Harvard’s interest costs are set to increase as much as $550 million over three decades because the US’s wealthiest and oldest university took advice from Goldman Sachs Group Inc, JPMorgan Chase & Co and Morgan Stanley.
Earlier, those same Wall Street banks sold Harvard, then led by Lawrence Summers, now an Obama administration adviser, derivatives that soured. When that worsened a cash squeeze, they recommended that the AAA rated school pay as much as 1.41 percentage points more than yields on identically rated corporate debt for a $1.5 billion December 5 bond sale. Five days later, they helped Harvard borrow $1 billion more at up to 5.80 per cent, to repay floating-rate debt that effectively cost it 3.4 per cent.
By accepting those terms, the college that trained such finance-world elites as John Thain and Gary Crittenden enriched initial buyers who sold the bonds as prices rose as much as 4.7 per cent in two days. It also reduced underwriters’ risks: If the bonds hadn’t sold out, Goldman, JPMorgan and Morgan Stanley would have had to buy the rest when they were hoarding cash and relying on government guarantees to sell their own debt.
“It was a riot,” said John Flahive, a senior vice president at BNY Mellon Wealth Management, of demand for the December 10 bonds. His $1 million buy “was only 20 per cent or 25 per cent of what I wanted.”
The bond sales by the university, which was established in 1636, were the largest ever by a private school and came after its endowment fell 22 per cent to $28.8 billion in the four months ended October 31. The endowment remains the biggest in the nation. Second-place Yale University had $17 billion as of mid-December.
The Cambridge, Massachusetts, school’s endowment has a reputation for investment savvy. In the past decade, it has gained an average of 13.8 per cent a year, compared with the Standard & Poor’s 500 Index’s 2.9 per cent.
In the year ending June 30, Harvard’s 8.6 per cent return beat the average of 4.7 per cent for the top 10 per cent of US endowments by performance, according to Commonfund Institute, a researcher in Wilton, Connecticut, affiliated with nonprofit money manager Commonfund.
Harvard Management Co, which administers the endowment, has been run since July by Jane Mendillo, former chief investment officer of nearby Wellesley College. She took over from Mohamed El-Erian, now chief executive officer of Pacific Investment Management Co, which oversees the world’s largest bond fund from Newport Beach, California. He succeeded Jack Meyer, who ran it for 15 years, in February 2006.
Best performers
Since the December sales, Harvard’s bonds have been among the US’s best performers as investors clamoured for generous yields from an institution that S&P rates AAA, the highest level.
After the first sale, which involved taxable bonds, the five-year notes rose an estimated 2.6 cents on the dollar on the first day of trading, Bloomberg data show. A day after the second sale, of tax-exempt bonds, securities firms traded $9.8 million of 5.5 per cent bonds due 2036 amongst themselves for as much as 97.08 cents per dollar, up from the initial price of 95.871, trading reports show. By the next day, they sold them for as much as 100.375, a 4.7 per cent increase from the initial price.
In the months since, Harvard’s 30-year, 6.5 per cent taxable bond has jumped to an estimated 109.43, up from 99.64, Bloomberg data show. The 10-year has climbed to an estimated 106.79 from 99.52, or 7.3 per cent. Prices of investment grade corporate bonds in a Merrill Lynch & Co index, with an average maturity of 10 years, rose less than 2 per cent in the same period.
Fees of $6 million
Harvard paid lead underwriters JPMorgan and Morgan Stanley, along with Goldman Sachs and other bankers, a total of $6.07 million for their services on the $1 billion tax-exempt issue, documents on the sale show. Those three banks earned an undisclosed sum as lead underwriters of the $1.5 billion sale of taxable bonds.
The university declined to provide on-the-record answers to questions about the bond sales. JPMorgan and Morgan Stanley had no comment.
Michael DuVally, a Goldman Sachs spokesman, said the bonds’ rates were reasonable given market conditions at the time.
“On the back of the Lehman Brothers bankruptcy filing in September, the world was a very fragile place,” he said in an e- mail. The prices of several “high-quality” bonds issued late last year have rallied since, and “Harvard happens to be one of these deals.” Those rallies have caused yield gaps between investment-grade bonds and Treasuries to narrow for all sorts of borrowers, not just Harvard, he said.
Not too generous
Christopher Cowen, who also advised Harvard on the sales as managing director of Prager, Sealy & Co in San Francisco, said the yields weren’t too generous because other borrowers couldn’t attract investors at the time and “institutional buyers just weren’t there.” Prices for Harvard’s bonds “certainly could have gone in the other direction,” he said.
Bankers studied yields on bonds from Johnson & Johnson and other AAA borrowers to determine how much Harvard should offer, Cowen said.
On the day of the first sale, Johnson & Johnson’s five-, 10- and 30-year bonds traded with yields lower than Harvard bonds of equal maturity by 0.6, 1.41 and 1.41 percentage points, respectively. With subsequent price increases, the 30-year Harvard bonds’ yield now is just 0.34 percentage point higher than Johnson & Johnson’s.
