Two scholars looked recently at the behavior of Canadian universities regarding the management of their interest rate risk. They found something peculiar. The universities are making an increased use of interest-rate swaps, apparently under the impression that they are hedging against risks. But they aren’t.
Almost all the swaps entered into by the capital managers of these institutions are variable rate to fixed rate swaps, which indicates a hedging intent. But the behavior could only be justified as speculation; it “actually destroyed an existing natural hedge and … created additional financial risk” for the institutions involved.
Comprehensive Universities
Glenn Leonard, Associate Professor of Accounting, Faculty of Business Administration, University of New Brunswick, and his co-author, Gopalan Srinivasan, Professor of Finance at the same University, express their conclusions politely (they are Canadian, after all), but a straightforward inference from their article might well be that the responsible administrators simply don’t know what they are doing.
The focus is especially on what the authors call mid-size “comprehensive universities,” that is, those with a “wide variety of graduate offerings.” They looked at eighteen such schools around Canada. Fifteen of those (or roughly 83% of the population under study) had swaps outstanding at the end of fiscal year 2013. The largest notional swap value at that time was that of Ryerson University, a public research university in downtown Toronto, C$226,324. That was 96.5% of Ryerson’s total long term debt. It should be noted that “long-term debt” for purposes of this calculation does not include future employee obligations, capital lease obligations, or asset retirement obligations. Still, the 96.5% seems an extraordinarily high percentage of swaps to debt. Certainly more than would seem warranted a priori were hedging the only goal.
The authors engage in an in-depth analysis of the position of their own academic home, the University of New Brunswick, which has campuses in Fredericton and Saint John. Although UNB has only one-ninth the total debt of Ryerson, its ratio of swap value to long term debt is even higher. Its 2013 outstanding notional debt under swap was C$26,058. That was 99.5% of its total long-term debt.
Two Transactions Instead of One
One of the peculiar features of UNB’s swaps position is that it has repeatedly entered into bank loans at variable rates of interest and then entered into a swap transaction with that same bank effectively to convert that into a fixed rate. Why the two-step process? Couldn’t the university simply have borrowed from those banks on a fixed interest rate directly?
As these authors write, “if a bank is willing to accept UNB as counterparty in a swap, there is no reason to believe it would not lend to UNB at the same fixed rate.”
The only obvious reason the university would want to enter into a two-part deal instead of a single bank loan at the fixed rate is: UNB is speculating (betting) on an increase in the market rate of interest over time, an increase which will make it the beneficiary of the swap contract. As it turns out, though, variable interest rates decreased in the period under consideration “and the university reported a loss on the swap and also reduced investment income.”
Aside from the risk of being on the losing side of such a bet, this two-step proceeding with bank loans has the effect of increasing transaction costs. Specifically: banks in Canada “generally levy a separate stamping fee for banker’s acceptances that form an integral part of all swap deals.”
Asking Why
Why do universities engage in such behavior? These authors suggest, among other possible answers, “asymmetric incentive structures and accounting processes.” What that seems to mean is that the right hand may not know what the left hand is doing. Responsibilities for “treasury, budgets, risk management and reporting are often quite separate, usually not even reporting to a common senior executive,” they write.
If the managers of public universities are consciously speculating on the movement of variable interest rates, the authors believe, one has to question whether that’s appropriate for officials with a public trust. If they aren’t conscious that this is what they are doing, if it just results from organizational silos and the like, the institutions certainly ought to work to correct that dysfunction.