Emptying the Endowment

By Hamish Macdiarmid

In a much-publicized report, Cornell University revealed that it had lost $280 million in its endowment funds because of the fact that interest rates have steadily been decreasing over the past 16 years. In fact, as economists are quick to point out, interest rates are at their lowest rate in 5,000 years which caught many companies and universities off guard, with their investment strategies ensuring that they lost money playing the markets. Institutions paying a fixed percentage to banks whilst relying on a payout based on the floating percentages used by the banks ensured that as interest rates decreased, universities like Cornell were putting in more than they were getting on returns. As institutions invest in interest rate swaps, a fixed interest rate is paid to their bank while the bank will in turn pay a variable rate on the debt issued by the institution. The variable rates have been lower than the fixed for 16 years, causing schools lose money.

For the uninitiated, an interest rate swap is an over-the-counter trade where two parties agree to exchange future interest payments for a second payment. The amount is agreed upon by the two parties, and it is often a method used by institutions such as Cornell to combat investment losses, manage their credit risks, and earn further income via speculation on the interest rate markets. However, it did not turn out to be the most beneficial investment for Cornell. In fact, their financial report from 2015 stated: “The University experienced an operating loss of $25 million this year; over $20 million of this loss is due to interest expense associated with unattached interest rate swaps, which have no associated debt. The University has a multi-year plan to gradually terminate these unattached swaps.”

Think of this as a borrowing a mortgage at a fixed rate of interest for 10 years or 30 years, which can be a useful tool to mitigate losses caused by variable rates. Interest rates are meant to ensure that risk is managed more effectively whilst generating income for the institution, but in this case 80% of the losses which Cornell experienced were directly due to this investment.

The Endowment of Cornell University decided to borrow money at a fixed interest rate of 4% in 2007-2008. Shortly afterwards interest rates dropped to record lows, close to zero percent, particularly for variable rate loans. Unfortunately for Cornell and the other Ivy League Universities who also experienced significant losses, they were all stuck with borrowing money at the higher rate of interest. It seems that the reported loss of $280 million was calculated by adding up the interest that Cornell University would have paid if they had taken out a lower cost variable rate loan rather than a fixed rate loan.

Cornell was somewhat prudent in taking out a long-term fixed rate loan. Imagine if they had decided on taking a variable rate loan, and if short term interest rates had risen to 10% because of rising inflation - Cornell would have lost a lot more money. So what Cornell did was sensible, and protected their downside risk. Whilst articles which covered the loss in a negative light saw it as a mistake on the University’s part, in reality, they protected their investments at a time when major financial markets were in dire straits.

So why did Cornell decide to borrow so much money – and what did they do with it? With an endowment of $6 billion in equity, Cornell should not be borrowing money at all. They should just be investing their cash, without any leverage or borrowing. So what, then, did they do with the money? As the representative for the College of Arts and Sciences in the Student Assembly, I know from first-hand experience that Cornell does not disclose much of what they do with their financials. For example, the university does not disclose what is specifically done with the budget for the College of Arts & Sciences.

Furthermore, it appears that the university intends to cut back on financial aid in order to save money, as confirmed by a faculty source close to the Provost, Michael I. Kotlikoff, who chooses to remain anonymous. They said “The University is proposing reducing unrestricted funds, which includes making financial aid ‘more efficient,’ which actually means reducing financial aid to some extent.” Provost Kotlikoff has already enacted a similar policy with International Students, ensuring that those from less affluent backgrounds would face a more stringent process to enter into Cornell University. Cornell could have used the extra money to invest into campus infrastructure; for example, in response to a contentious student petition, the University could have used the money to provide free hygiene products such as tampons in school bathrooms. The University estimates that such a plan would cost $20 million: while this may appear quite a large sum of money, relative to the total endowment it miniscule, and small compared to the loss that Cornell suffered.

In spite of their losses, if Cornell had openly invested in a project that made a return of more than the 4% cost of borrowing, then that would be a good use of the borrowed funds and would generate a profit, not a loss. For example, suppose the University buys a piece of real estate, borrowing at about 2.5% fixed rate, and investing the funds at 9% per annum rental return. While they could borrow at a lower 1% variable rate, the University would not because they are still making money, and wants the security of knowing that the cost of borrowing will not suddenly increase.

These convoluted financial disclosures beg the question: why is more information not easily available? For example, Harvard has been more open than Cornell about their loss of $1 billion on similar interest rate swaps. Harvard confirms that it borrowed funds for a major new science facility expected to cost several billion. In evaluating this investment, the main issues are did the campus expansion take place; was it a success; and did it produce an overall positive return for Harvard? Another key point is that they had to pay a lot of money to break the swap early—presumably Cornell had to do the same—which is usually a bad idea. Once the swap is in place it is typically better just to let it run to maturity and expire naturally.

All told, is the loss reasonable in the current financial environment? Cornell’s misfortune is not due to the plotting of evil banks or incompetent investment managers. All financial institutions lost a fortune in the financial crash, and today they are suffering due to the same issue of abnormally low interest rates. Banks’ return on equity are now about 5 or 6%, versus 20 or 30% in 2007, and banks like Deutsche Bank are verging on collapse today. In this respect Cornell did well to survive with their endowment intact, and despite their losses, the University is in a position where it is able to take advantage of the lack of competition once the sluggish growth in the economy has picked up sufficiently.