Last Year’s Losses
Harvard was the first of several universities to tap the bond market after their investments suffered losses last year, crimping budgets. The endowment provided about 35 percent of the school’s $3.48 billion in revenue in the fiscal year that ended June 30.
North American college endowments lost an average of 22.5 percent from July 1 through Nov. 30, according to the National Association of College and University Business Officers and Commonfund. The S&P 500 fell 29 percent in that period.
Harvard estimates it will lose 30 percent this fiscal year, which would be its worst in at least four decades, according to a Dec. 2 memo from President Drew Gilpin Faust and Executive Vice President Edward Forst, who was a Goldman Sachs executive before joining the school in September to help oversee its finances.
When Princeton University sold $1 billion in bonds in January, the New Jersey school’s 10- and 30-year notes sold for 2.7 percentage points above Treasury yields, compared with Harvard’s 3.35-point premium five weeks earlier.
Establishing a ‘Baseline’
“Harvard certainly helped us” by establishing a “baseline” for yields other schools didn’t need to approach, said Kenneth Molinaro, Princeton’s controller.
Harvard would save $150 million over 30 years if its $1.5 billion issue had sold at Princeton’s yield spread over Treasuries.
As for the $1 billion sale, the school’s annual report said the average rate on its tax-exempt floating-rate debt was 3.4 percent last year after taking into account derivatives known as interest-rate swaps that effectively converted some to fixed rates. Had it kept paying those rates instead of retiring the debt with higher-yield bonds, it would save another $400 million at least.
Harvard needed the $2.5 billion raised in December because the value of its investments had fallen. Last year’s losses triggered about $1 billion in margin calls, according to a person familiar with the endowment who spoke on the condition of anonymity. The value of its interest-rate swaps also plunged, prompting demands for more collateral to back them, said a person familiar with those contracts.
Goldman, JPMorgan
The school had 19 swap contracts with Goldman, JPMorgan Morgan Stanley, Bank of America and other large banks, according to an S&P bond-rating report.
Under the agreements, Harvard paid the banks fixed interest rates on a total notional amount of $3.52 billion in exchange for floating-rate payments from them. Some of the swaps were used in conjunction with existing floating-rate bonds, essentially converting their cost to fixed rates.
Most were intended to lock in rates for debt Harvard expected to issue as far off in the future as 2022, for a 340- acre campus expansion, according to Moody’s Investors Service. In 2006 and 2007 reports, Moody’s warned of risks from those so- called forward swaps, though it said the school’s strong finances and management experience mitigated them.
Summers’s Time
The forward swaps were signed when Summers, now the director of President Barack Obama’s National Economic Council, was Harvard’s president, from 2001 to 2006. Summers declined to comment on the record about the matter.
The value of Harvard’s swaps dropped as the fixed rates sought by banks in exchange for floating rates on new swaps fell below what the university was paying. By Oct. 30, its swaps were worth a negative $570 million, meaning that’s how much Harvard needed to pay to get out of them, S&P said. That was down from negative values of $330.4 million on June 30 and $13.3 million a year earlier, according to Harvard’s annual report.
The swap collateral requirements became a problem when combined with the endowment’s losses and margin calls, said the person familiar with the contracts. Other borrowers with lower ratings have negotiated swap deals that don’t require them to post collateral unless their ratings fall below a stipulated level, this person said.
‘Liquidity Needs’
“They definitely had some liquidity needs, without a doubt,” said Marc Savaria, an analyst at S&P, which confirmed Harvard’s AAA rating on Dec. 5, the day of the $1.5 billion bond sale.
Princeton’s Molinaro said he doesn’t use such interest-rate swaps because of the risks associated with counterparties whose ratings are lower than its AAA.
The cash squeeze prompted Harvard’s endowment to sell some stocks and withdraw money from hedge funds, while also trying without success to sell buyout-fund investments, said the person familiar with the endowment. By December, school officials decided to tap the bond market, rather than sell investments at a time when prices were depressed, this person said.
“It was heavy in equities, public and private, and hedge funds and all sorts of alternative assets, and for many years, those assets were continuous providers of cash return,” said John Morris, who helps oversee $30 billion for endowments and other clients as managing director of HarbourVest Partners in Boston. “And that party has stopped.”
Stopping Swap
Some proceeds from the $1.5 billion bond sale paid termination fees for the forward-rate swaps, the S&P report said. Harvard declined to say how much it spent to get out of the agreements. As much as $99.3 million of the $1 billion sale paid off swaps related to existing debt, Harvard’s official statement on those bonds said.
Those actions eliminated the need for collateral on the swaps, according to rating company reports. By paying off $881.9 million of tax-exempt floating-rate bonds and commercial paper, Harvard further reduced its ready cash needs because those securities had allowed investors to demand their principal back with as little as a day’s notice.
“They had to get out of a hole; they had to cover the swaps,” said D. Ronald Daniel, a former Harvard treasurer. When he left in June 2004, the school didn’t have any interest-rate swaps related to planned debt, “and we didn’t have any liquidity issues,” Daniel said.
To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net. Gillian Wee in New York at gwee3@bloomberg.net
