Swaps as Flops?

From the San Francisco Chronicle: Passing Proposition 30 prevented hundreds of millions of dollars in near-term cuts to the University of California, a laboratory of innovation that fuels our state's economy. But now a large part of that lifeline might be squandered in payments to Wall Street banks, according to a report released Tuesday by researchers at UC Berkeley.

Over the last decade, the UC Board of Regents has engaged in risky deals with Wall Street banks called interest rate swaps. Banks sold swaps to the university and other public institutions as insurance against rising interest rates on variable rate bonds. Under a swap agreement, borrowers such as the university paid a fixed rate to the bank in exchange for the bank paying the university a variable rate based on the markets' interest rates for borrowing.

Now these swaps have turned out to be losing bets. UC is taking huge losses because interest rates plummeted following the financial crisis of 2008 - allegedly in part because of illegal manipulation by the same banks that sold the swaps - and have stayed at record lows. Swap deals already have cost UC nearly $57 million, with $200 million more in losses anticipated. Of the $250 million UC expects to receive from Prop. 30, some $10 million a year will go to swaps payments unless the deals are ended...

All over the country, municipalities, universities and nonprofits fell prey to the swap scam. But many of these entities (including the Asian Art Museum of San Francisco and the cities of Oakland and Los Angeles) have undertaken aggressive efforts to renegotiate their swap agreements. Others are pursuing litigation to hold banks accountable. In contrast, the UC Regents so far have taken little action to stem the university's losses...

Full article at http://www.sfgate.com/opinion/openforum/article/Prop-30-funds-for-UC-will-go-to-Wall-Street-4031472.php

The article above is written by Adam Goldstein and Jacob Habinek who study the economic sociology of financial markets. They are both doctoral candidates in the department of sociology at UC Berkeley.

The report to which it alludes is at:
http://publicsociology.berkeley.edu/publications/swapping/swapping.pdf

Keep in mind - in looking at the report - that when insurance is taken out against a Bad Thing happening, there is often a cost.  If you have life insurance, you surely hope it turns out to be a really bad deal for you in the end. The benefit of life insurance is that if what you don't expect to happen does happen, your family will have some protection.  So losses on insurance are not  by themselves scandals.  The preamble to the report says that students carry the burden of losses in tuition but don't get the benefits.  Here is an excerpt which gives the flavor:  ...UC management has more than doubled the university’s debt burden from $6.9 billion in May 2007 to $14.3 billion at the end of 2011. Rather than contributing to UC’s core mission, funds have been directed toward more profitable UC enterprises like medical centers and attracting out-of-state students. Medical center profits have increased steadily to $900 million annually last year. Out-of state enrollment has doubled across UC—increasing from 11% to 30% at UC Berkeley...

Since particular loss dollars or gain dollars cannot be traced to particular purposes, the assertion that a particular loss raises tuition is questionable.  For example, UC has undertaken various financial strategies which benefit the pension fund.  The cost of the pension is eventually borne by UC and its various entities and could be reflected in tuition at some point.  So if those costs are mitigated, eventual tuition might be lower.  Again, to use the life insurance example, did the premiums you pay for such insurance come out of your grocery bills?  Or did you reduce your movie going?  Or did you buy a cheaper car?  You really can't say. Generally, in evaluating the performance of those in charge of investing funds, you would look at total results since they are likely to do poorly in some decisions and better than average in others.  

I am not sure a large fraction of the UC faculty would agree that med centers are not what UC has as part of its "core mission."  What is UC-SF all about?  Bringing in out-of-state students is meant as a mechanism to put more money into the overall system to make up for state budget cuts.  It is hard to see why that endeavor is termed a "profitable UC enterprise" or why it isn't seen as a way of holding back tuition increases for state residents.  What set in motion tuition increases and a shift of capital project support from the state to UC was the ongoing California budget crisis. We have not been shy on this blog at pointing out risky or wasteful expenditures and managerial deficiencies.  

The report does make a point (noted in the article excerpt above) that some UC losses on swaps might be mitigated through litigation.  Given the SF Chronicle piece, I suspect that UC will now say something about what, if any, litigation strategy it intends to pursue.