Monday, December 21, 2009

Has Harvard University Lost Its Nerve?

Did Harvard University panic during the financial crisis in the Fall of 2008? A recent article on implies as much. The story has to do with interest rate swaps Harvard took out in 2004 during the tenure of Harvard President Larry Summers and endowment head Jack Meyers to help finance its planned expansion across the Charles River into Allston. When benchmark interest rates fell to near zero during the financial crisis, Harvard was suddenly on the hook to its investment bankers for $1 billion.

The article seems to suggest some irony in Harvard President Drew Faust, endowment head Jane Mendillo, and lawyer Anne Olgiby losing their nerve and closing out the interest rate swaps at the worst possible time in December 2008, given Harvard President Larry Summers getting pushed out of Harvard after questioning women’s innate aptitude for math and science.

Larry Summers is now the chief economic advisor to U.S. President Barack Obama, and isn’t making any public comment.

I think the part of this story that the article misses is that these swaps were part of the financing for the Allston expansion. As long as Harvard was going to proceed with the expansion, the losses on the swaps meant Harvard would effectively have to pay a higher but still reasonable interest rate at the 2004 levels. However, with the decision to indefinitely postpone the Allston expansion, these swaps became naked bets on interest rates. So it probably did make sense to close them out, whether they could have gotten a better deal by waiting is easier to see in hindsight than it would have been a year ago.

More generally, many in the Harvard community have wanted the Harvard endowment to move away from the high risk, high reward strategies that characterized the Jack Meyer era. That means unwinding some of the things that were done in that era and living with potentially lower investment returns in the endowment going forward. I think the debate over endowment investment is still going on inside the Harvard community. As of June 30, 2009, the Harvard endowment was at $26 billion. That was down from $36.9 billion in June 2008 but still up from $22.6 billion in June 2004.

Harvard was betting interest rates would go up, and didn’t foresee they could instead go down to near zero. And that exposes a fundamental problem with derivatives. It’s not just that you are making what amounts to a complicated bet, you have to find a big investment bank to take the other side of the bet. Actually, these derivatives are sold, the investment bank finds you.

The old adage applies, if a man walks into a bar and wants to bet you that his pet dog will jump on the bar and sing the Star Spangled Banner while tap dancing, no matter how improbable that sounds to you, you can be sure the dog will do just that. In this case, the collapse of interest rates in the financial crisis was caused in no small measure by other derivative bets these big investment banks were making.

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