Oct. 16 (Bloomberg) -- Harvard University, the world’s richest school, paid almost $500 million to investment banks to escape interest-rate swaps that backfired, according to the school’s annual report released today.

Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The transactions began losing value last year as central banks slashed benchmark lending rates, forcing the university to post collateral with lenders, said Daniel Shore, Harvard’s chief financial officer. Some agreements require that the parties post collateral if there are significant changes in interest rates.

“When we went into the fall, we had some serious liquidity management issues we were dealing with and the collateral postings on the swaps was one,” Shore said in an interview today. “In evaluating our liquidity position, we wanted to get some stability and some safety.”

Harvard sold $2.5 billion in bonds, in part to pay for the swap exit, even as the school’s endowment recorded its biggest loss in 40 years, the Harvard report said.

Type of Derivative

Swaps are a type of derivative where two parties agree to exchange payments tied to a financing, typically receiving a variable-rate for a fixed-rate payment. The terminated contracts include three tied to $431.7 million of bonds the university sold in 2005 and 2007, the annual report said.

From New York to San Francisco Bay, tax-exempt issuers have paid hundreds of millions of dollars to unwind bond-and-swap transactions officials initially said would cut borrowing costs. The deals fell apart when municipal-bond insurers, who backed much of the underlying debt, lost their AAA ratings in 2008 and interest rates, instead of climbing, plunged to record lows in the worst credit crisis since the Great Depression. The swaps are often pegged to Securities Industry and Financial Association lending benchmarks or the three-month dollar London- Interbank Offered Rate, known as Libor. It closed today at 0.28 percent, from a 10-year high of 6.89 percent on June 1, 2000.

Yale University

Yale University in New Haven, Connecticut; Georgetown University in Washington and Rockefeller University in New York have reported interest-rate swap related losses, in some cases prompting the schools to pay termination fees to end the contracts.

The annual report provides new details on Harvard’s derivative-related losses. Many were entered into in 2004, said Christine Heenan. Lawrence Summers, director of President Barack Obama’s National Economic Council, was the university’s president at the time.

Harvard Management Co., which administers the endowment, has been run since July 2008 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.

“It says that people don’t understand the complexity of the products they are buying and selling that doesn’t begin and end with mortgage securities,” said Robert Doty, a municipal finance adviser at American Governmental Services in Sacramento, California.

‘So Highly Complex’

“It shows that with these products that are so highly complex, people are a long way from knowing as much about these products as they think they do,” he said.

The Harvard swaps involved bonds sold to finance a medical research building, graduate housing, parking and a Center for Government and International Studies, according to reports from Moody’s Investors Service.

The underwriters of the securities were New York-based JPMorgan Chase & Co. and RBC Capital Markets, a unit of Toronto- based Royal Bank of Canada, Moody’s said in reports when the bonds were sold.

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 released on Jan. 18, 2008.

Issuer’s Sophistication

Harvard paid “a large termination fee, but within the range that we’ve heard about over the last year,” Matt Fabian, the senior analyst and managing director of Municipal Market Advisors in Westport, Connecticut, said in an e-mail. “There is a reason why, regardless of the issuer’s sophistication, there should be limits to their exposure to derivatives and variable rate bonds.”

Harvard has frozen employee salaries, slowed hiring, cut staff and offered other workers early retirement as part of a cost-cutting program to compensate for losses in its endowment. The fund, which dropped to $26 billion in value over the fiscal year from $36.9 billion, paid 38 percent of the school’s bills during that time, the report said.

Alumni Request

The Faculty of Arts and Sciences, Harvard’s biggest unit, which includes its undergraduate school, is asking alumni and donors for more funds that can be used immediately and without restrictions to help close a projected $110-million deficit in its 2011 budget, Dean Michael Smith said in a recent speech. Current-use gifts rose 23 percent to $291 million from $237 million in fiscal 2008, the report said.

Harvard might have paid less to escape the swaps if it held out for better terms, Fabian said.

“A lot of issuers don’t have that kind of cash, and so they waited, and relied on their dealers’ patience and largesse to hold off terminating,” Fabian said. “If Harvard had waited, the cost of terminating may well have been lower, but they weren’t willing to take that risk.”

To contact the reporters on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net; John Lauerman in Boston at jlauerman@bloomberg.net.

Last Updated: October 16, 2009 17:57 EDT