Odd Lots - The 1MDB Scandal And The Nature of Debt

Episode Date: January 21, 2019

At the heart of government debt is a promise to pay back creditors. But governments sometimes don't do this - either by defaulting on their bonds or restructuring their debt. How are these decisions made? And what happens to borrowings that governments say should never have been done at all?See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. And welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. My co-host, Joe Wisenthall, is away this week. I believe he is sampling the electric scooter scene over in Los Angeles. But this actually gives me an opportunity to dig into a slightly geekier subject. And that would be so. sovereign debt restructurings. This is when governments opt to exchange their loans or bonds for new loans or bonds, you know, typically less expensive ones or when they decide to pay back their debt at a slower pace or a cheaper pace or whatever. All of this hashed out amongst lawyers, typically acting on behalf of the borrower, the country that borrowed the money, and the lenders, the investors that lent it.

And yes, I can sense your excitement from here. But before you turn this podcast off, we are actually going to be marrying one of the biggest stories in finance and markets right now with the theme of sovereign debt restructurings. And that story is 1MDB, the 1MDB scandal that is currently rocking Asia and has certainly extended beyond the region all the way over to Goldman Sachs in New York. And the interesting thing about 1MDB is that it involves government guaranteed debt, in addition to Super Yachts and Leonardo DiCaprio. And it can actually be, I think, a jumping off point to discuss the fundamental heart of sovereign debt,

which is a government guarantee or a promise that the borrower, the state, is going to repay the money that it's borrowed. So here with us to discuss this, and I'm very excited about it, is Mitu Galati. He's a professor of law at Duke University, and he also blogs over at Credit Slash. which I urge you all to read. So Mitu, thank you so much for coming on. Thank you, Tracy. It's a delight to be talking to you after such a long time. It has been a long time.

So I'm going to outsource some of my hosting abilities since Joe is away, and I'm going to ask you to set the scene for us. What is the 1MDB scandal, and how does it feed into your particular area of expertise? So the 1MDB scandal, And I'm going to draw here heavily from articles in Bloomberg and the Wall Street Journal and the Financial Times. I did not come to the one MDB scandal right at the start. I came to it like many others did because of writing in the press and this wonderful book that two Wall Street Journal reporters did.

But one bit about the one MDB scandal caught my attention. And that was that this finance vehicle, essentially a sovereign wealth fund for Malaysia, that didn't do the normal stuff that sovereign wealth funds did, which was to invest the money of the country. Instead, it was borrowing money, sort of the opposite of what you would normally do with a sovereign wealth fund. It was a sovereign wealth fund that had no wealth of the sovereign. it was accumulating wealth by borrowing from outside investors and then siphoning it off to these corrupt financiers who were running it. And what interested me about that was not only were they corrupt, but they had managed in a couple of the bonds to get the state of Malaysia to actually guarantee the payments to the outside investors. And so it sort of merged this corruption angle with sovereign financing because it was basically corruption in the raising of the money and then sticking the bill to the taxpayers.

Now, it got even more interesting sort of at the end of the story after the scandal is revealed. And then the Malaysian government falls, which is fairly stunning in corruption scandals in South Asia, usually for those of us who, live in South Asia, we're used to this kind of corruption scandal, but this was just bigger than even what we're used to. And the government falls and the new government comes in. And there were a couple of these one MDB financings that did not have a state guarantee. And the new government comes in. And one of the first things that the finance minister does is to slap a new guarantee on these corrupt debts, which to me was completely bizarre. So, Years ago, my friend Lee Bukhai and I worked on corrupt loans in Iraq.

And in our research, one of the things that we discovered was, you know, the one way for countries to get out of debt obligations in a restructuring or just in a court proceeding is to have evidence of corruption. If there's evidence of corruption by sort of, especially by the agents of the bank, then you can go to court and say, this is not really our. loan, stick this to the bank that was corrupt, and engineered the loan. Malaysia had this evidence in spades. I mean, the reporters had done a fantastic job of uncovering all this evidence.

So Malaysia could have said, we're not going to pay this. Instead, they did the opposite, which is to embrace the loan and say, even though it was corrupt, we're going to stick our taxpayers with it. And these are poor taxpayers, a poor country, and it dramatically increases is their debt stock. And, you know, so there are all sorts of bad things that happen. And that's what got my interest. And I started writing about this particular aspect of this. And I'm continuing to do research on this. And I'm happy to talk about that. But that's sort of the backstory on this. Right. So I definitely want to ask you about your research. But just in summary, the oddity here,

in your opinion, is that we basically had successive Malaysian governments who, have slapped guarantees or confirmed guarantees on one MDB bonds even after uncovering that alleged bad behavior on the part of the previous regime. And of course, despite that discovery, they decided to honor the debt in full, at least so far. And they've gone so far as to say this sort of explicitly. Why would they do that? What does your sort of early research suggest on that front? So there are two explanations in the literature. So in a sense, this is not a completely new phenomenon. So if you go back to, I mean, the most vivid example for me is South Africa and the transition from the apartheid government to the ANC government.

