Everyone knows Harvard. The prestigious 373-year-old university rejects 95% of the people who apply. But the ones who get in usually end up doing pretty well. The Ivy League institution counts JFK and FDR among its alumni -- but that's ancient history. It also can claim such respected finance gurus as former U.S. Treasury Secretary and current Obama economic advisor Larry Summers, and current U.S. Fed Chair and Time Person of the Year Ben Bernanke.
But that Summers fellow seems to have left Harvard with a little bit of a financial problem. That's because Summers didn't just attend Harvard -- he was its president from 2002 to 2006. During that time, he made some choices that later led to serious damage to its endowment, which peaked at $36.9 billion in June 2008 -- but has since lost 30% of its value, dropping to $26 billion, according to Bloomberg News.
(from Daily Finance, December 18, 2009)
In 2004, Summers also put some interest rate swaps on Harvard's books for its cash account. Later, Harvard had to pay $1 billion to get out of them. In fact, in October 2008, Harvard was in such fiscal hot water that it had to borrow $2.5 billion from the commonwealth of Massachusetts, almost $500 million of which was used within days to exit those swap agreements, which Harvard had entered in order to finance a Summers-led expansion in Allston, Mass., across the Charles River from its main campus in Cambridge.
What is an interest rate swap and how did Harvard get into so much trouble with them? Put simply, an interest rate swap is a bet on the direction of interest rates. Let's say Institution A issues a bond with a variable interest rate that it must make payments on, but it expects rates to rise. It wants to lock in what it thinks are the current low rates. Meanwhile, let's say Institution B is issuing a different, fixed-rate bond, but it fears interest rates will fall. Institution B wants to pay an interest rate that will go down as the market rate tumbles.
An interest rate swap lets B trade its fixed interest rate for A's variable one. In this scenario, the parties are playing a zero-sum game where one party's profit comes out of the hide of its counterparty. For example, if interest rates fall, A is in big trouble because it needs to pay B the difference between the higher original rate and the market's far lower one. It was just such a slip-up that made Summers' 2004 bet so costly for Harvard.
In December 2004, Harvard entered into agreements that locked in interest rates on $2.3 billion of bonds for the Allston construction, with plans to borrow $1.8 billion in 2008 after the school broke ground, and the remaining $500 million through 2020, according to Bloomberg.
At the time, the Fed's overnight interest rate was 2.25%, and Summers evidently forecast that rates couldn't go any lower. So he bet, buying those interest rate swaps. What he didn't foresee was the financial collapse in 2008, which caused the world's central banks to cut interest rates to near-zero -- a move that sent the value of those interest rate swaps plunging and forced Harvard to come up with the $1 billion in quick cash.
As a result, Harvard is poorer, and the school has been forced to fire hundreds of people and trim its budgets. And the university's Allston expansion? Cranes were recently removed from the construction site of a $1 billion science center that was to be it's centerpiece. Harvard suspended work on the building last week, according to Bloomberg.
Showing posts with label credit default swaps. Show all posts
Showing posts with label credit default swaps. Show all posts
Saturday, December 26, 2009
Monday, February 9, 2009
Senate Bill Would Regulate OTC Derivatives and Credit Default Swaps
Financial Crisis News Center reports: A bill introduced by Senator Tom Harkin would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges. The Derivatives Trading Integrity Act, S. 272, would establish stronger standards of transparency and integrity in the trading of swaps and other over-the-counter financial derivatives as a critical step toward restoring confidence in the financial system. Senator Harkin is Chair of the Agriculture Committee.
The broad goal of the legislation is to establish the standard that all futures contracts trade on regulated exchanges. According to the chair, it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated. Senator Harkin envisions that the regulated exchanges will work with the CFTC to ensure that trading on the exchange is fair and equitable and not subject to abuses. In calling for thee regulation of credit default swaps, SEC Chair Christopher Cox recently told the Senate Banking Committee that the credit derivatives market is a regulatory hole that must be closed by Congress.
Senator Harkin has noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.
The SEC’s current authority with respect to these instruments, which are generally security-based swap agreements under the Commodity Futures Modernization Act, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.Over the years, the CFTC and laws enacted by Congress have allowed instruments that are essentially futures contracts to be privately negotiated without the safeguards provided through exchange trading. In this economic downturn, said Senator Harkin, Congress does not have the luxury to sit back and let the markets work.
The Derivatives Trading Integrity Act will bring more transparency and accountability into the marketplace. Specifically, the bill amends the Commodity Exchange Act to eliminate the distinction between “excluded” and “exempt” commodities and transactions versus commodities and transactions traded or conducted on regulated exchanges. All commodities and transactions of the same nature would be treated the same.
In addition, the bill eliminates the statutory exclusion of swap transactions, and ends the CFTC’s authority to exempt such transactions from the general requirement that a contract for the purchase or sale of a commodity for future delivery can only trade on a regulated board of trade. In effect, this means that all futures contracts must trade on a designated contract market or a derivatives transaction execution facility. Virtually all contracts now commonly referred to as swaps fall under the definition of futures contracts and function basically in the same manner as futures contracts
The bill seeks to eliminate the negative consequences from the lack of price transparency and the failure to properly measure and collateralize the risk in trading over-the-counter derivatives. Similar problems have not been seen in the trading of financial futures on regulated futures markets, subject to CFTC oversight.
OTC credit derivatives emerged in the mid-1990s as a means for financial institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties.
They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.
The broad goal of the legislation is to establish the standard that all futures contracts trade on regulated exchanges. According to the chair, it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated. Senator Harkin envisions that the regulated exchanges will work with the CFTC to ensure that trading on the exchange is fair and equitable and not subject to abuses. In calling for thee regulation of credit default swaps, SEC Chair Christopher Cox recently told the Senate Banking Committee that the credit derivatives market is a regulatory hole that must be closed by Congress.
Senator Harkin has noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.
The SEC’s current authority with respect to these instruments, which are generally security-based swap agreements under the Commodity Futures Modernization Act, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.Over the years, the CFTC and laws enacted by Congress have allowed instruments that are essentially futures contracts to be privately negotiated without the safeguards provided through exchange trading. In this economic downturn, said Senator Harkin, Congress does not have the luxury to sit back and let the markets work.
The Derivatives Trading Integrity Act will bring more transparency and accountability into the marketplace. Specifically, the bill amends the Commodity Exchange Act to eliminate the distinction between “excluded” and “exempt” commodities and transactions versus commodities and transactions traded or conducted on regulated exchanges. All commodities and transactions of the same nature would be treated the same.
In addition, the bill eliminates the statutory exclusion of swap transactions, and ends the CFTC’s authority to exempt such transactions from the general requirement that a contract for the purchase or sale of a commodity for future delivery can only trade on a regulated board of trade. In effect, this means that all futures contracts must trade on a designated contract market or a derivatives transaction execution facility. Virtually all contracts now commonly referred to as swaps fall under the definition of futures contracts and function basically in the same manner as futures contracts
The bill seeks to eliminate the negative consequences from the lack of price transparency and the failure to properly measure and collateralize the risk in trading over-the-counter derivatives. Similar problems have not been seen in the trading of financial futures on regulated futures markets, subject to CFTC oversight.
OTC credit derivatives emerged in the mid-1990s as a means for financial institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties.
They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.
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