may 
include replacement of an existing facility.
    The definition of ``surplus cash'' has been clarified by defining 
the phrase ``days of cash on hand,'' which commenters found unclear, 
and by defining some terms used in the definition. In addition, instead 
of using the concept of cash earned, as proposed, the definition now 
considers surplus cash to be the cash remaining after certain 
conditions have been met.

Section 242.4 Eligible Hospitals: Transition Provisions

    The final rule adds a new paragraph (b) to clarify when the 
regulations of part 242, as revised by this final rule become 
applicable, and revises the heading of this section to reflect the 
addition of transition provisions.

Section 242.13 Parents and Affiliates

    The final rule clarifies that the purpose of assurances, 
guarantees, or collateral is to protect HUD's interests.

Section 242.15 Limitation on Refinancing of Existing Indebtedness

    The final rule has substituted the word ``capital'' for ``long-
term,'' because there may be instances where it is necessary to finance 
short-term debt.

Section 242.16 Applications

    The final rule clarifies an exception to the 3-year positive 
operating margin requirement for hospitals in a turnaround situation. 
Under the exception, only one year is required to submit an application 
and 2 consecutive years of positive operating margin are required for 
application approval. The final rule replaces the word ``applicant'' 
with the words ``mortgagor or mortgagee'' in Sec.  242.16(a)(4)(i) to 
reflect that both may expend resources in preparing an application.
    Section 242.16(b)(6) is revised to take account of the fact that, 
as a commenter stated, complete architectural plans may not be 
available at this stage. In the final rule, architectural plans are to 
be filed with the application ``in sufficient detail to enable a 
reasonable estimate of cost.''
    A reference to a 12-month timeframe for a decision on an 
application in Sec.  242.16(f) has been removed in

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response to a comment that the timeframe could imply that a 12-month 
wait for a decision is usual, and thereby discourage applicants. While 
HUD cannot promise a specific timeframe for its review, the agency 
endeavors to respond more promptly than 12 months.

Section 242.21 Refund of Fees

    This section along with Sec.  242.45(e) is revised to make clear 
that the portion of inspection fees paid for early commencement of work 
is not refundable.

Section 242.23 Maximum Mortgage Amounts and Cash Equity Requirements

    Section 242.23(c) is revised to permit a private nonprofit or 
public mortgagor, at HUD's discretion and subject to 24 CFR 242.49, to 
provide equity in the form of a letter of credit. Also, the rule is 
revised to clarify that cash equity is in addition to property, plant, 
and equipment.

Section 242.24 Working Capital

    The final rule clarifies that HUD did not intend to make an initial 
cash deposit a mandatory requirement. Whether such a deposit is 
required will depend in each case on the borrower's financial strength.

Section 242.26 Agreed Interest Rate

    The final rule clarifies that different interest rates may be 
applicable to a project; for example, construction and permanent loan 
rates can differ.

Section 242.28 Allowable Costs for Consultants

    Recognizing that hospital projects can have long planning times, 
this rule changes, from one year to 2 years, the time limit for 
allowing consultant's costs prior to the application.

Section 242.31 Accumulation of Accruals

    The final rule is slightly revised to provide greater flexibility 
for mortgagors in purchasing fire and hazard insurance.

Section 242.33 Covenant for Malpractice, Fire, and Other Hazard 
Insurance

    This final rule adopts language requiring the mortgagor to maintain 
adequate malpractice, fire, and hazard coverage acceptable to the 
mortgagee and HUD.

Section 242.35 Mortgage Lien Certifications

    The final rule is revised so that, in exceptional cases, certain 
personalty may be excluded from the mortgaged property or the insured 
lender may take a secondary lien position on it.

Section 242.37 Mortgage Prepayment

    The final rule permits the 30-day advance notice of intent to 
prepay the mortgage to be extended with HUD approval.

Section 242.39 Insurance Endorsement

    Section 242.39(c) incorporates subpart B of 24 CFR part 207, 
covering contract rights and obligations of the mortgagor, mortgagee, 
and HUD, into this rule. The cross-reference in Sec.  202.94 of the 
proposed rule is therefore no longer needed and is removed in this 
final rule.

Section 242.43 Application of Cost Savings

    The proposed rule required that any cost savings be used to reduce 
the mortgage and the mortgagor's equity contribution proportionally. 
Under this final rule, the mortgagor can elect to have a greater 
proportion of the savings go to mortgage reduction.

Section 242.45 Early Commencement of Work

    The final rule expands this provision to allow for early site 
preparation. It also provides that the cost of structures may be 
refinanced with insured mortgage proceeds if the work was completed 
more than 2 years before application. Where advance approval is sought 
for early site work and construction activity, HUD will require that 
key elements of an application be filed first, with the understanding 
that the remainder of the application will follow.

Section 242.49 Funds and Finances: Deposits and Letters of Credit

    Section 242.49(a) is revised to give a fuller explanation of the 
mortgagor's deposit.

Section 242.50 Funds and Finances: Off-Site Utilities and Streets

    For clarity, Sec.  242.50 has been modified to specify that there 
must be adequate funds available to cover cost of off-site utilities 
and streets.

Section 242.51 Funds and Finances: Insured Advances and Assurance of 
Completion

    This section is revised so that the amount of surety for completion 
is related to the construction contract (or Guaranteed Maximum Price, 
in the case of construction management) rather than the accepted bid 
price.

Section 242.53 Excluded Contractors

    Section 242.53(c) has been revised in this final rule to provide 
for remedial and enforcement actions other than refusing to insure 
further advances.

Section 242.54 Nondiscrimination

    HUD is revising Sec.  242.54 in this final rule to clarify that the 
section does not affect the eligibility of women's and children's 
hospitals for this program.

Section 242.58 Books, Accounts, and Financial Statements

    The final rule allows for the use of Governmental Accounting 
Standards in addition to Generally Accepted Accounting Principles 
because a number of hospitals use Government Accounting Standards.

Section 242.62 Releases of Lien

    The final rule provides that HUD may set thresholds ``or other 
standards'' for the sale, disposition, transfer, or encumbrance of 
property securing a lien under this program.

Section 242.74 Smoke Detectors

    This section is revised to provide that smoke detectors must comply 
with local law.

