Is Harvard A Hedge Fund?

Harvard has problems. Billion dollar problems. Exactly how many billions of dollars remains in dispute. What is beyond dispute, however, is that Harvard has lost around a quarter of its endowment in the last nine months, and a large part of the remaining funds are tied up in illiquid investments. This is quite a reversal. Indeed, only a year ago endowments at Harvard and other elite schools had swollen to such gargantuan sums that they were busy devising ways to spend enough to maintain their tax-exempt statuses. There was even talk of using the endowment to make Harvard free for all students. Ah, those heady pre-Lehman days. Of course, it is hardly surprising that Harvard's endowment has not been immune to the global financial turmoil. Markets everywhere have cratered. But the nature of Harvard's losses illustrates the extent to which the university has aggressively moved into nontraditional investments - "real" assets like forests and oil, as well as stakes in private equity. Harvard has become a hedge fund. But why did Harvard transform itself, as Jim Manzi wryly opined, into a "tax-free hedge fund with a very large marketing and PR arm called Harvard University"? And what does this tell us about how the bubble economy skewed our perspectives, and created perverse incentives to join the speculative crowd?

Because it was lucrative. Very lucrative. This is the short answer to why Harvard began managing its endowment like an amped up Wall Streeter trying to max out just before bonus season. This is not hyperbole. Ex-Wall Street alums ran the endowment, and were compensated along the same bonus system (although the Harvard Management Corporation did wisely include clawback provisions). As Edward Jay Epstein notes, they moved out of the types of assets endowments had traditionally held, such as Treasuries and other bonds, and into a broad range of often obscure, illiquid investments. After all, there were oversized fortunes to be made in these exotic bets. And Harvard made them. Under Jack Meyer's stewardship, Harvard's endowment ballooned from $4.7 billion in 1990 to $22.6 billion in 2005. Aggressive management accounted for at least $12 billion of this growth; 15% annual returns will do that.
Of course, it was not simply a Scrooge McDuck hoarding instinct that motivated this shift in investment strategy. The scorched earth competition that is elite higher education demanded it. As colleges entered an arms race in the last fifteen years to attract the best faculty and students, costs skyrocketed. There was an education bubble. And even a school with as strong a brand as Harvard could not afford to let its near peer institutions outspend it on research facilities, dorms, and professors. As former Citigroup CEO Chuck Prince remarked nearly two years ago about the credit boom (in a statement that retrospectively highlights the collective cluelessness of our erstwhile financial titans), "as long as the music is playing, you've got to get up and dance." So Harvard danced.

Harvard needed little cajoling to get up on the metaphorical dance floor. This unreserved jump into heretofore abstruse markets hints at the final dimension of the Harvard endowment's metamorphosis into a speculative enterprise: the school's changing culture. Beginning in the 1980s, increasing number of Harvard graduates flocked to Wall Street to get rich. According to Harvard economists Claudia Goldin and Lawrence Katz, the number of graduates going into finance grew from 5% in 1970 to 15% in 1990. A survey of the class of 2007 revealed that 20% of the men were headed for Wall Street. And who could blame all these wannabe Masters of the Universe - alumni in finance earned on average three times more than their former classmates in other fields. What explained this explosion in financial sector salaries? No one is quite sure. If anyone could explain, it would almost certainly be business journalist Michael Lewis, who had a firsthand view of the genesis of this brave new financial world while at Salomon Brothers. However, even he is slightly flummoxed. As Lewis explains in Liar's Poker, the money was just there. In terms of supply and demand it made little intuitive sense. Some confluence of new freedom from regulatory strictures and a generational forgetting of the toxicity of excess debt created a frenzied era of seemingly exponential growth for Wall Street. It certainly seems that by the early 1990s, recent alums and current students had so bought into the Wall Street way that maximizing the endowment's returns seemed obvious; following a conservative strategy would be an inefficient use of capital, after all. Now it is certainly possible that the changing career choices of Harvard alums had little or no impact on the investment strategy of the HMC. The fact that hosts of grads descended on the investment houses and the endowment reoriented towards higher-yielding (read: riskier) assets could both merely have reflected the immense profitability of the Great Bull Market.

Without large parts of the Harvard community internalizing the Wall Street ethos, it seems unlikely that the HMC would have been able to justify its shift in investment philosophy. Indeed, even this was not enough once HMC remuneration peaked in 2004. To some alumni who came of age before the go-go 1980s, the outsized paychecks HMC handed out to the endowment's managers were disquieting. Several members of the class of 1969 began a letter-writing campaign, and ultimately succeeded in pressuring the administration to establish pay caps. The student newspaper the Harvard Crimson, however, was not impressed. They told alumni to "stop calling for salary cuts" and end the "excessive scrutiny" of HMC - otherwise the university would be unable to retain its top financial talent. Besides, HMC did not pay its employees nearly as much as a hedge fund with identical returns would receive. Don't kill the goose that laid the golden nest egg.

