Guest commentary: UC placing the wrong bet by continuing costly interest-rate swaps

By Christine Rosen
Guest commentary

University of California faculty were troubled to learn from a new report that management has been compounding the university’s already-dire financial problems by failing to take steps to staunch enormous losses from investment in risky Wall Street financial derivatives.

The report, by UC Berkeley researchers, says the 10-campus system has already lost $56 million. It could lose another $200 million over the next 20 years if action isn’t taken to renegotiate the terms of the investments.

UC has responded that in fact the questionable investments have actually saved the university $46 million and that renegotiating the terms would put the university’s finances at greater risk of loss.

What’s the real story?

Since 2003, UC has taken on more than $13.5 billion in new debt — largely for construction projects unrelated to UC’s core academic mission, such as new sports facilities and medical center expansion. In the hopes of minimizing interest payments, UC chose to issue some of this debt in the form of bonds with variable interest rates. Because the initial rates on the variable rate bonds were lower than a fixed-rate bond, the university saved $46 million.

However, the variable rate meant that the university would lose millions if interest rates rose. To hedge against this, it entered into separate deals with investment banks, called “interest rate swaps.” UC agreed to pay the bank a fixed rate on a set loan amount every month.

The bank would then pay UC a variable interest rate on that same loan.

Unfortunately, interest rates plunged due to the 2008 financial crisis.

UC now loses almost $10 million a year on its swaps (which the Wall Street firms that sold them book as profits). It has lost more on the swaps at this point than it saved by issuing variable rate bonds.

The question is: What should UC do now?

Should it stand pat in hopes the economy soon revives, interest rates skyrocket and the swaps start paying off?

Or should it follow the lead of cities, universities and other public institutions across America that have worked with the financial institutions involved to renegotiate terms of their swaps to cut their losses?

A lot depends on whether you think interest rates are likely to rebound soon or stay at historic lows.

It is sobering to think that Japan’s central bank has kept its interest rates at close to zero for more than 20 years. And that the Fed is following in Japan’s footsteps by promising to keep the U.S. rate at current, near-zero levels for as long as it takes until the economy takes off.

This question matters because UC faces a worsening financial crisis. Decades of state budget cuts have not only damaged its ability to provide first-rate educations at affordable prices to California students, but also to recruit and retain world-class faculty. UC leaders warn that the university’s continuing financial shortfalls will force them to impose more cuts and order more tuition hikes in coming years, inflicting more damage.

By not renegotiating the swaps at a time when interest rates are likely to remain low, UC management is leaving potentially hundreds of millions of dollars on the table — money the system desperately needs.

Christine Rosen is an associate professor at UC Berkeley’s Haas School of Business.

[Source: Inside Bay Area]