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Who Else Is Paying For Those Fat Wall Street Profits?
There's another big reason -- besides AIG -- that Wall Street trading desks have been booking such fat profits lately: fees they're collecting closing out interest rate swaps that have been exploding in the faces of cities, states, towns and public utilities over the past year.
Put another way: they're not just booking those billions soaking the government, they're booking them soaking...the government. Along with hospitals, utilities, park authorities, pretty much every other realm of the public or nonprofit sector...
Including Harvard! In December the university raised $2.5 billion dollars in a bond offering partially designed to give them the capital to buy out of $570 million in underwater interest rate swaps it had invested in back in 2005. The swaps were expressly endorsed by then-president Larry Summers, now head of the National Economic Council.
Harvard sold the bonds with the underwriting and advisory services of JP Morgan, Morgan Stanley and Goldman Sachs -- the same group of banks, according to Bloomberg, that endorsed the "Summers swap." Another recommendation: that Harvard offer an interest rate as much as 1.41 percentage points higher than an identically rated corporation would pay to borrow the money to sweeten the deal for investors.
(That, if you were wondering, is an example of the unequal credit system perpetuated by the rating agencies differing standards for corporate and public debt that so rankles House Financial Services Chairman -- and Harvard alum -- Barney Frank.)
At those terms, money came flowing in to Harvard:
"It was a riot," said John Flahive, a senior vice president at BNY Mellon Wealth Management, of demand for the Dec. 10 bonds. His $1 million buy "was only 20 percent or 25 percent of what I wanted."And much of it came right back into the coffers of the banks with whom it had entered into its 19 swap contracts -- including Goldman, Morgan Stanley and JP Morgan.
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.It's hard to explain exactly how swaps sent so many public sector institutions into such fiscal peril so quickly, except to say that the contracts all hinged on the financial health of a few bond insurers that all went bust in tandem with AIG, and relatively liquid markets that started to collapse with Bear Stearns. But critics have long suspected the swaps were engineered primarily to ensure a steady stream of fees to the banks that arranged the deals -- and last year Ben Bernanke wrote a letter to Congressman Jim Moran suggesting public sector entities might consider banning derivatives in the future.
...
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.
As for Harvard, we're pretty sure their business model is safe. Good thing they got rid of that Summers guy though, huh.
Josh
Zachary
http://www.forbes.com/forbes/2009/0316/080_harvard_finance_meltdown.html
Harvard: the Inside Story of Its Finance Meltdown
Bernard Condon and Nathan Vardi, 02.25.09, 06:00 PM EST
Forbes Magazine dated March 16, 2009
The superstars at Harvard defied markets for years-- until now. Here's the inside story of how they finally tripped up.
Stocks were tumbling last fall as the new school year began, but at Harvard University it was as if the boom had never ended. Workers were digging across the river from Harvard's Cambridge, Mass. home, the start of a grand expansion that was to eventually almost double the size of the university. Budgets were plump, and students from middle-class families were getting big tuition breaks under an ambitious new financial aid program. The lavish spending was made possible by the earnings from Harvard's $36.9 billion endowment, the world's largest. That pot was supposed to be good for $1.4 billion in annual earnings.
Behind the scenes, though, a different story was unfolding. In a glassed-walled conference room overlooking downtown Boston, traders at Harvard Management Co., the subsidiary that invests the school's money, were fielding questions from their new boss, Jane Mendillo, about exotic financial instruments that were suddenly backfiring. Harvard had derivatives that gave it exposure to $7.2 billion in commodities and foreign stocks. With prices of both crashing, the university was getting margin calls--demands from counterparties (among them, jpmorgan Chase and Goldman Sachs (nyse: GS - news - people )) for more collateral. Another bunch of derivatives burdened Harvard with a multibillion-dollar bet on interest rates that went against it.
It would have been nice to have cash on hand to meet margin calls, but Harvard had next to none. That was because these supremely self-confident money managers were more than fully invested. As of June 30 they had, thanks to the fancy derivatives, a 105% long position in risky assets. The effect is akin to putting every last dollar of your portfolio to work and then borrowing another 5% to buy more stocks.
