Harvard Derivatives Whiz Fired For Emailing Larry Summers About “Frightening” Trades?

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Late update: Harvard spokesman John Longbrake called to emphasize that the university had conducted thorough investigations of all allegations about Harvard Management Company and point out the 13.8% annualized returns HMC delivered in the ten years that ended June 2008. In a separate development, we learned that Mack was scheduled to be the subject of a February 23 Newsweek story by Michael Hirsh that had been subsequently shelved. Hirsh declined to comment.

A former quantitative analyst at Harvard Management Company, the university’s once-vaunted endowment manager, tells the Harvard Crimson she was fired for voicing concern to then-university president Larry Summers’ chief of staff about the money manager’s risky use of derivatives the traders didn’t understand.

The episode dates back to 2002, when analyst Iris Mack, whose website identifies her as the second African American woman to earn a Harvard PhD. in applied math (and someone who likes primary colors) joined the much-venerated Harvard Management Company, which invests the university’s then $18 billion endowment, to find what she termed a “frightening” state of affairs.

“The group I was working for had no background whatsoever to be working on [derivatives],” Mack says, adding that, to her knowledge, several of her colleagues were not licensed securities traders. “Sometimes the ways they handled even basic Black-Scholes models [widely used to price stock options] were puzzling.”

So Mack took inventory of the abuses — high employee turnover, lax risk management practices and a “low level of productivity in the workplace” were among others, and detailed them in an email to Marne Levine, Summers’ chief of staff and a Treasury staffer on the Obama Transition Team. (Summers was the only person to whom Meyers reported, and according to a recent Forbes story he personally ordered the university’s biggest derivatives trade, a purchase of interest rate swaps that cost the university billions this year.)

A month after sending her email, Mack was fired after a meeting in which the endowment fund’s then-chief furnished her the emails and castigated her for making “baseless accusations.” She later sued for wrongful termination and settled out-of-court with the university. But she claims the practices “shocked” her, and — the punchline is — she had joined the company from Enron.Which is also to say, lest you dismiss Mack as an opportunistic snitch capitalizing on Summers fateful opposition to regulating the derivatives that wreaked havoc on the financial system, she had a pretty valid reason to believe in the importance of whistleblowing.

“I’m not trying to pretend I’m omniscient or anything, but a lot of people who were quantitative traders, in the back of our minds, we knew a lot of these models were just that: guestimates,” Mack says. “I have mixed feelings, on the one hand, I wasn’t crazy, I knew what I was talking about. But maybe if more and more people had spoken up, the economy wouldn’t be the way it is now.”

Mack is doing her part to affect change: she’s a vociferous advocate of better math education for minorities and like FDIC chairman Sheila Bair, the writer of a children’s book. It’s called Mama Says Money Don’t Grow On Trees (sequel idea: *…Unless You Are A Monstrously Overleveraged Bank With Access To The Federal Reserve Discount Window!).

If Mack’s allegations are true Harvard certainly paid the price for its recklessness: Summers’ swaps sowed the seeds for a financial disaster at HMC:

It doesn’t feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging market stocks and private equity partnerships, both disaster areas in the past eight months. The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.

For a long while Harvard’s daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won’t be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.

Mack’s boss at HMC, Jack Meyer, parted ways with the university in 2005. His bets were still paying off but his relationship with Summers had reportedly cooled — among other things, over alumni outcry led by the university’s Class of 1969 over the hedge fund-sized bonuses being awarded to employees of a supposed nonprofit. But if there’s anything we’ve learned from the past year, gratuitous compensation and gratuitous risk go hand-in-hand.

“The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed,” says a spokesman for the [Class of 1969], which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. “Even now we don’t really know how well it has done in the last ten years.”

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