If you haven’t read the story on the Harvard interest rate swaps here is the link to Nina Munk’s story in Vanity Fair. The developing pissing match in the blogosphere centers on an interest rate swap that cost Harvard big money to unwind. There seems to be a movement afoot to lay this at the feet of Larry Summers who was then the President of Harvard.
You may want to read the entire article but here is the relevant passage regarding the swaps:
Was Harvard desperate then? Is Harvard desperate now? One clue is this: last December, the university sold $2.5 billion worth of bonds, increasing its total debt to just over $6 billion. Servicing that debt alone will cost Harvard an average of $517 million a year through 2038, according to Standard & Poor’s.
To be clear, even if you’d tried hard, you could not have picked a worse time to sell bonds than December 2008; that was the precise moment when credit markets seized up. But Harvard, it seems, had no choice. Unwilling to sell its assets at fire-sale prices, it needed immediate cash to cover, among other things, what my sources say was approximately a $1 billion unrealized loss from interest-rate swaps. That’s a staggering figure: $1 billion, roughly a third of the university’s entire operating budget for last year.
Those swaps, put in place under Harvard’s then president, Lawrence “Larry” Summers, in the early 2000s, were intended to protect, or hedge, the university against rising interest rates on all the money it had borrowed. The idea was simple: if interest rates went up, the swaps would bring in enough money to cover Harvard’s higher debt payments.
Instead, interest rates went down. And for reasons no one can explain to me, even as interest rates were plunging in 2007 and 2008, the university simply forgot, or neglected, or chose not to cancel its swaps—with the result that Harvard wound up facing that $1 billion loss! Whose responsibility was that? Where were Harvard’s chief financial officer and treasurer while all this was going on?
Note the use of modifiers and qualifiers in this passage. The author doesn’t cite any hard evidence for the information she provides preferring to rely on “my sources.” She doesn’t say that Larry Summers was responsible for the transaction only that it occurred on his watch. Moreover, she seems confused about interest rate swaps. She talks about the swaps bringing in money to cover Harvard’s borrowing costs when they apparently were simple swaps of fixed for floating rates intended to lock in a rate.
So far, we have a writer doing what a lot do in these sorts of pieces — flinging around random bits of information in a less than diligent attempt to prove correlation and causation. Enter at this point the Epicurean Dealmaker blog (one of the best around by the way). He (she?) points out using a Bloomberg article that the swaps were actually put on as a hedge for future borrowings. Really future borrowings, like ten years in the future.
The Epicurean Dealmaker points out that you don’t normally hedge that far ahead, crystal balls getting fuzzy and all that far in the future. He also makes a credible case for why Harvard would have to eat a big loss to get out of the contracts. He, reasonably, refrains from nailing Summers to the cross.
Next we get Greg Mankiw this morning with this post.
I don’t know enough about Harvard’s finances to judge whether the bet was sensible ex ante. But it sure isn’t working out well ex post.)Update: Someone more knowledgeable than I am about the financial situation at Harvard emails me the following response to the Felix Salmon piece I linked to above:
1) The instrument in question was highly liquid and could be sold fully within a few days; essentially all money was lost in 2008 two years after Larry Summers left.
2) Harvard has a system where the treasurer makes these decisions with approval of the corporation and involvement of a debt management committee on which president does not serve.
3) Given the plan to borrow large amounts of debt in the future, doing something to lock in low rates made sense. Iif Harvard was borrowing big, there would be offsetting saving now. The big error was the failure to adjust hedge when Allston was scaled back and to take account of the risks associated with the change in the university’s credit rating.
Thanks to the reader who sent along this feedback.
Felix Salmon then weighs in with a post that dismisses Mankiw and adds this rather incredible bit of mind reading:
Summers was well aware of the risk of an economic crisis. Indeed, in 2004, at about the time that the swaps were put on, he gave a major address at the IMF/World Bank annual meetings about the systemic risks posed by the US current-account deficit, and warning of “a slowdown in growth that would be unacceptable in the United States and would have very severe consequences for growth globally”. But maybe because he had gone through so many other current-account crises abroad during his tenure at Treasury, he was pretty clear that he thought the big risk was that interest rates would go up, rather than go down. In response to one question from a central banker, he said:
I certainly would not want to suggest how you or any other central banker should manage your reserves, but I would point out that when you buy U.S. treasury bills, what you get is 1.75 percent, and it doesn’t really matter whether the U.S. economy grows rapidly or grows slowly. And that is, as I said, a negative interest rate in real dollar terms, and I think that’s the number that one should focus on.
Summers couldn’t have been much clearer that he was pretty convinced that interest rates in the US were going to have to rise: it seems quaint now, but back then 1.75% really did seem like an incredibly low interest rate on T-bills.
Given his analysis, and his ego, it’s pretty obvious how Summers decided to use the future Allston expansion as an excuse to engage in a massive interest-rate gamble outside the purview of the Harvard Management Company, which is the arm of Harvard with a real mandate to play the financial markets. The real reasons for the rate swaps can be found in that 2004 lecture, not in vague ideas that Harvard was sure to issue floating-rate debt at some point in the 2020s. And given those real reasons, it’s easy to see why there was no clear mandate to unwind the swaps when Allston was scaled back.
Basically, Summers took a massive gamble with Harvard’s money, and lost — big. The buck stops with him, and I look forward to Summers admitting as much sooner rather than later.
Wow! Larry Summers knew all along about the financial crisis and its aftermath, made a good bet at the time about interest rates rising based on all available information but because he knew that the economy would crash and the Fed would institute a ZIRP policy he really made a bad bet even though the swap wouldn’t kick in until 2020. Let me know if you can follow his logic. Even if you give Summers credit for precognition I still fail to see how it all ties together.
What this really boils down to is the Left’s inability to get over the Summers political correctness gaffe with the female scientists dustup. They went after his scalp and got it when he gave up the Harvard job but they apparently haven’t forgotten. Their worst nightmare is for Larry Summers to get the Chairmanship of the Fed and you can look at all of this trivia as the kickoff to the campaign to make sure that doesn’t happen.