Felix Salmon

Larry Summers’s billion-dollar Harvard gamble

Felix Salmon
Jul 24, 2009 02:07 UTC

Greg Mankiw adds some insider detail to the story of Larry Summers’s ill-fated interest-rate swap, in the form of an email from “someone knowldgeable about the financial situation at Harvard”.

The email is clearly meant to exonerate Summers, at least a little, but I’m unconvinced. Taking the three points in sequence:

1) The instrument in question was highly liquid and could be sold fully within a few days; essentially all money was lost in 2008 two years after Larry Summers left.

This is true, but misleading. When people speculate in the markets, it’s the act of putting on the position which is the point at which the gamble is made. After that point, you make money if the position rises in value, and lose money if it plunges. Interest rates could have fallen at any time after the bet was made, and Harvard would have lost the same $1 billion.

The argument about liquidity only serves to underline how speculative this bet really was. If it was a genuine long-term hedge of certain future borrowing needs, Harvard would not have needed the liquidity since the position would have been designed to sit on the university’s books for decades. On the other hand, if Harvard was intending to trade in and out of this position, then the liquidity helps, but the swap can no longer be considered a hedge at all.

Was Harvard maybe intending to keep the swaps on its books in the event that interest rates rose, while selling them if rates fell? That seems to be the implication here: that if Summers had still been around, he would have liquidated the swaps when rates fell, and thereby avoided massive losses.

Again, however, this argument doesn’t hold up to scrutiny. If Summers had wanted to buy a swap with limited downside, one which automatically unwound if rates fell to a certain level, he could easily have done so. But that’s not the instrument he bought. Instead, he bought a sophisticated financial product which left Harvard potentially on the hook for $1 billion or more — and then did nothing to address that tail risk.

2) Harvard has a system where the treasurer makes these decisions with approval of the corporation and involvement of a debt management committee on which president does not serve.

Does anybody believe that this hare-brained scheme was the idea of Harvard’s treasurer? Come on. Harvard had $1.6 billion in floating-rate debt, and it’s conceivable that the treasurer might want to swap that debt into a low fixed rate. It’s not conceivable that the treasurer would be interested in swapping nonexistent future floating-rate debt into today’s fixed rates — especially not when the hypothetical future borrowing wouldn’t even take place for as long as 20 years. This deal has Summers’s fingerprints all over it, and would never have been done had he not been president of the university.

3) Given the plan to borrow large amounts of debt in the future, doing something to lock in low rates made sense. Iif Harvard was borrowing big, there would be offsetting saving now. The big error was the failure to adjust hedge when Allston was scaled back and to take account of the risks associated with the change in the university’s credit rating.

I honestly don’t know what Mankiw’s anonymous source could be talking about when he or she refers to “offsetting saving”. Was it an egregious dereliction of fiduciary responsibility to keep the swaps on Harvard’s books even after the excuse for putting them on — the multi-billion-dollar plan to expand the university into Allston — was put on hold? Yes, of course. And you can’t blame Summers for that, since he had left Harvard by then. On the other hand, there was always a risk that Allston would be scaled back, and indeed one of the most likely reasons for scaling back Allston was that there might be a national economic crisis — exactly the sort of thing which is normally accompanied by a reduction in interest rates.

Summers was well aware of the risk of an economic crisis. Indeed, in 2004, at about the time that the swaps were put on, he gave a major address at the IMF/World Bank annual meetings about the systemic risks posed by the US current-account deficit, and warning of “a slowdown in growth that would be unacceptable in the United States and would have very severe consequences for growth globally”. But maybe because he had gone through so many other current-account crises abroad during his tenure at Treasury, he was pretty clear that he thought the big risk was that interest rates would go up, rather than go down. In response to one question from a central banker, he said:

I certainly would not want to suggest how you or any other central banker should manage your reserves, but I would point out that when you buy U.S. treasury bills, what you get is 1.75 percent, and it doesn’t really matter whether the U.S. economy grows rapidly or grows slowly. And that is, as I said, a negative interest rate in real dollar terms, and I think that’s the number that one should focus on.

Summers couldn’t have been much clearer that he was pretty convinced that interest rates in the US were going to have to rise: it seems quaint now, but back then 1.75% really did seem like an incredibly low interest rate on T-bills.

Given his analysis, and his ego, it’s pretty obvious how Summers decided to use the future Allston expansion as an excuse to engage in a massive interest-rate gamble outside the purview of the Harvard Management Company, which is the arm of Harvard with a real mandate to play the financial markets. The real reasons for the rate swaps can be found in that 2004 lecture, not in vague ideas that Harvard was sure to issue floating-rate debt at some point in the 2020s. And given those real reasons, it’s easy to see why there was no clear mandate to unwind the swaps when Allston was scaled back.

