Felix Salmon

Annals of rank hubris, Larry Summers edition

By Felix Salmon
July 23, 2009

This is why I love the blogs. The Epicurean Dealmaker has picked up on a detail buried in the 17th paragraph of a dry Bloomberg story from March about the relative funding costs of Harvard and Princeton — a story which, in light of TED’s comments, surely counts as having massively buried its lede.

The subject is those notorious interest rate swaps, put on by Larry Summers, on which Harvard lost a whopping $1 billion. And here’s the key graf:

Most of the swaps, signed when Summers, 54, was Harvard’s president from 2001 to 2006, were intended to lock in rates for debt that Harvard expected to issue as far off as 2022, for a 340-acre campus expansion, according to Moody’s Investors Service. In 2006 and 2007, Moody’s warned of risks from those so-called forward swaps, though it said the school’s finances and management experience mitigated them. Summers declined to comment on the record about the matter.

It turns out that Summers wasn’t protecting Harvard from having to pay more on its floating-rate debt were interest rates to rise. Instead, he was swapping hypothetical future floating-rate bonds into fixed-rate obligations. Says TED:

Forward swaps, or forward start swaps—which behave like normal swaps except the offsetting fixed and floating rate payments are scheduled to start at a date certain in the future—by themselves count as little more than rank interest rate speculation, specifically in this instance as a bet that short-term interest rates will rise in the future. They can make a great deal of sense when an issuer intends to sell bonds in the relatively near future and when the issuer wants to hedge against budgetary uncertainty by converting floating rate obligations into fixed rate debt. That being said, I have rarely encountered a corporate client who feels confident enough about both their absolute funding needs and current and impending market conditions to enter into a forward swap starting more than nine months into the future. Entering into a forward start swap for debt you do not intend to issue up to 20 years in the future sounds like either rank hubris or free money for Wall Street swap desks.

Of course, it’s not uncommon to see the term “rank hubris” applied in the general vicinity of Larry Summers. But let’s be clear, here: what Summers did could in no way be considered a hedge, under any common definition of the term. He was indulging in interest-rate speculation, just like Robert Citron. I think it’s fair to say that no previous Harvard president would ever have considered himself qualified to do such a thing, but Summers never let such considerations stop him. And his alma mater is now paying the 10-digit price.

11 comments so far | RSS Comments RSS


Keep it up on Summers.

Easily Obama’s worst appointment.

Check out the broadside from the economist community on LS.


Posted by sunsetbeachguy | Report as abusive

Of course it could be considered a hedge. Harvard was going to start a big expansion and knew it would need to borrow a lot of money in the future, so it paid fixed on a forward starting swap to lock in a rate. It’s the same thing as the eurodollar futures market, or any commodity market (except for wheat, I guess), for that matter.

But even ex-ante, it’s a stupid hedge, because it doesn’t protect Harvard from a scenario where its debt widens a lot relative to swaps.

Posted by Ron Mexico | Report as abusive

it may be stupid (in hindsight…), but it’s a hedge.


are we really supposed to believe that Summers played a role in putting on this trade? there is nothing in the article that suggests Summers was being consulted by his $20mm/yr portfolio managers on trades like this.

Posted by sean | Report as abusive

I agree with Sean above…

However, the endowment would be much better off by hiring Penn MBAs.

On another note.. I think the “epicurean dealmaker” has coined the term “rank hubris”, a search on google is very dry.

Posted by dvictr | Report as abusive

Excelent observation except please not ethat Larry Summers is an MIT grad, not Harvard.

Posted by Gregg Stone | Report as abusive

Larry is mentioned in this article as being the one who suggested entering into the swap deals. It also details the other screw-ups that caused Harvard’s endowment to tank.

http://nytimes.com/2009/02/21/business/e conomy/21harvard.html

So shame on Larry. He belongs in the same doghouse as Ben Stein.

Posted by HB | Report as abusive

While I do not agree with Larry Summers on many things, I think comparing his actions (or anyone else’s who were involved) related to these interest rate swaps to Robert Citron’s actions is one hell of a stretch. For those interested, the book “Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County” does a nice job of describing what happened with Citron’s investment strategy.

Regarding the article that is linked, we see this type of reporting from Bloomberg frequently. They are very good at pointing out trades that don’t look good on an ex post basis.
While their reporting in this manner might be an interesting story, it does nothing to assist decision makers with future decisions related to these matters. In fact it may be detrimental to the decision making process. Decision makers may remove viable options, regardless of how logical they may be on an ex ante basis, from the spectrum of possible options out of fear from articles similar to this one that could be written in the future.

Posted by AD_NYC | Report as abusive

If Summers entered into the swaps when short term rates were at 1% i.e. 2003 to 2004, it’s not unreasonable to believe that he was just trying to lock in low interest rates on the debt. (He probably figured that the likelihood that the Federal Funds Rate would fall below 1% was tiny.)

In fact, given the likelihood of inflation in the middle run, unwinding these contracts may turn out to be an incredibly stupid decision.

The problem really is that collateralized interest rate swaps aren’t really hedges (unless you’ve got a direct line to the Federal Reserve for liquidity). When the contract moves against you the cash call can be so large that retail derivatives customers can’t carry them to the point in time where they would be valuable. Calling a product with these characteristics a hedge is misleading.

Posted by csissoko | Report as abusive

I kind of disagree with “it seemed a good idea at the time defense.” Extrapolations twenty years out to the future are guesses in the extreme. To many Black Swans can happen. I don’t think a prudent fiduciary, who really feared being held accountable for his or her breaching a fiduciary duty would make such a gamble.

Posted by Rick Kane | Report as abusive

Summers may look like an idiot at the moment, but this ploy might yet become a stroke of genius if Bernanke ever stops printing money and giving it away.

Posted by ArtFart | Report as abusive

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