Section 242.76 Title Evidence

    The final rule is revised to state that the title policy shall 
include as insureds not only HUD and the Secretary, but their 
successors and assigns.

Section 242.89 Supplemental Loans

    This section has been revised to permit refinancing of debt 
incurred in connection with early commencement of work performed in 
accordance with the requirements of this rule.

III. Discussion of Public Comments on the January 10, 2005, Proposed 
Rule

    The issues that commenters addressed were numerous. Therefore, this 
discussion organizes the comments into general comments and those 
addressed to specific sections of the proposed rule. The latter are 
organized by section order for convenience.

General Comments

    Comment: The rule should be re-issued as an interim final rule and 
additional comments regarding ``any material concerns that remain after 
publication'' should be solicited. This is particularly important, 
since HUD policy tends to prohibit discussion about the rule after the 
close of the comment period.
    Response: HUD believes that the public comment process provided 
sufficient opportunity for comment on the proposed rule.
    Comment: The proposed rule was not adaptable and flexible enough 
for the hospital industry. This commenter stated that ``the Proposed 
Rule may inadvertently limit the application of a

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longstanding and effective underwriting approach to Section 242 
financing, which recognizes the organic and evolving nature of hospital 
delivery services.'' This is because hospital services are typically 
delivered in an ``evolving regulatory and service environment'' 
reflecting ``particular needs of a facility's service area as well as 
technological developments and revenue changes dictated by federal and 
state reimbursement rules.'' Adaptable underwriting standards will 
become more necessary as the program involves hospitals in new 
geographical areas. Absent needed flexibility, the ability of hospitals 
to participate in this needed program could be severely limited.
    Response: HUD viewed the lack of explicit, published underwriting 
standards to be a weakness. A principal reason for publishing the 
proposed rule was to correct this weakness, so that potential 
participants can know in advance what HUD's basic underwriting 
standards are and to avoid wasting time and money on applications with 
little or no chance of being approved.
    Comment: In order to make the program sufficiently flexible, HUD 
should move portions of the rule to informal program guidance. This 
non-regulatory, more flexible approach has worked well in other FHA 
programs.
    Response: HUD views the program as being sufficiently flexible to 
accommodate a wide range of circumstances.
    Comment: What is HUD's policy with regard to interest rate swaps?
    Response: The mortgagor may not engage in interest rate swaps or 
other derivative-type transactions, except in conformance with policies 
and procedures to be established by HUD. HUD does not believe that the 
detailed policies and procedures need to be included in the rule. 
However, after consideration of this comment, HUD is adding clarifying 
language in the final rule at Sec.  242.63, so that the section reads:

    The mortgagor shall not enter into any long-term debt, short-
term debt (including receivables/line of credit financing), 
equipment leases, or derivative-type transactions, except in 
conformance with policies and procedures established by HUD.

    Comment: ``Since loan to cost is based on the value of the 
mortgaged property I feel it is not applicable for periods beyond the 
date of closing. Distributions of equity if a concern should be a 
separate covenant if deemed a risk factor.''
    Response: HUD assumes the commenter is referring to the definition 
of surplus cash, because of the reference to distributions of equity. 
Distributions of equity are controlled by Sec. Sec.  242.65 and 242.66. 
There is a separate loan covenant in the loan documents based upon 
these sections.

Comments on Specific Sections

Revisions to Part 200
1. Section 200.24
    Comment: One commenter stated that, as a practical matter, this 
section eliminates Sec.  223(f) and part 242 refinancing for non-FHA 
insured loans, an unfortunate and unnecessary consequence. The rule 
should allow otherwise financially sound non-FHA hospitals access to 
much-needed debt service savings in a rapidly eroding low-interest rate 
climate when they have no present need for new capital improvements. 
This change would also allow FHA to realize additional fees and 
Mortgage Insurance Premium (MIP) revenues without related construction 
or start-up risk. This commenter stated that the application of Section 
223(f) to FHA's multifamily programs has been determined to be sound 
enough to permit a program MIP reduction. A 223(f)/242 program would be 
equally successful.
    A commenter stated that if the proposed deletion of Section 223(f) 
authority, which is currently in regulations, is adopted, and if at a 
subsequent date FHA determines Section 223(f) for hospitals to be in 
the public interest, FHA will face a difficult and time-consuming 
regulatory process to implement that result. This commenter states that 
there is no public policy benefit gained by deleting Section 223(f)/242 
financing authority and that existing regulations should remain in 
effect.
    Response: The reference to section 223(f) of the National Housing 
Act, 12 U.S.C. 1715n(f), in 24 CFR part 200, was never intended to 
provide program authority. Should the Department decide to implement 
section 223(f) for hospitals, explicit regulations would be required to 
provide program structure. HUD is not prepared to issue such 
regulations at this time, although it could consider doing so at a 
later date.
    Comment: FHA's ``Operating Loss Loans'' authority has been deleted 
from the draft regulations. The commenter recommends that it be 
reinstated.
    Response: With respect to Section 223(d), HUD's policy has been not 
to authorize any 223(d) loans for hospitals, and none have ever been 
authorized. The exclusion of Section 223(d) from the rule is consistent 
with that policy.
2. Section 200.40 HUD Fees
    Comment: Section 223(f)/242 authority should be kept in effect by 
adding the following text from current regulations to Sec.  200.40(c):

    For a mortgage being insured under Section 242 of the Act (12 
U.S.C. 1715z-7), an application fee of $1.50 per thousand dollars of 
the amount loaned shall be paid to HUD at the time the hospital 
application is submitted to the Department and the balance thereof 
no later than initial endorsement.

