Further Financial Fallout

The Harvard University Financial Report for fiscal year 2009 documents losses not previously detailed.

Understandably, the Harvard University Financial Report for fiscal year 2009, published in mid October, is dominated by the plunge in value of the endowment (see “$11 Billion Less,” November-December 2009, page 50). But it also documents previously undisclosed blows to the University’s fisc, notably including:

  • $1.8 billion of losses incurred in the “general operating account”—the principal cash funding mechanism for University operations—where assets, invested like the endowment’s, absorbed proportional declines in value; and
  • additional losses, which may ultimately exceed $1 billion, on Harvard’s interest-rate swaps associated with its borrowings.

The deflation in Harvard’s investments extended beyond the endowment (valued at $26 billion this past June, down from $36.9 billion at the end of fiscal 2008). The report draws attention to losses in the “University’s portfolio of pooled cash balances” or General Operating Account (GOA)—the funds used to pay the bills. This asset pool receives, manages, and disburses cash balances held by Harvard’s schools, academic centers, and the administration, but many of its assets have been invested alongside the endowment in what is called the General Investment Account—a step meant to generate returns far exceeding those of money-market instruments. In recent years of strong investment returns, that strategy benefited contributors and users of the funds. But during the past fiscal year, falling and illiquid markets produced losses of $1.8 billion.

Changes in accounting and financial reporting make it difficult to ascertain the disposition of GOA funds over time—and more detailed explanations have not been forthcoming. But it appears that GOA net assets doubled during the decade, to about $6.6 billion in fiscal 2008. During that time, the University sums reported as cash and short-term equivalents held roughly constant at between $1 billion and $2 billion in most years, while “funds functioning as endowment,” from all sources, more than doubled—peaking at about $9 billion in fiscal 2008; GOA assets accounted for within “pooled general investment net assets” (as first reported for fiscal 2005) rose from $3.4 billion then to peak at about $5.5 billion in fiscal 2008.

Although a decision was made during fiscal 2008 to “reduce the risk profile of the University’s pooled cash investments,” and implementation had begun, according to the financial report, the chaos that erupted in the fall of 2008 disrupted that transition and made it impossible to shield the GOA.

The decline in the value of investments, payments on swap losses and the infusion of the remaining proceeds from new debt offerings (see below), and other fund flows combined to reduce the GOA’s net asset balance to $3.7 billion at the end of fiscal 2009 from the $6.6 billion of a year earlier. The $11-billion decline in the value of the endowment is thus only part of the story: the value of Harvard’s net assets overall declined from $44.2 billion to $30.1 billion. And the decline in the GOA, like the loss of endowment value, represents a further reduction in wealth and future income. 

In an October 17 Boston Globe story headlined “Harvard admits to $1.8b gaffe in cash holdings,” reporter Beth Healy quoted a statement from University treasurer James F. Rothenberg to the effect that responsibility for the investment decisions and resulting losses in the GOA did not “sit with a single individual: the Corporation plays a role, the University’s financial team, including the CFO, play a role, and I play a role as treasurer.” (Neither her article nor Steven Sayre’s October 20 Globe column, “More red than crimson,” on sound cash management, appeared in the daily electronic news links circulated within the University.)

In an interview with the Harvard news office posted October 16, Rothenberg said all the endowment, GOA, and swap losses “were a function of last year’s extraordinary market conditions.” Asked if “the University’s investment strategies square with its responsibility to steward endowment funds,” Daniel S. Shore, vice president for finance and chief financial officer, told the news office, “There does need to be a balance between investing for long-term returns and managing for near-term needs, and we are now more conscious than ever of that balance….”

Responding to a query about “the Corporation’s responsibility for those investment decisions,” Rothenberg said, “The President and Fellows have ultimate fiduciary responsibility for the University, including its finances. We take that responsibility very seriously, and we devote quite a lot of our time, especially these days, to matters of financial strategy and planning, thinking about how to balance present and future needs.” Direct investment management, he noted, is conducted by Harvard Management Company (HMC), whose board he chairs. “There weren’t any reliable predictors of precisely when and how a global economic crisis would unfold,” he said, “and there were valid arguments for why the strategies in place made sense both when they were made and right up until last fall.” In the future, he said, “I think the likelihood is that the University will continue to invest portions of pooled cash alongside the endowment, but likely not to the same degree.”

