Harvard Debt Sales Draw Mixed Reactions

While recent accounts of Harvard’s financial affairs seem to border on cataclysmic, some finance experts question whether the University’s investment decisions resulted from a lack of foresight as suggested by some media outlets.

A recent Forbes cover story stated that Harvard’s “supremely self-confident money managers” were in a “cash-raising panic” after billions of dollars in derivatives investments went sour—forcing the University to post collateral it did not have. The dire situation, the article said, forced Harvard to pay unfavorably high interest rates to raise the necessary funds.

But other finance experts said the issuances were less the result of poor decision making in the past and more a reflection of the unpredictably volatile market in which it issued its debt.

David Scudder, a former vice president at Harvard Management Company who now serves as chairman of Aureus Asset Management, said that December was not an easy month to issue any bonds at all, and that 2008 was a “very exceptional year in which virtually every class around the globe, with the single exception of Treasury bonds, went down in value.”

He added that while institutions could have boosted their liquidity to hedge against extreme downturns, such a move would come at the cost of long-term investment returns.

“I don’t know if anybody has a particularly good answer to that trade-off,” Scudder said.

With the global financial market in free fall and the University’s endowment shrinking by at least 22 percent over the course of four months, Harvard issued $1.5 billion in taxable bonds on Dec. 5 and another $1 billion in tax-exempt debt five days later, bringing the University’s total debt in bonds and commercial paper to over $6 billion, according to a Dec. 5 credit report issued by Standard & Poor’s rating services.

Despite the debt increase, S&P reaffirmed Harvard’s AAA long-term rating, citing its “strong financial resources,” “balanced financial performance” in fiscal year 2008, and its “strong revenue diversity and demonstrated ability to raise funds.” The report also noted that as of Sept. 30, the University had a “sufficient” $2.8 billion in liquid assets and had arranged with external banks to provide further liquidity support.

According to Dan Shore, the University’s chief financial officer, the debt was issued “to manage our risk with previously issued variable rate notes [and] to enhance our cash position and our flexibility.” The variable-rate notes had allowed lenders to recall their principal on short notice, which could potentially drain the University’s cash holdings.

“We are confident that we issued our debt quite competitively given market conditions at the time,” Shore said.

But the Forbes story suggested that Harvard’s liquidity position was more precarious than Shore let on, due to the endowment slump and collateral requirements on derivatives holdings. According to media reports, Harvard had a negative 5 percent cash reserve as of June 30, indicating that the University was over-leveraged in its investments.

A recent Bloomberg analysis of the bond sales noted that Harvard’s debt paid out higher interest rates compared to a similar $1 billion bond issuance by Princeton five weeks later, a difference it attributed to Harvard’s derivatives “mishaps.”

But Princeton controller Kenneth Molinaro said that markets may have improved slightly by January, when his university issued their bonds, and that Harvard’s issuance may have even helped other universities issue debt by opening the market.

“Trailblazers are always at a little bit more risk than the settlers that follow,” said Vanderbilt associate controller Kevin R. Walker, who called criticism of Harvard’s December debt issuance unfair and said the current economic crisis is a black swan. “There was tremendous uncertainty [in the fall] with Bear Stearns, Lehman Brothers, and AIG, and I don’t think anybody knew what was going to happen.”

John F. Flahive, a vice president at BNY Mellon Wealth Management, which purchased $10 million of Harvard’s tax-exempt bonds, said that he does not think the bonds’ rates were inappropriate, nor does he think that the University’s collateral obligations forced financiers to issue debt at unfavorable rates.

“[There are] a lot of things they could have used the money for in an overall capital perspective,” Flahive said. “The underwriters were in a difficult environment and they did the best they could. In hindsight, everything’s 20-20.” He also said that if rates fall dramatically, the law governing tax-exempt debt financing gives issuers one opportunity to pay off their debt and reissue the bonds at the lower rate.

‘THE SUMMERS SWAP’

While documentation of the $1.5 billion bond sale could not be obtained because the sale was taxable, a prospectus of the $1 billion tax-exempt offering states that $881 million was to be used to pay off previously-issued variable rate debt and commercial debt, while $99 million would be used to terminate interest rate swap agreements that had been used to hedge risk from the variable debt.

According to the University’s annual financial report issued in October, “the interest rate exchange rate agreements were not entered into for trading or speculative purposes,” but were rather used to convert variable-rate borrowings to a fixed rate.

The Forbes and Bloomberg stories stated that the interest rate swaps dated back to former University President Lawrence H. Summers’ tenure, when Harvard began considering its ambitious Allston campus expansion. With interest rates favorably low and little inflation on the horizon, the University decided to use the swaps to lock in the rates. But instead, interest continued to decline, wreaking havoc on the swaps, which Forbes branded “The Summers Swap.”

As of October, the University would have had to pay $571 million to terminate its interest rate swap portfolio. The figure represents a stark decrease from the $330 million Harvard would have had to pay at the end of June 30, a figure given in the annual financial report.

Even though Molinaro said Princeton has never used interest rate swaps with regard to its debt portfolio because they decided “the incremental risk was not worth the modest savings” of a lower interest rate, Scudder said that such swaps are widely used by institutions seeking to reduce exposure to variable rate bonds.

Shore declined to comment yesterday on the current value of the swap portfolio, and would not say whether more of the swaps had been terminated beyond the $99 million from the tax-exempt bond sale.

—Staff writer Peter F. Zhu can be reached at pzhu@fas.harvard.edu.