Handling the financial crisis

Like so many other investment portfolios, the years of spectacular returns for college and university endowments abruptly ended last fall as the scope of the global financial crisis grew and markets plunged worldwide.

Now, instead of enjoying 10-, 15- and even 20-percent returns, endowment managers across the country are announcing losses of equal magnitude.

Harvard University has had the largest endowment in all of higher education — worth $36.5 billion as of June 30 — for the last seven fiscal years, according to the National Association of College and University Business Officers, which reports such data online beginning with the 2002 fiscal year. In December, school officials announced that Harvard’s endowment had suffered losses of about 22 percent, or slightly more than $8 billion, and could lose 30 percent by June 30, 2009.

A fellow Ivy League school, Yale University, has ranked second each of the last seven fiscal years; its endowment was worth $22.9 billion as of June 30. In December, the Yale Daily News reported that the university’s endowment had decreased to $17 billion — a loss of 25 percent — and that several capital projects on campus would be delayed.

And the University of California system’s endowment, one of the highest among public university systems, was worth $6.2 billion as of June 30. By the end of December, the UC system’s endowment had lost about 20 percent of its value, down to about $5 billion.

The University of Michigan has experienced similar difficulties. Here, the school’s endowment has temporarily lost about 17 percent of its June 30 value, down to $6.3 billion from $7.6 billion, according to a March investment report filing made by University Chief Investment Officer Erik Lundberg and Chief Financial Officer Timothy Slottow.

And that $6.3 billion figure uses values for the endowment’s illiquid assets from Sept. 30 — illiquid investments that are likely worth much less now. Lundberg estimated in a recent interview that the endowment has likely lost 20 to 25 percent of its value so far this fiscal year, which began on July 1, and could end the fiscal year with total losses in that same range.

But while other universities have been forced to make spending cuts — Princeton University recently announced it could trim as much as $82 million from the next fiscal year’s budget — the University of Michigan has largely shielded itself from the immediate impact of the financial crisis, and is poised to weather the ongoing financial storm better than most.

So far, the University’s capital projects are progressing on schedule, and no major budget cuts, layoffs or hiring freezes have been announced.

Looking back on the lucrative years preceding the financial crisis, smart investing decisions and foresight on the part of the University’s investment team appear to have gone a long way toward protecting the endowment and the money it pays out to University colleges, schools, departments and other operations from the worst financial crisis since the Great Depression.

AVOIDING THE SUBPRIME CONTAGION

The cause of the current economic meltdown can largely be attributed to the subprime mortgage crisis and the bursting of the housing bubble in 2007. During this time, years of high-risk lending practices came to bear as mortgage delinquencies and foreclosures soared and subprime mortgage-backed securities tumbled in value.

“It started as a credit crisis — it was small,” Lundberg said in a January interview at his downtown Ann Arbor office. “And now we’ve ended up with a full-blown credit crisis.”

But whereas other colleges and universities had significant investments in the kinds of mortgage-backed securities that lost so much of their value, University investors, Lundberg explained, chose not to invest very much in those securities.

“We chose not to invest in those, because we didn’t think the reward associated with the risk was worth it. We didn’t get paid enough for taking that risk,” he said. “So we steered away from the subprime (mortgage-backed investments) and a lot of these spread products, and focused the investments other places.”

As the financial crisis has grown, the damage inflicted by the subprime crisis has spread throughout the financial world like a contagion, crippling many other investments. And the University’s endowment, Lundberg conceded, has not been completely immune from its effects, given the breadth of investments comprising the endowment.

Nonetheless, the University investment team’s decision not to sink significant amounts of money into doomed subprime mortgage-related investments has in part prevented the endowment from suffering more losses than it already has.

A SHIELD AGAINST FINANCIAL VOLATILITY

The smartest and more prescient move made by the investment team, University officials and Investment Advisory Committee members say, was changing how the endowment pays out money to University colleges, departments, schools and other campus operations.

Just over two years ago, the University paid out 5 percent of its total value each year to University operations, and it calculated that payout amount using a three-year average value for the endowment, meaning it took into account three years’ worth of endowment values when determining how much to pay out to University operations.

But around that time Lundberg suggested to Chief Financial Officer Slottow that the average value of the endowment used to calculate the payout should be extended from three years to seven years.

A rolling payout using a seven-year average value for the endowment, Lundberg explained, would better take into account market volatility, and ensure that the annual payout to academic departments would remain steady. In other words, the seven-year payout would help to better compensate for spikes — either up or down — in the market much better than a three-year period because it uses many more endowment values.

And with a seven-year payout, those receiving funds from the endowment could count on a certain amount of funding each year and not have to adjust their budgets depending on the ups and downs of the markets — a crucial component for annual budgeting in an academic setting.

When asked why he decided to institute a longer rolling payout, Lundberg said he saw the period of high returns before the onset of the financial crisis as an opportunity to be proactive and protect the endowment for the future.

“In good times, you get very large increases year over year in spending, and then when markets go down you have (spending) cuts the following year — we saw some of that in the tail end of the tech bubble (in 2000 and 2001),” he said. “And so finding an opportunity to make the change is when the markets go up, because you will have an increase in spending anyways, and then you can take action then.

“You know,” he added, “just kind of being proactive.”

More than anything, the University’s rolling payout has shielded the school from the painful budget cuts taking place at other prominent colleges and universities, many of which, like Texas Tech University and the University of Texas at Austin, use three-year rolling payouts to calculate their endowment payouts.

Still, like many other college and university endowments, the University’s will surely end the 2009 fiscal year having suffered significant losses across all its assets.

And only when credit begins to flow more freely in the global financial markets will endowment performances pick up once again.

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Daily reporters Andy Kroll and Kyle Swanson will be taking questions all week about the series and about the University’s endowment, in general. Click here to access their Q & A.

Past installments in the “Anatomy of an Endowment” series can be found here.