Beyond the GOA losses, the report also refers delicately to “realized and unrealized losses on interest rate exchange agreements held by the University as part of the financing strategy for its capital program.”  As previously reported (Breaking News, harvardmagazine.com, December 19, 2008), the “notional” value of such swap agreements soared from $1.4 billion to $3.7 billion during fiscal 2005, when Harvard put in place forward interest-rate agreements to finance then-anticipated rapid campus development in Allston. The fair value the University would have paid to terminate those agreements, a volatile sum related to market interest rates, ballooned to $330 million at the end of fiscal 2008.

During the chaotic financial conditions of late 2008, problems arose in refunding very short-term debt instruments, and central banks pushed interest rates to record lows. That put Harvard in a double bind of refinancing its borrowings and covering its rising obligations under the swap agreements. As the annual report notes, the “unprecedented” fall in interest rates caused the University’s swap agreements “to incur sudden and precipitous declines in value, which in turn led to significant increases in associated collateral pledged to counterparties, creating liquidity pressures on the University.”

In response, Harvard terminated such agreements with a notional value of $1.138 billion during the year, buying its way out with cash payments of approximately $500 million. But it also entered into new swap agreements with a notional value of $764 million—structured to offset other, existing swap agreements—yielding unrealized losses of a further $425 million. This is, in effect, a financing transaction, locking in losses which will have to be realized in the future, but immunizing Harvard today from still steeper losses should interest rates remain adverse relative to the assumptions underlying the original swaps. Finally, the University remains exposed to risks amounting to an additional $250 million of swap-related losses, not hedged by offsetting transactions, as of last June 30.

Thus, during the year, Harvard realized and paid for a half-billion-dollars’ worth of swap-related losses, and ended the year with about $675 million of unrealized losses remaining (the fair value of the swap portfolio, with a notional value of $3.14 billion): about $425 million locked in by offsetting swaps, and $250 million of remaining exposure subject to the market.

In the news office interview, Rothenberg said of Harvard’s strategy, “Compared to most universities, our use of interest-rate swaps was certainly larger because the projected capital program that we were looking at was larger”: the planned construction in Allston was “a major focus, and we were planning that expansion aggressively.” He did not respond to requests for further comment on the assumptions made earlier in the decade. At the time the financings were arranged, in December 2004, Allston plans had been outlined broadly, but there were no public, detailed programs even for the first science building (the architect was announced in February 2006) or the relocated education and public-health campuses proposed for resiting there. Design work and Boston’s regulatory review and permitting would have followed. Even now, the Charlesview housing project in the center of the area seems unlikely to be relocated (to a Harvard-owned site farther west) for at least a few years. And the first, fast-tracked science complex—on which below-ground work has proceeded, but whose status and schedule are now under review (see “A New Economic Reality,” May-June 2009, page 48)—would not have been occupied before 2011.


Turning from these financial losses to the University’s continuing operations, Shore and Rothenberg write in their annual letter, “Notwithstanding the challenges we have faced during fiscal 2009, Harvard’s financial foundation is strong and will continue to enable the University to deliver on its guiding purposes: to achieve excellence in research and education; to prepare students for leadership and for lives of meaning and value; to advance the course of knowledge and ideas; and to serve society” (see the full text at http://vpf-web.harvard.edu/annualfinancial). In a conversation, Shore said that once the challenges became clear, the University set about adapting to what the report calls “a new economic footing” after an adverse period in which, he said, Harvard “certainly lost significant wealth.”

As evidence of that adaptation, in the fiscal year ended last June 30, the University achieved an operating surplus of $71 million, up from a $17-million surplus a year before. That result reflects both revenue growth budgeted before the financial crisis and ensuing recession and efforts to cut spending progressively as the extent of the problem became clearer.

Revenues grew a vigorous $345 million, or nearly 10 percent, to $3.83 billion—actually accelerating from the prior year. In both years, distributions from the endowment were the driving factor: in 2009, funds from the endowment distributed to support University operations increased $241 million, or a robust 20 percent, to $1.44 billion, thus accounting for nearly 38 percent of University operating revenue. That was four percentage points more than in the prior year. Every unit but the Graduate School of Education and the School of Engineering and Applied Sciences depended more heavily on endowment income in 2009 than in 2008.

Those trends will now reverse. In the current fiscal year, the operating distribution is forecast to decrease by 8 percent, or more than $100 million; and in fiscal 2011, the distribution is likely to decrease a further 12 percent from the now-reduced level—an additional $150 million or so.

Other sources of revenue were mixed. Support for sponsored research rose about 7 percent, to $714 million. But revenue from students declined 1 percent, to $678 million, as higher tuition and fees were more than offset by a 20 percent increase in scholarships applied against such income. Current-use giving rose 23 percent, to $291 million (a huge bequest and another large gift to the Faculty of Arts and Sciences accounted for 60 percent of the gain); but giving overall declined by $93 million, to $597 million, as gifts for endowment funds plunged $142 million (42 percent).

