The College Guide has written before about the importance of a college’s endowment and the hard decisions colleges have made due to financial meltdown and financial crisis beginning in 2007.

It looks like the collapse of endowment payouts might actually be the fault of college endowment managers, however. According to a paper released yesterday by Center for Social Philanthropy at the Tellus Institute indicates that six New England colleges— Boston College, Boston University, Brandeis, Dartmouth, Harvard, and MIT—made very risky investments last year and actually made the financial crisis worse. According to an article by Gillian Wee in Business Week:

“Harvard [in particular] highlights how terribly wrong the endowment model can go when pushed to certain extremes in a climate of leadership crisis,” said the 81-page report, which was released today. The endowment model, pioneered by Yale University’s investment chief, David Swensen, relies on alternative assets including commodities, real estate and private-equity holdings to boost returns.

The trouble with the endowment model, accord to one author of the Tellus paper, economic historian Joshua Humphreys, is that by transferring so much capital into high-risk, high-return, illiquid investments, most of these colleges’ money operated in the “shadow markets.” This made it difficult to evaluate and understand the risk of many university investments.

According to the report,

Far from being innocent victims of the financial crisis, endowments helped enable it. By engaging in speculative trading tactics, using exotic derivatives, deploying lever, and investing in opaque, over-crowed asset classes such as commodities, heads funds and private equity, endowments played a role in magnifying… systemic risks in the capital markets.

Furthermore, the apparent sophistication of the endowment model helped encourage this risky behavior by individuals and other institutions.

In the long term, Humphreys pointed out, this model makes money. The returns are very good but the trouble is that the investment strategy introduces incredible stress on college campuses and surrounding areas. Each of the schools they studied (which together control more than $40 billion, some 12 percent of American university endowments) is the major employer in its locations. Harvard, for one, is actually the second largest employer in the state of Massachusetts.

When Harvard loses billions almost overnight, as it did last year it doesn’t just mean, as Humphreys explained, that professors don’t have cookies in meetings; the school cuts people’s research budgets. Furthermore, universities employ thousands of people. When they have financial struggles they lay off their lowest paid workers. This has a devastating effect on local and regional economies.

Most importantly, however, there’s a limited benefit to this sort of investment strategy. Yes, in the long run the returns are higher, but where does all this money go anyway?[Image via]

Daniel Luzer

Daniel Luzer is the news editor at Governing Magazine and former web editor of the Washington Monthly. Find him on Twitter: @Daniel_Luzer