Failing at Harvard: Ivy Cash King Tumbles

March 1, 2009— -- 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.

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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) 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.

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%.

It doesn't feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging-market stocks and private equity partnerships, both disaster areas in the past eight months.

The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.

For a long while, Harvard's daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging-market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won't be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.

The strain of market turmoil is visible in staff turnover at the management company, which axed 25% of its staff recently and is on its fifth chief in four years. Mendillo, 50, came to Harvard last July after running Wellesley's small endowment. She declines to comment. But how much blame she should get is unclear; the big bets on derivatives and exotic holdings were in place before she got there. The bad bet on interest rates--a swap in which Harvard was paying a high fixed-interest rate and collecting a low short-term rate--goes back to a mandate from former Harvard President Lawrence Summers.