Thursday, July 18, 2013

Summer Time for the Fed? God help America!

Larry Summers's Billion-Dollar Bad Bet at Harvard
2013-07-18 13:35:11.738 GMT

By Matthew C. Klein

July 18 (Bloomberg) -- President Obama has only a fewmonths to pick a candidate to replace Ben Bernanke as chairman of the Federal Reserve, and while the betting website Paddy Power has Fed Vice Chair Janet Yellen leading the pack at 1:4 odds, Larry Summers remains a strong contender at 11:2.
 
Despite an impressive resume that includes stints as Treasury Secretary and chief economist of the World Bank, there is a very good reason Summers shouldn't be in charge of monetary policy: He seems to have trouble with interest rates.
 
During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university's president.  Interest rate swaps allow borrowers to lock in a fixed interest rate on floating-rate debt, which can be good to hedge against short-term uncertainty. The problem with Harvard was that Summers wanted to lock in interest rates for money that the university hadn't actually borrowed and  wasn't planning on borrowing for a very long time.
 
There aren't a lot of ways to interpret this exotic instrument except as a bet that the future level of interest rates would be higher than the market pricing implied at the time. That bet was wrong, and Harvard lost a billion dollars.

Anonymous finance blogger Epicurean Dealmaker puts it well:
     
"I have rarely encountered a corporate client who feels confident enough about both their absolute funding needs and current and impending market conditions to enter into a forward swap starting more than nine months into the future. Entering into a forward start swap for debt you do not intend to issue up to 20 years in the future sounds like either rank hubris or free money for Wall Street swap desks."
 
Why, back in 2004, did Summers feel so confident that interest rates were going to be much higher than they actually were? Reuters blogger Felix Salmon found one clue in a speech Summers gave in October of that year. Among other he things, Summers warned of the dangers created by the U.S. current account deficit and highlighted the seemingly absurd fact that short-term borrowing costs were lower than the rate of
inflation. Perhaps Summers's experience with foreign-exchange crises in Asia and Latin America convinced him that something similar could happen in a country that borrowed in its own currency.
 
Not only was Summers wrong in 2004 about where interest rates would be -- he was willing to bet a lot of other people's money that he knew better than everyone else. The damage at Harvard was bad enough. Imagine what that sort of thing could do to the U.S. economy.

(Matthew C. Klein is a writer for Bloomberg View.

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