How Harvard Nearly Went Bankrupt After A Rogue Interest Rate Swap Went Very Sour
The school that epitomizes the dangers of groupthink (especially by very intelligent people) and tends to get caught in both the virtues and vices of its own ingeniosity, saw just how expensive hubris can be in 2009. Harvard's endowment dropped 27.3% in 2009 to $27 after hitting roughly $10 billion higher the year before.
And this is how the Ivy league safety school characterized their own performance:
With a few notable exceptions, nearly every asset class did poorly. Our real estate portfolio, for example, suffered a loss of over 50% during the year after considering all final marks through June 30, 2009. While diversification has been a mainstay and a driver of the portfolio’s return over the long-term, the benefits of diversification did not bear out through the rapidly evolving and widespread events that unfolded in fiscal 2009.
With perfect hindsight we and most other investors would have started this year in a more liquid position and with less exposure to some of the alternative asset categories that were hardest hit during fiscal 2009. It is important to note, however, that our portfolio has benefited greatly from our asset allocation over the long-term, which has included substantial exposure to less conventional asset classes. Private equity, for example, has earned an average of 15.5% per year for the Harvard portfolio for the last ten years even after a 32% correction in fiscal 2009. Our natural resources portfolio, a more recent addition, has returned 13.0% per year for the last ten years. It would be a mistake to categorically avoid these types of investments because they are less liquid. But the balance of liquid and illiquid investments within the portfolio needs to remain in the forefront of our portfolio strategy.
Yet most notable in the entire report is an interesting story for all those who claim that representing the $200 or so trillion in interest rate swaps on the books of the Big 5 banks is completely irrelevant as the net exposure is just a couple trill here and there. Yeah, that's what Harvard thought too until it had to eat a 45% loss on $1.1 billion in IR swaps. And nearly go tits up in the process.
The University has entered into various interest rate exchange agreements in order to manage the interest cost and risk associated with its outstanding debt and to hedge issuance of future debt. The interest rate exchange agreements were not entered into for trading or speculative purposes. Each of these exchanges is collateralized, as described in Note 3, and thereby carries liquidity risk to the extent the relevant agreements have negative mark-to-market valuations (pursuant to methodologies described below). The interest rates in the table on page 35 reflect any applicable exchange agreements. In fiscal 2009, the University terminated interest rate exchange agreements with a notional value of $1,138.0 million, for which it realized a loss of $497.6 million. A portion of this loss was offset by $85.9 million in gains on the sale of U.S. Treasury bonds which had been purchased to hedge a portion of the liquidity risk associated with the interest rate exchange agreements.
And here is the double whammy of jumping into the fire of margin calls by issuing opposite pieces of paper: locking your liquidity escalating losses anyone?
Also in fiscal 2009, the University entered into additional interest rate exchange agreements with a notional value of $764.0 million, under which the University receives a fixed rate and pays a variable rate. These new interest rate exchange agreements, or ‘offsetting’ agreements, were intended to reduce the risk of further losses in value (with associated collateral posting requirements) within the portfolio of interest rate exchange agreements.
This is what Daniel Shore, Harvard CFO had to say about this near death experience:
“When we went into the fall, we had some serious
liquidity management issues we were dealing with and the
collateral postings on the swaps was one. In evaluating our liquidity position, we
wanted to get some stability and some safety.”
Funny how Harvard, one can argue, was in a comparable situation to none other than Lehman itself. Had Harvard's instantaneous liquidity situation gotten even worse, it would probably have spelled doom for the university Larry Summers, in his inimitable wit and wisdom, used to preside over.
Full Harvard report here: