Friday, December 18, 2009

Harvard's big bet on derivatives (with help from Wall Street)

There is a Bloomberg article entitled "Harvard Swaps Are So Toxic Even Summers Won't Explain" that goes into the gory details about how Harvard used derivatives to "bet" that interest rates would go higher in 2008. Interest rates went lower instead and Harvard had to borrow $2.5 BILLION in expensive bonds to "pay off" the Wall Street banks for these derivative "contracts" that were requiring additional "collateral". Ouch. Even the smart guys at Harvard thought they were doing the right thing at the time.

Lots of states and municipalities were doing the same thing. They were not "gambling" or "speculating" per se, but believed that they could "save a little money" by entering into these seemingly innocent contracts peddled by Wall Street.

Adding insult to injury, they thought they were doing the right thing by buying out of the contacts at the worst possible time in December 2008, since the contracts have "recovered" since then.

Why Harvard, with its huge endowment fund (now 30% smaller) was borrowing money to begin with makes little sense. The basic reason seems to be that the endowment fund was leveraged and they thought they could make more money with the fund than the cost of borrowing money for its expansion program.

Maybe the simple summary is that Harvard was being "Penny-wise, Pound-foolish."

But everybody was doing it... it was the "right" thing to do... or so the Wall Street story went.

Obviously it was all a very bad thing to do, but back in the years immediately preceding the crisis there was pressure on states and municipalities to "save money". Maybe you were personally one of those pesky taxpayers demanding that "your" government do more to "cut costs." For any of the money-management professionals to "say no" would have seemed irrational and offensive to "taxpayers" and their elected leaders who expected "their" government to "save money." If the crisis had not happened, any politician who hadn't tried to "save money" using these exotic instruments would have been likely to have been hounded from office for "wasting taxpayer money."

In fact, the infamous "New Jersey Swaps" that are costing $22,000 (see the Bloomberg article entitled "New Jersey Swap for Unsold Bonds Costs $22,000 a Day") a day are roughly the same thing and were "entered" back in 2004, nominally to "protect taxpayers against rising borrowing costs". Nobody objected at the time and everybody agreed with the "objective". Nobody thought of this as "gambling". They actually thought it was the "prudent" thing to do -- or so Wall Street misled them to believe.

"Penny-wise, Pound-foolish" definitely seems to fit the bill.

I would add the comment that it perfectly illustrates the danger of borrowing money. Borrowing seems so easy and relatively cheap, but it is crucially dependent on a future that none of us can know with the degree of certainty that our borrowing presumes. Borrowing is "seductive", but borrowing is also an "addiction" - where does it stop? After going through personal bankruptcy four years ago, it is now unlikely that I will ever again ever borrow even one cent or pay one cent of interest ever again for the rest of my life.

The thought that just crossed my mind... "We're from Wall Street and we're here to help you." Yeah, right... with friends like you, who needs enemies. These guys are more destructive to the American economy than any terrorist ever hoped to be.

And one more thing... if I ever try to borrow any money from you, please do us both a favor and just say "No."

-- Jack Krupansky

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