Increasingly the theme of these weekly posts involves, on the one hand, the collapse of our institutions, and the emergence of selected brave souls who have been willing to challenge them and speak up and tell the truth. Exhibit A last week was Harry Markopolos, who stalked Bernie Madoff for nine years. Exhibits B and C this week are the Telius foundation, a non-profit headquartered on Arlington Street in Boston, Massachusetts, and a surviving, active member of the GI generation, a New York federal judge named Judge Jack B. Weinstein, who has stood up against what is in my opinion a disgraceful federal statute even though his stance is bound to be unpopular among almost everyone. And both these exhibits involve subjects which I have given quite a bit of thought to myself.
In 2003 I was in the midst of one of my frequent phone conversations with my friend Bill Strauss, the co-author of Generations and The Fourth Turning, who since about 1995 had become a dear friend. He told me that he had heard that various managers of the Harvard Endowment were about to receive annual bonuses totaling tens of millions of dollars. Bill was a social conservative but an economic egalitarian, and he was appalled. So was I. We both belonged to the Harvard class of 1969, although we hadn't known each other then, and I recruited five or six other members to write a letter protesting these payments. That and subsequent letters generated considerable publicity.
Our original objection was based on morality and equity. First, we did not believe that anyone working for a non-profit should make that kind of money. Secondly, we didn't see how these payments could be reconciled with annual tuition increases several percentage points above inflation, resulting in a price for a Harvard education that was more than triple what we had paid (adjusted for inflation) by the mid 2000s. We were gratified when the University eventually did expand financial aid to make itself more affordable to well-to-do students but we were still troubled by the payments. I personally was troubled for another reason. Studying the limited financial data which the University would release, I could not see that its actual annual income from the endowment was rising nearly as quickly as the endowment itself was. I had also been told by a retired financial analyst that the bonuses were based on beating benchmarks which were notoriously easy to beat.
Well, the other shoe finally dropped, of course, in 2007-9, when the commodities and securities markets collapsed and Harvard lost 1/3 of its endowment. Since the managers had been allowed to put virtually all the school's ready cash into high-return, high-risk investments, the school found itself obligated to borrow short-term cash just to keep operations going. Ambitious construction projects had to be halted. It was not difficult for me to convince my surviving co-conspirators (Bill, sadly, had died late in 2007) to go further, and to suggest that the University adopt a new, more conservative investment strategy aimed at securing more modest but reliable growth in its operating income. The University never replied to us with anything but boilerplate, although the manager of the endowment has recently announced, reportedly, that some aspects of the investment stratregy has changed. The university also refused to tell us how much bonus money had been "clawed back," that is, how many deferred payments had been cancelled, as a result of the 33% loss.
The Telius Institute of the Center for Social Philanthropy has now produced a report on endowment management at six leading schools, including Harvard. Although this will make this quite a long post, I am going to reproduce the entire summary of their conclusions.
Educational Endowments and the Financial Crisis:
Social Costs and Systemic Risks in
A Study of Six New England Schools
the Shadow Banking System
Over the last two decades, wealthy colleges and universities placed an increasing share of their endowments into high-risk, high-return, largely illiquid investments. During the boom times, this socalled “Endowment Model of Investing” generated impressive financial returns. Then came the financial crisis, and in the space of a year, investment losses destroyed tens of billions in endowed wealth at
colleges and universities, up to 30 percent of endowment value at some of the wealthiest schools.Mounting endowment losses have been used by college administrations to justify some of the severest austerity measures in a quarter-century: deep budget cuts, diminished endowment payouts, staff layoffs, and other substantial reductions in force and benefits. The hardship caused by these measures has rippled out in the form of lasting job loss, stalled construction projects, and local business downturns in college communities that used to be secure havens of regional employment and economic resilience.
How did universities, once careful stewards of endowment income, get caught up in the Wall Street-driven financial meltdown? Did our higher education institutions, like America’s big banks and financial companies, take ill-advised risks chasing speculative returns? Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in the Shadow Banking System looks at what happens—and who suffers—when universities embrace high-risk investing.
This report examines six privately endowed New England colleges and universities—Boston College, Boston University, Brandeis University, Dartmouth College, Harvard University and the Massachusetts Institute of Technology—as case studies for exploring deeper connections between educational endowments and their impact on our institutions, our communities, and our economy. Even after the crisis, these six schools control nearly $40 billion in endowment assets, more than 12 percent of
the roughly $310 billion held in college and university endowments nationwide at the end of FY 2009.
They are among the largest employers in their communities in the Boston metropolitan region and the Upper Valley of western New Hampshire and eastern Vermont.
Based on this sample and a review of trends in endowment management, the study’s main
findings include the following:
The risks of the Endowment Model of Investing have been greatly underestimated.
