It’s Time for Our Universities to Pick Students Over Swaps

September 20, 2016

With the fall semester underway at American University in Washington, D.C., students are starting new classes, making new friends, and joining new clubs. Most of these students will pay over $43,000 this year in tuition and fees, and collectively their payments will account for nearly four-fifths of the school’s operating budget. But a sizable portion of that budget isn’t going toward better instruction, new classrooms, or even new dormitories and amenities: It’s going to Wall Street institutions that convinced American to enter into risky financial deals.

Over the last decade and a half, toxic interest rate swaps have cost American $91 million, enough to pay the full annual tuition and fees of more than 2,100 students. And it’s not over yet: American will likely pay another $76 million on these swaps in the coming years. The presence of current or former executives of these financial firms on American’s Board of Trustee raises serious questions about potential conflicts of interest.

This specific case may sound bad—and it is—but the swap situation at American is just one example of a larger trend known as “financialization.” This refers to the increase in the size, scope, and power of the financial sector that has placed bankers and their priorities at the center of daily life, business, policy, and more. While this is often measured as finance’s explosive growth as a share of GDP and corporate profits, financialization has also had a profound impact on other aspects of our economy and society, including higher education.

In a report released by the Roosevelt Institute network and the Refund America Project, we focus on one small but significant part of the financialization of higher education: interest rate swaps and a handful of other bad deals that have sent billions of dollars from students and taxpayers to Wall Street.

Broadly, an interest rate swap is a deal through which one institution “swaps” the variable rate on their bond for a “synthetic” fixed rate. In our case, the university agreed to pay the fixed rate to a bank, who in turn paid them back a variable rate. Theoretically, these rates should match up in the long term. In reality, though, they never did. Variable interest rates tanked following the 2008 crisis, meaning that although schools continued to pay pre-crisis interest rates to banks, they received only negligible amounts back through the terms of their swaps. Swaps were sold to schools as a way to lower borrowing costs and insure against rising interest rates, but the terms were tilted in favor of the banks and carried a lot of hidden risk.

To get a handle on the scope of the swaps problem in higher education, we surveyed a random sample of schools from a list of the top 500 colleges and universities in the U.S. and found that roughly 58 percent have, or have had, toxic swaps on their books. Then, aided by research from students across the country, we dove more deeply into a set of 19 case studies, ranging from Harvard University to the California Community College system. In all, these 19 institutions spent $2.7 billion on unnecessary swaps costs—enough to pay for the tuition and fees of 108,000 students.

In some cases, the magnitude of the losses was astounding. Harvard and Cornell, for example, were entered into swaps years before the bonds they planned to hedge against were even issued. Then both schools paid huge termination fees on a derivative that hadn’t even started. In 2008, Harvard infamously paid $1.25 billion to exit swaps as banks were demanding cash collateral payments.

Yet, although endowment-wealthy schools suffered, the destabilizing consequences of these deals were not as pronounced for them as they were for institutions such as HBCUs and community colleges. In some cases, these bad deals even helped push these more financially strapped institutions to the edge. Alabama State University, a historically black public college, is at risk of losing its accreditation due in large part to its financial situation. Over the last decade, the school has paid more than $5 million on a toxic swap, money it can ill afford to lose with the state of Alabama slashing its funding. In all, the school spends more than $6 million annually just to repay past borrowing from financial institutions. It’s no wonder, then, that the school operated at a loss of nearly $47 million in 2014 and more than $48 million in 2013.

The most significant danger of financialized higher education, however, comes from the changes in finance and regulation that make these bad deals the norm.

We see this in Illinois, where a private bond law firm wrote and cajoled politicians into passing a bill that opened the floodgates for toxic swaps. (The State Senator who introduced the bill told fellow legislators that he had a limited grasp of it.) As a result, swaps have cost the state $61 million for the University of Illinois alone.

The normalization of bad deals also played out at Georgetown University, which entered into a toxic swap with Lehman Brothers that was terminated in September 2008 due to Lehman’s bankruptcy. In its bankruptcy case, Lehman aggressively pursued additional fees from Georgetown even though it bore much of the responsibility for the financial crisis and the lowering of market interest rates that made the swaps toxic. This is a bit like a drunk driver crashing into your house and then suing you for their injuries. Yet, in a financialized system, no one raised an eyebrow.

With a potential $808 million in termination fees on the line, our universities need to take action. And there is hope for those who do: Banks that sold interest rate swaps to college and universities typically misrepresented the risks inherent in the deals. This likely violated federal and state laws, meaning schools may be able to take legal action to get out of existing deals or to recoup costs. And they wouldn’t be the first to take action: From Jefferson County, Alabama, to the City of Detroit and beyond, municipal governments have seen success in renegotiating their interest rate swap deals. Our hope is that this report is the beginning of the end of the Wall Street intrusion into higher education. College and universities should once again become centers of learning and research, not just another pool of money for bankers to exploit.