They had a point. While paying a combined $70 million to two bond traders in 2004 stoked outrage, this was a pittance compared to what Harvard would have had to pay to an outside firm for the same results. However, arguing that capping pay was short-sighted presupposed a key issue: that Harvard was a hedge fund. During the boom years, this might have seemed a pedantic point, but the current downturn has demonstrated the downside of running an endowment like George Soros runs his hedge fund. Like colleges everywhere, Harvard has instituted a hiring freeze, halted construction on new projects, and fired staff to cut costs in response to the global financial crisis. These austere measures have prompted a torrent of criticism. Despite its losses, Harvard's endowment still dwarfs those of other schools; indeed, Harvard has lost more than most ever had. Given the university's relative wealth, shouldn't they use the endowment to maintain services? Some contended the university was acting as if capital preservation mattered more than the students. Such are the dangers of turning a university into an investment vehicle.

Harvard is hardly alone in transforming itself into a hedge fund. The trend began with Wall Street itself in the 1980s. It is easy to forget now, but investment banks did not always trade on their own books. They advised companies on mergers and acquisitions; they underwrote securities; they executed trades for clients. But as Michael Lewis chronicles in Liar's Poker, the trading culture quickly spread from Salomon Brothers throughout Wall Street once it became clear what kinds of fortunes stood to be made. Institutional investors - university endowments, pension funds, and insurance companies - followed suit. Big ticket manufacturers - GE and GM - got in on the act as well, turning their financing arms into cogs in the larger banking system. At the bubble's peak, entire countries - yes, that means you Iceland - effectively leveraged themselves up and became de facto private equity firms and hedge funds. Why did everyone and their aunt borrow to speculate in the markets? Because they were afraid of being left out. They saw their relatives and neighbors and rivals making a quick buck, and they didn't want to be the sucker who didn't get rich. They let social pressure cloud their judgment. Their early "successes" in the markets only reinforced these pressures, and warped their values, sending them into self-congratulatory fits about how brilliant they were for doing so well.

But now that the age of leverage is over, never to return in our lifetimes, we must all go back to doing what it is that we did before the markets made us crazy. Iceland needs to go back to fishing; GE and GM need to go back to building wind turbines and cars; pension funds and insurance companies need to invest in safe, boring assets; and Harvard has to go back to just educating its students. A new age of responsibility is most certainly upon us.

Is Latvia the Next Lehman?

Latvia's government recently became the latest victim of the financial crisis. Despite receiving a nearly $10 billion bailout from the IMF late last year, Latvia's economy contracted at a 10.5% annualized rate in the fourth quarter of 2008, leading their finance minister to diagnose their economy as "clinically dead." Protests over this economic freefall forced the government to step down. But while the crisis in Latvia may yet abate, the question of whether a new round of financial contagion, this time originating in Eastern Europe, will infect the world remains open. Could Latvia - or Poland, or Bulgaria, or Ukraine - be the next Lehman?

Nearly every Eastern European nation faces a severe currency crisis. Indeed, no less an authority on the matter than Paul Krugman noted last October that the situation was "the mother of all currency crises." But what does this mean, how does it happen, and what needs to be done to done to stabilize the situation?

Let's consider a hypothetical country, Leveragestan. Let's say Leveragestan is a small country transitioning to a free market economy. They have a history of hyperinflation. They decide to peg their currency to a more stable currency (say the euro) to create a more credible investment environment. International capital pours in. The economy takes off. So far, so good. But the story so far is more complicated than simply "foreign money comes in and the economy grows." The international capital needs to be converted to the local currency (let's call them rubles). In terms of supply and demand, this creates more demand for rubles. To keep the ruble from gaining value (since they pegged it against the euro), the Leveragestan government must sell rubles on the foreign exchange markets, building up a reserve of foreign currency in return. Meanwhile, the new rubles in circulation within Leveragestan create a credit boom. Some of this money will go to legitimate investments. Some to speculation. And some to consumption. Soon Leveragestan increases its imports, and begins running a current accounts deficit. As long as the money keeps coming in from abroad, this isn't a problem. But what if international investors run for the exits?

First, why would foreign money suddenly stop coming in? Maybe Leveragestan's economy stops growing as fast as it was previously, and isn't as attractive an investment option anymore. Maybe the credit boom from the international capital created a speculative bubble that popped. Or maybe a major investment bank abroad collapsed, and investors everywhere are selling assets to raise cash. Regardless of the cause, once there is serious capital flight out of the country, Leveragestan's currency comes under assault. Its current accounts deficit, if large enough relative to the size of the economy, means that there is less demand for the Leveragestan ruble. The ruble is now overvalued. Subsequently, speculators begin to bet that it will decline. Leveragestan can defend its currency by using its foreign currency reserves to buy rubles on foreign exchange markets. But is more difficult to prop up a currency's value than to keep it down. Leveragestan can always print more rubles to put on foreign exchange markets if the government wants to keep the ruble from rising. They have a limited supply of foreign currency, however, to sell in order to keep the ruble from falling.

