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September 29, 2016

Report: Cornell Lost $280 Million in Interest Rate Swaps

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A report released by the Roosevelt Institute, Cornell’s first student-run think tank, asserts that the University may have lost as much as $280 million over the past 16 years due to interest rate swaps.

An interest rate swap is a deal that colleges conduct with banks, often when universities issue debt to raise money. The think tank asserts that this financial instrument was a major contributor to Cornell’s $25 million dollar budget deficit in fiscal year 2015.

According to the report, Cornell’s $280 million loss was one of the most drastic out of the 19 schools examined in the study. Only Harvard, which lost over a billion dollars — but enjoys a significantly greater endowment than Cornell — lost more money.

Interest rates on debt often correlate with broader national interest rates, but schools would often rather pay a fixed rate because they are less risky, so they buy interest rate swaps from banks.

When schools buy interest rate swaps, they promise to pay the banks a fixed interest rate, while the banks pay the variable rate on the debt that the school issued. When the variable rate is higher than the fixed rate, the school makes money. However, when the variable rate is lower than the fixed rate, schools lose money.

Therefore, in 2008 — when interest rates plummeted to nearly zero percent and Cornell had bought swaps at four percent — the University lost millions of dollars. Eighty percent of the deficit in 2015 was due to costs from interest rate swaps, according to the University.

Cornell is not alone, however, in losing money on interest rate swaps. The report shows that the 19 schools sampled in the report lost approximately $2.7 billion dollars due to swaps and based on a random sample, 58 percent of schools own interest rate swaps.

Jack Polizzi ’18, one of the report’s contributors, explained that the numbers are just estimates based on data on the swaps that Cornell provides on its website and the LIBOR rate, which was used as the benchmark variable rate in the swap deals.

He said that he hopes Cornell will release the actual data on the interest rate swaps.

“The thing that we want to see is transparency here,” he said. “We want to get answers, figure out why this happened, what we can do to prevent things like this in the future and hopefully actually get Cornell to release documents pertaining to these swaps so we can really take a look at what happened.”

He added that interest rate swaps are zero-sum deals because either the banks lose money or the schools lose money. That system presents a problem when the banks have a lot more people to predict how the Federal Reserve will set interest rates, which the LIBOR rate is strongly correlated with.

“It’s to some degree unavoidable because you have one party whose entire business model is based around understanding credit markets, Fed watching, trying to predict where the economy is going to go and then you have schools where that’s not their job at all,” Polizzi said.

He pointed out that banks can take advantage of their resources to make money off of schools and said some of the interest rate swaps that schools have bought are set for 30 years, much longer than swaps sold to any other type of institution.

“[Schools] have an investment committee which is maybe a few people who are not versed in instruments like this, so right away you have an information asymmetry which makes it relatively easy for the banks to take advantage of schools,” he said.

Joanne DeStefano, executive vice president and chief financial officer at Cornell, said the University has historically had a good track record in strategies designed to minimize interest paid on debt.

“However, in a plan designed to manage the University’s long-term capital plan in the most cost-effective manner, the University entered into certain interest-rate swap agreements in 2006 and 2007,” she said. “As with all financial instruments, swap agreements carry with them a degree of market risk; the great recession affected these swaps in a negative way.”

Despite DeStefano’s comments, Polizzi found records of swaps from other years besides just 2006 and 2007. In addition, he found that the results of the swaps has been extremely negative. According to the report, the total loss to colleges from these deals could pay for tuition for 108,000 students across the country.