Summers Schooled by Rates at Harvard Wants Job Setting ThemMichael McDonald
Lawrence Summers was president of Harvard University when in 2004 the world’s richest school came up with an inventive and ultimately flawed financial strategy.
Harvard was planning to build a state-of-the-art campus across the Charles River in Boston to complement its home in Cambridge, Massachusetts. Summers, 58, now a top contender to lead the U.S. Federal Reserve, approved a $2.3 billion financing method for the project that backfired in 2008 after he resigned, costing the university more than $900 million to unwind.
“That speaks to the risk-tolerance of this individual,” said Mark Williams, a former Fed bank examiner who is now an executive-in-residence at Boston University’s School of Management. “On Wall Street it works, but does it work as the chairman of the Federal Reserve?”
While serving as president of the 377-year-old university would typically burnish one’s standing, Summers’s five tumultuous years at Harvard left a legacy of hurt feelings and controversial decisions that are re-emerging as he is being considered by President Barack Obama to replace Ben S. Bernanke as head of the nation’s central bank.
Summers’s comments in a 2005 speech questioning women’s aptitude for science fueled a faculty revolt that led him to quit the following year. Yet clashes with the faculty plagued him from the outset, including a dust-up with professor of African-American studies Cornel West over his work and ending with his support for Andrei Shleifer, a Harvard economist caught in a conflict-of-interest scandal while working in Russia.
After Summers’s departure, the agreement to fund the university expansion with financial derivatives known as interest-rate swaps in a bid to secure low rates proved so damaging that Harvard was plunged into a liquidity crunch during the 2008 crisis. Cranes were removed the next year from the construction site of a science complex that was to be the focus of the project, and the school suspended work on the building.
Summers’s defenders dismiss criticism that he was at fault with the swaps, saying the university unwound the agreements at great cost well after he left the presidency in 2006.
Among the achievements they cite during his five years as president are expanding financial aid, recruiting top academics such as historian Niall Ferguson, promoting stem-cell research and other sciences as a greater priority, and beginning an overhaul of the undergraduate curriculum.
“He’s absolutely brilliant within this broad domain where his understanding of complex, large-scale situations eventuate into policy,” said Steven Hyman, a former Harvard provost who runs the Stanley Center for Psychiatric Research in Cambridge.
Running the Fed, which sets interest rates, is different than overseeing a university, with its independent faculty and unique politics, said Hyman. Harvard wanted a bold visionary when it hired Summers, an economist who was one of the youngest professors ever tenured at the school, while the central bank needs someone to build consensus on monetary policy, he said.
Kelly Friendly, a spokeswoman for Summers, declined to comment about his legacy at Harvard, including the swaps.
When Summers became president in 2001, he vowed to break down academic barriers between departments to promote a broader curriculum for students. Supporting the vision, the former U.S. Treasury secretary who had left Harvard for Washington in 1991 embraced a massive expansion that was a decade in the making. He declared it a foundation for the future where interdisciplinary work would produce the next scientific breakthroughs.
By 2004, Harvard had decided on a science complex as central to the so-called Allston Expansion, and had identified two schools that would be on the campus along with new dormitories. The final contours of the plan, which wasn’t formally unveiled until after Summers left, included more than 10 million square feet of development over 50 years at a cost of billions of dollars.
At the time, interest rates were near record lows. So in December 2004, the president and the members of Harvard Corp., the board of university trustees, approved $2.3 billion of interest-rate swaps that promised to lock in the cost of borrowing some of the money needed over the coming decades for the expansion.
“Everyone believed that interest rates were good and we should find some way to insulate ourselves,” said Hyman, who as provost participated in some meetings where the swaps were discussed. “There was some disagreement, but I never saw Larry making financial policy for the university by himself.”
While the swaps on paper locked in interest rates for future bond sales, they also introduced a number of risks for Harvard. The university had to track the value of the agreements, and if interest rates fell instead of rose, it would have to set aside collateral, essentially giving cash to its bankers in case the contracts had to be terminated.
At the time, such derivatives were popular with nonprofits and government borrowers. Yet Harvard’s agreements stood out. The amount was large and the time until the university would start selling bonds was long -- beginning in about four years -- which amplified the risks if the project didn’t go as planned.
“There was too little attention paid to the downside risk,” Edward Glaeser, an economics professor at Harvard and Summers supporter, said of the expansion, which he participated in as a member of the university’s Allston Life Task Force.
Harvard would learn just how risky the derivatives were in 2008 when financial markets imploded. The value of the swaps was linked to benchmark interest rates, which were slashed in the midst of the global credit crisis to near zero percent to prop up banks. The university had to post almost $1 billion of collateral, setting aside cash, against the risk that it would cancel the contracts.
Harvard was caught in a liquidity crisis. While it needed cash for collateral, it was on pace to lose $11 billion from its $36.9 billion endowment, the world’s largest, as the value of its investments crumbled amid a global market selloff. Making matters worse, it had stuck to a policy endorsed by Summers of investing its general operating account in the endowment, leaving little cash on hand.
Drew Faust, the historian who succeeded Summers, rang the alarm bell in December 2008. With the investment losses beginning to raise questions about the ability to pay for the ambitious expansion, the university started terminating swaps. It agreed to pay $923 million to unwind $1.9 billion of the derivatives to JPMorgan Chase & Co. and Goldman Sachs Group Inc.
“Rates were at what were then considered historic lows, so building in some budgetary certainty by locking in our financing costs had definite advantages,” Robert Reischauer, the chairman of Harvard Corp., said in an e-mail. “The 2008 economic crisis changes that, obviously, and we -- like the rest of the world -- learned important lessons about risk management and liquidity.”
The swap plan was developed by Harvard’s financial team and discussed with a debt-asset management committee that included trustees, faculty and staff before it was approved in 2004, the university said after the termination of the deals. The contracts were implemented and monitored by the staff, it said.
The blame lies with Faust and her administration, not Summers, said Brad DeLong, an economics professor at the University of California, Berkeley. They failed to monitor the contracts and opted to terminate them at a time when the financial panic made the cost of exiting more expensive.
DeLong, who was at the U.S. Treasury with Summers and was an associate professor at Harvard, said in his blog recently that the derivatives were a hedge against rising interest rates.
While Summers, who is currently on Harvard’s faculty, has declined to comment on whether the agreements might have been ill-conceived, one legacy at the university is a less-ambitious approach to the Allston expansion and more conservative financial management. Harvard now keeps more cash on hand and there is greater consultation between the president and Jane Mendillo, who was hired to run the endowment in 2008.
Faust, who in 2009 ordered a cap be placed over the foundation for an almost 600,000 square-foot science center in Allston, is only now preparing to restart construction. While the university says it’s committed to the original vision, the only additional projects on the drawing board are nine buildings totaling 1.5 million square feet, including a new home for the basketball team and hotel-conference complex.
An Allston fundraising campaign that was to begin under Summers will finally be unveiled later this year.
In a reflection of the lingering bitterness among some faculty members toward Summers, J. Lorand Matory, a former Harvard professor who helped lead the campaign for a no-confidence measure against Summers in 2005, said the former president’s record shows he’s unsuited for the Fed job.
“In five years, he’s already done so much harm,” said Matory, an anthropologist now at Duke University. “It’s concerning to me that, within the tenure of the Fed chair, one could do a lot of damage.”