Sunday, October 18, 2009

Harvard's big swap unwind

As we discussed a few months back, Harvard's lesson in Asset/Liability management had indeed been costly. What has come to light recently is the pain Harvard took on their interest rate hedges. As the school went on their construction spree and undertook a variety of capital projects in the last few years, they were running exposure to short-term rates. This was due to the way the university was financing these capital projects (which is typical for such financing).

In order to lock in their short-term rates on the capital projects' debt, they swapped floating for fixed (agreeing to pay fixed rate and receive floating). Simple enough. But as the rates collapsed late last year, Harvard got a massive margin call on the swaps. Again, this is standard - the value of the swaps went against them (they continued to pay the same fixed rate but were expected to receive floating rate that's significantly lower) and banks called for margin. In principal, that should be OK as well, because the swap losses should be offset by Harvard's lower financing costs.

But a couple things went wrong. Some of their capital projects were put on hold, so they couldn't take advantage of cheap financing. At the same time their liquidity in the endowment became significantly constrained because of the nature of their illiquid investments. And with the economy collapsing, unencumbered donations nearly dried up. The margin call was much more than they could handle and Harvard ended up issuing bonds to cover losses. They ultimately decided to get out of their exposure (possibly at the worst time.) They unwound some $1.1 billion of swaps. However, rather than unwinding the remainder of the hedges (and paying the losses upfront), they simply locked in the losses with offsetting swaps, creating a long-term liability stream. Here is the statement on the offsetting trades:

Harvard (see attached): ... in fiscal 2009, the University entered into additional interest rate exchange agreements with a notional value of $764.0 million, under which the University receives a fixed rate and pays a variable rate. These new interest rate exchange agreements, or ‘offsetting’ agreements, were intended to reduce the risk of further losses in value (with associated collateral posting requirements) within the portfolio of interest rate exchange agreements.

In fact this unwind and others like it at the time caused the 30-year swap spreads to go negative. The overall impact on Harvard's financials was severe:

Bloomberg: Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

So how can a bunch of really smart people run into so much trouble with a hedging program. The consultants out there are shouting - you should have hired us to do this. This is too complex for you Harvard guys.

Bloomberg: “It says that people don’t understand the complexity of the products they are buying and selling that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California. ... “It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

"so highly complex"? This is how this particular consultant gets paid, by making sure that everything in finance is "too complex" to do without his guidance. In fact this is not about complexity, it's about the practicalities and appropriateness of financial products. And this is when academia often fails - the rule of "we must hedge everything with swaps" was put in place by someone who is not only clueless about the simple mechanics of margin, but also doesn't understand the purpose of hedging.

What is the purpose of hedging here? For Harvard it was to avoid paying really high rates on their financing. But what is high? If LIBOR was at 4.5% when they started on their projects, would it be that difficult for them to pay 5% or 6%? Probably not. The real pain would kick in above say 8%. Hedging for this type of situation should be viewed as a form of insurance. And as we all know, when you buy insurance, the cost depends on your deductible. So Harvard instead of entering into swaps, could have easily bought some interest rate caps struck at say 8%, making sure they never have to pay above that level. It's a high deductible, making these caps reasonably inexpensive. In retrospect it would have been money wasted, but as with any insurance, you buy it hoping it will be wasted.

Alternatively, if they didn't want to pay upfront premium for caps, they could have put on cancellable swaps. The right to cancel would have made their fixed payments higher (depending on maturity, maybe a percent more). But they could have simply cancelled them last year with no breakup costs or margin call. It's a standard and fairly liquid product (in the category of "swaptions"). Of course some would say - oooo, this is too exotic. This concept is actually commonplace, as the "option to cancel" is built into most people's mortgage. When mortgage rates drop, most can refinance with no penalty of unwinding the old mortgage (something borrowers generally can't do in the UK for example). If you refinanced your mortgage before, you've exercised your "option to cancel".

The media is making this sound as though it's a "bad investment" gone wrong - mostly because they don't understand the situation, and it creates good hype. In reality it's simply an issue of sound asset/liability management, proper usage of financial tools, and a bit of common sense. Makes for a good Harvard Business Case study.

Harvard- Financial Report
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