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Not Smart: Harvard Bet on Interest-Rate Swaps Backfires, Costing School $500 Million

 
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10/18/2009 09:20 AM
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Not Smart: Harvard Bet on Interest-Rate Swaps Backfires, Costing School $500 Million
Harvard University’s failed bet that interest rates would rise cost the world’s richest school at least $500 million in payments to escape derivatives that backfired.

Harvard paid $497.6 million to investment banks during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the school’s annual report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The transactions began losing value last year as central banks slashed benchmark lending rates, forcing the university to post collateral with lenders, said Daniel Shore, Harvard’s chief financial officer. Some agreements require that the parties post collateral if there are significant changes in interest rates.

“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,” Shore said in an interview yesterday. “In evaluating our liquidity position, we wanted to get some stability and some safety.”

Harvard sold $2.5 billion in bonds in the fiscal year, in part to pay for the swap exit, even as the school’s endowment recorded its biggest loss in 40 years, the report released yesterday said. This is the first time the university has detailed the cost of exiting its swaps.

Further Pressure

“Substantial losses” in Harvard’s General Operating Account, a pool of cash from which bills are paid, further put pressure on the school, the report said. The net asset value of the account fell to $3.7 billion from $6.6 billion during the fiscal year, according to the report.

Harvard has typically invested a large portion of this operating account alongside the endowment, generating “significant positive investment results,” the report said. This year, the endowment’s losses hurt Harvard’s cash, according to the report.

Swaps are a type of derivative where two parties agree to exchange payments tied to a financing, typically receiving a variable-rate for a fixed-rate payment. The terminated contracts include three tied to $431.7 million of bonds the university sold in 2005 and 2007, the annual report said.

Unwinding Swaps

From New York to San Francisco Bay, tax-exempt issuers have paid hundreds of millions of dollars to unwind bond-and-swap transactions officials initially said would cut borrowing costs. The deals fell apart when municipal-bond insurers, who backed much of the underlying debt, lost their AAA ratings in 2008 and interest rates, instead of climbing, plunged to record lows in the worst credit crisis since the Great Depression.

The swaps are often pegged to Securities Industry and Financial Markets Association lending benchmarks or the three- month dollar London-Interbank Offered Rate, known as Libor. Libor closed yesterday at 0.28 percent, from a 10-year high of 6.89 percent on June 1, 2000.

Yale University in New Haven, Connecticut; Georgetown University in Washington and Rockefeller University in New York have reported losses related to interest-rate swaps, in some cases prompting the schools to pay termination fees to end the contracts.

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