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Financial Update: Harvard Retains Triple-A Rating, Princeton Foresees Deeper Cuts

4.8.09

Moody's Investors Service, the credit-rating agency, has issued a review of Harvard's creditworthiness, and maintained its Aaa and associated ratings on $5.8 billion of outstanding debt, with a "stable" outlook for the future. Its evaluation, released on April 1, took into account "the deleterious effects of the global financial crisis and recession" on University finances. Separately, on April 6, Princeton President Shirley Tilghman told her community that deeper endowment investment losses (30 percent, rather than a previous estimate of 25 percent) were now forecast for the fiscal year--in line with Harvard's public estimates since last December 2--necessitating deeper budget cuts, and longer-term adjustments than had previously been forecast. The latter assessment accords with Harvard's recent decision to reduce endowment distributions for each of the next two years, and fits with the larger environment influencing university finances generally as described by Moody's.

In summarizing Harvard's financial situation, Moody's noted that the principal short-term impacts of the credit crisis and recession are "large losses in the University's endowment, which combined with stress in the debt and swap markets, have created liquidity pressures." During the next few years, "the University will face constraints in its capital program while also dealing with a significant reduction in revenues available to support its operations from endowment"--references to both the reduced distribution of funds from the endowment and the decision, announced in February, to slow and possibly stop construction on the Allston science complex.

Moody's then specified "substantial" recent actions taken by University leaders that have "boosted liquidity" significantly, confirming prior reports about Harvard's financial challenges in recent months (see here, on Harvard's $2.5-billion debt financings in December, and concerns about liquidity within the endowment, exposure to losses on University interest-rate swaps, the institution's central "bank" for short-term funds, and  possibly "underwater" endowment accounts). Among the items Moody's highlighted:

Endowment. "Large losses in the investment portfolio," reflecting market declines, "reduced the valuations of the liquid portion of the University's endowment" and "raised concerns that large future capital commitments to private investments may not be funded from previously expected distributions from other private holdings," squeezing liquidity even further. (See here for more explanation of this problem, with a particularly helpful explanation from the management of the  University of Virginia's investment funds.)

As for "capital commitments to external money managers" who invest endowment funds in private equity, venture capital, and other private investment vehicles, Moody's found that the University has future commitments "exceeding $11 billion," extending to 2018. "[E]ven under extreme circumstances well beyond the University's actual projections, no more than half of this commitment would be called in the next year," as the general investment partners call on their limited-partner investors (like Harvard) to advance cash. The timing of such cash calls, Moody's noted, is related to conditions in the credit and investment markets; moreover, Harvard's existing "illiquid investments" still hold "substantial value and could be a source of liquidity over the medium term," although the market for selling such investments has been "challenging." (Harvard's endowment is described herehere, and in subsequent dispatches.) Obviously, large calls for cash to invest in the near term would place Harvard and Harvard Management Company in a challenging position: such calls would presumably reflect investment managers' perception that the opportunities exist for attractive returns--particularly if interest rates remain low and prospects for businesses and economic growth begin to look more favorable--but coming up with the money to fulfill such calls would be very difficult under current strained circumstances

Harvard's borrowings. "[T]he general disruptions in municipal variable-rate debt markets last fall increased the perceived risk that Harvard could experience a failed remarketing" of its own short-term, variable-rate borrowings. That risk forced the university to "reserve a large share of its liquidity for this contingency because all of the University's variable-rate debt and commercial paper is backed by its own liquidity." As reported, restructuring this debt and reducing this risk were motives for the University's December issuance of new long-term taxable and tax-exempt debt.

Swaps. "[R]apid declines in long-dated swap rates led to substantial declines in the fair value of the swap portfolio. Under the provisions of its swap agreements, counterparties demanded large collateral posting requirements, reducing immediately available liquidity." (The University's exposure to large losses on interest-rate swap agreements it put in place in late 2004  as part of forward financing for planned construction in Allston is reported here.)

Moody's detailed the December 2008 financing, and the resulting reduction in variable-rate debt, as important measures to buffer Harvard against further adverse developments in the credit markets. At the same time, it said, "The University has also taken a number of steps to reduce the liquidity risks of its swap portfolio, including terminating several existing swaps and entering into new swaps that counteract the fair market values of existing swaps. The effect of its actions should limit how quickly these requirements would grow should interest rates fall further."

Current liquidity. Looking ahead, the Moody's analysts found Harvard's "liquidity position…significantly improved." Its "self-liquidity debt" has been reduced, with daily limits of $250 million on commercial paper maturities, and weekly limits of $500 million in any five-business-day period. As for the "swap portfolio" and the exposure to future demands for collateral, "we believe that the University has sufficient liquidity to manage the necessary collateral posting even under highly stressful scenarious, including a 200-basis-point move lower to a 30-year swap rate of less than 1.25 percent." (The decline in interest rates caused losses on the interest-rate swaps to balloon, because the University put in place variable-rate borrowings and arranged fixed-rate swaps in the the expectation that interest rates would increase from the time the financing was arranged in mid decade.)