Basically, Summers took a massive gamble with Harvard’s money, and lost — big. The buck stops with him, and I look forward to Summers admitting as much sooner rather than later.


On point (3): So long as there was borrowing for the Allston project, the interest rate position was not something that created risk– it reduced risk, by hedging. Of course, if Summers had an opinion on how interest rates would move, that would make him all the more eager to hedge to a zero net position instead of gambling the wrong way.

This relates to your point (1), but makes it backfire. The position could have been undone at any time, and so it could and should have been undone when the Allston borrowing was halted. Up to taht point, the interest rate position reduced risk; after that, it increased risk.

I wouldn’t be surprised if this was Larry SUmmers’s idea, even tho he didn’t have formal reponsibility and there is no evidence for him being involved. If so, maybe it illustrates the perils of having a smart leader introduce an innovative new policy: After he leaves, the dummies left behind can make things worse because they don’t understand the purpose of the innovation.

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The end of Wendelin Wiedeking

Felix Salmon
Jul 23, 2009 23:33 UTC

Last year, I put together an interactive feature for Portfolio.com entitled “Watch Out Below”; it listed nine vulnerable “tall poppies” who were liable to be cut down to size over the coming year. There were three CEOs on the list: Shelly Adelson, Ken Lewis, and Wendelin Wiedeking. Maybe it’s to his credit that Wiedeking managed to hang on longer than the other two. But now he’s been fired, while the other two still have their jobs, even if their reputations are in tatters.

The weird thing is that although Wiedeking’s now gone, the jury’s still out on what he achieved. After all, the tiny sports-car company he transformed over the past 16 years is now being bought for €8 billion on sales of about €6 billion a year. As a hedge-fund manager — which is what he most resembled of late — Wiedeking came spectacularly unstuck, thanks to a liquidity crunch he couldn’t get out of. But the brand he leaves behind him is a strong one, and even with €10 billion in debt it still has significant equity value.

Wiedeking was a classic product of the boom years, and the saga of VW and Porsche will make for many gripping books. There’s no doubt that today’s a low day for him. But I suspect that history will be much less harsh on Wiedeking than it will be on, say, Lewis.


If Wiedeking just take the trouble to contact me I will show him a possible route to place him right on top again. Give him my tel. no. +27 766004227 or my Email

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Thursday links are eclipsed

Felix Salmon
Jul 23, 2009 16:41 UTC

Do 30 percent of seriously delinquent borrowers “self-cure” without receiving a modification?

Justin Fox defends Taibbi — and even Gasparino

Downgrade Berkshire at your peril

Measuring vehicle miles travelled: I’d like to see insurers kick-start this one, charging per mile.

“Innovation as regulatory evasion is something regulators should expect. What we had instead was precisely the reverse.

More than you could ever want on why “the affordable mortgage depression” won’t end until 2013


The new Wessell book sounds like a good read

Kindle is much better for fiction than nonfiction

Facebook, the Hollywood version

Beware for-profit loan modifiers


insurance on a per mile basis would be great for me, so someone tee it up, please. Road use charges on a per mile basis seems silly to me — gasoline taxes approximate the same effect, with an added tax on fuel inefficient vehicles. That seems like a sensible set up already in place.

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What weird spam is this?

Felix Salmon
Jul 23, 2009 13:13 UTC

On June 11, I got an email from mike.power200@gmail.com:

What are the tax if i live in ny and la?
Would you consider giving me a hand or at least some advice based on your experience?
Would you consider giving me a couple pointers?
Thank you in advance.

It was the first of many such weird, semi-targeted spams. June 22, from petrov.gazprom@gmail.com:

How much rent you can play on a 6 million house? What are the pros and cons I should be looking out for? Would you consider giving me a couple pointers? I really appreciate your help. Thankyou, Jerod

June 27, from winstonfinancial@gmail.com:

How much per square foot to build an apartment? I have been thinking about this for a while and was hoping you might be able to shed some light on the subject. Please point me in the right direction. Thank you for your help.

July 1, from the same winstonfinancial address, but this time with a different name at the bottom:

Are interest rates on cds going to go up? What Gotchas should I be aware of?
Please point me in the right direction.
Thankyou. Gratefully, John

On July 5, an email from petersons.production@gmail.com dispensed with the greeting entirely:

When are mortgages going back to normal?
I need a little help/direction before I can start. Any nuggets of wisdom would be absolutely great and very much appreciated. Would you consider giving me a couple pointers? Thank you very much. Warmest Regards, Terry

On July 10, the same email address asked me about fixed vs variable mortgages, signing itself “Susan”; on July 15, it was “Frank” looking to rent a house in the UK; and on July 19, the email had changed to petrov.gazprom@gmail.com, where “Tony” wanted to know “How much does it cost per day in london?”. By July 21, “Tony” had changed his email to iris.accountants@gmail.com, maybe because the petrov.gazprom address had switched over to “Leanne”, who, this morning, asked me “How much does 1 hour phone cost on the home phone?”.