Desperate for cash, Harvard Management went to outside money managers begging for a return of money it had expected to keep parked away for a long time. It tried to sell off illiquid stakes in private equity partnerships but couldn't get a decent price. It unloaded two-thirds of a $2.9 billion stock portfolio into a falling market. And now, in the last phase of the cash-raising panic, the university is borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills. Since December Harvard has raised $2.5 billion by selling IOUs in the bond market. Roughly a third of these Harvard bonds are tax exempt and carry interest rates of 3.2% to 5.8%. The rest are taxable, with rates of 5% to 6.5%.
continued at link above~
April 15, 2009 6:50 PM | Reply | Permalink
I realize that it's fashionable at TPM to bash Summers, but keep in mind that he, and Meyers (the then long time head of HMC) left Harvard years ago. HMC is now on its 4th or 5th head, so the turnover in the past 4 years has been pretty high. Also, Meyer took a lot of talent with him when he left in 2005, and it seems his private company has done okay. And Harvard strongly outperformed the market in the years aftet Meyer left until very recently. I also believe that some safeguards put in place by a Meyer successor were allowed to lapse in the past year or so.
That means pointing the finger at Meyer or Summers is mere errant scapegoating in this case.
I don't know whether Meyer was the one who initiated what this TPM article calls the "Summers swaps" or if that happened just after he left.
April 15, 2009 9:41 PM | Reply | Permalink
Nice that you'd step up for po' Larry, but perhaps you missed this article:
Looks to me like Larry was forcing Harvard to drink his Koolaid, and Ms. Mack was let go for pointing out the very real downside, which is now biting them in the arse.
April 16, 2009 12:27 PM | Reply | Permalink
I read that article when it first came out. Her story didn't add up to me then, and it still doesn't. But it's not that I'm standing up for Summers, I decry the abusive style of "journalism" in which the alleged muckraker mucks things up worse than they are.
Notice how much traction it found? Almost none.
Unfortunately for us, Ms. Mack probably signed a confidentiality agreement as part of her settlement. We'll never know the details of what she claims bothered her on the job or what settlement was arrived at. But my gut instinct, plus the argument I outlined above, are both that there's no beef there.
April 16, 2009 2:27 PM | Reply | Permalink
Paying for profits? What does that even mean? Harvard made a bet and lost. It's that simple. Now they are paying. I highly recommend a few classes on finance to the "author" of this story.
April 16, 2009 4:28 PM | Reply | Permalink
1) It is very unlikely that any investment bank would go naked on either side of an interest rate bet. The banks that sold the floating-to-fixed swaps to Harvard probably laid off the floating-rate risk to someone else, leaving them with no net interest rate exposure. In plain english, this means that every dollar that they took in from Harvard on these swaps went straight out the door to pay someone else. They made their profits on the up-front fees.
2) I don't see anything in that Bernanke letter you link to where he suggests banning derivatives.
April 17, 2009 10:46 AM | Reply | Permalink
If you read the Harvard Crimson and Boston Globe articles, you will find out that Dr. Mack was concerned about the derivatives trades in HER group - run by Jeff Larson. Just google Larson and Sowood. Larson was one of the first casualties of the subprime bust. He lost over $1.6 billion of his clients' moneys - $350 million money that went up in smoke was from Harvard Management Company. So her concerns were indeed justified and she was RIGHT about what went on in her group.
To learn more about Dr. Mack I've been following her on twitter.com.
Also, a taped interview of her on the Thom Hartmann show is on youtube.
April 18, 2009 10:19 AM | Reply | Permalink
P.S.: The youtube link for Thom Hartmann interview of Dr. Iris Mack is:
Derivatives Whiz Fired For Whistleblowing About Frightening Trades
http://www.youtube.com/watch?v=ciiKONDAucc
April 18, 2009 10:33 AM | Reply | Permalink