Once its foreign reserves dwindle, Leveragestan has two choices: raise interest rates or devalue the currency. Raising interest rates reduces the money supply and makes holding assets in Leveragestan more attractive; investments pay a higher rate of return. This could stop the capital flight. But spiking interest rates also choke off economic growth. Businesses can't borrow cheaply and hiring slows. A recession will follow. Devaluing carries its own risks. If done transparently and correctly, it will end the speculative attacks. Additionally, it will make Leveragestan's exports more competitive, since their goods will be cheaper abroad, and set the economy up for continued growth. Devaluing also gives investors confidence that assets are fairly priced. The perils are twofold: first, if done haphazardly, investors might panic, and the currency will fall more than it "should"; and second, that the real burden of debts denominated in foreign currencies will skyrocket for domestic borrowers.

Now where does Eastern Europe fit into this story? In the two decades since emerging from communism, the Eastern European countries have liberalized their economies, opening them to foreign investment, and pegging many of their currencies against the euro, in anticipation of someday joining the Eurozone. Western European banks - particularly Austrian, Swedish, and Belgian ones - lent heavily to Eastern Europe. This sparked a rise in consumption, and some gargantuan current account deficits. But the credit crisis has reversed this onetime frothy growth - and then some. As capital has left the region, Eastern European currencies have plummeted. While this would normally help their export sector, the reality is that with worldwide demand shriveling, there is no one to export to. Like Latvia, countries across Eastern Europe are contracting at or near double digit annual rates, as demand for their goods in Western Europe has disappeared.

This precipitous fall in GDP in conjunction with plunging currencies has created potentially a new source of contagion in world financial markets. First, let's consider the currencies. Raising interest rates to stem capital flight is not an option. Investors want to hold cash or safe government debt. This liquidity preference is, of course, not unique to Eastern Europe. But it means that offering higher rates of return will not dissuade investors from pulling their money out. And given the enormous current accounts deficits many Eastern European nations were running, this means - oftentimes massive - devaluation is the only option. Indeed, currencies across the region have fallen by nearly 20-50% against currencies such as the Swiss franc. This fall against the Swiss franc is particularly ominous, since so many Eastern European businesses and households took out loans and mortgages in Swiss francs during the bubble years to take advantage of low interest rates. But one example: 60% of Polish mortgages are denominated in Swiss francs; the Polish zloty has halved against the Swiss franc in recent weeks. As the real burden of debts of businesses and households nearly doubles across the region, defaults will skyrocket. Eastern Europe's cratering economies compound this problem. As job losses accelerate, even more borrowers will not be able to repay their debts - and that's before accounting for the rising real burden of debts as local currencies fall. This is Europe's subprime debacle. And its explosion will beget a new round of writedowns for Western European banks.

The web of financial interconnectedness is tangled and difficult to predict. But the failure of Western European banks - and countries - could potentially bring credit markets back to their apocalyptic post-Lehman levels. Austrian banks are perhaps most exposed to Eastern European debt, but they themselves borrowed heavily from Swiss banks. Switzerland could find itself at risk of sovereign default if it needs to nationalize its banks, as bank liabilities are roughly 1050% of Swiss GDP (Iceland's bank liabilities comprised 1000% of GDP for comparison's sake). For many of the small Western European countries, their banks are both too big to fail and too big to save. Italian, Belgian, and Swedish banks are all also highly exposed. Only an EU-wide response can stave off complete disaster. This essentially means getting France and Germany to agree to bail out their neighbors. After denying reality for months - resisting calls for stimulus spending and bailing out at-risk European countries - the German Finance Minister made some noise recently about bailing out Ireland. This is a good start. But much more is needed.

This is where President Obama comes in. A collapse in the European banking sector would surely bring down American banks as well. While major American banks are more or less insolvent already, we have them on life support now. A disorderly bankruptcy in the markets would send them on a new and rapid death spiral. At the upcoming G20 summit, President Obama should push for increasing IMF funding, and giving it a greater mandate to bail out countries. He should also push the EU members to more aggressively cut rates and spend on fiscal stimulus. But most importantly, we need an internationally coordinated banking rescue plan. This is a tall order. Getting consensus within America on fixing the financial sector is difficult enough without bringing in foreign leaders as well. But our financial markets are so interconnected that coordination is more or less necessary.

In 1931, the Austrian bank Creditanstalt failed, setting off a new stage of bank runs across the world. Let us hope that history indeed does not repeat itself. And that we can learn from it.

Update: European leaders' unwillingness over the weekend to create a comprehensive Eastern Europe bailout fund a la Hungary's suggestion is not encouraging. Treating each country on a "case-by-case" basis echoes of American policy towards investment banks until October. Eventually, political leaders will likely get bailout fatigue, or policymakers will simply underestimate the systemic importance of a country/bank, and let the wrong one go. If moralizing sentiment like from this recent interview - Eastern Europeans must devalue despite the enormous real burden of debt this will create to "learn not to borrow in foreign currencies" - takes hold, then enough of Eastern Europe might go bust to start a new stage of financial panic.