BY KHAIRIE HISYAM | Kinibiz
DECEMBER 18, 2015 8:00AM

With a number of questionable dealings over its seven years or so of existence, a considerable part of 1MDB’s shenanigans have involved Goldman Sachs who were handsomely, and extremely generously, rewarded. But why is the US firm so close to 1MDB?

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As the fires of the 1Malaysia Development Bhd (1MDB) controversy, long confined to embers unnoticed by the public, continue burning this year, authorities foreign and domestic have turned their attention to one of the company’s friends: Goldman Sachs.

It is no secret that Goldman Sachs seems to enjoy an intimate working relationship with 1MDB, having seen its services engaged for all three of 1MDB’s foreign market bond issuances.

However, the relationship raises questions as Goldman Sachs also seems to have reaped what appears to be extremely generous fees from these bond issuances, far above normal rates, which KINIBIZ looks more closely at further in this article.

The US Federal Bureau of Investigation (FBI) is now reviewing the firm’s business relationship with 1MDB as part of a broader probe into the latter, Reuters reported in October 2015. In November, the Malaysian Anti-Corruption Commission (MACC) also visited the firm’s KL office in its own probe into 1MDB.

These tie into a wider global investigation across three continents over possible money laundering activities involving 1MDB. However, as questions grow over 1MDB’s questionable dealings over the years, public attention has not perhaps been sufficiently directed towards the role Goldman Sachs have played.

Preferred overseas arranger

And it has been quite a role – of all 1MDB’s different borrowings, Goldman Sachs has been closely involved in arranging the single largest share of its RM42 billion or so in total borrowings.

The firm was the arranger for all three of 1MDB US dollar bonds, which amount to US$6.5 billion in total value, issued overseas. By contrast, 1MDB’s domestic financing exercises were spread across four different financiers.

At current exchange rates (US$1 = RM4.24 as of Dec 1, 2015) this US$6.5 billion figure comes to RM27 billion.

It would perhaps be fairer to use the 2013 exchange rates as the bonds were issued then. Statistics indicate that the lowest point of the ringgit relative to the greenback in 2013 was at RM3.30 to the US dollar, which translates into about RM21.5 billion in total value of the three bond issuances.

In any case, the RM21.5 billion in total from overseas bond issuances carry a fair value of RM19.8 billion, which makes up 47% of 1MDB’s total of RM42 billion or so in total borrowings, according to its latest available annual report.

Another RM16.3 billion in financing was raised domestically, with a fair value of RM13.9 billion. The remaining borrowings were inherited debt following 1MDB’s power asset purchases between 2012 and 2013.

Exorbitant fees for 1MDB

An interesting facet of 1MDB’s close relationship with Goldman Sachs is its questionable generosity towards the US investment banking firm. For its role in arranging the three bond issuances, the firm made about US$500 million.

This figure, which is nearly the same amount the Malaysian government was spending in 2013 to pay its monthly debt commitments, amounts to 7.7% of the three bonds’ total value. Part of these earnings contributed to an industry-beating growth of 69% in fixed-income underwriting fees in one quarter that year for Goldman Sachs, according to Bloomberg data.

That percentage raises eyebrows, considering underwriters earn on average 1.32% of US high-yield junk bonds in 2013. Among others, lawmaker Tony Pua, member of parliament for Petaling Jaya Utara and member of the Public Accounts Committee, has asked whether 1MDB was being “fleeced naked” by the US firm.

In comparison, other government-linked entities have raised funds by paying far fewer in fees on a percentage basis. Citing a previous fundraising exercise by state-linked Tenaga Nasional Bhd, Pua claims the power distributor paid only 2% to raise US$350 million (RM1.2 billion at the time).

Specifically for Goldman Sachs, Pua claimed that Goldman Sachs charged fees and expenses amounting to 1.3% in a previous fundraising exercise for Equisar International Inc while charging 0.3% for Apple Inc. In a previous financing exercise for the Mexican government, Goldman Sachs charged 0.2% in fees and expenses.

First bite in bond mispricing?

While seemingly excessive, Goldman Sachs’ earnings from arranging the three 1MDB bonds were not all from underwriting fees. Part of the earnings came from the firm buying the bonds at a discount to face value before marking them up for on-sale to investors, according to a previous Bloomberg report.

It raises concerns on potential wrongdoing that may border on the criminal. The three bonds arranged by Goldman Sachs were among the four bonds by 1MDB that had been identified as grossly mispriced, resulting in an unidentified party reaping windfall gains by essentially flipping the bonds for huge profit after buying them cheaply (see Part 3 of this issue on the bond mispricing).

According to KINIBIZ calculations, these three bonds were mispriced by some RM4.8 billion or thereabouts, resulting in 1MDB losing out on this amount which it should have gotten by issuing the bonds. The fourth bond, which was issued domestically and underwritten by AmInvestment Bank, was mispriced by RM1 billion, meaning 1MDB lost nearly RM6 billion in total from mispricing its bonds.

In contrast, the parties given a massively discounted first bite to the bonds were able to pocket the difference – a mind-boggling sum of billions – instantly.

And the question is why 1MDB allowed any party to make such huge gains. Coming back to Goldman Sachs, two basic issues arise on ethics and whether 1MDB was deliberately allowing this to happen.

On the ethical question, what arises is whether it is proper for Goldman Sachs, acting as arranger for the bond issuances, to also be the first buyer considering that leads to a conflict of interests – its own as a buyer as well as that of its client, the seller, whom it is supposed to be advising.

However, a previous lawsuit filed in 2013 by former New York Federal Reserve senior examiner Carmen Segarra claimed that Goldman Sachs had no firm-wide policy against conflict of interest in its dealings.

She was contesting her termination for refusing to comply with alleged orders to falsify her findings on Goldman Sachs, which had already come under fire in recent years for advising both sides in several deals as well as being seen as putting its own interests above that of its clients.

This followed a high-profile incident in 2010 when the US Securities and Exchange Commission charged the firm for fraud after it advised clients to buy its collateralised debt obligation products while itself taking a short position against them.

A second, secret, client?

The question around Goldman Sachs’ ethics leads to the second issue: was 1MDB misled by Goldman Sachs into grossly discounting the bonds or did 1MDB sanction this action?

The latter scenario points to a potential breach of fiduciary duty on 1MDB’s directors’ part and suggests a starker possibility of criminal intent.

If Goldman Sachs proves to be the mysterious party being allowed to pocket such clean, instant profit, the numbers do not add up – RM4.8 billion or so translates into roughly US$1.5 billion according to the lowest 2013 exchange rate of RM3.30 to the US dollar.

By contrast Goldman Sachs’ total earnings from the three bond issuances only amount to US$500 million, including the portion that came from fees and expenses.

Where were the rest of the mispricing gains? Did someone involved in the exercises also pocket part of the mispricing difference for their own gain? These questions remain unanswered today and, unfortunately, have not been asked enough to 1MDB.

In any case, it is clear from what information is available that the intimate relationship 1MDB enjoys with Goldman Sachs carries troubling implications insofar as proper governance goes and any independent probe interested in the truth should also look closely at 1MDB’s undue generosity towards its preferred advisor.

Yesterday: Other questionable use of loans – the Goldman bonds

Tomorrow: The RM7 billion PetroSaudi caper