    Response: For the same reasons discussed in connection with 
comments regarding hospital loans under section 223(f) of the National 
Housing Act, HUD is not adopting this suggested change.
Subpart A--General Eligibility Requirements
3. Section 242.1 Definitions
    Comment: The term ``applicant'' should be defined as to whether the 
term is meant to apply to the lender or mortgagor throughout the 
regulations. The ``applicant'' should be the mortgage lender.
    Response: HUD agrees that ``applicant'' should be defined because 
of the possibility of confusion between the roles of lender and 
mortgagor. Therefore, a definition of ``applicant'' has been added.
    Comment: The term ``application'' should be defined.
    Response: HUD sees no need for a definition of this term; 
``application'' is commonly understood in the industry.
    Comment: The definition of cash should include operating cash, 
short-term investments, and funded depreciation accounts. By 
definition, this would exclude all trusteed accounts. Days of operating 
expenses should be defined as total operating expenses minus 
depreciation and interest.
    Response: The comment appears to be a reference to the calculation 
of ``days of cash on hand,'' a term appearing in the definition of 
``surplus cash.'' In order to clarify this term, a definition of ``days 
of cash on hand'' has been added as a separate definition.
    Comment: The definition of ``chronic convalescent and rest'' should 
be revised to delete the terms ``respite care services,'' ``hospice 
services,'' and ``rehabilitation services.'' Instead, the definition of 
``chronic convalescent and rest'' should be tied directly to the types 
of services provided in the Section 232 program. There is no evidence 
that the term ``chronic care'' set forth in the National Housing Act 
(NHA) includes respite care, hospice, or rehabilitation, particularly 
when delivered on an independent basis and not in

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connection with chronic convalescent patients. The proposed definition 
would appear to exclude revenues received from these services from 
inclusion in the calculation of acute care patient days for purposes of 
determining whether a proposed project meets the NHA's 50 percent 
chronic care bed limitation.
    Response: The inclusion of respite, hospice, and rehabilitation 
patient days in the definition of ``chronic convalescent and rest'' is 
consistent with the language in the introductory paragraph of the 
statute. That language would preclude patient days for such services 
from being counted for the purpose of calculating hospital eligibility 
based on patient days under the statute's ``50 percent rule.'' The 
statute, 12 U.S.C. 1715z-7(a), states:

    The purpose of this section is to assist the provision of 
urgently needed hospitals for the care and treatment of persons who 
are acutely ill or who otherwise require medical care and related 
services of the kind customarily furnished only (or most 
effectively) by hospitals.

    Respite, hospice, and chronic rehabilitation services are not acute 
care services and do not require the services furnished only (or most 
effectively) by hospitals. Typically, these services are not provided 
in hospital beds, but rather in sub-acute settings. These services are 
most accurately included in the broad category, specified in the 
statute, of ``chronic convalescent and rest'' and, in some cases of 
rehabilitation, in the excluded categories of ``drug and alcoholic'' 
and ``mentally deficient.''
    Comment: The rule should include a definition of ``commitment.''
    Response: HUD sees no need for a definition; the concept of a HUD 
mortgage insurance commitment is well understood in the industry.
    Comment: The rule should include a definition of ``credit 
instrument.''
    Response: Where the term ``credit instrument'' appeared in the 
proposed rule, HUD has substituted the term ``mortgage note'' in this 
final rule for clarity.
    Comment: A commenter stated that the definition of ``debt service 
coverage ratio'' should be revised to remove the second and third 
sentences, which reference a high coverage ratio. These sentences are 
unnecessary and potentially problematic. The proposed definition 
suggests that absent a ``high debt service coverage ratio,'' which is 
undefined, a project is ineligible. The language potentially conflicts 
with specific coverage standards set forth in Sec.  242.16, and as such 
there would appear to be no need for a nonspecific policy statement of 
this type. At a minimum, a cross-reference should be made to Sec.  
242.16 to avoid interpretation conflicts.
    This commenter also stated that the commenter presumes that the 
formula in the definition describes the formula currently in use.
    Response: HUD agrees that the second and third sentences are 
potentially problematic and has removed them. The formula in the 
definition has been clarified, as follows: Debt Service Coverage Ratio 
(total debt service coverage on all long-term capital debt) equals:
[GRAPHIC] [TIFF OMITTED] TR28NO07.051

    Comment: A commenter states that the rule should add a phrase to 
the definition of ``hospital'' to accommodate possible future changes, 
as follows:

    Hospital means a facility that has been proposed for approval or 
has been approved by HUD under the provisions of this subpart, as 
this definition may be modified from time to time pursuant to the 
Act. * * *

    The commenter states that possible future changes may include, for 
example, an extension of the exclusion of Critical Access Hospitals 
from the 50 percent acute care requirement beyond its current 2006 
sunset, or the elimination of the 50 percent rule in its entirety.
    Response: The definition of ``hospital'' is statutory, as is the 
exclusion of critical access hospitals from the 50 percent rule. (See 
12 U.S.C. 1715z-7(b)(1).) At the time of the comment period on the 
proposed rule, the statutory exemption for Critical Access Hospitals 
ended in 2006. On July 10, 2006, the exemption for Critical Access 
Hospitals was extended through July 31, 2011. The relevant portion of 
this final rule has been conformed to that statutory change. HUD does 
not believe further definition is necessary.
    Comment: The definition of ``identity of interest'' should be 
modified as follows to permit identity of interest transactions subject 
to additional underwriting criteria, and to give HUD the ability to set 
the criteria:

    Identity of interest means a relationship that must be disclosed 
and may be either prohibited or subject to additional underwriting 
or criteria pursuant to the requirements of HUD or the Regulatory 
Agreement.

    Response: HUD does not believe that this concept needs to be 
explicitly stated. HUD has the authority to waive provisions in the 
Regulatory Agreement for good cause. However, for clarity, HUD includes 
examples of identity of interest relationships in the definition in 
this final rule.
    Comment: The definition of ``mortgagee or lender'' should be 
revised to remove material regarding trust indentures, and to expand 
the definition to include the ``proposed lender with respect to an 
application for commitment.'' Regarding the indenture, the commenter 
states that indentures, in the sense the industry uses the term, are 
not involved, and that the FHA mortgagor would not be a party to the 
indenture (the commenter states that ``indenture'' means a contract 
between a government bond issuer and a bond trustee for loans financed 
through tax-exempt revenue bonds). The suggested revised definition 
would read as follows:

    Mortgagee or Lender means the proposed lender with respect to an 
application for a commitment and/or the original lender under a 
mortgage, and its successors and assigns, which is the holder of the 
governing mortgage and other related credit instruments (All 
official contacts and actions by HUD shall be with or through a HUD-
approved lender).

