Derivative Exposure Causing Higher Bond Interest Cost For Harvard

Harvard University, buffered by its huge endowment, has long enjoyed AAA credit. But now, as a result of some past interest rate swaps positions that have went against them, Harvard is now finding itself paying a higher interest rate on recently floated bonds (see Bloomberg article). In fact, Harvard's main rival, Princeton University, was able to obtain better terms recently, as much as 50 bps or more on some debt going out 10 to 30 years. As a result, if Harvard's recent December sale of $1.5 billion in debt had yielded rates similar to what Princeton would have received, the savings for Harvard would have been on the order of $150 million.

It appears that the problem stemmed from the purchase of interest-rate swaps that were being used to protect the school against rates increasing in the future. Unfortunately for Harvard, rates fell, causing Harvard to look for more cash in the bond markets just as credit dried up. At one point the value of the swaps had fallen enough that they were worth a negative $570 million to the endowment. To add insult to injury, the losses required Harvard to post additional collateral, just as the market was falling and its portfolio was losing additional value. The $1.5 billion sale of debt was believed to have been done in part to allow Harvard to get out of the interest rate swap position. Unfortunately, the sale had to be made right at the time when the credit markets were freezing up, resulting in the higher cost for floating the debt. As they say, when markets are crashing, correlations have a tendency to go to one. This is surly something they will no doubt be teaching at Harvard. Liquidity risk is probably another.