So that's one case in which, you know, a lot of the debts that the apartheid government incurred was to buy arms to put down, you know, armed insurrection. and basically the pro-democracy movement. So one would have thought, and many NGOs thought, look, those debts are as ugly and corrupt and evil as any debts possibly could, and the new government can repudiate it. The new government of South Africa, post-Apartheid, did not repudiate them. They paid those debts in full. And their rationale was, look, our foreign advisors who help us raise money on the capital markets,

I've said, it will show that we are good borrowers that we'll pay all our debts, regardless of, you know, what they were used for. We're just so good. And, you know, there is some economic logic to it, I guess. But we just didn't know the answer to the question of whether it helps you or not if you pay stupid debts or corrupt debts. Right. You're basically dealing in theoreticals, right?

If you go down one course of action, which is honoring the debt, you're never going to know what would happen if you repudiated the debt? Yeah. So one course of action is sort of that you think it'll improve your credit rating or lower your borrowing costs. The other course is you can reduce your debt stock. And so there are these two stories, but the story for paying it is it'll improve your reputation as a borrower.

And we just don't know the answer, but that's the theoretical conjecture that it will improve your reputation as a borrower. So how does this play into 1MDB and what you've found so far? So the 1MDB case is very useful because usually the way this situation arises is that you have a corrupt debt that the country could repudiate, but it doesn't repudiate. It just goes on paying it. So when I say corrupt debt is one that a court would recognize as corrupt and would say, okay, you don't have to pay it. In 1MDB, they had at least a few of these 1MDB debts that did not have a state guarantee, and then they slapped the state guarantee on them afterwards.

So it allows us to empirically test at the point at which they put on this guarantee whether or not the market for other Malaysian bonds actually improved. So do the borrowing costs of Malaysia go down after it does this? And we can measure quite precisely whether the benefit from slapping the guarantee was actually greater than the cost of the guarantee. And basically, the data shows so far, this is work that I'm doing with Hugo Panizza at the Graduate Institute in Geneva. And we can't find any evidence of even the slightest benefit to Malaysia. Their yields didn't go down at all. Like, basically, it's just a huge loss for the Malaysian people and the new government.

So if there's no empirical evidence, no hard evidence of a benefit to Malaysia from honoring the debt, is there maybe a technical reason that they might have been thinking about? For instance, are they worried that if they don't honor 1MDB bonds, they're going to cause like a cross default or something on their other debt? Ah, good question. The 1MDB bonds did not have cross-default provisions with the other bonds. And that leads to the possibility of another explanation, which unfortunately from my 20 years of working on sovereign debt restructurings is the one I think is the more plausible explanation, which is that there are people in the current government, even though it's a new government, who were either involved or who know there are people who were involved in the corruption that took place earlier. and they don't want a trial where that corruption would get uncovered. And I think that in almost all of these cases, even though you have a new government, the new government does not want to uncover the ugly secrets of what happened.

And they don't want a discovery process of the bad behavior. Yeah, because some investor is going to sue regardless, saying you have to pay me, because they're always innocent investors who bought this on the secondary market. And then you'll have at least some court process or some journalists will then go uncover this stuff because it's so juicy and then, you know, more politicians will fall. I mean, this is, you know, if we talk about this later, the news story that is in the headlines, the Mozambique story, is just, it's almost at the one MDB level of corruption and hiding and successor governments who are even more corrupt or, you know, in. in collusion with prior governments and everybody's just sticking the bill to the population of a poor country. Oh, yes. I definitely want to ask you about Mozambique in a few minutes. I can't resist an opportunity to talk about tuna bonds. But before we do, just generally, how difficult is it for a country to establish that debt issued by a previous regime was actually corrupt?

What would they need to prove? Ordinarily, it is very difficult to do that. So, you know, academics for almost a hundred years have been wrestling with this question of whether or not new governments should have to pay the debts of prior corrupt governments. It's called the doctrine of odious debts. But the problem is international law has never recognized such a doctrine of odious debts. periodically people have tried to get it to recognize, but the international law of state, what is called state succession is quite strict. You have to pay the debts of a prior government regardless. But there are, of course, since this is law, there are exceptions.

