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How Harvard Nearly Went Bankrupt After A Rogue Interest Rate Swap Went Very Sour

Tyler Durden's picture





 

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:

 

 


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Fri, 10/16/2009 - 18:54 | Link to Comment Fritz
Fritz's picture

No sweat.

The squid showed them a powerpoint about how to borrow taxpayer money at no cost.

Lever up a few T-Bonds and its green grass and high tides baby.

Fri, 10/16/2009 - 19:08 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:55 | Link to Comment pigpen
pigpen's picture

Anon, you aint kidding in terms of the pulchritude of the mammaries.  So funny they are doing fundraising calls right now for the endowment and I love speaking with the freshmen callers and discussing our former president mr. summers. He and all the crony money managers at the asset management company can go fuck themselves as they don't deserve a dime in alumni donations.

Cheers,

Pigpen

Fri, 10/16/2009 - 19:12 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:18 | Link to Comment Miles Kendig
Miles Kendig's picture

The esteemed quality of the HBS process shines through once again, this time doing its own home.

Classic.

Fri, 10/16/2009 - 19:24 | Link to Comment torabora
torabora's picture

Was Larry Summers the set-up man?

Look where he landed.

Fri, 10/16/2009 - 19:27 | Link to Comment Fritz
Fritz's picture

"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."

Any guess as to who the counter party was?

I'll just throw it out there that it may have been another squid attack.

 

 

 


Fri, 10/16/2009 - 19:53 | Link to Comment ZerOhead
ZerOhead's picture

There is a 97% chance you are correct. But which squid?

Sat, 10/17/2009 - 22:16 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:30 | Link to Comment SWRichmond
SWRichmond's picture

They just needed to find the right counterparty to net with.  See?  You just write one, then write an opposite one, and then it's time for crumpets!  There's so little risk!  Some might even say it's tiny!

I hate myself for saying that.

Fri, 10/16/2009 - 19:55 | Link to Comment ZerOhead
ZerOhead's picture

Ha ha ha... Some did say 'tiny' didn't they? :-)

Fri, 10/16/2009 - 19:32 | Link to Comment ChickenTeriyakiBoy
ChickenTeriyakiBoy's picture

Presumably these agreements were conceived by Mohamed El-Erian.

 

Nice exit from Boston, though, Mohamed. The 10x salary in Newport Beach must be a nice new normal..

 

 

Fri, 10/16/2009 - 19:40 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:41 | Link to Comment Green Sharts
Green Sharts's picture

Presumably these agreements were conceived by Mohamed El-Erian.

Yeah, let's just presume that whether we know it to be true or not.

 

Fri, 10/16/2009 - 19:45 | Link to Comment ChickenTeriyakiBoy
ChickenTeriyakiBoy's picture

Wow...Pimco employee? I'm just saying...exposure that big would have to be signed off on from the top. No?

Fri, 10/16/2009 - 20:15 | Link to Comment Green Sharts
Green Sharts's picture

Yeah, I must be a Pimco employee.  Turn it on me.  It doesn't matter whether the transactions were initiated during El-Erian's tenure at Harvard and/or if he knew of them. Let's just trash him.  He's a public figure and he's not here to defend himself.

Fri, 10/16/2009 - 21:24 | Link to Comment ChickenTeriyakiBoy
ChickenTeriyakiBoy's picture

Hey buddy--not turning anything on anybody. I thought When Markets Collide was a very good book. The guy is clearly smart. But I think it does matter when the transactions were initiated. El-Erian wasn't at Harvard for a long time, and Swensen may be more responsible for creating the vogue endowment investment strategy, but such a massive miscalculation should be traced to somebody. If I were a donor, I would want to know whether the current or former CFO is responsible for this miscarriage. That's a lot of tuitions for a single position. Or a couple of fully decked out institutes/centers.

 

If I had money with Pimco, I would also want to know.

