Sunday, May 31, 2009

Drew Gilpin Faust and the Incredible Shrinking Harvard

Are there any lessons here for the University of Minnesota?

From Boston Magazine:

For her first commencement address as president of Harvard University, just a year ago this month, Drew Gilpin Faust spoke in defense of money. The school's endowment, swollen by years of double-digit returns, had grown to almost $37 billion. As a result, Faust explained to her audience, it had become "something of a target, publicly both envied and maligned." Politicians like GOP Senator Charles Grassley were proclaiming that Harvard had so much money, it had a moral obligation to spend down its endowment—then the largest in the world by the comfortable margin of $15 billion or so.

Yet Harvard was not as well-off as it might seem, Faust said. True, the endowment was big. But it supported a growing institution of great public import. Harvard had 20,000 students and 16,000 employees. It contained "a huge and very costly research enterprise," satellite campuses around the globe, and "libraries and museums that house priceless collections of books, manuscripts, artworks, cultural artifacts, and scientific specimens." Paying for it all required staggering sums: To meet its $3 billion annual budget, the university relied on $1.4 billion a year in endowment payouts. Take away that easy cash, and Harvard would be—to paraphrase—up a creek.

While the failed presidency of Lawrence Summers generated more headlines, this quiet crisis is actually a greater threat to Harvard. The university has been so rich for so long that most of its denizens can't remember a time when money was a concern. While Harvard officials are doing their public-face best to downplay the problem, the numbers don't lie, and this economic crunch will leave the school a profoundly changed place. Harvard will have to become smaller and academically more modest, and as it does it will chafe at having grand plans without the resources to fund them. For the first time in decades, it will worry about merely paying its bills. The university will have to decide: If it is no longer so rich that it doesn't have to make choices, what does it really value? What are its priorities? It won't be a comfortable debate.

Sound familiar?

As Peter Gomes, chaplain of Harvard's Memorial Church and a sociologist of Harvard culture, once told me, "A great Harvard president is made by doing the ordinary job of president extraordinarily well."


Guiding a university through this recession would challenge any president, and some of Harvard's competing institutions—Yale, Princeton, Stanford, MIT—also find themselves under financial duress. But the situation at Harvard is worse and the consequences will be more dire.

One reason is the growth in university spending, most notably in the Faculty of Arts and Sciences. The last time the endowment stood at $25 billion, in 2005, the FAS budget was $812 million. Now it's $1.2 billion—a particular problem because FAS depends on the endowment to provide more than half its annual budget. During the past decade, FAS embarked on a giddy hiring binge—according to Harvard Magazine, the number of FAS professors has increased by 126, a 22 percent jump—and a building spree including some $800 million in science labs alone.

The buildings cost money, the people to go into them cost money, there is upkeep and maintenance... Again these problems sound strangely familiar.

The roots of Harvard's fiscal crisis go all the way back to 1990, when money manager Jack Meyer left the Rockefeller Foundation and assumed the reins at the Harvard Management Company (HMC). Breaking with the traditionally conservative approach, Meyer was in the forefront of university portfolio managers who integrated complicated financial instruments into endowment investments. He reduced the amount of stocks and bonds in Harvard's portfolio to less than 30 percent and diversified into illiquid assets such as commodities, real estate, timber, hedge funds, and private equity. He also ventured into financial tools such as derivatives and emerging market debt that carried more risk than stocks and bonds but promised much larger returns. "There's not much plain vanilla in our portfolio," Meyer told BusinessWeek in late 2004.


Meyer left in 2005 amid controversy over the multimillion-dollar bonuses paid to some of his money managers. Rumors also swirled that he had clashed with Larry Summers over control of HMC. It's hard to know: Neither man is talking. Still, there is no question that Summers took a much more active role in Harvard's money management than his predecessors.

After Meyer stepped down, he was replaced by Mohamed El-Erian, a managing director at the bond giant Pimco, who lasted just under two years in the post. He was followed by Jane Mendillo, who had been managing Wellesley College's endowment, and whose assumption of the job last July would become the very definition of bad timing.

The turnover may have hurt, because last fall's stock market meltdown seemed to catch HMC asleep at the wheel. As of June 30, 2008, the Harvard endowment was 105 percent invested: HMC had borrowed above the endowment's value in order to make additional bets. With the vast majority of its money tied up in holdings from which it could not easily be extracted, the university was ill prepared when the tanking Dow spurred anxious counterparties to call in their chits. Those margin calls forced Harvard to put up collateral—cash that it did not have. And it couldn't unload its illiquid investments to come up with that money, because their value had fallen so precipitously that no one had any idea what they were really worth.

Further squeezing Harvard was a transaction Summers had pushed it into in 2004, when he successfully argued that the university should engage in a multibillion-dollar interest rate swap with Goldman Sachs and other large banks. Under the terms of the deal, Harvard would pay Goldman a long-term fixed rate while Goldman paid Harvard the Federal Reserve rate. The main goal was to lock in a low rate for future debt, and if the Fed had raised rates, Harvard would have made hundreds of millions. But when the Fed slashed rates to historic lows to try to goose stalled credit markets, the deal turned equally sour for Harvard: By last November, the value of the swaps had fallen to negative $570 million. The university found itself needing to post more collateral to guarantee those swaps, and would ultimately buy its way out of them at an undisclosed cost.

HMC "took the university right to the edge of the abyss," one alumnus, a financier who is privy to details of the university's balance sheet, told me. I asked what he meant. "Meaning, you're out of cash.

"That," he added, "is the definition of insolvency."

"If you can't afford to lose the money"—and a university that depends on its endowment to defray operating costs can't—"don't play the game," says one Harvard grad, an investor who was once involved in the university's finances.

"You had very smart people [at HMC] who never had a real answer to the question 'What would happen if this doesn't work out your way? What if what the black box is predicting doesn't occur?'

"The answer would always be 'That's impossible,' or 'You don't understand.'

"The arrogance," says this alum, "was palpable."

In the midst of its economic pain lies an opportunity for Harvard. It can reconsider itself, restate its core values. It can conduct the kind of soul-searching that should have been sparked by Larry Summers—intentionally or not—but was lost in the mad rush to oust him.

"If Harvard is honest," says one high-powered alum active in university affairs, "we'll say, ‘We want a sustainable, long-term, top-notch university. And we can't be all things to all people. What we can do is excel, and that means we have to live within our means.'"

These last two paragraphs are crucial. Simply substitute University of Minnesota for Harvard.

The question for us at Minnesota is: "Do we have the courage and leadership to excel and to live within our means?"

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