Report reveals Carnegie Mellon and 18 other universities lost millions on deal

Shlok Goyal Nov 20, 2016

The Roosevelt Institute released a report last year that revealed that Carnegie Mellon has lost $44.75 million since 2004 on five variable-to-fixed rate swap agreements and is expected to lose $44 million more on these deals.

Carnegie Mellon uses a swap to hedge against variable interest rates. For example, Carnegie Mellon issued a bond in 2006 (essentially taking on a loan) in order to finance new construction and pay off existing debts. Since interest rates in the market often change, Carnegie Mellon made an agreement with PNC Financial Services to pay a $100 million fixed interest rate every month until 2028. PNC, in turn, would pay Carnegie Mellon the variable interest rate based on the constantly fluctuating LIBOR rate.

“The university took this action to reduce its exposure to rising interest rates on variable rate debt,” Ken Walters, Executive Director of Media Relations said. “The agreements eliminated the risk of the university being exposed to higher variable interest rates by changing the debt to a less risky, fixed rate.”

After the Great Recession of 2007 and 2008, however, central banks like the Federal Reserve lowered interest rates to zero and some to sub-zero. This meant that the bank was paying an almost-zero rate to Carnegie Mellon while Carnegie Mellon was still paying the fixed rate based on the market in 2006. This created a discrepancy between what Carnegie Mellon was paying PNC and what it was receiving from the bank, leading the school to lose $24 million in this particular agreement and $44.75 million through the five total payments so far.

The university is expected to lose more money on these swaps since interest rates remain at levels far below those in 2006. While the Roosevelt Institute report says that Carnegie Mellon has paid $39.15 million and is expected to pay $34 million more, the latest annual financial report released last week shows that Carnegie Mellon has so far paid $44.75 million and its forecasted actual loss will be an additional $44.175 million, for a total loss of $88.925 million. Carnegie Mellon cannot terminate these contracts without paying the fair value, or expected value of the deal, which is effectively the loss the agreements will garner, nullifying any benefit of canceling the agreement.

Carnegie Mellon spent $5.6 million on paying the swap interest this past year and since the highest-value swap agreement doesn’t end until 2028, most of this payment is going to be consistently present until then.

Considering, however, that Carnegie Mellon’s total operating and non-operating expenses were $1.09 billion, this loss only accounts for 0.5 percent of the university’s annual expenses, indicating that it hasn’t created a substantial loss to the university.

At the same time, the loss Carnegie Mellon has realized so far in swap agreements could pay the tuition and fees of 855 undergraduate students in 2016, or 13 percent of the undergraduate class. It must be noted, however, that this loss has occurred over 12 years rather than a single year.

For the future, Carnegie Mellon already agreed in 2007 to four swap agreements worth a total of $80.425 million that will go into effect from 2028 to 2031. This offers the university stability for however the market looks like at the time, but locks it into a contract into the future.

One benefit to the swap agreement has been that Carnegie Mellon now knows the rate it must pay each year for the life of the agreements. While protecting against rising interest rates, though, this exposed to Carnegie Mellon to a loss in income induced by lower rates. Thus, the university is now paying more than it otherwise would be without a swap agreement.

In addition to Carnegie Mellon, the report also studied losses generated by 18 other universities on similar swap agreements. The phenomenon is not unique to Carnegie Mellon, as Harvard, for example, has lost $1.25 billion and the University of Michigan has lost $85.5 million. In total, the 19 institutions have paid $2.7 billion on swap agreements they signed, some starting over a decade ago. According to the Roosevelt Institute, the money lost on these swaps could have paid the tuition and fees of 108,000 undergraduate students for one year at the 19 institutions.
In general, having low interest rates should help an university that issued bonds to finance construction or other investments since it could now refinance its debt and pay a lower interest rate in the future. However, the swap agreements’ termination penalties often make it difficult for colleges to exit the agreement.

These penalties also rose when the interest rates fell since they are based on the net expected value Carnegie Mellon will gain from these deals, which became further negative when the rates declined.

One action the report recommended schools with bad swap deals take is to ask the Securities and Exchange Commission to investigate whether banks did not properly explain the risks of the swap agreements. According to the report, they are legally required to do so, but banks often “downplay the risks and highlighted the savings that borrowers would enjoy if none of the risks associated with these highly risky deals materialized.”

Another action the report recommended to universities was to look into suing the bank based on whether it manipulated the LIBOR rate. The LIBOR rate is an interest rate set by the most prominent global banks in the world and is the one which financial institutions’ payments to Carnegie Mellon are based on. Many of the banks, including JPMorgan Chase, illegally colluded to keep this rate low from 2007 to 2010, potentially increasing the losses Carnegie Mellon and other institutions generated from the swap agreements.

Raaga Kalva, co-president of the Roosevelt Institute’s Carnegie Mellon Chapter, cited increases in tuition and the lack of adequate financial aid offered by Carnegie Mellon as being problematic for students. He believes the money that was lost could have been “used for the students and for the faculty and for our institution versus going to these banks.”

The Roosevelt Institute cites the spread of swap agreements as a sign of the increasing influence of financial firms.

Kalva backs the sentiment, saying, “the lack of our financial expertise should not be something that becomes a factor in the way that students’ lives are affected because that’s not the goal of our institution.”