 

Nothing personal. If I were interested in defending every market participant simply because they are a "public figure", I'd be reading and posting on another website.

Mon, 10/19/2009 - 12:39 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:38 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:09 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:39 | Link to Comment putbuyer
putbuyer's picture

I wait for the day that Harvard is one giant piss hole. I will be there to make a deposit. I worked between HaRRRvard and MIT for a while. Everyone back then was a drone - ready to obey. I actually was able to play people.

1. here is a buck, get me a bagle. drone - it's 2 bucks?, me, onion and now. They paid the rest like good little Obamabots.

Mon, 10/19/2009 - 12:45 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:40 | Link to Comment lizzy36
lizzy36's picture

amazing how quickly a liquidity issue become a solvency issue.

wonder if their luck will hold the next time around?

Fri, 10/16/2009 - 19:44 | Link to Comment Miles Kendig
Miles Kendig's picture

Cramer's, Jamie's & Meg's trust will pony up...

Give the GOV a hurrumph

Fri, 10/16/2009 - 19:48 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:23 | Link to Comment Howard_Beale
Howard_Beale's picture

Bonner, Wiggins, myself and others considered to be "perma-bears" were not seeing the future. It was already done when the Nasdaq burst. THe lost decade in the Dow and S&P prove that.  The problem is, and always has been, that people get sucked into endless bubbles, out of control debt, and shady accounting with an incredible faith in the USA. They just don't realize that this bear market didn't start in Oct 2007--it started in 2000. I've read the Daily Reckoning for over a decade. While timing has not been perfect--those of us that were aware of the reality behind the facade, have done well.  The Harvard boys were not just Summers and El-Erian. It was a gang of Hedgies, Goldmanites, and other super brains that got screwed by the bear. No brain science necessary. You play the leverage game, you pay the price. BTW, there was a great article in Vanity Fair on the Harvard endowment 5 months ago that went into the players extensively. No one person is to blame.

Sat, 10/17/2009 - 02:33 | Link to Comment Anonymous
Fri, 10/16/2009 - 19:51 | Link to Comment Anonymous
Fri, 10/16/2009 - 20:01 | Link to Comment Anonymous
Fri, 10/16/2009 - 20:10 | Link to Comment Green Sharts
Green Sharts's picture

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

I don't think one can credibly argue it, but it's certainly easy to innuendo it.

Fri, 10/16/2009 - 20:27 | Link to Comment Green Sharts
Green Sharts's picture

Andy, is it just me or is ZH's quality control well on the way to going completely out the window?  As in we throw shit on the wall and it's up to somebody else to disprove it?

This piece started with a comment on the danger of groupthink among bright people and my first thought was how they could write that without grasping the irony.  This place is on the way to becoming a lynch mob; accuracy and fairness be damned.  Look at the thread on J.P. Morgan.  ZH put up a half-baked "analysis" from an anti-semitic crackpot who directed people to his hate filled website.  Did you know the Jews funded the Nazis?

Fri, 10/16/2009 - 20:51 | Link to Comment pinkboxtrader
pinkboxtrader's picture

momo traders heatmapping newly unjunked stocks as allegory for ZH's own rise in the financial blog-o-whatever?

Fri, 10/16/2009 - 21:13 | Link to Comment Fritz
Fritz's picture

+100

Fri, 10/16/2009 - 21:07 | Link to Comment Tyler Durden
Tyler Durden's picture

While we are amused by your very own use of ironic hyperbole, maybe you can elaborate what exactly you disagree with in this post?

Fri, 10/16/2009 - 21:18 | Link to Comment Green Sharts
Green Sharts's picture

maybe you can elaborate what exactly you disagree with in this post

The comparison of Harvard to Lehman, the suggestion that a loss of less than $500 million net on an interest rate swap and hedge gone awry almost caused a university with an endowment of over $30 billion to go broke.

