Thursday, October 02, 2008

The Financial Crisis and Colleges: Part II

By Richard Vedder

One fallout of the current turmoil in financial markets that I did not fully anticipate was revealed in the Wall Street Journal today, namely that hundreds of colleges have literally billions of dollars of assets tied up in a frozen Wachovia account. Wachovia administered the monies for the Commonfund, which the Ford Foundation helped create nearly 40 years ago to help colleges get higher returns on endowments by engaging in more aggressive (i.e., riskier) investment strategies. The Short Term Fund portion of the Commonfund had nearly one-quarter of the Commonfund's total assets.

Colleges now cannot withdraw their funds from the Commonfund. Some of the assets were invested in mortgage backed securities, which are trading at a meaningful discount from par value, so the assets of the fund do not fully cover the stated values of deposits (the fund "broke the buck.") Small schools naively thought they could earn a bit more interest putting their money in this fund instead of treasury bills or keeping funds in cash. Some schools used these funds to meet immediate (e.g., payroll) needs, and are now scrambling to deal with the problem.

I have been worried for some time about the rise of highly risky investment strategies by greedy endowment managers, and the Wachovia/Commonfund problem shows my worries are justified.


Is the bailout bill passed by the Senate something that must pass? I very, very reluctantly had concluded that the risks of a true economic melt-down from a loss of confidence was small, but sufficiently large that an insurance policy with a hefty premium was needed --something like the bailout package that failed to pass the House. People lose money all the time on homeowners insurance, since their house typically does not burn down or suffer big damages. But that does not mean you should not have homeowners insurance. The revisions in the rescue package bill made to win House votes, are mostly bad, in my judgment. I know a little bit about deposit insurance (I wrote my doctoral dissertation on the FDIC), and I consider a 2.5 fold increase in coverage done hastily to be a questionable thing, and one that would likely only have modest positive effects in any case. I think requiring health insurance policies to mandate mental health coverage is bad, bad, bad, and certainly not germane to the bill. As usual, Congress is taking a simple proposal --the original bill was only 3 pages long --and making it complex and less useful to the matter at hand. I am close to indifferent on the bill as it currently stands, and I believe that there is a very high probability that private market-based solutions would work better, for example, strong institutions and private investors buying shares in weaker institutions, infusing them with capital (that is already happening to some degree).

George Soros, a refugee from Communist Hungary, wants a return to the good old days of government ownership of the means of production, it seems, as he favors the government taking significant financial interests in financial institutions. Fortunately, that idea is a non-starter in Congress (I think). At the same time, however, there are ways that the taxpayer can be protected, and even benefit, from a bailout package, but as the bill gets longer and more complex, the important issues --restoring stability to the financial system --get subordinated to the whims of the special interests.


seriously? said...

Are you serious?

The Short Term Fund is essentially a money market fund. To suggest that it was irresponsible for institutions to manage their cash assets in such a fund is rediculous. It would have been irresponsible for them not to, and the Short Term Fund was structured in such a way as to take advantage of the particular cash flow patterns of higher ed institutions.

The fund didn't break the buck. From Commonfund's statement, "To date, no securities in the STF portfolio have defaulted and all continue to pay timely principal and interest." The bank that served as trustee for the fund was sold and resigned as trustee. Without anyone to make trades to liquidate individual institutions' positions, the current investments are being allowed to mature.

In short, between your portrayal of Short Term Fund investments as irresponsible, your misunderstanding of its situation, and the fact that you only heard about this today, I think you're fairly well disqualified from participating in this conversation.

capeman said...

but seriously, the colleges were "naive" not to put their money in T-Bills or "cash". They were "greedy". They even sought to make a few extra bucks to meet payroll, of all things. Sordid, no? Especially when you compare to the rest of the financial system. Another disgrace in the nonending saga of academia.

Bill said...


You just have to understand Vedder's shifting rationale. He's simply a good conservative. In the same way that tax cuts are always the answer to everything (i.e. budget surplus? need a tax cut; oops, now we have a budget deficit? answer's a tax cut) so go the shifting sands of one Dick Vedder's intellect.

