March 3 (Bloomberg) -- Harvard, the oldest and richest academic institution in America, with more U.S. presidents than any other university, isn’t getting the respect it deserves in the bond market.

Even with its pristine AAA credit, the President and Fellows of Harvard College are paying more than similarly rated schools and companies for the first time in memory after even the smartest money managers in Cambridge, Massachusetts, became entangled in derivatives that proved toxic. The extra interest that Harvard, founded in 1636, had to give bondholders for its $1.5 billion December sale is the consequence of the most sophisticated financing gone awry from Wall Street to the Ivy League.

The trouble started a few years ago, when Lawrence Summers, then Harvard’s president and now director of President Barack Obama’s National Economic Council, presided over the purchase of so-called interest-rate swaps to protect the school against rates going up. Instead, the swaps backfired as rates fell, forcing Harvard to search for more cash in the bond market late last year just as credit dried up.

As a result of its mishaps, Harvard wound up enabling Princeton University, with an identical AAA rating, to obtain better terms from investors in January. While Harvard’s bonds yielded 3.37 percentage points more than Treasury yields on its $500 million of 6.5 percent notes due in 2039, the New Jersey school paid a smaller premium of 2.7 percentage points five weeks later when it borrowed $1 billion, divided between 10-year and 30-year maturities. .

“Harvard certainly helped us” by establishing a “baseline” for yields that other schools didn’t need to approach, said Kenneth Molinaro, Princeton’s controller.

Johnson & Johnson

The Harvard bonds will pay $150 million more in interest over 30 years than if it had matched Princeton’s spread over Treasury yields, according to data compiled by Bloomberg.

Bonds of companies with AAA ratings traded with lower yields than Harvard when it sold notes due in 2014, 2019 and 2039. Bonds of Johnson & Johnson, the world’s biggest maker of health-care products and a benchmark in the $6.1 trillion market for corporate debt, yielded as much as 1.41 percentage points less than the university’s on the day it was sold, according to data compiled by Bloomberg.

Harvard’s high-yielding securities were so cheap that professionals couldn’t get enough of them. Investors snapped up so many of the 30-year bonds that they now yield 0.53 percent more than comparable maturity notes of New Brunswick, New Jersey-based J&J’s securities.

Tax-Exempt Sale

Harvard also sold $1 billion of tax-exempt bonds with interest of 5.8 percent. Those securities replaced debt that paid an average rate of 3.4 percent last year, after taking into account derivatives that include interest-rate swaps that effectively converted some to fixed rate, according to the school’s annual report.

The new debt increased interest costs by at least $400 million over the 27-year life of those bonds, according to Bloomberg data.

The tax-exempt bonds also proved generous for investors. A day after the Dec. 10 sale, securities firms traded $9.8 million of 5.5 percent bonds due 2036 for as much as 97.08 cents per dollar, up from the initial price of 95.871, trading reports filed with the Municipal Securities Rulemaking Board show. By Dec. 12, banks sold them to customers for as much as 100.375 --a 4.7 percent increase from the initial price.

“It was a riot,” said John Flahive, a senior vice president at BNY Mellon Wealth Management in Boston, who purchased $1 million of the debt, “only 20 percent or 25 percent of what I wanted.”

Rubin, Schwarzman

The university, whose alumni include former Goldman Sachs Group Inc. co-Chief Executive Officer and Treasury Secretary Robert Rubin, 70, and Stephen Schwarzman, the 62-year-old chairman and chief executive officer of Blackstone Group LP, needed the $2.5 billion because it got hit by a double whammy of losses in both derivatives contracts late last year and in its $28.8 billion endowment, the world’s largest, as of Oct. 31.

A 22 percent slump in the four months ended Oct. 31 in the endowment triggered about $1 billion of so-called margin calls, or demands from lenders to cover losses, according to a person familiar with the endowment who spoke on the condition of anonymity. At the same time, the value of Harvard’s interest- rate swaps plunged, prompting demands for more collateral, said another person familiar with those contracts.

Harvard had 19 swap contracts with New York-based Goldman Sachs; JPMorgan Chase & Co.; Morgan Stanley; Charlotte, North Carolina-based Bank of America Corp. and other large banks, according to a bond-ratings report by Standard & Poor’s.

