Drew Gilpin Faust and the Incredible Shrinking Harvard

Meyer left in 2005 amid controversy over the multimillion-dollar bonuses paid to some of his money managers. Rumors also swirled that he had clashed with Larry Summers over control of HMC. It's hard to know: Neither man is talking. Still, there is no question that Summers took a much more active role in Harvard's money management than his predecessors.

After Meyer stepped down, he was replaced by Mohamed El-Erian, a managing director at the bond giant Pimco, who lasted just under two years in the post. He was followed by Jane Mendillo, who had been managing Wellesley College's endowment, and whose assumption of the job last July would become the very definition of bad timing.

The turnover may have hurt, because last fall's stock market meltdown seemed to catch HMC asleep at the wheel. As of June 30, 2008, the Harvard endowment was 105 percent invested: HMC had borrowed above the endowment's value in order to make additional bets. With the vast majority of its money tied up in holdings from which it could not easily be extracted, the university was ill prepared when the tanking Dow spurred anxious counterparties to call in their chits. Those margin calls forced Harvard to put up collateral—cash that it did not have. And it couldn't unload its illiquid investments to come up with that money, because their value had fallen so precipitously that no one had any idea what they were really worth.

Further squeezing Harvard was a transaction Summers had pushed it into in 2004, when he successfully argued that the university should engage in a multibillion-dollar interest rate swap with Goldman Sachs and other large banks. Under the terms of the deal, Harvard would pay Goldman a long-term fixed rate while Goldman paid Harvard the Federal Reserve rate. The main goal was to lock in a low rate for future debt, and if the Fed had raised rates, Harvard would have made hundreds of millions. But when the Fed slashed rates to historic lows to try to goose stalled credit markets, the deal turned equally sour for Harvard: By last November, the value of the swaps had fallen to negative $570 million. The university found itself needing to post more collateral to guarantee those swaps, and would ultimately buy its way out of them at an undisclosed cost.

HMC "took the university right to the edge of the abyss," one alumnus, a financier who is privy to details of the university's balance sheet, told me. I asked what he meant. "Meaning, you're out of cash.

"That," he added, "is the definition of insolvency."

And so last fall HMC had no choice but to sell some $2 billion worth of stock into a plunging market. Harvard also raised an additional $2.5 billion by selling bonds on which—again because of the awful timing—it will pay interest at a significantly greater rate than identically rated corporate debt. As Bloomberg News has reported, the terms of Harvard's bond sale mean that its interest costs will mushroom to as much as $550 million over three decades. In February, HMC, suddenly not looking so smart anymore, started laying off about a quarter of its staff.

On campus, there has been widespread denial about the severity of this crisis, a deep reluctance to admit that the endowment losses are going to have profound long-term ramifications. And many Harvardians still don't know or understand exactly what happened, because the people who do know don't want to talk about it. Some of Faust's closest advisers actually opposed her initial letter to the Harvard community last November regarding the endowment plunge, essentially saying they could tough it out until the year-end financial report, by which time the markets might have risen.

Though the stock market hemorrhaging appears to be over, Harvard isn't out of trouble. According to the university's 2008 financial report, in the next 10 years it must pay various private investors some $11 billion in capital commitments. Where will that money come from if, as seems likely, endowment growth over
those years is minimal or nonexistent, and alumni's own strained budgets limit their generosity? 

"If you can't afford to lose the money"—and a university that depends on its endowment to defray operating costs can't—"don't play the game," says one Harvard grad, an investor who was once involved in the university's finances.

"You had very smart people [at HMC] who never had a real answer to the question 'What would happen if this doesn't work out your way? What if what the black box is predicting doesn't occur?'

"The answer would always be 'That's impossible,' or 'You don't understand.'
"The arrogance," says this alum, "was palpable."