Expenses grew $291 million, or 8.4 percent, to $3.76 billion. Salaries, wages, and benefits—49 percent of total expenses—increased 11 percent, to $1.84 billion. But included in that total is $59 million in one-time severance and benefit costs associated with the staff early-retirement-incentive program and layoffs, which together resulted in the departures of more than 800 employees last spring (see “Finding a New Footing,” September-October 2009, page 44). Adjusting for those costs, compensation expenses were still up more than 7 percent—perhaps in part for hiring associated with sponsored research. That growth underscores the pressure to maintain controls on filling open positions, to restrain faculty appointments, and to consider whether to extend the salary freeze for faculty and non-union staff beyond the current year. (It also helps explain the early-retirement incentive offered to 180 tenured professors—reported at harvardmagazine.com on December 2, 2009.) Meanwhile, Shore said, “We got a good, honest start” on reining in discretionary “other expenses” (purchased services—from consultants to janitors—as well as travel, publishing, postage, telephone, and so on).

Unfortunately, the stand-out expense item is rising sharply. According to the report, the University incurred about $58 million in increased interest costs. That reflects the issuance of nearly $1 billion of fixed-rate tax-exempt bonds during the year, with an effective annual interest rate of 5.4 percent (well above the cost of the short-term variable-rate notes paid off in part with the proceeds), and of $1.5 billion of taxable bonds at a 5.8 percent rate. Because that debt was on the books for only about half of fiscal 2009, it appears that the added interest expense will rise by an additional amount of the same magnitude—another $50 million to $60 million—this year.

Capital spending and property acquisitions totaled $644 million, up about $50 million from fiscal 2008. Major projects included the Law School’s Northwest Corner complex; the prospective renovation and expansion of the Fogg Art Museum; and the Allston science complex. Shore said Harvard was “still in the process of planning and thinking about the options for all” major construction projects: design details, construction costs, and financing are still being reevaluated.

Unanticipated but significant projects are the renovation and relocation of Cambridge laboratories to accommodate stem-cell scientists, and similar work in the Longwood Medical Area for bioengineering researchers; both groups had been assigned to the Allston complex. These extra costs will be covered by the Allston-related infrastructure fund (the half-percent annual administrative levy on endowment accounts yielded $176 million in fiscal 2009). 

No other significant work is in the pipeline. Instead, Shore noted, Harvard must identify appropriate interim uses for the Allston properties it has acquired but now will not occupy or redevelop soon. He said institutional uses, codevelopment options, and private use by other investors might be considered.


Shore did not forecast University expenses for the current fiscal year, nor the likely change from 2009. Harvard has set its endowment distribution to the various schools at a lower level, but other factors—sponsored-research support, the volume of giving—will still affect revenues and expenses. Most schools have some reserves (for instance, see “FAS’s Progress—and Prognosis,” November-December 2009, page 58) to help buffer the budget cuts they would face otherwise.

Shore also pointed to longer-term opportunities for administrative savings, in functions ranging from procurement to the provision of human-resources expertise to information systems and technology. The goal, he said, is not simply to centralize, but to find the best performers and practices, adopt “different aggregations of activities,” and realize economies across the institution. Such savings, he said, are meant to support academic aims—preserving junior-faculty slots, for example: just one item among those at the core of Harvard’s mission.

From a financial manager’s perspective, Shore said, the new reality means maintaining a much more flexible posture toward plans and budgets, testing diverse scenarios at different revenue levels, and helping the whole community cope with heightened uncertainty by assuring that Harvard can be kept appropriately nimble. A Financial Management Committee (expanded to tap alumni and faculty expertise, and including both Rothenberg and HMC president and CEO Jane Mendillo) is better integrating University and endowment perspectives on risk, risk management, liquidity, and investment opportunities. It advises Shore himself, Katie Lapp (the new executive vice president), and through them, President Drew Faust and the Corporation, where financial policies and endowment distributions are finally vetted and approved.

In any event, Shore said, the critical balance remained the same: not cutting budgets so deeply now that essential activities were irreparably harmed, but not treading so lightly that cutting would have to extend many years into the future to restore distributions from the now-reduced endowment to a sustainable level. If the balance can be set properly, he said, once investment returns strengthen, Harvard will find itself sooner able to increase those distributions once again, to support essential academic work and innovations.

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