Fri, 10/16/2009 - 21:30 | Link to Comment Howard_Beale
Howard_Beale's picture

Yale lost even more money in their endowment YOY. I agree with you Sharts that the comparison is shoddy regarding Lehman. While there are buildings that will never be completed when Summers got ambitious, the truth is that both universities hired hot shots that got crazy with leverage and paid the price.

Fri, 10/16/2009 - 21:32 | Link to Comment Tyler Durden
Tyler Durden's picture

As others pointed out a liquidity crunch can become a solvency one practically instantaneously. It is not a matter of an absolute margin call value, but how that affects other collateral backing related assets (think chained downgrade calls in GE's capital structure for example). The Lehman analogy is relevant in that a seemingly controlled (in liquidity terms and otherwsie) variable, sunk the firm. Lehman's balance sheet was over 700 billion: how much of this cost the firm the liquidity crunch that brought the whole house of cards down?

And, by the way, the whole point of this post is to demonstrate the gross to net (close) identity. However, if the Harvard issue touched a nerve, we apologize profusely.

Fri, 10/16/2009 - 22:25 | Link to Comment Green Sharts
Green Sharts's picture

The Lehman analogy is relevant in that a seemingly controlled (in liquidity terms and otherwsie) variable, sunk the firm.

Lehman had a balance sheet loaded with toxic waste and relied on continuous short-term credit from the financial markets for its survival.  In looking at the investment allocations of the Harvard endowment which are in the annual report it appears to me that they had something in the neighborhood of $13 billion of investments that could have been liquidated (U.S. and foreign equities, corporate debt, etc.) to cover a problem of less than $500 million.

if the Harvard issue touched a nerve

No, I have no connection to Harvard and certainly have no affection for it.  But the ridiculous attempt to compare Lehman to Harvard insulted my intelligence.  Seeing you dig your heels in to defend it is even worse, particularly given that you guys act like you're an oasis of intellectual integrity in the middle of a sea of corruption.

Sat, 10/17/2009 - 02:38 | Link to Comment Anonymous
Sat, 10/17/2009 - 11:05 | Link to Comment I am a Man I am...
I am a Man I am Forty's picture

If an endowment of $30B can't come up with $500M in short order then everyone should be fired.

 

Sat, 10/17/2009 - 21:34 | Link to Comment Counterparty (not verified)
Mon, 10/19/2009 - 13:11 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:28 | Link to Comment Green Sharts
Green Sharts's picture

Tyler, did you guys see this website which belongs to the guy whose half-baked "analysis" of JPM was posted late this afternoon?  Surely you weren't aware of it.

http://www.iamthewitness.com/

Fri, 10/16/2009 - 21:34 | Link to Comment Howard_Beale
Howard_Beale's picture

Sometimes free speech makes my stomach sick. Awful site.

Fri, 10/16/2009 - 21:35 | Link to Comment Tyler Durden
Tyler Durden's picture

No, and frankly we don't care. If people have a passionate opinion on a topic, we are willing to provide a forum to voice their (hopefully logical and justified) grievance. If that site promotes satanic worship and 3 headed vibrators, that is of no concern to us, nor should it be the concern of our readers. There are many posts that link up to the WSJ, the NYT, Bloomberg, and other MSM, which an objective person can find much more fault with than the site you referenced (I imagine at least their agenda is clear cut). W/r/t "messenger" issues, we refer you, and anyone else who shares your skepticism, to our manifesto.

Fri, 10/16/2009 - 22:14 | Link to Comment Green Sharts
Green Sharts's picture

There are many posts that link up to the WSJ, the NYT, Bloomberg, and other MSM, which an objective person can find much more fault with than the site you referenced

Pathetic.  Absolutely pathetic. 

Sun, 10/18/2009 - 12:26 | Link to Comment Anonymous
Mon, 10/19/2009 - 13:16 | Link to Comment Anonymous
Fri, 10/16/2009 - 22:32 | Link to Comment lizzy36
lizzy36's picture

It is not that site it is "his site".  It is where he promotes his thoughts and work.  His piece directed one to that site.   

