Debt ‘swaps’ avoid risk, save money

By Peter Taylor

The University of California has come under criticism for its finance decisions — specifically three interest rate “swaps” made on funds borrowed over the past 10 years to expand university medical centers.

Swaps exist to insulate borrowers such as UC from volatile interest rates. They work like this: The university borrowed money at a variable interest rate, with the payments rising and falling with interest rates. It then swapped those payments for payments at a fixed rate. Thus, if the interest rate rises, then the university pays less than it would have if it had stayed with the original loan. But if the interest rate drops, as it has, then the university pays more.

Like any public institution, UC must not have too much exposure to rising interest rates or it risks coming up short for expenses. We are not in the business of gambling with funds entrusted to us by taxpayers, students and parents, and patients in our hospitals.

But these critics unwittingly advocate that UC do just that. A group of sociology graduate students recently published a report that suggests the UCLA medical center would have been better off if we had taken unhedged variable rate risk on a 2007 bond sale. They further suggest that canceling our existing swap and leaving us with a floating rate would somehow benefit the medical center — at the time when the health care industry is facing an uncertain future.

At present, floating rate debt looks like a bargain because interest rates are at record lows. But history teaches that floating rates go down and up — and when rates go up, the cost can be hazardous to a university’s health. In fact, the bond issue for the UCLA medical center matures in 2047, and these graduate students suggest we remain unhedged until then. Perhaps they possess a crystal ball that shows the future of interest rates?

UC has followed a conservative approach to fund capital and uses two tools to do so: fixed-rate bonds and floating rate bonds swapped to a fixed rate. It’s the latter that the students misunderstand. They make a classic beginners’ error of comparing the fixed rate paid on the swaps with floating rates. The proper comparison is between the two choices that the university did weigh: getting to a fixed rate with a swap or with traditional fixed-rate bonds. UC has used swaps only when the advantage is significant. When this comparison is done correctly, it shows that UC has saved more than $40 million through the life of the bonds through swaps.

The students who have criticized these decisions insinuate that our costs would have been lower had we issued more variable rate debt. But do they point out that since 2008 the credit rating agencies have made it much harder to issue variable rate bonds? Do they calculate the cost of a ratings downgrade because of too much interest rate exposure?

UC actively manages its debt to keep costs low. Since August 2011 alone, we have refinanced $1 billion of existing bonds to save $170 million in future debt payments. And when we do choose to execute swaps, the swap policy adopted by the Board of Regents in 2011 is as carefully constructed as any in higher education throughout the nation.

As much as I love Shakespeare, I don’t pretend to be qualified to teach a class on his works. Similarly, the students who have criticized the university’s policies should understand that just because they are in graduate school doesn’t mean they are experts in everything. Their miscalculations are outrageous. Indeed, if this level of “research” were produced for a class on finance, it would merit an “F.”

— Peter Taylor is the chief financial officer in the University of California Office of the President.