Harvard's Toxic Swaps: Interest Rate Bets Cost It Billions

Everyone knows Harvard. The prestigious 373-year-old university rejects 95% of the people who apply. But the ones who get in usually end up doing pretty well. The Ivy League institution counts JFK and FDR among its alumni -- but that's ancient history. It also can claim such respected finance gurus as former U.S. Treasury Secretary and current Obama economic advisor Larry Summers, and current U.S. Fed Chair and Time Person of the Year Ben Bernanke.But that Summers fellow seems to have left Harvard with a little bit of a financial problem. That's because Summers didn't just attend Harvard -- he was its president from 2002 to 2006. During that time, he made some choices that later led to serious damage to its endowment, which peaked at $36.9 billion in June 2008 -- but has since lost 30% of its value, dropping to $26 billion, according to Bloomberg News.

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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