    Response: The reference to ``trust indenture'' in the proposed rule 
derived from an obsolete reference. HUD does not insure trust 
indentures. Therefore, use of the term ``trust indenture'' would be 
confusing because many mortgages are funded with bond issues, pursuant 
to trust indentures. Therefore, this final rule changes the definition 
of ``mortgagee'' to:

    The original lender under a mortgage, and its successors and 
assigns, including the holders of mortgage notes issued under a 
trust mortgage or deed of trust, pursuant to which such holders act 
by and through a trustee therein named.

    Comment: The first sentence of the proposed definition of 
``mortgage reserve fund'' should be revised to read:

    Mortgage Reserve Fund means a trustee-held account for the 
benefit of the

[[Page 67528]]

Commissioner to which the mortgagor contributes funds required by 
HUD and from which withdrawals must be approved by HUD.

    Response: The mortgage reserve fund is not only for the benefit of 
HUD, it is also for the benefit of the hospital to preserve the value 
of the hospital and to help prevent default. In order to clarify this 
purpose, the first sentence has been modified to state, ``Mortgage 
reserve fund means a trust account, or an account held by the 
mortgagee, for and on behalf of the mortgagor, to which the mortgagor 
contributes funds required by HUD and from which withdrawals must be 
approved by HUD.''
    Comment: The second and third sentences of the definition of ``non-
operating revenues and expenses'' should be revised, as follows:

    Examples of items classified as non-operating are State and 
Federal income tax, general contributions, gains and losses from 
investments, and unrestricted income from non-designated endowment 
funds, and income from related entities received by a hospital 
sponsor. Classification of items as operating or non-operating shall 
be in accordance with generally accepted accounting principles or 
other applicable accounting standards.

    Response: The suggestion is to insert ``non-designated'' before 
endowment funds to make the wording state that ``unrestricted income 
from non-designated endowment funds'' is excluded from operating 
income. HUD does not agree and would consider unrestricted income from 
all endowment funds to be non-operating revenue.
    The commenter suggests that generally accepted accounting 
principles determine classification of operating and non-operating 
revenue and that investment income should be included in operating 
income. It is true that some endowment funds generate income for the 
general benefit of the hospital. However, the income these funds 
generate, depending on the type of investment and market conditions, 
are subject to variance and may not be available for servicing the 
mortgage in future periods. There is no direct corresponding expense 
associated with the investment income that can be eliminated if the 
investment income decreases. Therefore, this final rule retains the 
wording without change.
    Comment: One commenter suggests a minor editorial revision to the 
definition of ``operating revenue'' under the heading of ``operating 
margin,'' to add the phrase ``but not limited to'' after ``including'' 
in the parenthetical example.
    Response: HUD agrees that the items listed were intended to be 
examples and not an exclusive list.
    Comment: The rule should add a definition of ``acute care patient 
days'' and provide for adjustment of ancillary non-bed hospital 
services to an acute care patient day.
    Response: This term is not used in the rule and no definition is 
necessary. Also, HUD believes that the calculation of adjusted patient 
days is at a level of detail that is not necessary to include in the 
regulation.
    Comment: A portion of the definition of ``personalty'' (from the 
third sentence beginning ``Generally, intangibles * * *'' to the end) 
should be revised, as follows:

    Generally, intangibles shall also include all cash and cash 
escrow funds which are not otherwise pledged in connection with 
obligations of the mortgagor outstanding at initial endorsement, 
such as, but not limited to: depreciation reserve fund or mortgage 
reserve fund accounts, bank accounts, residual receipt accounts, all 
unrestricted contributions, donations, gifts, grants, bequests and 
endowment funds by donors, and all other revenues and accounts 
receivable from whatever source paid or payable. All personalty 
shall be securitized with appropriate UCC filings and any excluded 
personalty shall be indicated in the Regulatory Agreement and the 
Security Agreement.

    The commenter states that the language regarding otherwise-pledged 
obligations should be added to provide an exception for funds pledged 
at or prior to initial endorsement in connection with bond-related 
obligations (such as construction fund negative arbitrage) issued to 
fund the FHA loan or in connection with other outstanding obligations 
of the mortgagor described in the FHA application. The qualifier of 
``unrestricted'' should be added because under state law, donor 
restricted funds may be governed by terms and conditions set by the 
donor.
    Response: HUD does not believe it is necessary to narrow the 
definition of ``personalty,'' because Sec.  242.64 already permits 
exclusions for specific personalty.
    Comment: One commenter suggests a minor clarification to the 
definition of ``preapplication meeting'' to specify that a potential 
applicant in this case is a mortgagor or lender, while elsewhere in the 
rule the term should refer to a mortgagee. The commenter suggests 
clarification of these usages.
    Response: HUD has clarified the definition.
    Comment: The definition of ``preliminary review letter'' should be 
revised, as follows:

    Preliminary Review Letter means a letter from HUD to a potential 
mortgagee communicating the result of the Preliminary Review. The 
letter may: (1) State that an application for mortgage insurance 
would result in a rejection and provide the reasons for this 
determination, (2) state that there are factors that need to be 
further developed before a determination as to acceptability of a 
project for Preliminary Review may be made, or (3) state that no 
factors that would cause an application to be rejected have been 
identified, and therefore there appears to be no bar to the 
applicant proceeding to submit an application for insurance.

    The commenter states that, even though an early determination of 
eligibility is desirable, the definition ``may be unnecessarily 
severe'' as proposed, and that the rule should provide for further 
discussion or the submission of additional materials at an early stage, 
which may present HUD with sufficient evidence to reverse an initial 
rejection. Also, the term ``next step'' is too vague and should be 
specified.
    Response: HUD agrees that ``potential applicant'' in the first 
sentence should be replaced. HUD has replaced that term with ``proposed 
mortgagee or mortgagor.'' This language allows HUD to receive and 
fulfill requests for a preliminary review not only from proposed 
mortgagees, but also from proposed mortgagors (hospitals) that are 
seeking to determine if they are viable candidates for an insured loan, 
before they retain a mortgage lender.
    HUD does not believe it necessary to insert the language the 
commenter proposes as clause (2), because communication often takes 
place between the mortgagee and HUD to clarify matters during the 
preliminary review and because there is already flexibility in Sec.  
242.16 for HUD to reconsider a negative determination.
    HUD agrees that the phrase ``the next step in the application 
process'' is vague and has replaced it in this final rule with ``a 
preapplication meeting.''
    Comment: The definition of ``project'' should be revised as follows 
to include the soft costs of construction (interest, taxes, MIP, etc.), 
as follows:

    Project means the construction (which may include a replacement 
of an existing hospital facility), rehabilitation, modernization, 
expansion, or renovation of an eligible hospital, including 
equipment, which has been proposed for approval or has been approved 
by HUD under the provisions of this subpart, including the financing 
and refinancing of existing indebtedness and other related costs in 
connection therewith, if any, plus all related activities involved 
in completing the improvements to the property.

