This Bloomberg report on the financial crisis at Harvard University last year is worth reading, even if you just breeze through all the technical talk about interest rate swaps.
There is, first, the almost epic poetry of this fact: that a big player on seemingly every side of this web of contract and abstraction and folly… is a Harvard man!
In the midst of the crisis that triggered this Great Recession, Harvard University suddenly faced a crisis of its own. The University owed a Harvard man’s company (a fragment of the old Morgan empire), along with other banks, huge sums in collateral calls. It had sought to trim its capital costs with purchases of interest-rate and forward swaps. The degraded swaps went precipitously illiquid last fall, and far from lowering the school’s capital costs, instead opened a gaping hole in its available capital. “Harvard was so strapped for cash,” according to the Bloomberg report, “that it asked Massachusetts for fast-track approval to borrow $2.5 billion.”
The University survived, but its endowment fund lost close to $10 billion. A big chunk of the cash collateral went to JPMorgan Chase & Co., a firm whose history intertwines with the august Cambridge institution. (J. P. Morgan, Sr., himself had bequeathed to Harvard Medical School $1 million in 1901.)
And one of the men from the Government hired to clean up the crisis that wounded Harvard and most of American high finance — well he used to be the President of Harvard when the school purchased the toxic swaps, and indeed, he answers to a President who graduated from Harvard Law School. Many of the deputy financiers in this story also have Harvard ties.
Harvard’s historic losses came in that bewildering infrastructure of speculative debt that grew up around the industries of real estate, development, and above all real estate finance in the United States over the past thirty years. Indeed, the swaps were purchased precisely to hedge against the interest-rate risk on bonds floated — wait for it — in order “to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts.”
Further details from the Bloomberg article fill out the peculiar picture. Harvard was doing more than just hedging exposure; it was actively speculating in the derivatives market, “as early as 1994.” Its endowment fund took on many characteristics of a hedge fund: Its managers devised ways to do more than the usual effort to “fix borrowing costs for capital projects” by these derivatives contracts; they also “used swaps to profit from interest-rate changes.” Larry Summers, Harvard President from 2001 to 2006 (when he was driven out of the place by p. c. enforcers), came to the school after serving as U.S. Treasury Secretary during the end of the tech bubble, the bursting of which bubble shifted the focus of investment in America from technology firms and IPOs to real estate and structured finance. He had earned his Ph.D. at Harvard, and was made a tenured professor at the tender age of 28.
In the summer of 2005, Summers pushed for a big real estate investment by the university. He “unveiled his vision for a campus expansion replete with new laboratories, dormitories and classrooms, renovated bridges and a pedestrian tunnel beneath the water.” To fund all this he called on the endowment, now a decade into its operations in speculative trading. “Harvard was flush at the time”; the endowment was worth $22.6 billion and “had returned an average of 16 percent during the previous 10 fiscal years.” Not too shabby. Might the exuberance of Harvard Square have resembled the morbid optimism of the Financial Products unit of A.I.G. in London?
Bloomberg quotes the almost touching confidence of the Harvard Square financiers, in the minutes of a faculty meeting: “Harvard would be able to generate adequate resources. The only real limitation faced by the Faculty was the limit of its imagination.” The financiers had put in a year’s worth of work, “behind the scenes, devising a financing strategy” for putting derivatives to use in the real estate expansion. “The Allston project was to transform an industrial and working-class neighborhood of two-family wood homes and small shops by building two 500,000- square-foot (46,000-square-meter) science complexes and a redrawn street grid.”
University endowment funds have been active in the derivatives markets for many years. Bloomberg notes a handful of other financing projects at other Ivy League schools that employed swaps and other devices. Many of these, too, produced big losses, though none on the scale of Harvard’s.
On the other side of these derivatives contracts are the big banks. “For more than 20 years, investment banks such as Goldman Sachs Group Inc., JPMorgan, and Citigroup Inc., all based in New York, have been selling swaps as a way for schools, towns and nonprofits to reduce interest costs and protect against rising interest payments on variable-rate debt.”
In another eerie parallel to A.I.G., where former CEO Maurice “Hank” Greenberg was driven out by political pressure after massively expanding that firm into the field of finance wizardry, Harvard’s finance whiz Summers was run out of town for venial political reasons. He spoke vaguely of differences in cognitive abilities between men and women, and the feminists pounced.
When the financial world fell to pieces in September 2008, both A.I.G. and Harvard would face crisis and calamity due to their exposure to derivatives. A.I.G. became the very emblem of catastrophe and bailout for this Great Recession; its gargantuan rescue by the U.S. Treasury and Federal Reserve would have to be (rather embarrassingly) reworked multiple times; its officers would be dragged before Congress for rhetorical bludgeoning; and its notorious London unit traders would in time figure as symbols for the reckless risks of the financier class. Only now, a full year later, has A.I.G. started to recover, though only as a shadow of its former self.
Harvard, meanwhile, would have to receive special authority from a Massachusetts state agency in order to raise the funds to fill the hole in its capital base. The bonds sold to raise this cash were sold at the very nadir of the market. Bloomberg quotes an analyst who does not mince words: “December 2008 was, by an enormous amount, the worst time in history” to have to float bonds to terminate the swaps.
A year out from this mess, Harvard has reduced its development and finance planning dramatically. The financiers of Harvard Square have pulled in their horns. Bloomberg again: “Cranes were recently removed from the construction site of a $1 billion science center that was to be the expansion’s centerpiece, a reminder of Summers’s ambition.” Work on the expansion project is suspended.
Here then is another instance of what I have called the great usury crisis, the breakdown of this speculative trade in securities and derivatives, all interlocking to form a vast infrastructure of debt finance. The basic fragility of this system, which spread over the past thirty years from America to almost every corner of the developed world — and many dark and seemingly obscure corners of the developing world — is now evident to everyone with eyes to see. The integration of world capital markets by means of mathematical abstraction, probabilistic modeling, and huge leverage ratios, has midwived an astounding transformation in the political economy of the Republic, decisively away from Free Enterprise and towards a bizarre sort of technocratic Socialism.