The University of California has lost tens of millions of dollars, and is set to lose far more, after making risky bets on interest rates on the advice of Wall Street bankers.

University officials agreed to the financial deals – complex contracts known as interest-rate swaps – because they believed they could save money in the midst of an aggressive building spree.

But the deals are now costing the university an estimated $6 million a year, according to its financial statements.

And university accountants estimate the 10-campus system will lose as much as $136 million over the next 34 years that it is locked into the deals. Those potential losses would be reduced only if interest rates start to rise.

Already officials have been forced to unwind a contract at UC Davis, requiring the university to pay $9 million in termination fees and other costs to several banks. That sum would have covered the tuition and fees of 682 undergraduates for a year.

The university is facing the losses at a time when it is under tremendous financial stress. Administrators have tripled the cost of tuition and fees in the past 10 years, but still can’t cover escalating expenses. Class sizes have increased. Families have been angered by the rising price of attending the university, which has left students in deeper debt.

The interest-rate bets have the same outlines as those made by Robert Citron, the former Orange County treasurer. Twenty years ago, the county went bankrupt when Citron’s investments in arcane securities tied to interest rates went sour. There was one difference: Citron bet interest rates would fall. The university gambled that rates would rise.

Timothy Schaefer, a municipal finance adviser in Newport Beach, said he warns clients about the dangers of interest-rate swaps.

“I don’t think they are suitable for most public agencies,” Schaefer said. “You have to have a tolerance for risk.”

In interviews, Peter Taylor, the university’s chief financial officer, defended the decisions. He said he was confident that interest rates will rise in coming years, reversing what the deals have lost.

“We have a long-term view,” he said.

Taylor was a top banker in Lehman Bros.’ municipal finance business in 2007 when the bank sold the university a swap related to debt at UCLA that has now become the source of its biggest losses on the deals.

The university hired Taylor for the $400,000-a-year position in 2009. He has continued to sign contracts for interest-rate swaps in cases where he and his staff estimate they will save money over the cost of traditional debt.

He pointed to the university’s new guidelines, which require an analysis of the expected costs and risks of each proposed swap deal before it is approved.

“They are part of our toolbox,” he said of the swaps. “If they don’t save us money, we won’t do them.”

PROMOTING NEW ‘BORROWING PRODUCTS’

The university began using interest-rate swaps in 2003 after John Augustine, a Lehman Bros. banker, advised officials of their potential advantages.

Minutes from the July 16, 2003, meeting of the Board of Regents show that the university had hired Lehman Bros. to assist with its debt strategy.

Among Augustine’s advice was for the university to greatly increase its borrowing by pledging student tuition monies to cover the debt. Until that time, the university had counted on the state government to issue bonds, which were secured by taxes.

Augustine also told officials about “new variable rate borrowing products,” according to the minutes, and how the use of interest-rate swaps could save the university money.

At that time, Lehman Bros. and other banks were peddling the swaps to colleges and universities across the country.

For example, in a presentation at a bank-sponsored convention in San Antonio in 2007, Augustine encouraged a group of treasury officers from various colleges to adopt methods used in corporate finance, including the frequent use of interest-rate swaps.

Augustine, who now works for Barclays in New York, declined to comment.

The swaps were designed so that universities could take advantage of variable-rate bonds, which often have lower interest rates than traditional fixed-rate debt.

The bankers said the universities could use swaps to protect them from rising interest rates.

Under the swap contracts, the bank agreed to pay the variable rate on the university’s bonds, while the school pledged to pay an artificially fixed rate to the bank over the life of the bonds.

While the bank would lose money if interest rates rose above that artificially fixed rate, it would profit if they fell.

After the 2008 mortgage-banking crisis, interest rates plummeted, resulting in the transfer of billions of dollars from colleges and other public institutions to the banks that had sold them the swaps.

Michael Greenberger, a law professor at the University of Maryland and an expert in derivatives, said most public officials agreeing to enter the swap agreements don’t understand the risks. The agreements include boilerplate terms, he said, that protect the banks’ interests.

“It’s a total nightmare,” he said, “and you can’t get out of it.”

A BANKER ON THE BOARD

While the university agreed to swap contracts with multiple banks, Lehman’s work on the deals stands out.

In 2006, the university hired Lehman for additional advice at the urging of Richard Blum, who sits on the Board of Regents. Blum, an investment banker, is the husband of U.S. Sen. Dianne Feinstein.

Blum had told university officials that he believed the system’s debt strategy was overly conservative, according to meeting minutes.

In January 2007, Augustine, the Lehman banker, presented an analysis to the Regents, which concluded the university could issue $11 billion more in debt.

Six months later, the university issued $200 million in bonds related to construction at UCLA’s medical center. Not only did officials decide to pay Lehman to underwrite those bonds, but they also chose the bank for an interest-rate swap on the debt.

At that time, Taylor was a managing director at Lehman and head of the bank’s West Coast public financing operations. He oversaw 15 investment bankers, according to his résumé.

Taylor was also then closely connected to top university officials. He was on the board of directors of the UCLA Foundation and had earlier served as a regent.

Taylor and Augustine reported to the same Lehman banker in New York, according to bank records.

In an interview, Taylor said he had no part in the UCLA swap agreement. He said his clients at Lehman had included cities, counties and the state – not universities.

“Mr. Taylor was concerned with his own deals, not those of others,” said a university spokesperson, “and his supervisors did not share details of the swap agreement with him.”

In November, the Register asked Taylor for a list of fees paid to Lehman since 2003.

“We don’t track that,” Taylor said. “I don’t keep a running tab on who we pay fees to.”

A CHANCE TO GET OUT

One danger of the swap agreements became clear to university officials on Sept. 15, 2008 – the day Lehman Bros. filed for Chapter 11 bankruptcy protection.

The bankruptcy automatically terminated the swap. Under the contract, the university was required to pay a $25 million termination fee to the now-bankrupt bank.

But at that point, there was one upside. Interest rates were volatile, but had not yet plunged. The swap was not yet deep underwater. The university was out of a gamble that looked increasingly precarious.

In a decision that is still not clear, university officials decided to find another bank to provide a swap with the same terms. Deutsche Bank agreed to pay the university $31 million to reissue the swap – which officials now estimate will produce $123 million in losses in coming years.

Taylor had not been hired at that time. But he said the university’s finance officials decided to sign another swap agreement because they did not want to be exposed to the risk of higher interest rates in the coming decades.

Sandra Kim, the university’s executive director of capital finance, had just recently joined the university when Lehman declared bankruptcy.

“There was a little bit of chaos,” she said, “and it was important to move quickly.”

But Greenberger, the Maryland law professor, said the university should have learned a lesson.

“Stupid decisions were made twice,” he said.

Questions about the swaps, including by Governor Jerry Brown, came up at a Regents meeting in late 2012 after a group of doctorate students from Berkeley wrote a paper about the losses. Taylor told the board that the students’ paper was wrong. The university has been careful with its debt program, he said, and has not taken imprudent risks.

Contact the writer: 714-796-2478 or mpetersen@ocregister.com