Yale's
Investor Keeps Playbook
In Line for First Loss Since '88, Mr. Swensen Still Champions 'Alternatives
He isn't a
household name. But as the Yale University's endowment's chief investment
officer for two decades, David Swensen has earned a reputation as one of
the world's savviest and most successful investors.
He pioneered
an approach that de-emphasized stocks and bonds while embracing less-traditional
fare like hedge funds, private equity, and oil and gas. During his tenure,
Yale has had an average annual return of 16% for the past 10 years through
June, compared with a 2% average for the Standard & Poor's 500-stock
index. Yale's assets more than tripled over that period to $23 billion,
trailing only Harvard University's in size.
David Swensen,
investment chief for Yale University's endowment, says institutional investors
should be built for growth, not to withstand stock-market downturns. Yet
even Yale hasn't escaped the financial crisis.
The university
estimated late last month that the endowment had lost 25% of its value since
the end of June. That is expected to lead to budget cuts and puts Mr. Swensen
in line for his first negative fiscal year since 1988. Other endowments
that have set out to follow the strategy he has advocated are also suffering.
Nonetheless,
Mr. Swensen is sticking to the same investment approach that he's used in
the past. He describes that process in detail in his book, "Pioneering
Portfolio Management," which he revised and which was reissued this
month.
He spoke to
The Wall Street Journal about the financial crisis, hedge funds, scandal-scarred
money manager Bernard Madoff, and ill-fated efforts to mimic Yale's investment
strategy. Here are questions and his answers, edited for context and clarity.
Wall Street
Journal: As you revised your book, first published in 2000, did any sections
strike you as dated?
David Swensen:
It was more in the other direction. The book talked about an approach to
investing that has succeeded over the past decade. In the '90s, all you
had to do was put your money in the S&P 500. In the ensuing decade,
a diversified strategy just crushed the S&P. The book talks about a
sensible approach that was also profitable."
WSJ: Yet,
other endowments have attempted a Yale-like approach, usually with less
success. What goes wrong?
Mr. Swensen:
A lot of institutional investors think they are emulating Yale, but they
are not. Most endowments use fund of funds and consultants, rather than
making their own well-informed decisions. You can divide institutional investors
into two camps: those who can hire high-quality, active-management investors
and those who can't. If you are going to invest
in alternatives, you should be all in, and do it the way Yale does it --
with 20 to 25 investment professionals who devote their careers to looking
for investment opportunities. Or you belong at the other end, with a portfolio
exclusively in index funds with low fees. If you're not going
to put together a team that can make high-quality decisions, your best alternative
is passive investing. With a casual attempt to beat the market, you're going
to fail.
If someone
looked at what we're doing superficially and made superficial attempts to
copy us, then I have little sympathy for them. It's a much more complicated
process than that, and I explain it in detail in the book. If someone read
my book and failed, I'd have some sympathy.
WSJ: What
about fund of funds and consultants? Can they be a solution?
Mr. Swensen:
Fund of funds are a cancer on the institutional-investor world. They
facilitate the flow of ignorant capital. If an investor can't make an intelligent
decision about picking managers, how can he make an intelligent decision
about picking a fund-of-funds manager who will be selecting hedge funds?
There's also more fees on top of existing fees. And the best managers don't
want fund-of-fund money because it is unreliable. You need to be in the
top 10% of hedge funds to succeed. In a fund of funds, you will likely be
excluded from the best managers. [Mr.] Madoff also relied enormously on
these intermediaries. He wouldn't have had nearly as much resources were
it not for fund of funds.
Consultants
make money by giving advice to as many people as possible. But you outperform
by finding inefficiencies most of the market has not yet uncovered. So consultants
ultimately end up doing a disservice to investors.
WSJ: Does
the poor performance of most assets last year suggest you need to tinker
with the endowment's portfolio to better withstand another year like 2008?
Mr. Swensen:
I don't think it makes sense for an institutional investor with as long
an investment horizon as Yale's to structure a portfolio to perform well
in a period of financial crisis. That would require moving away from equity-oriented
investments that have served institutions with long time horizons well.
WSJ: With
hedge funds suffering their worst year on record, will institutional investors
have more power to demand lower fees?
Mr. Swensen:
Put that in the category of wishful thinking. It would be nice if fees were
not so onerous. But you still have investors who are happy to pay a high
price in hopes of getting the holy grail of extraordinary returns.
WSJ: Many
hedge funds share little information with investors beyond their general
strategy. Is that acceptable?
Mr. Swensen:
We require complete transparency. We either know every position, or we don't
invest. I have access to every position in every hedge fund in which we're
invested. If they won't trust us with that information, why should we trust
them with our money?
WSJ: Looking
ahead, what investments do you like?