    Response: In reviewing the definition of ``project,'' HUD realized 
that the word

[[Page 67529]]

was used to mean different things in different places. In several 
instances, the proposed rule used ``project'' when referring to the 
hospital or mortgagor. This usage derives from HUD's multifamily 
housing programs, in which ``project'' is used to refer not only to the 
construction project and the financing thereof, but also to the ongoing 
operations of the residential rental business during the life of the 
loan. For clarity, this final rule makes a distinction between 
``project'' as defined here and ``hospital'' or ``mortgagor.''
    HUD also considered the use of terms such as ``modernization,'' 
``renovation,'' and ``expansion.'' The final rule uses the term 
``substantial rehabilitation'' to encompass all of these activities, 
and a definition of this term has been added in Sec.  242.1.
    Finally, HUD believes that the definition of ``project'' is not the 
appropriate place to introduce the concept that a construction project 
includes soft costs.
    Therefore, the definition of ``project'' has been revised to 
specify the meaning of the word in all contexts in which it is used in 
the rule, and to conform the definition to the final rule's definition 
of ``substantial rehabilitation.''
    Comment: The definition of ``regulatory agreement'' should be 
modified to include lessees of the mortgagor, if applicable, as 
regulated entities under the regulatory agreement. The commenter cites 
the Shoshone Medical Center as an example.
    Response: HUD disagrees. As a general policy, leasing of the entire 
hospital is not contemplated. However, HUD does have the authority to 
approve leasing, on a case-by-case basis, for good cause, as was 
demonstrated in the example offered.
    Comment: One commenter suggests revisions as follows to the 
proposed definition of ``security instrument'' and also questions 
whether the definition is required, given that there is also a proposed 
definition of ``mortgage.''

    Security instrument means a mortgage, deed of trust or any other 
document evidencing security for the indebtedness represented by a 
note endorsed for insurance by HUD and shall be deemed to be the 
mortgage as defined by the National Housing Act, as amended, 
implementing regulations, and HUD directives.

    Response: HUD believes that the definition of ``security 
instrument'' is adequate, and that it is inappropriate to include 
discussion of the note in this definition.
    Comment: A commenter asked whether the rule could provide a 
definition of what constitutes the service area, and stated that some 
hospitals serve patients from all over the country or all over the 
state, although most of their patients come from the nearby surrounding 
community.
    Response: In order to avoid ambiguity, a definition of ``service 
area'' is added to Sec.  242.1 of this final rule.
    Comment: The definition of ``state'' should be revised to change 
``Virgin Islands'' to ``United States Virgin Islands.''
    Response: HUD agrees, and this final rule adopts this change.
    Comment: The definition of ``surplus cash'' is a departure from 
existing practice, particularly when proprietary sponsors are involved, 
in that it would no longer permit distributions of cash earned in prior 
periods that a mortgagor elected not to distribute. To eliminate this 
problem, surplus cash would be better defined in terms of cash 
remaining as opposed to cash earned in a fiscal period. This change 
would be in accordance with HUD Circular 4615.2 and HUD's draft 
applicant's guide. In addition, the commenter suggests changes to give 
HUD more flexibility to set standards. The commenter also proposes 
enlarging the ``days in accounts receivable'' portion of the test 
because, historically, many hospitals are unable to meet the proposed 
test. Accordingly, this commenter suggests the following revised 
language:

    Surplus Cash means any cash in the applicable fiscal period or 
prior fiscal periods, including accounts receivable, remaining after 
the following have been achieved:
    (1) Mortgage payments for the preceding 12 months have been made 
when due, including any grace period;
    (2) There is a Debt Service Coverage Ratio greater than or equal 
to 1.50 or such other ratio as HUD may deem appropriate;
    (3) Days in Accounts Receivable are less than or equal to 100 or 
such other day count as HUD may deem appropriate;
    (4) Days in Accounts Payable are less than or equal to 120 or 
such other day count as HUD may deem appropriate;
    (5) The Mortgage Reserve Fund is compliant with the scheduled 
balance;
    (6) All income, property, and statutory employer payroll taxes 
and employee payroll withholding contributions have been deposited 
as required;
    (7) The Current Ratio is greater than or equal to 1.50 or such 
other ratio as HUD may deem appropriate;
    (8) Days of cash on hand are greater than or equal to 15 days or 
such other day count as HUD may deem appropriate; and
    (9) The payment of:
    (i) All sums due or currently required to be paid under the 
terms of the Mortgage Note and Regulatory Agreement due on the first 
day of the month following the end of the applicable fiscal period, 
including, without limitation, in the Mortgage Reserve Fund or any 
other reserves as may be required by HUD; and
    (ii) All other current obligations of the hospital (accounts 
payable except for a 100 day exception and accrued, unescrowed 
expenses), unless funds for payment are set aside or HUD has 
approved deferment of payment.