Investment risk-taking has jeopardized the security of endowment income.
For the past two centuries, endowment management has centered on protecting the principal of endowed gifts and generating reliable income. Investments were traditionally made in relatively transparent, liquid securities such as publicly traded equities, bonds, and money-market instruments.
But in the last 25 years, many universities have followed the path of schools such as Harvard and Yale and embraced a new model of investing that relies on radical diversification of endowment*portfolios into illiquid, riskier asset classes: private equity and venture capital, hedge funds, and various “real assets,” such as oil, gas, and other commodities, private real estate and timberland.
By taking on higher financial risk, endowment managers generated high returns for a time—but at the cost of intensifying colleges’ exposure to the rampant volatility of the global capital markets. Resulting investment losses, endowment declines, and liquidity squeezes have jeopardized the very security of income that has traditionally defined what an endowment is.
Far from being innocent victims of the financial crisis, endowments helped enable it. Much attention is rightly being paid to the role of for-profit financial institutions in the weakly regulated “shadow banking system” in provoking the recent financial crisis. But the role of nonprofit institutional investors in heightening risk in the capital markets requires much closer scrutiny as well. Given the scale of capital under their control and the academic credibility they lend to high-risk investment strategies, the influence of college endowments on financial markets extends far beyond the ivory tower.
By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets. Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling
markets, magnifying volatile price declines even further. The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
The seeming success and sophistication of the Endowment Model also encouraged other
institutional investors and their advisers—smaller endowments, pension funds, foundations, investment consultants, and asset managers—to imitate these high-risk strategies and place more assets into the shadow banking system.
Wall Street’s influence has undermined endowment stewardship.
Conflicts of interest on governing boards weaken independent oversight of investments. College governing boards have failed to guarantee strong oversight of the Endowment Model by relying heavily upon trustees and committee members drawn from business and financial services, many from the alternative investment industry. The report begins to document the predominance of business and finance professionals on college boards and the numerous potential conflicts of interest that arise when the investment firms of trustees from the finance industry provide investment
management services to the very institutions on whose boards they serve.
To take only one example, Dartmouth’s board has included more than half a dozen trustees whose firms have managed a total of well over $100 million in investments for the endowment, over the last five years. Even when there are not potential conflicts of interest, the oversight abilities of many trustees and investment committee members seem to have diminished because of their professional connections to the shadow banking system or their corporate directorships. By working
in bailout banks, venture capital, hedge funds, private equity, and other alternative asset management firms, many trustees may be de-sensitized to the risks associated with exotic, illiquid investments that they deem “normal” business activities.
The rise of the CIO has ratified a culture of risk-taking and excessive compensation.
The complexity of investments under the Endowment Model has spawned a new class of
highly compensated investment officers on campus. Whereas a decade ago, only one of the schools in our study had a chief investment officer (CIO), today five out of six do. CIOs and investment officers from investment banks and consulting firms are now wooed by colleges with some of the highest compensation packages in the nonprofit sector. The increasingly intertwined worlds of higher education and high finance reflect how the culture of stewardship in nonprofit endowment management has been eroded by a Wall Street culture focused on profitable investment returns as if
they were central to colleges’ institutional missions.iii
The full costs of the Endowment Model of Investing are much greater than the short-term value of endowment declines. Although they had little responsibility for endowment management or oversight, students, faculty, staff, alumni, and local communities are bearing the brunt of the Endowment Model’s consequences:
from widening pay inequity to demoralizing layoffs, hours and benefits cuts, and hiring and pay freezes; from program cuts to reduced student services; from construction delays and stalled economic development to forgone tax revenues. Because these six schools are among the very largest employers in their communities, the widening pay gap between over-compensated senior administrators and more
modestly compensated staff not only distorts pay structures on campus but also deepens social inequality within surrounding communities.
Layoffs and reductions in force have wider negative economic impacts.
Layoffs and reductions in force as a result of endowment declines serve to magnify growing income gaps in disproportionate ways, contributing to regional unemployment and scarring communities economically in ways that are difficult to quantify. Nevertheless, the report provides conservative preliminary estimates of the regional economic impacts due to announced layoffs and positions eliminated:
o nearly $135 million in lost annual economic activity in the Boston metropolitan region
o more than $30 million in lost annual economic activity in the Upper Valley
Program cutbacks and stalled project plans negatively affect communities.
The sudden postponement of planned construction projects, most notably Harvard’s ambitious Allston Initiative, translates into lost jobs, broken promises, and diminished opportunities for community economic development. Based solely on potential earnings from the anticipated jobs that fail to materialize from the Allston delays, the report conservatively estimates that more than $860
million in expected economic activity will be lost over the next three years. Longer delays will deepen community economic losses. Proposals to cut back educational programs and to close institutions such as the Rose Art Museum at Brandeis University have weakened community cultural development in less readily quantifiable, but no less important ways.