Mr. Swensen:
Distressed securities are one of the most interesting opportunities for
institutional investors. But returns won't come right away because the credit
markets are fundamentally broken. TIPS [Treasury-Inflation Protected Securities]
are pretty attractively priced. They promise reasonable returns, and protection
against inflation is really important. We may not see it in the next year
or two, but the government's massive fiscal stimulus can't help but produce
massive inflationary pressures. Stocks also look a lot more attractive than
they have for a long time. We prefer higher-quality companies with low leverage.
WSJ: Your
compensation has been as much as $2 million a year. Are you and other endowment
managers are paid too much?
Mr. Swensen:
Compensation in the investment-management world, broadly defined, is excessive.
Not-for-profits have not exhibited the same excesses as the private sector.
But the amount that endowment and foundation investment managers get paid
is extremely generous.
WSJ: Amid
the Bernard Madoff scandal, there has been criticism of a university for
investing in a fund that was run by someone on its investment committee.
The fund, it turns out, was invested with Mr. Madoff. What's your view on
that issue?
Mr. Swensen:
Yale doesn't have a rule that we can't invest with someone on our investment
committee. Such a rule would diminish the overall quality of our investment
committee quite dramatically. But members don't participate in deliberations
about whether to invest in their funds. For as many times as I have recommended
an investment with a committee member, I have recommended against. You have
to be tough about it and only recommend those things that make an enormous
amount of sense for the institution.
In Michigan,
Bank Lends Little of Its Bailout Funds
By ERIC LIPTON and RON NIXON of the New York Times
TROY, Mich.
— The bad bets made by executives at Independent Bank of Michigan are
on display in spots across the state: a defunct bowling alley, a new but
never occupied shopping center and the luxurious Whispering Woods Estates,
which offers prime lots for never-constructed dream homes.
Now it is
the federal government making the big bet here.
The Treasury
Department has invested $72 million out of the $700 billion in federal bailout
funds to help prop up this community bank, which traces its roots back 144
years in Michigan. It is a small chunk of the giant rescue fund being wagered
by Washington to encourage banks like Independent to resume lending and
jump-start the frozen economy.
But Independent,
hard put to find good borrowers in a suffering economy, and fearful of making
the kind of mistakes that got it into trouble in the first place, is not
doing much lending these days. So far it is using all of the government’s
money to shore up its own weak finances by repaying short-term loans from
the Federal Reserve. “It is like if you are in an airplane and the
oxygen mask comes down,” said Stefanie Kimball, the bank’s chief
lending officer. “First thing you do is put your own mask on, stabilize
yourself.”
This is not
what the Treasury Department had in mind when it started this program, saying
it would give the nation’s “healthy banks” enough money to
start lending again, so that people could buy homes and businesses could
invest and create jobs, thereby invigorating a disintegrating economy.
A close look
at Independent Bank’s handling of its government money demonstrates
just how much harder this has turned out to be, and the conflicting challenges
that banks across the United States are confronting in the new bailout era.
Like hundreds of other banks, it is caught between the government’s
push to increase lending and its own caution.
As of Tuesday,
257 financial institutions in 42 states had received $192 billion in capital
injections from the Treasury’s Troubled Asset Relief Program, or TARP,
out of $250 billion set aside for this purpose. Seven giant banks —
like JPMorgan Chase and Citigroup — have received more than 62 percent
of the total so far, and have gotten most of the attention.
But it is
the smaller community banks like Independent that are seeing the largest
number of investments, with 186 banks so far getting allocations of less
than $100 million. With little public attention, this money in recent weeks
has been streaming out to community banks across the nation, in dollops
as small as $1 million — the amount set aside for Independent Bank
of East Greenwich, R.I. Ultimately, more than 1,000 banks are expected to
take part in the program.
While most
of the banks that have received money appear to be relatively healthy, dozens
of other banks that received federal funds are, like Independent Bank of
Michigan, financially stressed by a high volume of delinquent loans.
Economists
say the decision by banks like Independent to use the federal money for
purposes other than lending, while perhaps disappointing, is not surprising,
given that the Treasury Department did not honor its plan to give the money
only to healthy banks.
“It’s
a matter of logic — when you are in a perilous position, like many
of them are, you try to bolster your balance sheet,” said Alan S. Blinder,
a monetary policy economics professor at Princeton. “But this is a
real flaw in the program.”
Some banking
experts are even questioning if the bailout may be doing more harm than
good, in some cases, by giving banks like Independent a cushion as they
struggle to fix their problems, rather than forcing them to sink or swim
on their own. It could also delay mergers of weaker banks with healthier
ones.
