Harvard's Toxic Swaps: Interest Rate Bets Cost It Billions
In 2004, Summers also put some interest rate swaps on Harvard's books for its cash account. Later, Harvard had to pay $1 billion to get out of them. In fact, in October 2008, Harvard was in such fiscal hot water that it had to borrow $2.5 billion from the commonwealth of Massachusetts, almost $500 million of which was used within days to exit those swap agreements, which Harvard had entered in order to finance a Summers-led expansion in Allston, Mass., across the Charles River from its main campus in Cambridge.
What is an interest rate swap and how did Harvard get into so much trouble with them? Put simply, an interest rate swap is a bet on the direction of interest rates. Let's say Institution A issues a bond with a variable interest rate that it must make payments on, but it expects rates to rise. It wants to lock in what it thinks are the current low rates. Meanwhile, let's say Institution B is issuing a different, fixed-rate bond, but it fears interest rates will fall. Institution B wants to pay an interest rate that will go down as the market rate tumbles.
An interest rate swap lets B trade its fixed interest rate for A's variable one. In this scenario, the parties are playing a zero-sum game where one party's profit comes out of the hide of its counterparty. For example, if interest rates fall, A is in big trouble because it needs to pay B the difference between the higher original rate and the market's far lower one. It was just such a slip-up that made Summers' 2004 bet so costly for Harvard.
In December 2004, Harvard entered into agreements that locked in interest rates on $2.3 billion of bonds for the Allston construction, with plans to borrow $1.8 billion in 2008 after the school broke ground, and the remaining $500 million through 2020, according to Bloomberg.
At the time, the Fed's overnight interest rate was 2.25%, and Summers evidently forecast that rates couldn't go any lower. So he bet, buying those interest rate swaps. What he didn't foresee was the financial collapse in 2008, which caused the world's central banks to cut interest rates to near-zero -- a move that sent the value of those interest rate swaps plunging and forced Harvard to come up with the $1 billion in quick cash.
As a result, Harvard is poorer, and the school has been forced to fire hundreds of people and trim its budgets. And the university's Allston expansion? Cranes were recently removed from the construction site of a $1 billion science center that was to be it's centerpiece. Harvard suspended work on the building last week, according to Bloomberg.
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