The general rubric is clear: a foo.bar@gmail.com email address, a question, a plea for help, and a sign-off. Is anybody else getting these emails? And what is their purpose?


Annals of rank hubris, Larry Summers edition

Felix Salmon
Jul 23, 2009 01:26 UTC

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.


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.

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Morgan Stanley’s risk taking

Felix Salmon
Jul 22, 2009 23:51 UTC

The NYT’s Graham Bowley comes out and says it in his report on Morgan Stanley’s weak earnings today:

The results were in sharp contrast to rivals Goldman Sachs and JPMorgan Chase, which both reported strong second-quarter profits last week. Those two banks in particular have rebounded more quickly, mostly by taking on more risk in trading for themselves and their customers. But Morgan Stanley, which was burned more severely by the crisis, has moved to reduce its risk taking and try to build a stable, less volatile firm.

While analysts say the approach may pay off in the long run, for now Morgan’s losses are raising questions about the strategy being pursued by its chief executive, John J. Mack.

This seems clear: Goldman Sachs is making money because it’s “taking on more risk”; Morgan Stanley is losing money because it “has moved to reduce its risk taking”. What’s more, anonymous analysts seem to think that the take-less-risk approach is a good idea.



Clearly there are limits to reducing risk-taking. And if you use the purest indicator of risk-taking that Morgan Stanley reports quarterly, it’s going up, quite fast, not down. (From $105 million to $154 million in five quarters is a 36% annualized growth rate.)

So how come Morgan Stanley is so weak while Goldman Sachs is so strong? It’s very unclear to me.


Perhaps the modified value at risk would be a better way of measuring risk. See http://investexcel.net/223/modified-valu e-at-risk/

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Blogging and firewalls

Felix Salmon
Jul 22, 2009 10:39 UTC

File under “getting results”: after I kvetched (not for the first time) about how both The Audit and Dealscape served up truncated RSS feeds, both have now switched to full feeds. Dealscape has an interesting model, which I haven’t seen before: its free content gets served up in full, interspersed with truncated versions of its paid content. Essentially, the RSS feed is acting as an advertisement for the subscription service.

OK, scratch all that. I wrote the above, and then went out for a walk in the Chinese countryside, and when I came back, although The Audit still had its full RSS feed, Dealscape had re-truncated theirs. Why? It makes no sense: everybody I’ve talked to who’s switched from partial feeds to full feeds has seen their web traffic go up as a result. (Update: Now The Audit has re-truncated too! Aargh!)

But that’s not the only thing which doesn’t make sense about The Deal’s blogs. For instance, after I said that I tended not to blog stuff behind subscription firewalls — “controlled-circulation magazines, research reports, paysite passwords, that sort of thing”, Yvette Kantrow responded by saying that “Salmon’s readers could, in fact, read virtually anything they choose to read, even if it is behind a firewall, if they are willing to pay for it”.

No, actually, they couldn’t. Of the three examples I gave, two are specifically not available to anybody willing to pay for them. Yvette Kantrow might live in a world where “reader” is synonymous with “well-connected and important US-based financial-market professional”, but I don’t, and I don’t want to, either. I’m glad I have such readers, but I’m also glad I have lots of other readers, too, who can’t pick up the phone and ask a bank for a copy of a research report, and who don’t have the kind of cachet which lands them on the distribution list of controlled-circulation magazines.

A lot of them don’t even live in the US, which means that even if they wanted to go down to their local newsstand to buy a copy of Rolling Stone, they couldn’t. International payment systems are still a bit rickety, and in many countries it’s still pretty much unthinkable for people to give out their credit-card details over the internet. In any case, the fact is that if I link to something behind a subscription firewall, the chances are that only a small proportion of my readers will be able to read it.

Kantrow continues:

Call me hopelessly old-fashioned, but why not ask readers to foot some of the bill for content journalists create — especially now, when online ad sales are severely depressed? Do bloggers value journalism so cheaply? In Salmon’s blog-infused world, any content that isn’t available for free, online, simply doesn’t exist. As he puts it, “you can’t link from your blog to a magazine sitting on your bedside table.” True enough, but by the same token, you can’t link to a phone call or a human conversation, either. Would Salmon “feel like an idiot” blogging about one of those if its content were compelling?

Firstly, there’s nothing old-fashioned about readers paying for journalism: the historical business model behind journalism was to give the content away in an attempt to maximize circulation, and then charge advertisers for access to those readers. If readers did pay a subscription fee, it was always less than the printing and distribution costs of the physical object — they’d partially pay for the paper, and the news came free.

