Tuesday, July 21, 2009


In the days when Harvard’s endowment provided only a fraction of the university’s operating budget, a loss would have been unfortunate, but not tragic. In recent years, however, Harvard’s soaring endowment has become the engine fueling the university’s growth. In 2008 alone, so-called distributions from the endowment were $1.2 billion, representing more than a third of Harvard’s total operating income, up from only 16 percent two decades ago.

During the boom years, it was assumed without question that the value of Harvard’s endowment would keep rising. Trusting in that false certainty, the already profligate university went wild, increasing its annual operating budget by 67 percent, from an inflation-adjusted $2.1 billion in 1998 to $3.5 billion in 2008—this, even as the number of students remained constant. While I was reading through Harvard’s financial reports from the past decade, the word “delusional” sprang to mind. So did “unsustainable.” It was like feeding an addiction, having access to so much quick and easy money.

— Nina Munk, “Rich Harvard, Poor Harvard,” Vanity Fair

Reading Nina Munk’s generally excellent and entertaining piece in Vanity Fair on the fallout at Harvard University from the spectacular implosion of its endowment, I was struck by a particularly confusing passage.

In it, Ms Munk explained that Harvard’s apparently panicked sale of $2.5 billion of bonds in December of last year—possibly the worst time in the last few decades to try to sell new debt in the marketplace—was necessitated because “it needed immediate cash to cover, among other things, what [her] sources say was approximately a $1 billion unrealized loss from interest rate swaps.” Swaps, Ms Munk explained, which “were put in place under Harvard’s then president, Lawrence ‘Larry’ Summers, in the early 2000s, ... to protect, or hedge, the university against rising interest rates on all the money it had borrowed.”

But this makes no sense. As of June 30, 2008, Harvard had no more than $1.6 billion identified as variable rate debt on its books, and no more than $4.1 billion in total. If Harvard’s swaps were designed to pay fixed and receive floating—which is the simplest and most common way to hedge existing variable rate bonds against increasing interest rates—those must have been some enormous fixed rate payments to trigger a $1 billion loss on the swaps.

In fact, it turns out that Harvard had to raise new funds last December for two primary reasons. First, it faced around $1 billion in margin calls on the depreciated value of the investment positions in its endowment portfolio, positions it either did not want to or could not sell into the falling market. Second, it faced mark-to-market losses on swaps covering not only the $1.6 billion in floating rate debt already on its books but also an additional $2 billion of debt it planned to issue in the future. Bloomberg explains:

Harvard had 19 swap contracts with New York-based Goldman Sachs; JPMorgan Chase & Co.; Morgan Stanley; Charlotte, North Carolina-based Bank of America Corp. and other large banks, according to a bond-ratings report by Standard & Poor’s.

The agreements required Harvard to pay banks fixed interest rates on a total underlying amount of $3.52 billion in exchange for receiving floating-rate payments. Some of the swaps were used with existing floating-rate bonds, essentially converting the school’s cost to fixed rates.

Most of the swaps, signed when Summers, 54, was Harvard’s president from 2001 to 2006, were intended to lock in rates for debt that Harvard expected to issue as far off as 2022, for a 340-acre campus expansion, according to Moody’s Investors Service. In 2006 and 2007, Moody’s warned of risks from those so-called forward swaps, though it said the school’s finances and management experience mitigated them. Summers declined to comment on the record about the matter.

The value of the swaps dropped as the fixed rates charged by banks in exchange for floating rates on new contracts fell below what the university was paying. By Oct. 31, its swaps were worth a negative $570 million, meaning that’s how much Harvard needed to pay to get out of them, S&P said. The losses widened from $330.4 million on June 30 and $13.3 million a year earlier, according to Harvard’s annual report.

Given the continuing plunge in swap prices from the end of October to December 2008, it is not hard to believe that Harvard’s cost to exit its interest rate agreements ultimately approached $1 billion.

Now forward swaps, or forward start swaps—which behave like normal swaps except the offsetting fixed and floating rate payments are scheduled to start at a date certain in the future—by themselves count as little more than rank interest rate speculation, specifically in this instance as a bet that short-term interest rates will rise in the future. They can make a great deal of sense when an issuer intends to sell bonds in the relatively near future and when the issuer wants to hedge against budgetary uncertainty by converting floating rate obligations into fixed rate debt. That being said, I have rarely encountered a corporate client who feels confident enough about both their absolute funding needs and current and impending market conditions to enter into a forward swap starting more than nine months into the future. Entering into a forward start swap for debt you do not intend to issue for up to 20 years in the future sounds like either rank hubris or free money for Wall Street swap desks.

Of course, the entire article recites a litany of stupidity, arrogance, hubris, greed, and backstabbing bureaucratic infighting which makes the average investment bank look like a Montessori preschool.

It’s reassuring to see that Wall Street doesn’t have the market for organizational dysfunction cornered, after all.

© 2009 The Epicurean Dealmaker. All rights reserved.