Moody's has downgraded its rating on Fairview Health Services' debt, forecasting weaker margins for the nonprofit amid higher labor costs and already reduced patient volumes at many of the health system's hospitals and clinics.

The change does not take into account Minneapolis-based Fairview's proposed merger with South Dakota-based Sanford Health, or a proposal by the University of Minnesota to reacquire its teaching hospital from Fairview, the rating agency said.

The trouble with labor expense and volume trends compound existing challenges with inflation and the regular transfer in funding from Fairview to the U, according to the Jan. 18 report from Moody's Investors Service.

Moody's evaluates the creditworthiness of borrowers, issuing reports that are used by potential lenders and investors.

"The downgrade ... reflects Moody's expectation that weak operating performance, which began prior to the pandemic but worsened in 2022, will be difficult to reverse," the report states.

In a statement, Fairview said the report "reflects the ongoing challenges we face and the urgency with which we must address them."

"Joining forces with Sanford is a proactive, bold change that will drive innovative solutions and ensure we can continue to provide care to Minnesotans well into the future," the health system said. "Together, we can strengthen our financial footing and improve the experience for both patients and providers in a way that neither Fairview nor Sanford can do alone."

When the merger was first announced, Fairview chief executive James Hereford pushed back in an interview against the idea that the combination was required to solve its financial problems. Through the first nine months of the year, Fairview reported an operating loss of $248.5 million.

"We feel confident that there's a path for us, as we stand today," Hereford said in November. "This [merger] is not about that."

Last month, Moody's also issued a downgrade at Minneapolis-based Allina Health Services, although the Allina rating is three notches higher than Fairview's. Whereas the rating agency put Allina's outlook at stable, Moody's put the outlook at Fairview as negative.

Fairview's status as an academic health system through its connection with the U continues to be a "distinguishing factor" in a competitive Twin Cities health care market, Moody's said in a separate credit opinion report issued Thursday. A merger with Sanford and/or the U acquiring its teaching hospital "would result in meaningful changes to Fairview's overall profile," the rating agency said.

"The recently announced Sanford transaction and ongoing university negotiations will likely require management attention at a time when Fairview faces a difficult operating environment," Moody's said. Referring to Hereford, the agency added: "This risk is partly offset by the presence of a CEO with prior [academic medical center] experience."

The downgrade recognizes a serious deterioration in Fairview performance that seems to date to 2018-19, said Nancy Kane, a hospital finance expert at the Harvard T.H. Chan School of Public Health.

Fairview has seen a marked reduction in its operating cash flow margin, Kane said in an email. The situation that might not be helped by Fairview selling the teaching hospital, she said, but could instead require renegotiating the complex agreement by which Fairview provides regular funding to the U.

The contract for affiliation currently runs through the end of 2026. Last year, Fairview provided more than $83 million to support medical education, research and patient care at the university.

U officials have said they don't understand why Fairview is losing money given the volume of patients that university physicians are treating within the health system. They also contend the level of annual financial support from Fairview — which increased significantly starting in 2018-19 — is now middle-of-the-pack compared with other academic medical centers.

"When you look at this, this is minuscule to the ... $6.2 billion [in revenue] enterprise that Fairview is," Dr. Jakub Tolar, dean of the U medical school, said during a Jan. 12 news conference. "The revenue that our clinicians bring to the system is logarithmically higher than the academic support."

Moody's said higher labor costs, service constraints and trouble transferring patients to sub-acute settings are exacerbating an already challenging operating environment at Fairview.

Several Fairview hospitals were among those that agreed in December to new contracts with the Minnesota Nurses Association, delivering 17% to 18% pay increases over three years.

"Recent union activity including a three-day strike will add to this burden," Moody's wrote. "Fiscal 2022 inpatient admission trends for Fairview remain well below pre-COVID levels [down about 18%] although management expects some growth in fiscal 2023."

The Moody's action lowered from A3 to Baa1 the rating on about $1.6 billion worth of Fairview debt. The outlook is negative, the ratings agency said.

Moody's last lowered its rating on Fairview's debt in February 2020, citing requirements for increased funding from Fairview to the U as well as losses at the old HealthEast operations. Fairview and HealthEast, which operated primarily in the east metro, announced a merger in 2017.