Tax-exemption is costly to communities.
The public pays for colleges’ tax-exempt status in multiple ways, supposedly in exchange for the public benefits that colleges provide. The tax revenue that cities, states and the federal government have forgone because of tax-exemption has allowed college endowments to accumulate considerable wealth.
o PILOTs and Forgone Property Tax Revenue
As major property holders in their communities, the six schools in our study own taxexempt real estate worth more than $10.6 billion, yet collectively they made negotiated payments in lieu of taxes (PILOTs) totaling less than 5% of the $235 million in taxes they would owe if they did not have the privilege of their tax-exempt status. Some schools make no PILOTs whatsoever.
o Tax-Deductible Endowment Gifts and Gains
Gifts to endowment are tax-deductible to donors, and investment gains and income that
endowments generate are tax-exempt. Endowment managers can therefore rapidly trade without considering the potential tax consequences of their investment decisions.
o Indirect Arbitrage Using Tax-Exempt Debt
Tax-exempt bonds have allowed colleges to borrow at low interest rates while keeping
their endowment assets fully invested in high-risk, high-return investments. Endowments pocket the difference in yields tax free, while investors in tax-exempt bonds also receive favorable tax treatment on income. Congressional leaders and the Congressional Budget Office are exploring how colleges benefit from this indirect tax arbitrage when they use tax-exempt bond proceeds for operating expenses in order to use other investments to chase higher rates of return. Because of the excessive levels of illiquidity in their investment portfolios, colleges have increasingly turned to the bond markets for cash.
From Systemic Risk to Sustainability
The Endowment Model of Investing is broken. Whatever long-term gains it may have produced for colleges and universities in the past must now be weighed more fully against its costs—to campuses, to communities, and to the wider financial system that has come under such severe stress. The financial crisis has revealed that the risks of the Endowment Model of Investing—of volatility and illiquidity—are
much higher than previously understood, particularly when amplified by the use of leverage. This report analyzes those risks but also insists that a full understanding of the costs and consequences of the Endowment Model must go beyond narrow discussions of risks and returns merely at the level of the
portfolio. As long-term investors, colleges and universities have an important stake in the sustainability of both the wider financial system and the broader economies in which they participate. Rather than contributing to systemic risk, endowments should therefore embrace their role as nonprofit stewards of sustainability. Rather than helping to finance the shadow banking system, endowments should provide
models for transparency, accountability and investor responsibility.
The aftermath of the financial crisis clearly calls for a transformation of the Endowment Model of Investing—not simply a return to a more “conservative” investment strategy. Instead, a more sustainable endowment model of investing is needed. Endowments need to foster greater resilience in times of crisis by investing in assets with greater liquidity and lower volatility, and a portion of excess returns generated during good times needs to be set aside in rainy-day funds for the bad. But more fundamentally, endowments need to pursue “responsible returns” that remain true to their public purpose and nonprofit mission as tax-exempt institutions of higher learning. By integrating sustainability factors into investment decisions and becoming more active owners of their assets, endowments can begin to seize the
opportunities of long-term responsible stewardship.
College and university endowments were among the first institutional investors to take their rights and responsibilities as corporate shareowners seriously. In the early 1970s, Harvard and Yale developed the first campus committees on investor responsibility, which developed some of the earliest ethical investment policies for endowments. Since then, they have made recommendations for how endowments should vote their proxies on shareholder resolutions related to social issues and provided
models for similar governance structures at dozens of other schools. However, with the rise of the Endowment Model of Investing, its diversification into new asset classes beyond domestic public equities, and the increasing use of external investment managers, committees of investor responsibility designed for an earlier era have watched their relevance erode. Given the social costs of the Endowment
Model of Investing, which this report only begins to document, it is high time for colleges and universities not only to reassess risk but also to reclaim this legacy of responsible institutional investment
Now it is my belief that anyone who received a rigorous liberal arts education--as I was lucky enough to do 45 years ago--and who has continued to exercise his critical faculties, can quite easily see through the kind of professional claptrap that has infected almost every profession today. Indeed I think that belief is critical to any real faith in bureaucracy. That was why Bill Strauss (who certainly felt the same way) and I and our classmates weren't afraid to challenge these practices before their consequences became evident. Yet to be vindicated in this way by impartial analysts who obviously know the subject much better than any of us did is obviously a source of satisfaction, as well as of sorrow.
Judge Weinstein's story is equally interesting, but I have given you all more than enough to think about for one day. I shall try to post it at a later time.