Losing on Swaps

The agreements required Harvard to pay banks fixed interest rates on a total underlying amount of $3.52 billion in exchange for receiving floating-rate payments. Some of the swaps were used with existing floating-rate bonds, essentially converting the school’s cost to fixed rates.

Most of the swaps, signed when Summers, 54, was Harvard’s president from 2001 to 2006, were intended to lock in rates for debt that Harvard expected to issue as far off as 2022, for a 340-acre campus expansion, according to Moody’s Investors Service. In 2006 and 2007, Moody’s warned of risks from those so-called forward swaps, though it said the school’s finances and management experience mitigated them. Summers declined to comment on the record about the matter.

The value of the swaps dropped as the fixed rates charged by banks in exchange for floating rates on new contracts fell below what the university was paying. By Oct. 31, 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. The losses widened from $330.4 million on June 30 and $13.3 million a year earlier, according to Harvard’s annual report.

‘Liquidity Needs’

The losses required Harvard to put up more collateral, causing a cash squeeze because the tumbling value of the endowment also required payments, said the person familiar with the contracts.

“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.

The cash demands prompted the endowment to sell 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 realized they needed to tap the bond market, rather than sell assets at depressed prices, 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.”

Credit-Market Freeze

Harvard was forced into credit markets that were still reeling from the collapse of Lehman Brothers Holdings Inc. in September. When the university issued its bonds, the so-called TED Spread that measures the difference between what banks and the Treasury pay for three-month loans was about 2.17 percentage points.

In the decade before the collapse of subprime mortgages caused markets to begin freezing in July 2007, the TED Spread averaged 0.54 percentage point.

Some of the money from the $1.5 billion bond sale paid fees to terminate 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, according to Harvard’s statement on those bonds.

Endowment Losses

“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.

Investment losses are a departure for Harvard’s endowment, which gained an annual average of 13.8 percent over the past decade, compared with the Standard & Poor’s 500 Index’s 2.9 percent.

In the year ending June 30, Harvard’s 8.6 percent return beat the average of 4.7 percent for the top 10 percent of U.S. endowments by performance, according to Commonfund Institute, a researcher in Wilton, Connecticut, affiliated with nonprofit money manager Commonfund.

The losses in the four months through October left Harvard’s fund with $28.8 billion, compared with Yale University, which has the second-largest, at $17 billion as of mid-December.

Most Presidents

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, which depended on the endowment for about 35 percent of its $3.48 billion in revenue during the fiscal year that ended June 30, is more accustomed to accolades.

Obama is the eighth U.S. president with a Harvard degree -- more than any other college, the Harvard University Gazette Online said on Nov. 5, citing journalist Robert Windrem. Harvard’s alumni include John Adams, John Quincy Adams, Rutherford B. Hayes, Theodore Roosevelt, Franklin D. Roosevelt, and John F. Kennedy. George W. Bush got his business degree from the university in 1975, and Obama is a 1991 graduate of Harvard Law School, the article said.

Now, the performance is getting worse. Harvard estimates the endowment will lose 30 percent this fiscal year, the most 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.

Bond Gains

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.

In the months since the sale, Harvard’s $500 million of 30- year, 6.5 percent taxable bonds rose to an estimated 109.60 cents on the dollar from 99.64, Bloomberg data show. The $500 million 10-year note climbed to an estimated 107.11 from 99.52, or 7.3 percent. Prices of investment grade corporate bonds in a Merrill Lynch & Co. index, with an average maturity of 10 years, rose less than 2 percent in the same period.

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.

JPMorgan, Morgan Stanley and Goldman earned an undisclosed sum as lead underwriters of the $1.5 billion sale of taxable bonds.

Wall Street Alumni

The university declined to comment publicly about the bond sales. JPMorgan, whose CEO Jamie Dimon received his business degree from Harvard Business School, and Morgan Stanley had no comment.

Michael DuVally, a spokesman for Goldman Sachs, said the bonds’ rates were reasonable at the time they were sold. Goldman CEO Lloyd Blankfein graduated from both Harvard College and Harvard Law School.

“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.”

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.

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

Last Updated: March 3, 2009 13:30 EST