In that bizarro world, whatever the universities do is the wrong answer--i.e. had they put all their money into T-bills, we would all be reading Vedder's wisdom on how wrong they were and how it was a plot to rip off the students and their parents instead of going for more substantial gains.

capeman said...

bill, I would not agree that Vedder is a "good conservative". Any more than saying that tax cuts are the answer to a deficit makes one a good conservative. (A good conservative would say that spending cuts or at least restraints are necessary to deal with a deficit over the long term.)

Vedder seems to have a very destructive streak and a very vindictive attitude toward higher education. I think this must be very off-putting to most academics -- those who even know who he is -- even those who might find areas of agreement with him on some things.

Cowboy said...

I am unable to find any statement in your blog that could be interpreted in any way as a position on investing in the Commonfund which has holdings in The Short Term Fund that produces about 5% of the Commonfund’s revenue.
“Beating Treasuries - 

The Commonfund Short Term Fund behaves like a money-market fund by maintaining a $1 share value, though it doesn't formally report daily net assets. It was designed to beat the average return of three-month U.S. Treasuries, which it has done since its inception in 1974. In the past year, the fund has returned 4.75 percent.

About 15 percent of assets are held in commercial paper issued by financial companies, Commonfund Chief Investment Officer Lyn Hutton said today in a conference call with investors. The Short Term Fund owned commercial paper and mortgage-backed securities in its aim to beat its benchmark, Luke said. ‘That's a reach for return,’ Louis Morrell, vice president for investments and treasurer at Wake Forest University in Winston-Salem, North Carolina, said in an interview. `A short-term cash fund is not a place to make bets like that.'”
Since the Short Term Fund held mortgage-backed securities, it most assuredly is not a “money market fund” as one of your commenter’s suggests. And I do believe that the devaluation of the mortgage backed securities, the 37% cap on withdrawals, and most importantly – the liquidation of assets would arguably put this fund in the “broke the buck” category.

But what anyone wants to call it is of no consequence or consolation.
I would also strongly agree with thinking that putting money into a short term fund that holds mortgaged backed securities (which mostly have 5, 7, 15, and 30 year maturities) is not only na├»ve, but excessively risky – and quite stupid. Now, with that said, I can understand the irrational thinking behind such investments, but I certainly do not agree with it.
And there also seems to be a belief by a commenter here that payrolls are made by liquidating assets in investments. This is not only laughable, but this kind of retarded thinking doesn’t pass muster in fantasyland or reality. Why would a college want to pay capital gains tax and income tax on liquidated investments to make payroll? That strategy, aside from being quite humorous, is also a non-starter and in effect it would drive up labor costs and make them unpredictable since it is difficult to know what your future tax liabilities (income and capital gains) would be. Payroll comes out of the cashflow of a business. Or it can come from cash reserves. But I must say that I find any implication that assets are liquidated to make payroll an exceptionally hilarious new one, Securities lose value too – they don’t always make money. So, heads you lose, tales you lose.
It seems that there has been selective quoting from the Commonfund memorandum distributed on October 1st.
I do recall this issue of endowment managers and the risky investments they were making being discussed on this very blog almost 1½ - 2 years ago.
Some believe you are destructive, by your words, to Higher Education. They want their insolent voices and opinions to be heard – but do not respect your right to do the same. But the shallowness of the thinking that goes into such comments by the usual suspects is what is destructive to Higher Ed. and society. I do believe “capeman” claims to be an academician. That is truly horrifying. However since s/he seems to spend a lot of her/his time diddling on the internet (must be on his University’s welfare system for dead wood & boat anchors), if we can keep him on the internet, the less damage he will do.
I guess when you uncover problems in Higher Education’s establishment and their established practices to maintain the status quo ante, you are going to tick off a lot of people who think that what we have today is the very best that we can do.

capeman said...

Cowgirl, you're getting better all the time. Keep putting out.