And in giving him a voice you are by association giving his website a voice. Like you noted when one links to a MSM piece you are giving the whole MSM site a voice.    

If one links to a Tyler Durden piece, one is by association giving ZH a voice.  And while a single piece may give ZH and/or Tyler Durden notoriety, the totality of the work on this site gives you credibility.  

Perhaps there are objective people better than I.  Prior, to linking to his site, I found his piece on JPM at best to be somewhat immature and his analysis deficient.  Once i linked to his site, (which he must be proud of because he directed me there), I thought he was a crackpot who ideas have little merit.  I will never take anyone seriously, who espouses and promotes the views that he does on his website. 

There is passionate opinion, difference of opinion and logical debate. Which is why i come to and believe in ZH.  I don't come here for crappy financial analysis and to be linked to some website promoting the Protocals of the Elders of Zion.

 

Sat, 10/17/2009 - 02:42 | Link to Comment Anonymous
Sun, 10/18/2009 - 08:38 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

EXCELLENT response TD. I couldn't have said it better myself. As long as you truly believe (and act on) what you wrote here, ZH will continue to reach new heights despite the occasional berating or two by lunatics such as Green Sharts.

Fri, 10/16/2009 - 21:37 | Link to Comment ChickenTeriyakiBoy
ChickenTeriyakiBoy's picture

Absolutely agree Green Sharts. That guy is either a nutbag or has no regard for his own associations. And his analysis happens to be shoddy, misusing highly selective balance sheet data. 

 

But don't conflate the issues we are raising in this post with the wingnut shit Muhammed is bringing to the table. The debate over how aggressively a university endowment should be managed is a legitimate one.

Sat, 10/17/2009 - 18:40 | Link to Comment Anonymous
Fri, 10/16/2009 - 20:22 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:09 | Link to Comment Johnny G.
Johnny G.'s picture

Great Clip!  How is Stewart allowed to say that out loud with BB listening?

Fri, 10/16/2009 - 20:39 | Link to Comment Anonymous
Sat, 10/17/2009 - 16:03 | Link to Comment Anonymous
Sat, 10/17/2009 - 19:55 | Link to Comment McGriffen
McGriffen's picture

I'm changing my moniker to Ricky 'the dragon' steamboat !

Fri, 10/16/2009 - 21:06 | Link to Comment Leo Kolivakis
Leo Kolivakis's picture

Where is Jack Myers now? He left before the storm. By the way, Harvard's horror decimated pension funds that followed their lead, along with that of Yale, into alternative investments.

Fri, 10/16/2009 - 21:06 | Link to Comment WealthDeath
WealthDeath's picture

Oh the irony between this article and fact that Ivy League graduates run the US economy.

Fri, 10/16/2009 - 21:20 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:24 | Link to Comment Anonymous
Fri, 10/16/2009 - 21:39 | Link to Comment Anonymous
Sat, 10/17/2009 - 12:03 | Link to Comment Anonymous
Fri, 10/16/2009 - 22:19 | Link to Comment Anonymous
Fri, 10/16/2009 - 22:45 | Link to Comment Anonymous
Fri, 10/16/2009 - 22:47 | Link to Comment Anonymous
Sat, 10/17/2009 - 01:28 | Link to Comment McGriffen
McGriffen's picture

Yep, it appears.  Supposedly pay-fixed vs receive Fed rate (discount rate, id guess)

Sat, 10/17/2009 - 10:41 | Link to Comment KidDynamite
KidDynamite's picture

that was my question - how did they lose 45%?!?! but i didn't do the math... is that all it takes?  a 250 bp move in swap spreads?!?!? oy vey

Sat, 10/17/2009 - 11:21 | Link to Comment McGriffen
McGriffen's picture

In practice it's the combined change in long-term Treasury rates and long-term swap spreads.  Swap spreads, while volatile the past 24 months, aren't quite that prone to such a move.

coulda shoulda woulda...perhaps a few Receive fixed swaps would have been in order 2-3 years ago.  Just in case, those would've added positive market value.  That, or using a frickin' ladder on maturities.

