We've noted before that there is a fine line between hedging and speculating. Harvard University--Harvard!--has learned that in a painful way. Bloomberg offers an eye-opening look at the mess the university got into with its interest rate swaps ploy. It backfired miserably when rates plunged, and left the university on the brink of financial disaster. The university was forced to borrow $2.5 billion in emergency funds, 20 percent of which was used immediately to extricate the university from soured interest rate swap obligations.

All told, the university has agreed to pay $1 billion to get out of swaps-related obligations. Bloomberg suggests Harvard panicked; the market turned in its favor later on. If only it had waited. But can you blame it for wanting to cut its losses fast, like any good trader. The problem was that the banks that arrange these deals essentially extend credit. As the value of swaps decline, they contract calls for more collateral to be posted. It was those demands that got Harvard into trouble.

We've seen this time and again at the corporate level. It's absurd to think that hedges are low cost, though interest rate options would have served Harvard better. This is not to suggest that rate swaps should somehow to be avoided; they should not. But sometimes the sheer size of bets and the duration can be the real issue. 

For more:
- here's the article

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