07 August 2009

It's all arbitrage

The news of the day is that the University of California is lending the State of California about $200M. This is because, not unsurprisingly, the University has a better credit rating than the State and so it can borrow money more cheaply.

In order to keep a number of construction projects (mostly in the medical sciences) at various UC campus moving along, the University has borrowed $200M on the bond market. The money is then immediately loaned that back to the State at a 3.2% interest rate — higher of course than that which the money was borrowed — so that the State can, in turn, give the money back to UC for those projects (huh?).

Besides: (i) the preeminent role of the medical and health sciences in this story (they seem to be the real winners in the whole UC budget debacle); (ii) the circuitousness of the whole plan (why can't UC just borrow money for those projects?); and (iii) the fact that UC is going to turn a profit on this, there is still one more question looming.

When asked about the loan yesterday in Santa Barbara, Yudof replied: "It's all arbitrage," meaning that UC is taking advantage of an inbalance in interest rates to turn a profit. But of course, as any first-year economics student would know, and unless UCOP thinks investors are stupid, the net effect of this ruse will be just to decrease the University's credit rating correspondingly. After all, the University is taking more risk by lending the money to the State than the 3.2% rate of return on that loan warrants, because otherwise the State could have just borrowed the money itself.

The net result will be to make future loans that the University might want to take out more expensive. This kind of wooly-headed thinking that seems to enjoy a lot currency at UCOP will not help solve the University's problems.

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