And the exception is if in the making of the loan, the prior debt, there was corruption by the agents, particularly the agents of the lenders. Then the court just says, well, then that's not a debt of the country. We're just going to shift that debt to either the corrupt government leader or the banks. The banks who did it, they were corrupt. So it's their debt. But importantly for us, it is not shifted to the people. But this is very difficult to engineer. And it is almost never done.

Governments just don't want to do it. One MDB actually gave us a case where it could have been done. Because, you know, no thanks to the Malaysian government, but thanks to the reporters who spent years. And maybe thanks to Leonardo DiCaprio, because that's what, you know, and Beyonce and whoever else was involved who made the story really interesting. Wait, wait. I need to stand up for Beyonce. I don't think Beyonce was involved for the record. Okay. I'm sorry.

My knowledge of pop culture is really, really bad. But I remember there were some big music, Swiss beats, okay, if that's a person who makes music. But yes. But Leonardo certainly got the whole world interested. And this new character, Joe Lowe, who, you know, was running around on his yacht and the Thai waters cavorting with Thai generals. But we know a lot. And so this could have been the one case where we did it. And instead, the Malaysian government just stuck the bill to its people.

Although now I think, you know, after the U.S. prosecutors have gone after the Joe Lowe's assets, the Malaysian government is saying, you know, Goldman Sachs should pay the bill. But I'm skeptical that they're really going to be able to stick them with the whole bill. Yeah, they are going after Goldman Sachs, and it will be interesting to see that one play out in the U.S. judiciary system and actually judiciary systems around the world now. But Mintu, you touched on this a few minutes ago. governments that did choose to repudiate debt under this, you know, odious debt doctrine, how many of those have we seen? Can you name some specific examples? Well, yes, there are some very famous examples that, in fact, the repudations are still in existence. So the revolutionary government in Russia post the Tsar, I think, I mean, my history, is fuzzy 1917. They still haven't. Those bonds are still outstanding. So if you go to London to an antique store, you can probably buy for a couple of pounds old Russian bond that in

theory is still a valid obligation of the Russian government. And the successor Russian governments, including Mr. Putin, have refused to pay that on the grounds that it is an odious debt of the Tsarist government. The same for the imperial government in China. Those debts still have not been paid. They're outstanding debts, but successor governments have refused to pay them. Now, the question, though, is whether a court in the U.S. in particular, since U.S., basically, U.S. and the U.K. are the world's governments in terms of which court systems govern these laws

would recognize such a debt. and no court has recognized, I mean, recognized such a defense. No court has recognized a defense. And these are two very powerful countries that creditors can't easily seize their assets, although there are some classic cases where creditors have, for example, tried to seize, you know, Russian paintings that are on tour around the world or, you know, airlines flying the president and things like that. But none have really succeeded.

And so those are the two most famous examples of successor government saying the predecessor government was just so evil. And the purposes of the loans, you know, for example, the Chinese railroad loans that were, you know, largely engineered so that the Western powers could, you know, divide up China into different spheres of influence were, you know, illegitimate. And we were throwing out the Western devils. So we're not going to pay those. Canadian women are looking for more. More out of themselves, their businesses, their elected leaders, and the world around them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart.

And I'm Catherine Clark. And in this podcast, we interview Canada's most inspiring women. Entrepreneurs, artists, athletes, politicians, and newsmakers, all at different stages of their journey. So if you're looking to connect, then we hope you'll join us. Listen to the Honest Talk podcast on IHeart Radio or wherever you listen. to your podcasts. Let's talk about some modern examples then, some ongoing cases of bad bonds and, you know, bad in many senses of the words. So you mentioned one already, which is tuna bonds in Mozambique. There's another big one, which I think would have to be Venezuela. Which one do you

want to start with? Oh, I don't know. Those are the hunger bonds from Venezuela and the tuna bonds from Mozambique are two of the most vivid cases that we've seen in years. And so I hate to delight in them because they're really sad from the perspective of the people of those two countries. But why don't we start with the tuna bond since it's in the news literally this week and last week. And it's so vivid. It may even be worse than the one MDB scandal. Because I think even in the one MDB scandal, there were a few dollars in the pot. What happened here, I think it was about three years ago, was that Mozambique's economy had begun to do a little bit better.

You know, it's a very poor country, so much so that Mozambique had never been able to issue a Euro bond and tap the international financial markets. But as a first step to tapping the markets, they decided, along with the help of Credit Suisse and VTB, a Russian bank that is very important in almost all of the modern stories of corruption, they decided we'll do a loan. We'll do a loan to help us buy both naval boats and tuna boats. Since tuna is a big part of our industry, we're going to take a loan and we're going to buy tuna boats to help our economy.