“You
are keeping a lot of troubled institutions in kind of a status quo state,”
said Eric D. Hovde, the chief executive of a Washington-based hedge fund
that invests in the banking industry. “They can continue on their merry
ways.” In Congress, anger over the management of the TARP program runs
deep. Many lawmakers say that there is little oversight, and that they can
see no evidence that the taxpayer money is making its way from the coffers
of banks to businesses and consumers. The program is likely to be fundamentally
changed under the administration of Barack Obama, who on Monday asked President
Bush to request that Congress release the remaining $350 billion.
Some lawmakers
have criticized the Treasury for allowing banks to use the government’s
bailout money to acquire rival banks.
As additional
evidence of the growing anxiety, bank regulators on Monday sent a notice
to banks receiving federal money ordering them to disclose how they are
using it. It also pushed them to emphasize new loans. “A lot of the
money is already out there and the inspector general needs to get up to
speed on how banks are using it,” said Senator Claire McCaskill, Democrat
of Missouri. “We need to make sure we get this money back and the only
way we can do that is with strong oversight on how this money is spent.”
Neel Kashkari,
the interim assistant secretary at Treasury running the bailout program,
said he was convinced that it was delivering the promised results by stabilizing
banks while also encouraging them to help out their communities. Even if
overall lending is not up, it is higher than it would have been without
the program, he said.
“We’re
still in a period of fairly low confidence,” he said. “So, banks
are understandably nervous about extending a lot of new credit. And consumers
are nervous about taking on new credit.”
Independent,
which has 106 branches and $3.1 billion in assets, illustrates all of these
complexities.
By no means
is Independent the worst off among the country’s community banks. Some
banks that sought TARP funds were considered so weak that Washington officials
discouraged them from even applying. Other banks were rated slightly stronger
but still were required to raise private capital before they were approved
for federal help.
When it applied,
Independent was considered “well capitalized” by federal standards.
It had not been subject to any recent regulatory orders to change management
or lending practices, for example.
But it was
struggling nonetheless. Indeed, of all the banks that received bailout money
as of Jan. 6, it had the second-highest ratio of bad loans, when compared
with its capital and its cushion of reserves in case of further loan losses.
Its assets are shrinking and it lost money in the third quarter. It began
cutting its dividend last year, when it stood at 21 cents a share. It is
now a penny a share. And it had lost millions of dollars from bad stock
market investments.
But Independent
is hardly a high roller plagued by gold-plated executive perks, and it was
not a big subprime lender, as many banks were.
Based in Ionia,
Mich., 30 miles east of Grand Rapids, it is the kind of local institution
that foots the bill so the state’s high school bands can march in the
annual Grand Rapids Santa Claus Parade. This month it has George Foreman
grills stacked up in its lobbies to reward customers who bring in friends
and neighbors to open new accounts. Independent is one of the biggest employers
in Ionia, a city of 10,000 with classic, turn-of-the-century storefronts
dominating its main street. Driving across suburban Detroit in his black
Mercedes sedan, Keith Lightbody, a senior vice president at Independent
Bank, said it was easy, in retrospect, to see how banks like his ended up
where they are today.
Mr. Lightbody,
a former JPMorgan Chase bank executive hired almost two years ago by Independent,
tours the sites of the bank’s many broken dreams, like the Whispering
Woods residential subdivision in Farmington Hills. The bank financed the
construction of roads and utilities for the subdivision, only to see the
developer go belly up before most of the lots were sold. Snowdrifts now
nearly cover the “for sale” signs.
Perhaps even
more distressing are the empty storefronts in Shelby Township, Mich., where
a developer backed by the bank built what was supposed to be a vibrant streetscape,
bustling with shops and shoppers.
Instead, other
than a restaurant at the front of the complex, there is only a row of darkened
windows, with the work halted on the would-be stores even before their floors
were built, leaving the insides looking like a sandbox filled with random
construction debris.
As of the
end of September, the bank was burdened by $115 million in bad debts, or
nearly 5 percent of its overall loan portfolio, compared with less than
1 percent in 2005. Each of these failed projects has something essential
in common, Mr. Lightbody said.
“We didn’t
step back and look at the big picture, asking ourselves, are we really doing
the right thing with this loan?” he said. “Everyone was making
a lot of money.”
Independent
is publicly traded and under pressure from investors to shrink its troubled
loan portfolio before lending anew. Yet it still very much wants to make
loans, said Robert N. Shuster, Independent’s chief financial officer.
In normal
times, Independent would lend up to $8 for every $1 in bank capital. The
$72 million in federal money, therefore, could generate up to $576 million
in loans — a powerful leveraging effect that was the goal of the TARP
program.
“Our
whole business is predicated on making loans — that is what we do,
that is the mission of the bank,” he said. But the bank cannot afford
to simply pass out money, Mr. Shuster said, or everyone involved will lose
— the borrower, who would probably default on the loan; the bank, which
would experience bigger losses; and the federal government, which is counting
on Independent to pay back the $72 million, along with 5 percent dividend
payments.
