Holiday Reading Recommendation and a Research Question on the 1MDB C...

The 1MDB case has been on the front pages of the financial papers on a number of occasions recently. The reason: The US justice system is investigating the scam and senior executives from everyone’s favorite ethical investment back, Goldman Sachs, including Lloyd Blankfein, have been caught up in it. And this leads me to my recommendation for holiday reading, if you like reading financial fraud books. The book is The Billion Dollar Whale, by Bradley Hope and Tom Wright of the WSJ. At first, I thought that the book was about the London Whale, but it turns out to be about the rise and fall of a Wharton educated Malaysian named Jho Low – a fascinating character who appears to have engineered one of the biggest financial frauds of the century, while also throwing the most ostentatious parties ever. If you want more background, there is a fun discussion of the book on my favorite financial podcast, Slate Money (Emily Peck, Anna Szymanski and Felix Salmon are a brilliant, and often hilarious, combination). Indeed, I picked up the book after listening to their podcast on it.  There is also a short, but on the money, review in the New Yorker by Sheelah Kolhatkar. Among the many colorful characters involved in the version of the story told in The Billion Dollar Whale are Gary Cohn (of Goldman and the Trump’s economic advisory team), Leo DiCaprio, and the Wolf of Wall Street (both the movie and the main character, Jordan Belfort).

What got me interested in this story is an aspect that Felix Salmon briefly mentioned on his Slate Money podcast, which is that the investment vehicle at the center of the fraud – 1MDB – had received a guarantee from the Malaysian government.  Best I can tell from some superficial digging that I did, all of the 1MDB issuances of bonds did not start out with guarantees from the Malaysian government (and at least one had a guaranteed from an Abu Dhabi government fund). Instead, somewhat bizarrely, the Malaysian government seems to have slapped its sovereign guarantees on a large portion of the 1MDB obligations that lacked such guarantees after the fraud was unearthed.  Reuters, on May 22, 2018, reported the new Malaysian Finance Minister, Lim Guan Eng as saying:  “We will honor those [1MDB bond obligations] even though we are not happy with 1MDB, but we have to honor our international obligations.” This is especially strange because the fraud was done under the prior government and one of the campaign promises that the opposition had made was to investigate the shenanigans at 1MDB under the former Prime Minister Najib Razak (that the WSJ and others had been reporting on).

Here is the question that intrigues me:  Why in the world did the new Malaysian government, after having overthrown the corrupt prior government, use the state’s resources to give creditors (many of them likely rich overseas investment funds) the windfall of a sovereign guarantee that those creditors had not paid for?  The Finance Minister explained that the reason was to assure the markets that the Malaysian government knew what it was doing. (“I think this will reassure the markets that this government knows what it is doing.”). I am skeptical. Why would the markets (to say nothing of taxpayers) think that the government was smart and responsible if it was taking on obligations that it was not legally obliged to?  Sounds stupid and irresponsible to take on obligations that one never agreed to in the first place.

But maybe there is some kind of reputational story here. Maybe the markets for sovereign debt gave Malaysian sovereign debt a boost because its actions in the 1MDB case showed how devoted the Malaysian government was to paying its debts, whether or not those were really their debts? If so, this should be empirically testable. We should be able to do an event study centered around the dates of the guarantee announcements where we can measure the impact of the unexpected guarantee given the 1MDB bondholders (and other claimants) on the yields of other Malaysian government obligations outstanding at the time (we should see those other yields go down, if the Finance Minister Eng’s logic was correct).  On the flip side, if my skepticism is justified and that markets see this move as idiotic rather than smart, yields should go up. Dubai, interestingly, took the opposite tack in late 2009 when Dubai World tanked and investors went to the state, arguing that there was an implicit guarantee.

More broadly, the question here is whether new governments -- from a pure cost of capital perspective -- should pay those debts of their corrupt predecessors against which they have strong legal defenses.  Ukraine, with its $3 bn debt to Uncle Vlad’s Russia (money lent to prop up Ukraine’s prior pro Russian government) has chosen the opposite route to Malaysia.  And it is fighting the Russian claim in the English courts  (and winning, as of this writing). So, one might ask: Is Ukraine suffering a reputational penalty from its other creditors because it is fighting the claims of the Russians?  I suspect not.  But no one has taken a serious look at this question.

By contrast, the post-apartheid South African government, somewhat depressingly, chose to pay all of those apartheid-era debts – even though there were legal defenses that could have been tried. The logic there – that had no real empirical basis – was that the markets would reward South Africa for paying those prior debts.

Given that this is a question that will keep coming up, as long as we have corrupt governments, it seems worthy of inquiry.  Indeed, this question is likely to come up very soon in Venezuela.  Assuming that Mr. Maduro is on his last legs, the question of what the new government should do with some of the shady borrowing that his government engaged in (the infamous “Hunger Bonds” are a prime example -- Ugo Panizza and I have written about the Maduro government’s shady borrowing in papers on Hunger Bonds and Maduro Bonds). It would be nice to have a concrete answer as to what the impact on the new Venezuelan government’s cost of borrowing will be if it chooses to repudiate the prior regime’s shady debts.