Felix Salmon

Those Harvard swaps: Even more of a fiasco than we thought

By Felix Salmon
December 18, 2009

Bloomberg takes a dive into the Harvard swaps fiasco today, and uncovers some pretty juicy information. For instance, check out Larry Summers’s state of mind when he was entering into the swaps:

Summers told Faculty of Arts & Sciences professors in May 2004 that he hoped they wouldn’t be “preoccupied with the constraints imposed by resources, for Harvard was fortunate to have many deeply loyal friends,” according to minutes of a faculty meeting.

“Harvard would be able to generate adequate resources,” according to the minutes. “The only real limitation faced by the Faculty was the limit of its imagination.”

Money? Don’t worry about money. Larry can take care of all that. He’s Larry! And Larry was certain of two things: firstly that his beloved Allston project was a go — despite the fact that he hadn’t raised the funds for it, and secondly that interest rates would rise by the time construction started. Therefore, he decided to lock in funding costs by using forward swaps.

At the same time, Larry decided to be cheap (in a move which turned out in the end to be incredibly expensive). He could lock in funding costs simply by buying an option, but that would, you know, cost money. The swaps, by contrast, required no money up front. So, that makes them better!

We all know what happened next: Summers was ousted as president of Harvard, interest rates plunged, and the university decided to issue new bonds in order to be able to pay a billion-dollar ransom to get out of the swaps contracts.

You can’t blame Summers for the timing of the exit, which couldn’t have been worse: Bloomberg quotes swaps adviser Peter Shapiro as saying that “December 2008 was, by an enormous amount, the worst time in history” to terminate the swaps by borrowing money. Not only was the 30-year swap rate a mere 2.69%, down sharply from 4.25% in November, but the credit spread for non-sovereign AAA-rated issuers like Harvard also hit an all-time high, maximizing Harvard’s borrowing expense.

In hindsight, the decision to exit the swaps was just as disastrous as the decision to enter them: swap rates are now back up to their December 2004 levels, which means that had Harvard simply waited, it could have exited at no cost whatsoever.

The big winner here is JP Morgan, which both wrote most of the original swaps and which underwrote the bond deal which allowed Harvard to exit them. After the bond deal closed, JP Morgan bankers went out to dinner at Mistral in Boston to celebrate with Harvard officials.

Not that they picked up the bill. To the contrary, JPMorgan invoiced the Massachusetts state finance agency $388.78 for three employees who attended. Classy, that.


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