    Response: The addition of the qualifiers, ``or as HUD shall deem 
appropriate,'' negates the intended purpose of this rule to make clear 
the minimum financial standards applicable to hospitals with insured 
loans. With respect to ``surplus cash,'' HUD agrees that cash earned in 
prior periods that a mortgagor elected not to distribute would be 
included and that ``surplus cash'' should be defined as earned cash 
remaining as opposed to cash earned in a fiscal period.
    This final rule also adds language to the definition requiring the 
hospital to meet particular minimum equity requirements and restricting 
distributions until those requirements are met. The final rule 
clarifies that the most recent audit required under the regulatory 
agreement, in conjunction with the effect of the distribution on the 
interim financial statements, will provide the basis for limitations on 
distributions. Items 9(i) and 9(ii) of the proposed definition were 
deleted as being duplicative. Accordingly, the final rule revises the 
definition of ``surplus cash.''
    Comment: One commenter stated: ``We feel that 21 and 15 are very 
low standards. We would suggest it be raised to 30 days.''
    Response: HUD assumes that this comment is meant to refer to the 15 
days of cash on hand portion of the definition of ``surplus cash'' in 
the proposed rule. HUD agrees that 15 days cash on hand is a very low 
standard and has increased it to 21 days cash on hand. HUD considered 
the commenter's suggestion to increase the days of cash on hand to 30. 
However, HUD did not believe it necessary to raise the standard that 
high. The increase to 21 days strengthens the prior standard, provides 
sufficient liquidity to make a payroll, and is currently met by 50 
percent of the hospitals in the HUD portfolio.
    Comment: One commenter stated that ``average payment period'' would 
be a better measure to use in this definition.
    Response: HUD assumes that the commenter was referring to the use 
of the term ``days in accounts payable'' in the definition of ``surplus 
cash.'' The measure ``average payment period'' has become the standard 
in the industry because it is more comprehensive and less subject to 
manipulation. HUD

[[Page 67530]]

agrees to the substitution of this measure for ``days in accounts 
payable.''
    Comment: One commenter suggests that the definition of ``working 
capital'' be deleted because it is used only once in the rule (Sec.  
242.24).
    Response: HUD agrees with the comment. This final rule removes the 
definition of ``working capital'' in favor of a phrase that is better 
understood, ``initial operating capital,'' and revises the title of 
Sec.  242.24 to ``Initial Operating Costs.''
4. Section 242.3 Encouragement of Certain Programs
    Comment: One commenter states that everything after the word 
``hospitalization'' should be deleted because the language ``is neither 
an eligibility requirement of the Act.* * *nor, to our knowledge, a 
statement of current FHA policy.'' The commenter is concerned that this 
language may be interpreted as a mandatory underwriting requirement, 
making otherwise eligible projects ineligible.
    Response: The language that the commenter requests be deleted is 
indeed a requirement stated in the statute, 12 U.S.C. 1715z-7(f). This 
section states that:

    The activities and functions provided for in this section shall 
be carried out by the agencies involved so as to encourage programs 
that undertake responsibility to provide comprehensive health care, 
including outpatient and preventive care, as well as 
hospitalization, to a defined population, and, in the case of public 
hospitals, to encourage programs that are undertaken to provide 
essential health care services to all residents of a community 
regardless of ability to pay.

    HUD's underwriting reflected this requirement in the past and will 
continue to do so in the future. HUD included the words ``and certain 
not-for-profit hospitals'' after ``in the case of public'' in 
recognition of the role that many not-for-profit hospitals fulfill in 
providing indigent care in areas where there are no public hospitals or 
in which public hospital capacity is limited. In response to the 
commenter's concern about mandatory underwriting requirements, HUD 
notes that encouragement of the provision of comprehensive health care 
to a population does not mean that a hospital is ineligible because it 
does not plan to provide comprehensive care or does not plan to provide 
services to all residents regardless of ability to pay. It does mean, 
however, that HUD should consider the provision of care and the role 
that a proposed hospital would play across the service area.
5. Sections 242.4 and 242.5 Eligible Hospitals and Eligible Mortgagees
    Comment: Section 242.4 should be revised to conform to the 
definition of ``project'' by adding the phrase ``modernization, 
expansion, or renovation'' before the phrase, ``of an existing 
hospital.''
    Response: The definition of ``project'' has been revised in 
response to other public comments to mean the ``construction or 
substantial rehabilitation'' of an eligible hospital. This change also 
addresses the issue cited by this commenter. In addition, HUD has added 
a paragraph on transition to these regulations.
    Comment: The title to Sec.  242.5 should be revised to read 
``Eligible mortgagees/lenders.''
    Response: HUD agrees, since this title reflects the terminology 
used in the final rule.
6. Section 242.7 Maximum Mortgage Amounts
    Comment: The following phrase should be added after the word 
``installed'' and before the period at the end of the sentence:

* * *and other related project development costs, including but not 
limited to capitalized interest and Commissioner approved fees.

    Response: HUD intended this section to outline broadly the maximum 
mortgage amount as a percentage of replacement cost. The level of 
detail sought by the commenter is outside the scope of this section.
7. Section 242.9 Physician Ownership
    Comment: The last sentence of this section, as proposed, would 
require an ``unqualified legal opinion'' regarding compliance with 
applicable federal law. An unqualified legal opinion is difficult to 
obtain, and ``an opinion satisfactory to HUD'' would be a more 
appropriate standard.
    Response: HUD has been able to obtain unqualified legal opinions on 
all professionally owned hospitals since the decision to accept these 
sponsors into the program was made in January 2003. It would take an 
inordinate amount of time and expertise for staff to perform the due 
diligence reflected in an unqualified opinion. The unqualified opinion 
benefits mortgagors that otherwise would have to obtain an opinion from 
the Inspector General at the Department of Health and Human Services 
(HHS). Therefore, in the best interests of the program, HUD shall 
retain the requirement of an ``unqualified legal opinion.''
8. Section 242.10 Eligible Mortgagors
    Comment: Lessees of mortgagors should also be included for the same 
reason as in the definition of ``regulatory agreement.'' The commenter 
also states that the section should be revised to read in its entirety:

    The mortgagor shall be a public mortgagor (e.g., an owner of a 
public facility), a private nonprofit corporation or association, or 
a profit-motivated mortgagor meeting the definition of ``hospital'' 
in Sec.  242.1. The mortgagor or a lessee of the mortgagor shall be 
approved by HUD and shall possess the powers necessary and 
incidental to operating a hospital. Eligible proprietary or profit-
motivated mortgagors may include for-profit corporations, limited 
partnerships, and limited liability corporations and companies.