And they do these three big loans, and they back the loans with state guarantees. And almost immediately, like literally before the first couple of interest payments have to be made, they run out of money. And they run out of money in part because none of the boats ever get used. and almost no money. I mean, I think they can't find even a single dollar of the proceeds of these loans that went to the Mozambique government. Right. So from what I remember, the allegations and these are still being investigated, but the allegations are that Mozambique government officials basically were siphoning off millions of dollars that were meant to be going into the Mozambique economy like the tuna industry through these financings. I taught a class on sovereign debt restructuring in Portugal to a small group of sort of young government officials who were going to be working on these deals.

And this was before, or right around the time, I think, the first scoop came out in the Western financial press about these tuna bonds, not ever having caught a single tuna. These government officials, they didn't know about the articles in the Western press, but they were officials from the Mozambique government, young people. And they said, look, you know, we can look out our windows and we just see these boats sitting there. And they never go out into the water. And where's all that money gone? And then what happens is every single one of these defaults. And no money goes into Mozambique.

Mozambique goes quickly from having fairly good fiscal position for such a poor country to becoming one of the most indebted countries in the world without having gotten a single dollar of benefit. Now, the original loans were eventually, again, from what I remember, they were swapped into euro bonds, right? Because they still had that government guarantee, which was valuable to investors. And in fact, I think this was Mozambique's first Eurobond. And I remember it was being pitched at the time.

There were a lot of people saying it was an excellent way to get yield via frontier market exposure to Mozambique. A loan that could have been easily repudiated, the prior ones where the original lenders were still in place and, you know, probably could have identified them. Or at least the state could have said, at least. least our guarantee that we put on it, we're taking that off. And you can chase the tuna company if you want, but we, as we both know, there's nothing in the tuna company for any creditor to go after. But once they converted it into a nice tradable Mozambique Euro bond, then the country was on the hook for it. And then there would be new lenders who were buying traded instruments, and it would be near impossible to repudiate that. So, you know, one of these things with, you know,

both with the one MDB scandal and with the tuna bond scandal, is that you see how even things that legally you could repudiate can be converted if the government in place is not strong enough to want to repudiate it, they can be converted into much prettier and safer instruments that are protected from legal attack. And that's what we've seen. I mean, that's the really sad part of these stories. Now, even in the tuna bonds, you know, U.S. prosecutors are going after the bad guys. But that never works because getting bad guys assets is just very difficult.

They don't have that many assets. They tend to spend it all. And, you know, it also tends to be the fact that in many of these corrupt situations, it's not just one bad guy. There are hundreds of people who have been taking, and we never catch them all. And so the people invariably get stuck with the bill. Well, let's talk about another instance of, well, bad behavior, I guess, in the debt market. Venezuela and the hunger bonds has to be a major, major example of this. And, you know, we were talking about why governments would choose to honor or not honor their debt earlier.

and one of the weird and unusual and very sad things about Venezuela is that even as ordinary Venezuelans were starving, the Majuro regime, you know, continued to repay its debt for a very, very long time, you know, longer than a lot of people had expected. So why would they choose to do that? And what's the future of the bonds issued under the Majuro regime? Okay. So the Hunger Bond, is another astounding. I mean, 2018, 2019 must be the years of corrupt sovereign debt issuances. But the Maduro government, you know, Venezuela has the largest oil reserves in the world. So it's incredibly rich. And one of the effects of being so resource rich is even though

they have this basically kleptocratic government in place, foreign investors are willing to invest in their bonds in incredibly large amounts because they expect that some future government sometime will come in and revive the economy and then be able to pay them all. So Venezuela, unlike Mozambique or even Malaysia, has sort of the resource curse of investors are willing to keep plowing money in no matter what. And on the flip side of it, the government, because it is dependent on the money from the investors, on new money from the investors, is willing to keep paying the coupons on the old loans as long as it can just so as to continue to keep its connection to the financing markets. So that's sort of the

cycle that they get into in Venezuela, and it is why the economist at Harvard, Ricardo, Hausman, started calling these hunger bonds because people in Venezuela were malnourished, not getting medication, while at the same time the government is paying out millions of dollars, because Venezuela has such a large debt stock, in coupon payments to foreign investors. So Venezuela, for a number of years, had been the best performing emerging markets sovereign debt by a wide margin, I think. So Venezuelan people are starving, and yet, you know, if you buy Venezuelan bonds, you're having a giant party. So this one bond, but this all, you know, this all eventually comes crashing down because the government is