“That
is what got us where we are today,” Mr. Shuster said, of the bank’s
past easy-lending practices. “You can’t put consumers in a position
where they aren’t going to be successful.”
Ms. Kimball,
the chief lending officer, comes face to face with this debate each day.
She has continued
to tighten lending standards, generally turning away applications, for example,
for single-use commercial buildings, like restaurants, because of the difficulty
in selling the properties if the bank needed to foreclose on the loan, she
said. Independent is also taking a more critical look at appraisals submitted
to justify housing loans, which is considered a necessity now, because national
companies that buy up mortgages from banks like Independent are demanding
such scrutiny.
“We are
not going to lower our credit standards at this point to make a whole bunch
of extra loans just to deploy the money,” Ms. Kimball said. “We
need to make loans that are reasonable in this day and age.”
Working from
the Troy office, Ms. Kimball, who has a cool, stern tone, and a self-confidence
that comes from 25 years in the financial services business, is overseeing
this effort as the bank moves, in particular, to cut the size of its real
estate loan portfolio.
“It is
not something that changes overnight,” she said from her corner office
overlooking Troy. “It is like turning a ship around in the ocean.”
She knows
many of the bank’s big commercial borrowers personally — taking
the time to go out on the road and visit their factories or businesses to
get a better sense of just how well positioned they are to repay their loans.
One manufacturer
from western Michigan, a customer of another bank, came to Independent looking
for a business loan. Her examination of the company’s books showed
that its sales were slipping and, worse, that it was having a hard time
collecting on bills it had sent to its remaining customers, who also were
suffering from the economic downturn.
So the bank
had to make the hard choice of turning the company down.
“That
is just not something we can do,” Mr. Shuster said, declining to name
the company. “We just can’t lend there.”
With the tighter
lending standards and the damage the miserable Michigan economy has done
to so many of its businesses, the pool of eligible borrowers has shrunk
considerably. The net result is that the overall balance of outstanding
commercial loans the bank carries — which was about $1 billion as of
last June — has shrunk by $50 million and will most likely continue
to shrink through much of the first half of this year, Ms. Kimball said.
There are,
of course, exceptions.
Ultimate Hydroforming
of Sterling Heights, Mich., which makes prototypes for the aviation and
automobile industry, like the battery casing for the new Chevrolet Volt,
a planned electric car, has been able to obtain new credit recently and
will probably get even more from Independent.
The company’s
manufacturing plant is only a few miles from a half-dozen giant automobile
assembly plants. But Ultimate Hydroforming had started several years ago
to look for ways to diversify, so its business is still growing, even as
the automobile industry goes into a deep slump.
Ms. Kimball,
on a recent visit, was greeted by the plant operations manager, Shane Klyn,
and then given a tour of the factory, which is installing towering new hydraulic
presses — thanks to loans from Independent — as part of an expansion
that it hopes will lead the company into profitable work making parts for
solar energy devices.
“This
will allow us to move into new projects and markets,” Mr. Klyn said
as he walked through the plant with Ms. Kimball, who by then had a big smile
on her face, despite the freezing winds and piles of snow just outside.
“The bank is giving us the opportunity to expand.”
But companies
like Ultimate Hydroforming are extremely hard to find, particularly in Michigan,
where the unemployment rate is far above the national average.
With no surge
in lending taking place right away — and the bank very much looking
for a way to improve its own balance sheet — Independent took the $72
million check that arrived from Treasury in mid-December and immediately
transferred it to the Federal Reserve to pay down short-term loans it had
taken out.
This month,
the bank is planning to leverage that bailout money to buy about $160 million
in mortgage-backed securities from institutions like Fannie Mae, an investment
that it hopes will produce enough interest income to pay the dividend it
owes the federal government. Again, this will bring little immediate benefit
to Michigan businesses and residents. In essence, the $72 million has been
stuffed into Treasury’s own mattress.
Mr. Hovde,
the hedge fund investor who says he believes the bailout program is putting
off judgment day for many banks, said his fear was that many of the banks
would burn through their federal money only to face a squeeze again. And
they will never have made the extra loans that the Treasury had hoped would
jump-start the economy.
Treasury officials
remain confident that the investments are wise ones.
“There’s
going to be more lending than had we not done this,” Mr. Kashkari said.
“Even if the overall numbers are down year-over-year, it’s going
to be a lot more than if we had not put the capital in the system.”
And Mr. Shuster,
back in Michigan, said he was determined to prove that Mr. Kashkari —
whom he has never spoken to or met — is right.
“Even
if things get tougher, I am confident we can work our way through this and
pay every dime back to the U.S. Treasury,” he said. “There is
no stone we won’t turn over to make sure we are good stewards of this
money. We feel an enormous responsibility to this Treasury. I am a taxpayer
too.”
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