Monday, April 19, 2010

Were Universities Complicit in the Financial Crisis?

University seals, logos, coats of arms, and policies rest on such principles as truth, freedom, honor code, transparency, and ethics. Do their investments in the financial crisis of 2007-09 conform with those ideals?

A flood of books, articles, statements, and comments on the causes and consequences of the financial crisis fills bookstores, the media (television, radio, print), the blogosphere, oficial testimony, and academic conferences. The culprits include federal and state regulatory agencies, the Federal Reserve Board, unqualified home buyers, mortgage brokers, wall street financiers, and professors of economics and finance who laid the intellectual foundation with theories based on rational man, the efficient market hypothesis, self-regulating markets, value at risk models, monetary policy, and so forth (although few professors have yet to say “mea culpa”). To-date, little attention has been given to the investment behavior of managers of university endowments.

The Ivies (including Stanford) outperformed the general market over the past 10-20 years by a considerable amount, building up large endowments. These funds enabled rapid expansion of facilities and faculty, and generous aid for students. Books and articles were written about the “Yale model,” largely copied by Harvard, Dartmouth, Princeton, Stanford, and others. The investment strategy paid off until 2007, until it backfired with a vengeance in 2008-09. Endowment returns plunged billions of dollars, forcing cancellation of building projects, staff layoffs, faculty buyouts, and the need to sell bonds to raise cash for operating budgets or contingencies.

Harvard University Financial Report 2009 is 48 pages long. It sets out investment returns for the 1, 5, 10, and 20 years. Its fiscal 2009 performance was dreadful, taking severe losses in private equity, special situation funds, interest rate exchange agreements, and real assets (property, commodities, etc.). Investment assets are divided into three levels of pricing: (1) active markets, (2) inactive markets but assets can be priced directly or indirectly, and (3) prices based on inputs that are unobservable. (The latter rests on what managers of private equity and commodity funds tell the university, not on the university management company’s independent evaluation.) Of the total value of investment assets on July 1, 2008, nearly two-thirds was in level 3, calling into question the real as opposed to overstated value of the endowment.

The 2009 report from the Stanford Management Company that is available to the public on its website is exactly four page long, of which three pages consist of comparisons with benchmarks. Long-term policy targets include 35 percent real estate, private equity, and natural resources. The one year comparison (fiscal year 2009 vs. 2008) against benchmarks reveals massive losses in natural resources, real estate, and special situations.

Here’s the question for Harvard, Stanford, and other similarly managed university endowments: where are the details? Were any funds placed with Lehman Brothers, Goldman Sachs, and other miscreants? Did the endowments hold mortgage backed securities, other asset backed securities, credit default swaps, collateralized debt obligations, synthetic collateralized default obligations, and other obscure derivatives that were doomed to collapse? Were the trustees and other university officials responsible for overseeing the investment companies aggressive in asking tough questions or did they just go along with their reports, assuming good times would continue without interruption? Universities enforce a strict honor code among students, send out annual memos to faculty about proper use and misuse of licensed materials, and warn about plagiarism, among others. However, stakeholders of donors, faculty, and staff are not accorded symmetric treatment on the specifics of endowment managers.

Every year, TIAA/CREF, Vanguard, Merrill Lynch, and other firms that manage retirement funds distribute annual reports itemizing assets in their funds, along with purchases and sales of securities. These reports are required under government regulations. Shouldn’t university portfolios be subject to similar disclosure?

President Obama is seeking financial reform legislation that strengthens existing regulations and add new regulations to reduce the risk of a future meltdown of financial markets. If enacted, which seems increasingly likely, university endowment managers may no longer be able to place risky bets that bring outsized returns. The new investment landscape may require universities to accept less ambitious targets for expansion and program development. Perhaps universities can save several million dollars by replacing expensive management companies with index funds.

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