    The commenter states that ``natural persons, joint ventures and 
general partnerships'' are eligible mortgagors in other FHA insurance 
programs and is unaware of any program or legal basis for excluding 
such ownership forms from Section 242 eligibility if underwriting 
criteria are otherwise met. The sentence beginning ``for new 
organizations'' should be deleted and ``treated as a program, not a 
regulatory requirement.'' Finally, it would also seem inappropriate 
that stockholders of a privately held corporation should be required to 
admit other parties to its board of directors (although it may be 
considered for advisory board purposes), or to otherwise require that 
private corporations be treated as public entities. The term ``broad 
community participation'' is undefined, may be difficult to precisely 
define, and should be treated in a ``more flexible, case by case non-
regulatory fashion.''
    Response: Generally, this section states the statutory requirements 
for an eligible hospital mortgagor. Regarding the statement that 
lessees of mortgagors should also be included, the National Housing Act 
makes it clear that HUD can insure mortgages where long-term ground 
leases are involved. However, HUD generally prohibits leases of the 
entire hospital. In those rare instances where a lease is necessitated 
by local law, HUD will continue to evaluate each situation on a case-
by-case basis.
    The comments also suggest striking the latter portion of the 
section. This wording was carefully developed and HUD believes that 
there is considerable wisdom in not permitting mortgagor entities with 
other obligations that could interfere with the operation and stability 
of the hospital. The same is true of ensuring the continuity of the 
mortgagor entity so that a legal entity is in place for as long as HUD 
insures a mortgage loan. Finally, HUD does not agree that the language 
in this section

[[Page 67531]]

requires that private corporations be treated as public entities.
9. Section 242.11 Regulatory Compliance Required
    Comment: One commenter suggests minor editorial changes, as 
follows:

    An application for insurance of a mortgage under this part shall 
be considered only in connection with a hospital that is in 
substantial compliance with regulations of the Department of Health 
and Human Services and the applicable State governing the operation 
and reimbursement of hospitals. A hospital that is under 
investigation by any State or Federal agency for statutory or 
regulatory violations is not eligible so long as the investigation 
is unresolved, unless HUD determines that the investigation is minor 
in nature, that is, the investigation is unlikely to result in 
substantial liabilities or of otherwise substantially harming the 
creditworthiness of the hospital.

    Response: HUD adopts these minor clarifying changes to the final 
rule. Noncompliance with HHS and state regulations can result in 
significant liabilities and can increase the risk of suspension or 
cutoff of reimbursements from federal or state payors, significantly 
increasing the risk that the hospital will default on the FHA-insured 
mortgage loan.
10. Section 242.13 Parents and Affiliates
    Comment: One commenter suggests editorial revisions, as follows:

    As a condition of issuing a commitment, HUD may require 
corporate parents, affiliates, or principals of the proposed 
mortgagor to provide assurances, guarantees, or collateral with 
respect to the mortgage loan. HUD may also require financial and 
operational information on the parent, other businesses owned by the 
parent, or affiliates of the proposed mortgagor and may also require 
a parent or affiliate to agree that it will not take any actions 
which could impact the financial viability of the hospital and its 
ability to repay the mortgage loan.

    Response: HUD agrees that more language is needed to clarify the 
first sentence ending in ``collateral.'' However, the suggested 
language is too narrow. In the final rule, the sentence is revised to 
read, ``As a condition of issuing a commitment, HUD may require 
corporate parents, affiliates, or principals of the proposed mortgagor 
to provide assurances, guarantees, or collateral to protect HUD's 
interests.'' HUD interprets the second suggested revision also as 
narrowing HUD's ability to protect its interests. Thus, the existing 
language in the second sentence will be kept.
11. Section 242.14 Mortgage Reserve Fund
    Comment: One commenter suggests editorial revisions, as follows:

    As a condition of issuing a commitment, HUD may require 
establishment of a Mortgage Reserve Fund (MRF), a trustee-held 
account to which the mortgagor will contribute and from which 
withdrawals must be approved by HUD. The mortgagor shall be required 
to make contributions to the MRF such that, with fund earnings, the 
MRF will build to one year of debt service at five years following 
commencement of amortization, increasing thereafter to two years of 
debt service on and after ten years following commencement of 
amortization according to a schedule established by HUD, unless HUD 
determines that a different schedule of contributions is appropriate 
based on the mortgagor's risk profile, reimbursement structure, or 
other characteristics. In particular, hospitals that receive cost-
based reimbursement may be required to have MRFs that build to more 
than two years of debt service. Expenditures from the fund may be 
made for such purposes, including the payment of debt service as HUD 
may determine or in accordance with the mortgagor's MRF Schedule. 
Upon termination of insurance, the balance of the MRF shall be 
returned to the mortgagor provided that all obligations to HUD have 
been met.

    Response: The benefit of the MRF has been tested over time, and its 
availability has afforded hospitals in financial distress the time and 
relief needed to effectuate a turnaround. For that reason, HUD 
disagrees with the suggested substitution of the word ``shall'' with 
``may.'' The availability of an MRF has served HUD, the mortgagee, and 
the mortgagor well, and this final rule continues to require it.
    With respect to expenditures from the fund, HUD believes that the 
original language is clear on its face and that the additional wording 
is likely to result in confusion and misinterpretation as to the 
primary intent of the MRF, which is for the payment of debt service.
    HUD concurs that the inclusion of ``following commencement of 
amortization'' clarifies the MRF funding requirement and has made the 
appropriate change.
    Also, the final rule removes the text in the first sentence 
following the second comma, because the revised definition of 
``mortgage reserve fund'' makes this language redundant.
12. Section 242.15 Limitation on Refinancing of Existing Indebtedness
    Comment: One commenter states that the restriction to long-term 
debt should be removed and that 15 percent rather than 20 percent of 
the mortgage must be used for hard costs. As to the former suggestion, 
the change is necessary to permit loans to fund projects completed 
prior to initial endorsement and financed on the basis of short-term 
rather than long-term loans. As to the latter, the 20 percent 
requirement is not a statutory requirement, and the lower standard will 
allow ``otherwise necessary'' projects to be able to utilize the 
program. The revised language would read as follows:

    Some existing debt may be refinanced with the proceeds of a 
section 242 insured loan; however, at least 15 percent of the amount 
of the mortgage must be used to fund the hard costs of construction, 
equipment and mortgageable costs and expenses related thereto, 
including but not limited to interest, taxes and other Commissioner 
approved fees typically included in a commitment.

