UC: Swapping Our Future

SWAPPING OUR FUTURE:
How Students and Taxpayers Are Funding Risky UC Borrowing and Wall Street Profits

By Charlie Eaton, Jacob Habinek, Mukul Kumar, Tamera Lee Stover, Alex Roehrkasse, and Jeremy Thompson

TABLE OF CONTENTS

• Executive Summary
• Introduction
• From Risky Deal to Losing Bet: A Short History of UC’s Interest Rate Swaps
• Responding to Derivative Disasters
• Why Hasn’t UC Management Renegotiated?
• Recommendations
• Appendix
• Endnotes

EXECUTIVE SUMMARY

This report examines the role of interest rate swaps in the University of California’s massive expansion of borrowing from Wall Street over the last decade. The report highlights the costs to students and taxpayers of UC’s interest rate swaps and debt-driven profit strategies. Such strategies have been called into question for Wall Street banks, let alone for public universities. Based upon our findings, we offer recommendations regarding renegotiation of UC’s interest rate swaps and the governance practices for UC’s overall borrowing program. Key findings include the following:

• A UC management has more than doubled the university’s debt burden from $6.9 billion in May 2007 to $14.3 billion at the end of 2011. Rather than contributing to UC’s core mission, funds have been directed toward more profitable UC enterprises like medical centers and attracting out-of-state students. Medical center profits have increased steadily to $900 million annually last year. Out-of state enrollment has doubled across UC—increasing from 11% to 30% at UC Berkeley.

• UC borrowing is often backed by student tuition, but profits on debt-funded investments have not been used to mitigate service cuts or tuition hikes. As a result, students are made to bear the costs and the risks of poor returns, but have not received benefits from positive returns: tuition has increased 300% since 2002 and total enrollment of freshmen from California declined by 10% from 2008 to 2011.

• UC is currently losing about three-quarters of a million dollars each month on interest rate swaps associated with debt issued for two of its medical centers. Since 2003, UC’s swap agreements have cost the university nearly $57 million and could cost the university another $200 million.

Given these Findings We Offer Three Recommendations:

1. UC should seek to renegotiate its interest rate swap agreements with Deutsche Bank and Bank of America. Given record-low interest rates and the manipulation of LIBOR rates scandal, public institutions around the country are holding banks accountable by renegotiating interest rate swaps. In the Bay Area, the San Francisco Asian Art Museum successfully terminated its swaps without penalties, saving the museum $40 million, and the City of Richmond renegotiated its swaps, saving taxpayers $5 million a year. The City of Oakland has also unanimously voted to renegotiate its swap agreements.
2. UC should explore the possibility of LIBOR litigation. All of the swaps covered in this report use LIBOR as the basis for the variable rate received by UC from its bank counterparties. There are over a dozen banks under investigation for LIBOR manipulation, including JPMorgan Chase, Bank of America, Goldman Sachs and Deutsche Bank. Some of these banks have served or continue to serve as counterparties for UC’s swaps. We estimate that UC paid banks about $1.92 million more than it should have absent the alleged manipulation of LIBOR between August 2007 and May 2010. If UC were to successfully file suit under federal antitrust statues and seek treble damages, the university may be entitled to $5.76 million.
3. UC should increase transparency in the governance of its borrowing practices by appointing a committee of delegates from key UC communities — including persons from independent student organizations, faculty organizations, employee unions, and parents — to conduct a comprehensive review. UC’s outstanding swap agreements are held by Wall Street banks with close ties to UC Regents and executives. Such relationships and potential conflicts of interest must be scrutinized so that swap renegotiation decision-making processes are both transparent and accountable to all UC stakeholders. Key relationships for examination include:

• UC Regent and former Regents Finance Committee Chair Monica Lozano has received approximately $1.5 million in compensation for serving on the board of Bank of America,¹ which could make as much as $28 million from the UCSF interest rate swap.²
• In his previous job as Managing Director for Public Finance for Lehman Brothers, UC’s current CFO Peter Taylor was serving on the UCLA Foundation board at the same time he had authority over Lehman’s business with public institutions in 2007 when UC contracted with Lehman as both bond broker and swap counterparty for the UCLA Medical Center Swap. The UCLA swap could cost UC up to $170 million.³
• In his previous job as Managing Director of Western Region Public Finance for JP Morgan, UC Executive Vice President Nathan Brostrom worked on financings for UC when his firm was contracted in 2003 both as bond broker and swap counterparty for the UC Davis Medical Center swap. UC terminated the swap in 2008 to cap losses at $22.5 million.⁴

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INTRODUCTION

“We shouldn’t be in the banking business, we should be in the education business.” — Leon Botstein, President of Bard College

Public funding for the University of California has declined drastically. Between 2007 and 2011, annual state funding of UC declined from $3.8 billion to $2.2 billion. At the same time, UC Regents and executives have increased borrowing via sophisticated financial instruments. Management has more than doubled the university’s debt burden from $6.9 billion in May 2007 to $14.3 billion at the end of 2011 (see Figure 1).⁵ Although student tuition provides the collateral for much of this borrowing,⁶ returns on debt-financed investments have not been used to curb drastic tuition increases, and important sectors of UC remain critically underfunded.