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College Killed on Risky Derivatives Play

The College’s huge monetary losses that we discussed a few weeks ago, where working capital was squandered in cowboy-style hedge fund investments, were not the only wasteful financial moves that the College made in past years. It seems that the finance staff took several even more disastrous flyers using derivatives.

derivative (dɪˈrɪvÉ™tɪv) — adj
1. resulting from derivation; derived or making use of other sources; not original or primary.
2. a contract or security that derives its value from that of an underlying asset (as another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (as a stock index)

There are any number of definitions of the word “derivative” in the academy; in the Humanities, the adjectival use of the term is the ultimate pejorative for work lacking in originality. However that meaning should now be pushed from its spot as Dartmouth’s top dirty word by the the term’s use as a noun: a modern financial instrument.

During the 2000-2004 fiscal years, using complex and risky derivatives called interest rate swaps, Dartmouth’s dynamic team of Executive V.P. of Finance & Administration Adam Keller and Associate V.P. for Fiscal Affairs Julie Dolan (both no longer with the College) entered into complicated transactions of which they had little understanding. The Trustees’ equally unschooled Finance Committee signed off on all of their decisions. The plays hinged on speculative bets regarding the direction of interest rates as they related to potential payments on the College’s fast-growing debt burden. They bet wrong.

An interest rate swap derivative transaction involves exchanging the risk of movements in interest rates with a counter-party. In this case, the College traded the risk of the interest cost rising on its variable rate bonds for the payment of fixed interest rates. The counter-party must make good on any gains that the College might earn on the transaction; it also benefits from any losses that the College may suffer. So, just like dancing, it is important to know your partner.

Throughout the period in which the College was in this disastrous play, Dartmouth’s financial statements contained the following note:

Swap History Credit.jpg

Ponder for a moment the last few words of this paragraph: financial stability and creditworthiness. The above note appeared in Dartmouth’s FY2007 financials, dated October 30, 2007. Less than eleven months later, on September 15, 2008, the College’s counter-party declared bankruptcy in one of the financial world’s largest-ever catastrophes. Keller and Dolan dealt with this firm right up until its demise, despite the fact that then-Chief Investment Officer David Russ had been warning for close to two years of its instability. Yes, as you might have guessed, the financial firm in question — used for every single one of Dartmouth’s swaps — was Lehman Brothers.

When Lehman failed, the College was obliged to find other counter-parties to cover its interest rate risk, and it had to cover the losses on the derivative plays then due to Lehman as they stood at that moment. In order to do so, in 2009 the College paid out $43,014,000 in cash to cover the losses on the Lehman swaps (below is a excerpt from page 21 of the College’s 2009 financial statements).

Dartmouth Swap 2009 loss.jpg

Notably, the market value of the new swaps into which the College entered to replace the Lehman swaps continued to fall in 2010; in the last fiscal year, the College sustained a paper loss of $35,914,000 (See page 3 of the College’s 2010 financial statements).



These paper losses might not become actual cash losses if the College holds the swaps to maturity, but the earlier $43,014,000 loss is real cash money that Dartmouth will not see again. To put the amount of the College’s derivatives loss in perspective, during this period Dartmouth’s net annual income from undergraduate tuition was less than $100 million each year.

Where were the members of the Board of Trustees while inexperienced staffers threw tens of millions of dollars around? Will anyone take the blame for this lack of supervision?

Note: As we observed several weeks ago regarding the College’s losses from the imprudent investment of its working capital, for accounting purposes, payments and losses from swaps are not part of the the endowment; therefore the above-mentioned losses would not be incorporated in the calculation of the endowment’s gains or losses for the various fiscal years during which they were incurred.

Note: Harvard suffered the same fate as the College when it entered into complex, poorly understood interest rate swaps to protect itself from a potential increase in interest rates. When rates plummeted, financial managers there felt a cash crunch, too, and they sold their positions at the worst possible moment. If you are interested in a well told story about foolish human behavior and high finance in education, Bloomberg published an extended piece on the whole debâcle.


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