Dec. 18 (Bloomberg) -- Anne Phillips Ogilby, a bond attorney at one of Boston’s oldest law firms, on Oct. 31 last year relayed an urgent message from Harvard University, her client and alma mater, to the head of a Massachusetts state agency that sells bonds. The oldest and richest academic institution in America needed help getting a loan right away.
As vanishing credit spurred the government-led rescue of dozens of financial institutions, Harvard was so strapped for cash that it asked Massachusetts for fast-track approval to borrow $2.5 billion. Almost $500 million was used within days to exit agreements known as interest-rate swaps that Harvard had entered to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts.
The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university. Cranes were recently removed from the construction site of a $1 billion science center that was to be the expansion’s centerpiece, a reminder of Summers’s ambition. The school said last week they will suspend work on the building early next year.
‘Case Study’
“For nonprofits, this is going to be written up as a case study of what not to do,” said Mark Williams, a finance professor at Boston University, who specializes in risk management and has studied Harvard’s finances. “Harvard throws itself out as a beacon of what to do in higher learning. Clearly, there have been major missteps.”
Harvard panicked, paying a penalty to get out of the swaps at the worst possible time. While the university’s misfortunes were repeated across the country last year, with nonprofits, municipalities and school districts spending billions of dollars on money-losing swaps, Harvard’s losses dwarfed those of other borrowers because of the size of its bet and the length of time before all its bonds would be sold.
In December 2004, Harvard completed agreements that locked in interest rates on $2.3 billion of bonds for future construction in Allston, with plans to borrow $1.8 billion in 2008 after they broke ground and the remaining $500 million through 2020. At the time, the benchmark overnight interest rate set by the U.S. Federal Reserve was 2.25 percent. The agreements backfired last year after central banks slashed lending rates to zero and the value of the contracts plunged, forcing the school to set aside cash.
‘Education Business’
Borrowers use swaps to match the type of interest rates on their debt with the rates on their income, which can help reduce borrowing costs. Lenders and speculators use swaps to profit from changes in the direction of interest rates. A bet on higher rates, for example, means paying fixed rates and receiving variable. At Harvard, nobody anticipated some interest rates going to zero, making the university’s financing a speculative disaster.
Harvard’s woes stemmed from misunderstanding its role, said Leon Botstein, president of Bard College in Annandale-on-Hudson, New York.
“We shouldn’t be in the banking business, we should be in the education business,” Botstein said in a telephone interview.
Making Sense
The financing plan using the swaps was developed by the university’s financial team and discussed with the Debt Asset Management Committee, an oversight group, according to James Rothenberg, a member of the President and Fellows of Harvard College, or Harvard Corp., and the school’s treasurer, a board position.
The swaps plan was then approved by Harvard Corp. and implemented and monitored by the financial team, Rothenberg said in an e-mail.
Summers, who left Harvard in 2006, declined to comment. As president and as a member of the Harvard Corp., the university’s seven-member ruling body, Summers approved the decision to use the swaps.
The strategy made sense in the economic climate of the time, Rothenberg said in another e-mail. Rothenberg is chairman of Capital Research & Management Co., the investment advisory unit of Capital Group Cos. in Los Angeles.
“Rates were at then-historic lows, and the university was contemplating a major, multibillion-dollar campus expansion,” Rothenberg said. “In that context, locking in our financing costs so that we would achieve some budgetary certainty had definite advantages.”
Demanding Cash
Harvard’s failed bet helped plunge the school into a liquidity crisis in late 2008. Concerned that its losses might worsen, the school borrowed money to terminate the swaps at the nadir of their value, only to see the market for such agreements begin to recover weeks later.
Harvard would have avoided paying the costs of its swap obligations by waiting. Its banks, including JPMorgan Chase & Co., headed by James Dimon, were demanding cash collateral payments -- ultimately totaling almost $1 billion -- that Harvard in 2004 had agreed to pay if the value of the swaps fell. At least $1.8 billion of the swaps the school held were with JPMorgan, said a person familiar with the agreements. Dimon, a 1982 Harvard Business School alumnus, declined to comment on the agreements through a spokeswoman, Jennifer Zuccarelli.
Darkest Days
Drew Faust, Harvard’s president since 2007, said in an interview about the financial crisis she experienced some of her darkest days as she watched the collapse of U.S. markets that deepened the school’s losses.
“Someone would say that this happened, that had happened, they were going to bail out AIG or Lehman is failing,” Faust recalled in an interview, referring to the September 2008 bankruptcy of Lehman Brothers Holdings Inc. in New York and the subsequent government bailout of American International Group Inc. in New York. “We were wondering what was going to happen tomorrow.”
Harvard speculated in the swap market as early as 1994, according to rating companies’ reports. Under Jack Meyer, former chief executive of Harvard Management Co., the school’s endowment used swaps to profit from interest-rate changes. The university also used them to fix borrowing costs for capital projects.
Summers became president in July 2001, after serving as U.S. Treasury Secretary. He earned a Ph.D. in economics from Harvard, and became a tenured professor there at age 28. He served from 1991 to 1993 as chief economist at the World Bank, which initiated the first interest-rate swap with International Business Machines Corp. in 1981.
