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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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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