Besides community outreach, el-erian also had the lofty goal of
restructuring the Harvard Management Company. Speaking to
Bloomberg at the close of 2006, el-erian asserted that the university
should “not have to go through such a transition again,” referring to
the departure of the fixed-income team. The task of restructuring
would be a “marathon”; no quick fixes would be found. To begin this
race, he made a significant decision, one that, at the time, was seen
by many as prudent but, in hindsight, was masterfully ill-timed—he
set out to reduce the fixed-income exposure of the endowment.
When Meyer and his team left, they sent a clear message: Be wary of
overreliance on a single strategy or group. With little tying managers
to the endowment besides loyalty, el-erian knew that he could well
be exposed to the risk of one day arriving at 600 Atlantic Avenue and
seeing empty desks. To avoid such desertions, el-erian rebalanced
Harvard’s Policy Portfolio and reduced bond exposures significantly.
The trend continues to this day: For the current fiscal year, Harvard
has only 9% of its endowment in fixed-income investments, the same
percentage as such classes as timber and real estate.
This worked well, for a time: In the first full year under el-erian, HMC
returned 23% on its investments, besting the university’s benchmark
by 5.8%. Annoyingly, Yale made 28% in that same time frame, but
only the most cantankerous Harvardian could complain about the
best returns the school had seen in years.
Then, suddenly, el-erian was gone. Only 23 months after he arrived,
he was back under the cobalt-blue sky of Southern California,
watching golf balls shoot by his office window at PIMCO. Citing
family pressures, el-erian’s marathon ended more like a sprint, and
Harvard was left leaderless once again.
Back Bay, Boston
500 Boylston Street is built on pillars of sand. An ornate office building
in Boston’s Back Bay—the posh borough bordering the south side
of the Charles River basin—500 Boylston and its stately neighbors
sit on what used to be an uninhabitable salt marsh. Starting in 1859,
this marsh was filled with gravel and dirt brought in by trains arriving
every 45 minutes for nearly half a century. The sons of Boston
society gradually followed, bringing with them some of the city’s most
prominent businesses. In time, former HMC manager Jeffrey Larson’s
Sowood Capital would take up residence here, on the 17th floor of
500 Boylston. A $3 billion hedge fund, Sowood was levered to the
hilt in hopes of maximizing returns for its investors, one of which was
Harvard. Instead, in a structure built on landfill, while Mohammed
el-erian was busy producing sizable returns for the endowment,
Harvard had its first glimpse of the perils of leverage.
When Jack Meyer began to accelerate the outsourcing of the
endowment’s management, larger fees to managers were not
the only consequence. Although HMC used small amounts of
borrowed money—sources say that, internally, the endowment
was levered about two to one, a figure that has fallen dramatically
since Meyer’s departure—it had never before been exposed to
extreme leverage. When Meyer seeded the hedge funds of former
managers, he was also for the first time exposing Harvard to what
many call “the death spiral.” For a time, the university saw no major
drawdown due to the excesses of leverage but, in the summer of
2007, this would all change.
It started innocently enough. Larson, a former commodities and
equities trader, was taking a classic bet: go long on senior debt while
going short on junior debt and stocks. Spreads between commercial
paper and Treasury bills were tight—meaning that the market believed
defaults to be very unlikely and, thus, was willing to lend them money
at cheap rates—and Larson clearly expected them to remain that
way. His hedge was the shorting of junior debt and stock, in the belief
that, if defaults occurred or were seen as more likely, the junior debt
and stock market would fall by just as much, causing the short-sale
to protect him. To make his bets pay off more handsomely, Larson
borrowed about $18 billion to supplement the $3 billion that he had
raised from Harvard and other investors. The collateral for the loans
were the assets he bought with them.
A funny thing happened at the end of July 2007 though: The
markets did not behave the way they usually do. Over the final
weekend of the month, spreads between senior debt and Treasury
bills widened at an alarming pace when investors became
spooked about the potential for defaults. However, there was no
corresponding decline in the stock market, leaving Larson exposed
on both sides of the trade: He was losing money with the purchase
of senior debt, just as he was with his shorts. His lenders, wanting
security, began to demand more collateral for their loans. This
forced Larson into selling assets—first, ones that he could offload at
good prices and then ones he could not. On the Friday, Larson was
down 10% on the year; by Sunday, this figure was more than 40%.
The assets he still held were illiquid, yet lenders were still demanding
more collateral. He was, by this point, levered 12 to one. To fend off
disaster, he approached his former employer for a large investment
or a line of credit, but was rebuffed by el-erian. In a desperate act
to save at least a percentage of the original investments, he sold the
remaining assets to Ken Griffin’s Citadel Investment Group. Investors
lost at least half their money in one weekend.
Harvard lost $350 million, a significant but not debilitating sum. Other
investors lost just as much, and many were less able to withstand
the drawdown. If Larson had executed such a strategy at Harvard,
he would have survived the initial hit and gone on to make a healthy
profit, just as Citadel has done with Sowood’s leftovers. However, on
his own, Larson lacked the money to back up the trade.
This exposed a serious problem with Harvard’s structure. When HMC
invested with its former managers, they expected to get the same
returns as when these men worked in-house. However, what they
usually saw was increased leverage and risk borne by funds lacking
the financial resources of HMC. Any returns, although often solid,
were built on unstable ground; with less oversight and financial heft,
the managers who departed Harvard were increasingly prone to the
kind of death spiral that Sowood Capital experienced.
Despite being burned badly by Larson, the collapse of Sowood did
not fundamentally alter HMC’s approach to its alternative holdings.
el-erian, who was heading the endowment during the turmoil, made
no move to decamp from more esoteric investments, leaving Harvard
exposed to often-solid returns but also incalculable risk. When he
decided to return to California, many outsiders watched to see whom
the venerable institution would pick to fill his place. Through their
choice, Harvard would be sending a signal on how these investment,