Feeling Flush
In the 1990s, Harvard began amassing 220 acres (89 hectares) for construction near Harvard Business School and its football stadium, located in Allston. In June 2005, Summers unveiled his vision for a campus expansion replete with new laboratories, dormitories and classrooms, renovated bridges and a pedestrian tunnel beneath the water. The Allston project was to transform an industrial and working-class neighborhood of two-family wood homes and small shops by building two 500,000- square-foot (46,000-square-meter) science complexes and a redrawn street grid.
Harvard was flush at the time, with an endowment of $22.6 billion that had returned an average of 16 percent during the previous 10 fiscal years. Summers told Faculty of Arts & Sciences professors in May 2004 that he hoped they wouldn’t be “preoccupied with the constraints imposed by resources, for Harvard was fortunate to have many deeply loyal friends,” according to minutes of a faculty meeting.
Forward Swaps
“Harvard would be able to generate adequate resources,” according to the minutes. “The only real limitation faced by the Faculty was the limit of its imagination.”
When the plan was made public in 2005, Harvard’s financial team had been busy for more than a year behind the scenes, devising a financing strategy for the project using interest- rate swaps. These derivatives enable borrowers to exchange their periodic interest payments. They typically involve the exchange of variable-rate payments on a set amount of money for another borrower’s fixed-rate payments.
In 2004, Harvard used swaps for $2.3 billion it planned to start borrowing four years later. The AAA-rated school would have paid an annual average rate of 4.72 percent if it had borrowed all the money for 30 years in December 2004, according to data from Municipal Market Advisors. The swaps let it secure a similar rate for bonds it planned to sell as it constructed the campus expansion during the next two decades.
‘Relatively Rare’
The agreements were so-called forward swaps, providing a fixed rate before the bonds were actually sold. Harvard was betting in 2004 that interest rates would rise by the time it needed to borrow. The school was also assuming the expansion would proceed on the schedule set by Summers and his advisers.
While the university could have paid banks for options on the borrowing rates, the swaps required no money up front.
That time frame, along with the size of the position, was unusual, said Peter Shapiro, an adviser at Swap Financial Group Inc. in South Orange, New Jersey.
“There have been lots of forward swaps, but out longer than three years is relatively rare,” Shapiro said in a telephone interview. That duration increases the risk, because the longer the term of the contract, the more volatile the value of the swap, he said.
Columbia, Yale
Columbia University is breaking ground on a $6.5 billion expansion in New York City, and last year used an interest-rate swap for its borrowing of $113 million of bonds sold seven months later. Yale University in New Haven, Connecticut, is also AAA-rated. It had 32 separate swap agreements totaling $975 million as of Oct. 31, hedging the school’s $1.4 billion variable rate debt and commercial paper, according to Moody’s Investors Service Inc.
Corporations might use derivatives to lower their borrowing costs as many as four years before a bond sale, according to bankers who sell derivatives. Anadarko Petroleum Corp. used the swap market in December 2008 and January 2009 to secure rates for $3 billion it plans to refinance in October 2011 and October 2012, according to the Houston, Texas-based company’s third- quarter report from Nov. 3. Matt Carmichael, a company spokesman, declined to comment.
Key Player
Rothenberg, a Harvard College and Harvard Business School graduate, said he was among the key players involved in developing the financing strategy. His Los Angeles-based company, Capital Group, operates American Funds, the second- biggest family of stock and bond mutual funds in the U.S. He had been Harvard’s treasurer for six months when the school arranged the Allston swaps in December 2004.
Ann Berman, Harvard’s chief financial officer at the time, also played a role in developing the plan, Rothenberg said. Berman declined to be interviewed. She stepped down in 2006 when she was named an adviser to the president, according to the school’s Web site. A certified public accountant, Berman got her master’s in business administration at the University of Pennsylvania’s Wharton School of Business in Philadelphia and had earlier served as a financial planner and adviser for Harvard’s dean of the Faculty of Arts & Sciences.
Rubin, Reischauer
Other members of Harvard Corp. in 2004 and 2005, who served with Summers and Rothenberg, were former U.S. Treasury Secretary Robert Rubin, Summers’s previous boss and predecessor at the U.S. Treasury, who was an instrumental supporter of his bid for the Harvard presidency; Robert D. Reischauer, former director of the Congressional Budget Office, who was a colleague of Summers and Rubin’s in Washington; Conrad K. Harper, a lawyer at Simpson Thacher & Bartlett LLP in New York; Hanna Gray, former president of the University of Chicago; and James R. Houghton, chairman of Corning Inc., the world’s biggest maker of glass for flat-panel televisions, in Corning, New York.
All except Rothenberg declined to comment or didn’t return telephone calls.
Harvard University’s finance staff worked with JPMorgan to develop the size and the length of the forward-swap agreements, said a person familiar with the contracts. Final negotiations to set the rates were left to Harvard Management, which oversees the endowment, because it had swap contracts in place with JPMorgan dating back to 1996 that set terms for the agreements, according to a copy of the agreement obtained by Bloomberg News.
Continued>>>>
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