just so incompetent that it can't even run its own oil industry properly. And they stop being able to make even their coupon payments. But then the government comes up with the strategy. And their new strategy is, look, you know, we can't raise new bonds on the international market. You know, nobody will underwrite our bonds. So what we'll do is we've got some old bonds that we weren't able to sell to anybody. And we had, you know, parked them in local financial institutions, but never raised any money for those. What we'll do is we will find some investors out there. And now, because we're basically bankrupt, we can't promise investors high interest rates because if you're going to go bankrupt, nobody wants a high interest rate because once you go into

bankruptcy or basically an insolvency proceeding, you don't get paid that high interest rate. The game then is what you have to promise me is that I will get priority over the other lenders, the prior lenders. Now, in sovereign debt, if you get really into the weeds, There's no priority promise because there's no bankruptcy system. But the way to use financial engineering to get priority is to give somebody a dramatically inflated claim. So it's as if, you know, you, Tracy, are willing to lend me, you know, $100 million, but you don't want a high interest rate and I'm very risky.

So the way I do that is I say, look, Tracy, give me the $100 million. I'll give you a piece of paper that says on it a billion dollars. So when I eventually go bankrupt and when I have taken my ill-gotten gains and gone to Switzerland and you come to the new government and turn in your claim for the restructuring, they will think you are owed a billion dollars. And essentially with the hunger bonds, that's what happens. They give this one bond issue, do you think it was a 2.2.2.2.2. billion dollar issue and I can't remember I'm 2.2 billion but I think the actual amount that

Venezuela gets is close to 800 million dollars. And so the Venezuelan government, you can look at their capital reserves and on the roughly around the day the bond is, you know, this parked bond is is sold. Their capital reserves go out, go up by exactly this amount with a little discount for whoever got the side payment. And this hits the press through social media. And it spreads like wildfire under the name of the hunger bond. And Marco Rubio tweets it out and Ricardo Hausman tweets it out. And everybody's outraged and the market starts penalizing this bond very, very heavily.

So in some ways, this is a story both of the kinds of things that bad governments do in order to preserve their power. But for once, this is also a story of how social media can, you know, if people understand what sort of bad stuff is going on and sort of stopping the bad deals. And, you know, in this case, the happy part of it is Wall Street took such a beating. for having done this deal that basically every major investment bank, including institutions like Credit Suisse that were involved in the tuna bond, promised not to touch this bond and not to do these kinds of deals again. Well, I want to press you on this point, because I think this is going to be the thing that sort of links all these different stories

that we've been talking about together, you know, whether it's one MDB or tuna bonds in Mozambique or hunger bonds in Venezuela. But what do you think is the most effective way of dealing with sovereign debts, bad sovereign debts incurred by corrupt leaders or, you know, through unsavory actions or questionable governments? How can people actually deal with those? I liked talking about the stories because I had stuff to say about that. Now you are pointing to, you are asking the question that I don't actually know have a good answer for. We have been working on this for years as long as I have been in this business and how to devise a system to improve the sort of the quality of sovereign debt borrowing and in particular to reduce the amount of corrupt borrowing. and we have largely failed.

I think the best suggestion out there, and especially drawing from the hunger bond experience, unfortunately is not one that I came up with, but it is one that Ricardo Hausman and Hugo Panizza, these two economists, have been talking about, which is to do early in the process of bond issuances, a kind of an odiousness rating for the bond, where you would really use the ability of the financial markets to rate bonds in terms of how corrupt the particular bond issuances or the process of

bond issuance, for example, whether or not they got proper legislative approval, was audited properly, because all of these situations that we're talking about, if in hindsight we go back and look at them, they were all filled with very clear markers that this was not done properly. It's just, in all of these cases, we've only discovered them well after the fact. But if we had some kind of public rating systems that, a public rating system that investors could actually look at, then maybe we would have a market mechanism to do what the court systems and the existing international, you know, financial standard system has not been able to do.

But, you know, it's just a conjecture. I mean, in my work, the stuff that I have tried to work on in terms of, you know, sort of putting in place legal mechanisms in the courts has utterly failed. So I have to turn here to the work of other people, which, of course, pains me because I would like to turn to my own work. All right. Well, I think we're going to have to leave it there, Mitu. It's been so lovely to talk to you again. And honestly, I could talk to you about sovereign debt for many more minutes and certainly hours. But it's all the time we have. Mitu Galati, Professor of Law at Duke University. Thank you so much. Oh, thank you so much, Tracy. It was a real treat to talk to you. This has been another episode of the Oddlots podcast. You can follow me on.

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