Annals of Rank Hubris, Larry Summers Edition

This is why I love the blogs. The Epicurean Dealmaker has picked up on a detail buried in the 17th paragraph of a dry Bloomberg story from March about the relative funding costs of Harvard and Princeton — a story which, in light of TED’s comments, surely counts as having massively buried its lede.

The subject is those notorious interest rate swaps, put on by Larry Summers, on which Harvard lost a whopping $1 billion. And here’s the key graf:

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.

It turns out that Summers wasn’t protecting Harvard from having to pay more on its floating-rate debt were interest rates to rise. Instead, he was swapping hypothetical future floating-rate bonds into fixed-rate obligations. Says TED:

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 up to 20 years in the future sounds like either rank hubris or free money for Wall Street swap desks.

Of course, it’s not uncommon to see the term “rank hubris” applied in the general vicinity of Larry Summers. But let’s be clear, here: what Summers did could in no way be considered a hedge, under any common definition of the term. He was indulging in interest-rate speculation, just like Robert Citron. I think it’s fair to say that no previous Harvard president would ever have considered himself qualified to do such a thing, but Summers never let such considerations stop him. And his alma mater is now paying the 10-digit price.

Comments

[derryl]

So a billion dollar gift to Wall St is the price of ensuring one's return to relevance in Washington?

2009 Jul 23 01:06 AM

[nobby73]

I think you've got this wrong. What they were doing was entering into a forward starting swap as a hedge for fixed rate issuance. They pay fixed receive floating under the swap and when they issue the fixed rate bond, if rates are higher, there is a gain in the swap to offset the increased interest costs, if rates lower, they have a lower coupon in the bond but a loss under the swap.

It's not that uncommon, but if this was for issuances so far out in the future, it seems a bit too clever as there are plenty of second order factors that make an impact in the longer term.

2009 Jul 23 02:06 AM

[Ferdinand E. Banks]

This article doesn't present enough information for an unbiased reader to label Summers a dummy. And I really wonder if the captain of the good ship Harvard had to OK every transaction entered into by deckhands and messboys.

2009 Jul 23 09:07 AM

[Greame H]

of course looking forward, Summers is now close to being in a position to make his bet work out ( reflating our way out of the debt black-hole) ...clever,clairvoyant, or just plain evil ?

2009 Jul 23 11:51 AM

[Alan Young]

The interest rate swap may have too many moving parts to figure out from this distance, but the campus expansion itself is a real eye-opener. The floor space of the proposed expansion would be more than the entire Pentagon.
That's right--Harvard wanted to ADD the equivalent of the entire US Defense Dept. to its campus. Now, THAT is Hubris.

[ Off-topic to Felix: "lede"? "graf"? Have you suddenly outsourced your editing to Twitter ? ]

2009 Jul 23 12:32 PM

[morph366]

Hard to disagree that Summers suffers from distasteful hubris but in the big scheme of things losing a billion ranks as small change compared to the miscalculations of operators like Joe Cassano and Dick Fuld.

2009 Jul 24 07:48 AM

[Graham and Dodd Investor]

Larry Summers had the hubris to "know" EXACTLY what his capital spending needs would be over EACH of the next 20 years, including after he was gone.

2009 Jul 24 08:47 AM

[Rollerball]

They'll get it back when Summers becomes the next Volcker winter.

2009 Jul 24 08:57 AM

[Robert H. Heath]

The Epicurean Dealmaker makes an important observation that misses the mark.

"... 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."

Note the modifier "corporate" here. While Harvard University is managed by an organization called "Harvard Corporation" the university should not be confused with a "corporate client."

Harvard has been pursuing the same educational mission since 1636 and probably will be for the next 373 years. Corporations rarely last 100 years, and when they do, it's usually in greatly modified form.

It certainly seems reasonable that with a multi-decade planning horizon and assumptions about the endowment level, future alumni contributions, investment returns and operating expenses, Harvard would have wished to lock down future funding costs well into the future. That would be fairly described as a "hedge" and not "rank speculation."

In the current interest rate environment, the swap position has gone south. But if the intent was to lock in funding costs for a few decades, that's not a terribly important criticism. It's a bit like saying your 401(k) investment in the S&P 500 last year was "rank speculation" because you could've waited and bought it cheaper today.

Harvard's bigger problem would seem to be the other side of the hedge, namely its spending (hence borrowing) plans. With the dramatic reduction in its endowment and probably lowered expectations of both investment income and alumni donations, it may not be able to spend (and borrow) as much as it planned when it entered into the interest-rate swap position. So the (mark-to-market) loss on the swap may not be offset by the funding cost certainty of the future borrowing.

Incidentally, a fair number of astute commentators are worried about the impact our massive deficits may have on future inflation. Homeowners who "hedged out" interest rate risk by locking in fixed-rate mortgages in the late 1960's at sub-5% interest looked pretty smart for the next 30 years. If current deficits lead to sustained inflation, a 20-year interest rate lock from 2006, may look shrewd in a few short years.

True, Harvard got itself into a liquidity bind, forcing it to resort to short-term financing moves in an adverse market in late 2008. And that raises many more interesting questions that I've covered here:

roberthheath.blogspot....

Did Harvard extrapolate bull-market returns too far into the future? Probably. Did Harvard rely on its endowment income to fund too much of its annual operating budget? Absolutely. Did portfolio diversification fail in a global financial crisis as correleations between asset classes increased? Yes indeed. But in this, Harvard looks like any other asset manager (and a great number of US homeowners).

There is a more interesting story here that Nina Munk alludes to in her Vanity fair article. Namely, did Harvard fail (perhaps through inattention) to unwind the swap position in mid- or late-2008 as market conditions deteriorated and long-term borrowing plans might reasonably have been curtailed? As this time period corresponds to management change at the Harvard Management Company, this is an interesting question that Munk asks, but goes unanswered.

But since Larry Summers stepped down as Harvard president in 2006, it's hard to imagine that a fumbled hand-off in 2008 can be blamed on him personally.

2009 Jul 24 12:33 PM

[whidbey]

Admit it, you don't like Larry. True he does not help one to like him, but since when is arrogance a disqualification for greatness? His remarks always assume that those present agree with his world view, and he dislikes having help the lame out of the boat, so he is often a little condescending or something very like it when speaking to the slow ones in the room. In his case it is best to get his world view before ever undertaking to talk with him or criticism his work.

Those who have taught on the same faculty can tell you he does not breath the same air as ordinary humans. You know, you may be right about him.

2009 Jul 28 02:18 PM