Moody's forecast that Harvard would withdraw $1.5 billion to $2.0 billion from the endowment to fund University operations in the current and forthcoming fiscal years, but noted that Harvard projected that distributions would be "at the low end of this range or lower"--and that has now been confirmed, with plans to use $1.4 billion in fiscal year 2009 and 8 percent less in fiscal year 2010. (These figures apparently do not include any additional "decapitalization" such as the use of endowment resources for the administrative assessment to fund campus development in Allston; in recent years, decapitalizations have amounted to as much as another $400 million of endowment funds dispersed.)

In all, Moody's said, as of February 28, Harvard held $3 billion of money-market funds, $2 billion of U.S. Treasury securities (excluding securities used in lending programs or pledged as collateral), and could liquidate as much as $9 billion of the general investment pool (which includes endowment assets) within one year. Further, it maintains a $2-billion line of credit.

Measures to maintain a financial flexibility and strength. Beyond the steps taken so far, Moody's noted that Harvard is "considering significantly reduced capital spending plans, and has already announced budget actions to bring endowment spending to levels in line with a long-term spending policy." Beyond the initial Allston science complex--with an estimated project of cost of $1.1 billion and an expected completion date of 2011, now likely  to be deferred--Harvard's planning "had previously called for a rapid and significant expansion into Allston." Combined with other capital projects, that would have pushed capital spending to $1 billion annually, funded by "as much as $3 billion in new debt over the next three or four years"--for which the 2004 futures borrowing had presumably been arranged. (In fiscal year 2008, Harvard spent $591 million on capital projects and acquisition of land and buildings, the latter principally in Allston. The Faculty of Arts and Sciences Northwest Building and Laboratory for Integrated Science and Engineering--very large, expensive projects--were completed then, although not completely fitted out for scientists' use. The Law School was well along in its Northwest Corner project then. But the Allston science complex had just begun, and the Fogg Art Museum renovation and reconstruction were still in the planning stage.) In light of new economic circumstances, Moody's forecast, the University "has put several projects on hold and is planning for a reduction in both capital spending and projected new debt issuance, potentially in the range of 50 percent lower than prior projections." Whether Harvard could or would attempt even that reduced level of new borrowing, in the present circumstances, is uncertain. Stronger fundraising or better economic growth could enable Harvard to "shift back to a higher level" of capital spending, Moody's reported. That is the context in which the review of the Allston science complex's future is taking place, as administrators decide whether to continue, "pause," or redesign the project.

Finally, Moody's noted the reductions in endowment spending and in expenses--through early-retirement incentives, salary freezes, and so on.

What could threaten Harvard's Aaa rating? "[T]he University is more exposed than other organizations (outside of higher education)…to rapid and large additional declines in investment markets, given the magniture of its balance sheet and equity exposures and the high reliance on endowment income over the long term for operations."

Princeton retrenches. In a letter on April 6, President Shirley Tilghman wrote:

Unhappily, the news from the financial markets has not improved since January. Indeed the markets have continued to decline in value, and Andrew Golden, the President of the Princeton University Investment Company, has now advised us that we should be planning for a 30 percent decrease in the value of the endowment on June 30, 2009, the end of our fiscal year, rather than the 25 percent we have been using in our budget projections for next year. This is, of course, a "best guess," but it is one that we must take seriously.

Accordingly, Princeton will reduce its Fiscal Year 2010 budget further. Faculty and staff members whose salaries exceed $75,000 have agreed to do without increases, so the funds can be directed to lower-paid members of the community, a transfer of $4 million. Because spending from the reduced endowment will represent a distribution rate of 6.7 percent, versus the university's long-term goal of  4 percent to 5.75 percent, academic units are being directed to reduce nonpersonnel administrative budgets 5 percent, and spending from endowment income 8 percent, in the coming fiscal year; combined with administrative savings, the budget for that year has been trimmed $88 million (about half the reduction Harvard's Faculty of Arts and Sciences faces)—a 6.8 percent decline from actual spending of $1.3 billion in the current year.  In the following fiscal year, Tilghman outlined a further 8 percent reduction in endowment spending (in line with what Harvard has now mandated University-wide), yielding two-year savings of $170 million.

As similarly situated institutions have increasingly concluded (see reports on Yale and Stanford), Princeton, Tilghman said, still will not be in compliance with its long-term endowment-spending policy for at least another year after the reductions contemplated during the next two academic years: that is the reality of sharp declines in endowment values and the increasing reliance on endowment-derived income for operations during the past favorable decade of high investment returns. As a result, "The steady growth in both faculty and staff that we have enjoyed over the last 10 years will end, and the university will have to contract in size." As at Princeton (which is in the middle of a large capital campaign), so likely at Harvard (which has deferred its fundraising plans). Finally, construction is on a new leash: "The slowdown in all new projects, which we put in place in January, remains in effect, and any decision to go forward with a renovation or new construction project will be made on a case-by-case basis, contingent on having 100 percent of the funding in hand." Planning will proceed, so Princeton can be "shovel ready" for its highest-priority arts and sciences projects should funding materialize .

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