Higher Bond Interest Cost for Harvard Due to Derivative Exposure

Harvard University, buffered by its huge endowment, has long enjoyed AAA credit. But now, as a result of some past interest rate swaps positions that went against them, Harvard is now finding itself paying a higher interest rate on recently floated bonds (see Bloomberg article). In fact, Harvard's main rival, Princeton University, was able to obtain better terms recently, as much as 50 bps or more on some debt going out 10 to 30 years. As a result, if Harvard's recent December sale of $1.5 billion in debt had yielded rates similar to what Princeton would have received, the savings for Harvard would have been on the order of $150 million.

It appears that the problem stemmed from the purchase of interest-rate swaps that were being used to protect the school against rates increasing in the future. Unfortunately for Harvard, rates fell, causing Harvard to look for more cash in the bond markets just as credit dried up. At one point the value of the swaps had fallen enough that they were worth a negative $570 million to the endowment.

To add insult to injury, the losses required Harvard to post additional collateral, just as the market was falling and its portfolio was losing additional value. The $1.5 billion sale of debt was believed to have been done in part to allow Harvard to get out of the interest rate swap position. Unfortunately, the sale had to be made right at the time when the credit markets were freezing up, resulting in the higher cost for floating the debt. As they say, when markets are crashing, correlations have a tendency to go to one. This is surely something they will no doubt be teaching at Harvard. Liquidity risk is probably another.

Comments

[donzelion:]

A better explanation (other than the implied cause and effect in the story) is that Harvard issued bonds in December, and Princeton issued them in January, and during those two different months, available terms changed. Yes, Harvard may have made some bad bets, and perhaps Princeton didn't make the same bad bets. Perhaps they did. But there's just no evidence that the one bad bet caused the other outcome.

Bear in mind, Bloomberg has a history of implying causality when there's not any real proof. That's how the Bloomberg herd were able to run the markets up to unprecedented levels in 2007 - and to run it down in 2009. However, bear in mind that your average televangelist has just as much reliable basis for his predictions about the future.

Mar 04 06:04 AM