    Response: By deleting but not replacing ``long-term,'' the proposed 
revision would permit any existing debt to be refinanced, such as 
operating debt. This would be contrary to the intended purpose of the 
program to insure the financing of capital projects. However, HUD 
understands that there may be cases where it would be appropriate to 
refinance some short-term capital debt. Therefore, HUD has substituted 
the word ``capital'' for ``long-term.'' Reducing the 20 percent 
requirement to 15 percent would blur the distinction between Section 
242 and Section 223(f), which HUD is not implementing for hospitals 
through this rule, and HUD does not agree to this revision.
Subpart B--Application Procedures and Commitments
1. Section 242.16 Applications
    Comment: One commenter asks whether HUD determines the need or the 
state CON (Certificate of Need) process does, and states that the rule 
should clarify this issue.
    Response: HUD conducts the same analysis of need whether or not the 
state has a CON process. There is wide variation in the methods CON 
states use to decide whether or not to issue a certificate. HUD 
believes that the Act's required need assessment is best performed 
using a method that is applied consistently to hospitals in all states. 
Should the state's CON process and HUD's assessment of need reach 
differing conclusions on the need for a proposed project, HUD will 
review the case closely to determine if its conclusion should be 
changed.
    Comment: One commenter suggests a variety of substantive and 
editorial changes to this section. The commenter would revise Sec.  
242.16(a)(1), as follows:

    (a) The process for approval of an application shall include 
consideration of the following financial and programmatic factors.

[[Page 67532]]

    (1) Market need. The approval process shall include an analysis 
of the market need of the proposed project, on a market-wide basis, 
the impact of the proposed facility on, and its relationship to, 
other health care facilities and services; the number and percentage 
of any excess beds; and demographic projections.
    Generally, except in cases acceptable to HUD, Section 242 
insurance may support start-up hospitals or major expansions of 
existing hospitals only if existing hospital capacity or services 
are not adequate to meet the needs of the population in the service 
area.
    (i) If the State has an official procedure for analyzing need 
for hospitals, HUD shall require that such procedure be followed 
before the application for insurance is submitted, and that the 
application shall document that need has also been established under 
that procedure; provided that in circumstances acceptable to HUD, an 
application may be submitted and review commenced prior to the 
issuance of such State approval.

    Response: The commenter suggests deletion of the requirement that 
HUD consider the impact of the proposed facility on other health care 
facilities that ``have a disproportionate share of Medicaid and 
uninsured patients,'' because it is not a program requirement.
    However, the statute, 12 U.S.C. 1715z-7, requires HUD to administer 
the program ``so as to encourage programs that undertake responsibility 
to provide comprehensive health care including outpatient and 
preventive care, as well as hospitalization, to a defined population. * 
* * Disproportionate share hospitals are a critical element in 
providing such care, acting as a ``safety net'' for care of the 
uninsured. These hospitals typically use profitable product lines to 
subsidize unprofitable activities in a practice known as ``cost 
shifting.'' A new project that takes profitable business away from a 
disproportionate share hospital can have the effect of reducing its 
ability to provide comprehensive health care to the local population. 
For this reason, HUD believes that it should pay particular attention 
to the impact of a proposed project on disproportionate share 
hospitals. Also, see HUD's response to comments on Sec.  242.3.
    The commenter also stated that ``in circumstances acceptable to 
HUD'' the rule should allow for an application to be submitted prior to 
issuance of official state approval. The commenter stated that as the 
program gets broader national application, there will be instances 
where it is ``prudent and equitable'' to begin the review of an 
application before a certificate of need is issued, ``particularly when 
it is reasonably inferred that a certificate of need will eventually be 
issued and the mortgagor is willing to pay the required application fee 
to reimburse FHA's costs.'' The commenter stated that this concern is 
``particularly important in the context of the extensive construction 
periods associated with hospital projects, as well as the impact of 
escalating costs on project feasibility.''
    However, HUD interprets the statute, 12 U.S.C. 1715z-7, to require 
that the certificate of need will be submitted as part of the 
application.
    Comment: One commenter stated that Sec.  242.16(a)(2) should be 
revised, as indicated:

    Operating margin and debt service coverage ratio. (i) Hospitals 
with an aggregate operating margin of less than 0.00 when calculated 
from the three most recent annual audited financial statements are 
not eligible for section 242 insurance, unless HUD determines, based 
on the financial data in those statements or other financial 
criteria or empirical information acceptable to HUD, that the 
hospital has achieved a financial turnaround resulting in a positive 
operating margin in the most recent year, calculated using 
classifications of items as operating or non-operating in accordance 
with guidance that shall be provided in accordance with generally 
accepted accounting principles or HUD is satisfied based on other 
available financial information or evidence acceptable to HUD that 
the project constitutes a reasonable underwriting risk.

    The commenter stated that this change would permit flexibility, for 
example, in cases such as Critical Access Hospital applications where 
prior financial statements were allowed to be retroactively restated to 
reflect unusual circumstances such as prospective cost plus 
reimbursement. The commenter stated that negative historical operating 
margins may not always be relevant to a determination of a facility's 
prospective viability. For example, a hospital may have had an 
historical negative operating margin substantially, if not solely, as a 
result of excessive debt service, which may be fully eliminated through 
the proposed FHA financing. Similarly, a proposed mortgagor may be 
trying to reposition a struggling hospital and new or rehabilitated 
facilities, and equipment may enable that facility to compete more 
effectively, deliver services more efficiently, provide a higher 
quality of services, or offer new services without which a needed 
facility might never be able to improve its financial posture. The 
commenter states that negative historical margins should not result in 
automatic disqualification.
    Response: HUD believes that in almost all cases, the proven ability 
to operate in the black is an essential prerequisite for consideration 
for mortgage insurance. Hospitals transitioning from the prospective 
payment system to cost-based reimbursement may recast financial results 
to present them as if they had been receiving cost-based reimbursement 
in prior years. In unusual circumstances, the applicant can request a 
waiver of the regulatory requirement for a positive operating margin.
    Comment: The commenter states that there is no requirement that a 
start-up hospital (without an operating histor