Sat, 10/17/2009 - 01:35 | Link to Comment McGriffen
McGriffen's picture

bostonmagazine.com has this story authored by Bradley (last name anywho).  Old news, as the print date shows June 2009.  But it details the swap transaction a little bit more.


DREW GILPIN FAUST AND THE INCREDIBLE SHRINKING HARVARD

Sat, 10/17/2009 - 07:42 | Link to Comment SWRichmond
SWRichmond's picture

Great article, reads like Wall Street comes to Harvard: the embodiment of hubris. The fact that Summers is now where he is makes it even more pungent.

Goldman screws Harvard, and Summers, with a lovely and very very benign Interest Rate Swap, which carried only a tiny risk; I guess there's no honor among thieves:

Further squeezing Harvard was a transaction Summers had pushed it into in 2004, when he successfully argued that the university should engage in a multibillion-dollar interest rate swap with Goldman Sachs and other large banks. Under the terms of the deal, Harvard would pay Goldman a long-term fixed rate while Goldman paid Harvard the Federal Reserve rate. The main goal was to lock in a low rate for future debt, and if the Fed had raised rates, Harvard would have made hundreds of millions. But when the Fed slashed rates to historic lows to try to goose stalled credit markets, the deal turned equally sour for Harvard: By last November, the value of the swaps had fallen to negative $570 million. The university found itself needing to post more collateral to guarantee those swaps, and would ultimately buy its way out of them at an undisclosed cost.

An ignorant and untrained observer would be tempted to conclude that this deal contained functional 'leverage', and that leverage can work both ways.  Imagine!

Sun, 10/18/2009 - 08:22 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

The observer would also note that it is sheer idiocy to bet against Goldman - the firm which always - ALWAYS - bets on KNOWN outcomes.

Sat, 10/17/2009 - 06:47 | Link to Comment Anonymous
Sat, 10/17/2009 - 11:49 | Link to Comment Anonymous
Sat, 10/17/2009 - 16:25 | Link to Comment Leo Kolivakis
Leo Kolivakis's picture

Harvard is an excellent university but their endowment fund learned a painful lesson in liquidity. They will make some of the money up in 2009, but not all of it. And they still hold a lot of private equity funds that are worth a whole lot less. At stake here is the prestige of Harvard, Yale and their mighty endowment funds that at one point looked totally invincible. Well, after 2008, all those mighty endowment managers came back to earth.

Sun, 10/18/2009 - 08:19 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

"Harvard is an excellent university"

Considering the hub of criminal activity that stuffed-to-the -gills-with-Harvard-alumni Wall Street is today - I have my doubts about that statement.

Sat, 10/17/2009 - 18:48 | Link to Comment Anonymous
Sun, 10/18/2009 - 08:12 | Link to Comment Gordon_Gekko
Gordon_Gekko's picture

"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."

This is how IRSwaps generate artificial demand for Treasuries. Considering the fact that IRSwaps comprise the majority of TBTF banks' hundreds-of-$TRILLION derivative positions, now you know why interest rates are still going through the floor and why the Treasury market has not imploded - yet - and when it does, it will bury all the Prechterites under its rubble. The Treasury market/interest rates as a means of conveying anything happening in the real world is UTTERLY broken, and so is the stock market.

Sun, 10/18/2009 - 09:20 | Link to Comment SWRichmond
SWRichmond's picture

The dollar as the safe-haven reserve currency, and the U.S. Treasury market as the "risk free rate of return".  The final Ponzi.

Mon, 10/19/2009 - 11:11 | Link to Comment McGriffen
McGriffen's picture

GG, is it possible to explain the statement above:  "IRSwaps generate artificial demand for Treasuries".  I can venture a guess, but it's only that.

thanks

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