Harvard’s decision to use derivative investments to lock in low interest rates on the school’s mounting debt cost the University $500 million this past year and will cost it at least $425 million more over the next few decades, according to the University’s annual financial report released Friday.

Harvard entered into interest rate swap agreements—which are used to hedge against rising interest rates—in 2004, when it seemed that interest rates had reached favorable lows and that locking in those rates would help the University finance its mammoth, long-term expansion into Allston. But the agreements backfired this past year when the global financial crisis pushed interest rates to unprecedented lows, thereby decimating the value of the swaps.

Harvard, looking to safeguard its cash supply from the increasing threat of losses associated with the swaps, decided to post $500 million in collateral this past year to terminate agreements on $1.1 billion of its debt. In addition, the University will pay another $425 million over the next 30 to 40 years for new “offsetting” interest rate swaps, which will essentially negate the effect of the original swaps on $764 million of its debt.

“A precipitous drop in interest rates and liquidity considerations made it important for us to scale back the swaps substantially,” said University Treasurer James F. Rothenberg ’68 in a interview posted by Harvard. “That has come at a real cost, but at least we are now in a better risk position going forward.”

After the terminations, Harvard now has $3.1 billion of debt subject to interest rate swap agreements.

Many other universities have similar interest rate swap agreements in effect, but not to the magnitude of Harvard’s arrangements. Rothenberg said that this was because Allston presented Harvard with a “unique opportunity” to aggressively expand.

CASH CRUNCH

Friday’s report, which follows Harvard’s announcement last month that its endowment had shrunk by 30 percent this past year, also reveals billions of dollars in losses sustained through the University’s investments of cash designated for short-term expenses.

Harvard has traditionally pooled cash from the University’s various schools in a General Operating Account that is invested alongside the endowment—a practice that the report said “generated significant positive investment results” in the past. But this year, that strategy backfired, dragging the value of the GOA down from $6.6 billion last year to $3.7 billion this year. Part of that decline reflects the payments made to terminate interest rate swap agreements.

Harvard’s investment strategy, which has long emphasized broad diversification of assets, has also made the portfolio more illiquid, or difficult to convert back into cash. This has proved especially problematic amid the broadly slumping markets of the past year.

According to the report, the GOA is used to manage and execute all University financial transactions, including routine bill payments.

This weekend, the Boston Globe’s article on Harvard’s financial report suggested that the University’s decision to invest short-term cash alongside higher-risk endowment assets was unusual, and cited Stanford spokeswoman Lisa Lapin as saying that her school “wouldn’t take a cash account and invest it with the endowment.”

But in an interview with The Crimson, Lapin said that her comments may have been misinterpreted and emphasized that she was saying that her school’s operations are funded by investments held alongside the endowment. Stanford’s 2008 financial report, the most recent one available, states that the California university uses an “Expendable Funds Pool” partially to fund operations, of which a “substantial portion [is] cross-invested” in the Merged Pool, which consists of the endowment and other long-term funds.

Dan Shore, Harvard’s CFO, also told The Globe that the GOA losses did not prevent the school from meeting its existing obligations, and that the University’s cash position was secured by new debt issued by the school this year. Nevertheless, Shore said in an interview posted by Harvard that the school has adjusted its investment strategies to emphasize short-term flexibility and cash needs and will continue pursuing such “rebalancing efforts” in the future.

—Staff writer Peter F. Zhu can be reached at pzhu@fas.harvard.edu.