As for content which isn’t available for free online, I don’t think it doesn’t exist. But the bar is raised a lot before I’ll write about such material on my blog, and indeed I’ve been known to spend some time going back and forth with editors and publishers asking them to make a certain article free so that I have something to link to.

There’s also something a bit broken about the idea that I should ask my readers to foot the bill for someone else’s journalism — especially when a very high proportion of the stuff I link to I think is fundamentally wrong or misguided. If Ben Stein were behind a subscription firewall, for instance, I would never want to be considered to be encouraging my readers to pay for his execrable columns. The ecology of hyperlinks breaks down immediately when money gets introduced: you get a sharp uptick in bloggers writing extremely annoying things like “a certain publication, which I shan’t link to here, has accused me of” etc etc. Blog readers, who used to be part of the conversation, at that point find themselves essentially just overhearing one side of it. And that serves no one.

What about those phone calls and human conversations? I blog those very rarely, for precisely that reason. Reporters make phone calls and write them up; bloggers can and do report occasionally, but it’s by no means a necessary part of their job.

There are no hard and fast rules in blogging; that’s one of the reasons I like it so much. But in general blogging is all about the free exchange of information. And yes, Yvette, that means that bloggers tend to “basically ignore anything that’s not available for free, online”. There are always exceptions to that rule. But it’s important to understand that it’s not a function of some kind of doctrinaire position in the free vs paid debate. It’s just a function of what bloggers do — which is to enjoin the public debate, rather than private debates accessible only to people paying an entry fee.


Willingly I accept. The theme is interesting, I will take part in discussion. I know, that together we can come to a right answer.

Is the 401(k) a good thing?

Felix Salmon
Jul 21, 2009 23:42 UTC

Mike Konczal (he’s come out now) says, plausibly enough, that the most important financial innovation of the past 30 years is the 401(k). Which is not to say, of course, that it’s a good thing.

Mike says the 401(k) is “the creation of a loophole in a tax bill”, which I think is doing it something of a disservice — the move from defined-benefit to defined-contribution pensions is a global one, and Mike’s really just using the 401(k) in particular as a proxy for defined-contribution pensions in general. Those would have taken off regardless, even if that particular tax bill hadn’t existed.

Mike’s right that such plans aren’t an obvious improvement on what went before. In fact, looking at his arguments in favor (“it’s a plus that consumers can directly manage their retirement finances”), one in general isn’t very impressed: there’s no reason to believe that consumers are particularly good at managing their retirement finances, and quite a lot of reason to believe that they can be extremely bad at it. That said, Mike’s right that there’s an air of historical inevitability to the whole thing. You might not like it, but it was bound to happen sooner or later.

There’s also however an air of historical inevitability about individuals schooling and working longer before they have families; I don’t think that the 401(k) was an important cause of that particular trend, although the hypothesis is intriguing.

In any case, Mike’s done nothing to counteract my thesis that financial innovation over the past couple of decades has been, on net, a bad thing. The 401(k) might be very important. But I’m far from convinced that Americans are better off for it.


\”Well, of course you’re right, Felix. We are always better off when someone more intelligent and capable is looking out for our interests. We even have a name for them; we call them Democrats\”

As everybody knows, we are the best to decide what is best for ourselves. That way, we get health insurance that covers what we do not need and pushes us towards bankruptcy, invest in retirement having no idea of the risks involved, buy \”explosive cars\’ (a.k.a. Ford Pintos) and so on.
Of course, as we are left in the hook for the whole bill others make fortunes out of it
We even have a name for those who predate on others\’ ignorance and make tons of money out of it: Republicans.

Prof. Zvi Bodie wrote quite a bit against making financial experts out of the average Joe; but if you believe otherwise, I suggest following Bodie\’s advice: next time you need surgery just get a pamphlet of what the surgery is about and operate yourself. Sounds idiotic? Well, it is what most of 401(k) holders do.

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Elizabeth Warren returns to blogging

Felix Salmon
Jul 21, 2009 23:09 UTC

Congratulations to the Baseline Scenario chaps for getting Elizabeth Warren to blog for them — she’s provided a good riposte to those who argue against the creation of a Consumer Financial Protection Agency.

Before Warren became head of the Congressional Oversight Panel, she was a frequent contributor to CreditSlips. It would be great if she started up there again, since there’s obviously nothing preventing her from blogging, and since she equally obviously has a lot to say on this kind of thing. And really, the head of the CFPA (Warren is the obvious prime candidate for the job) should be blogging.


I doubt that I am the only one Elizabeth Warren has touched with her straight, honest talk on issues that truly impact the majority of everyday Americans. As someone in his 60\’s I am consumed with a political passion I have never experienced in the past. This voice of reason and reality about how this country is run is what our nation needs. I don\’t know how to start a campaign to see her in a higher (elected/appointed) position but am willing to crawl over broken glass to have her voice reach a larger audience. Warren in 2012!!

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