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Noted for July 25, 2013

Illegitimate and Unfair Larry Summers Bashing: The Smart and Thoughtful Matthew Klein Gets One Wrong

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Matthew C. Klein:

Larry Summers's Billion-Dollar Bad Bet at Harvard: There is a very good reason Summers shouldn't be in charge of monetary policy: He seems to have trouble with interest rates. During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university's president…. Summers wanted to lock in interest rates for money that the university hadn't actually borrowed and wasn't planning on borrowing for a very long time. There aren't a lot of ways to interpret this exotic instrument except as a bet that the future level of interest rates would be higher…. That bet was wrong, and Harvard lost a billion dollars…. Not only was Summers wrong in 2004 about where interest rates would be -- he was willing to bet a lot of other people's money that he knew better than everyone else. The damage at Harvard was bad enough. Imagine what that sort of thing could do to the U.S. economy.

As I understand the story, this is completely garbled. As I understand the story, this is how it went down:

  • In 2004 Larry Summers decides that Harvard should expand massively into Allston/Watertown in the late 2000s--and that it should in the late 2000s borrow massively in order to finance that construction project.

  • Harvard's debt management committee worries about the extra burden on Harvard's cash flow that would be imposed if interest rates were to rise between 2004, when the planning begins, and 2008, when the money is borrowed.

  • Harvard's Debt Management Committee decides to hedge the risk that interest rates will rise by taking on a huge long-run swap position--thus insulating itself against losses if interest rates rise, but also giving up the gains that would otherwise accrue if interest rates were to fall. Summers does not overrule but rather approves the DMC.

  • Summers resigns the Harvard Presidency in mid-2006.

  • Successors Bok and Faust cancel the expansion.

  • Harvard's DMC does not liquidate its swap position now that it is no longer a hedge, and so turns it into a very large directional bet that Treasury interest rates are going to go up.

  • In late 2008, in a panic during the panic, Harvard's DMC sells the position at the bottom, when it is worth the least.

No, nobody has ever given me a coherent explanation of why the swap position was retained when the project that the swap position was a hedge for--the borrowing for Allston/Watertown--was deep-sized.

You can find a lot of goats to scape in this story, but "Larry Summers lost Harvard a billion dollars because he vainly and stubbornly forced it to bet that interest rates would rise" ain't a sensible interpretation of this chain of events. A president who resigns in 2006 is not responsible for the fact that Harvard held a portfolio that was exposed to silly risks in 2008: the president in 2008 is responsible.

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