Caracas Chronicles

According to a Reuters story, BCV is eyeing a repurchase (“repo”) transaction with the Japanese investment bank, Nomura, in what seems like a desperate bid to raise dollars without disturbing bond markets.

As hardcore bond enthusiasts might recall, in 2014, PDVSA issued a mysterious 6% bond maturing in 2022. Those bonds were never sold to the general public — they were sold to BCV behind closed doors instead. Since they were never transacted, valuations are speculative, but people figure they may fetch $1-1.3 billion on the market right now based on the pricing of comparable bonds. The way this Repo Deal would work is that BCV would sell those mystery bonds for $1 billion, but with an agreement to repurchase the bonds three years later at an as-yet unspecified price.

This is a relatively exotic financing arrangement – most countries just issue bonds when they need money. It’s unclear if Nomura will put down the cash for the transaction, or if Nomura is merely structuring it for other institutional investors.

The deal is being handled with all the transparency BCV has become world-famous for. Nobody has seen a prospectus, offering memorandum or term sheet for the deal. That’s unfortunate, because repos come in a lot of varieties and the devil is always in the details. But one thing is clear: the regime is unbelievably strapped for cash and it’s willing to compromise the country’s future to get relief, even if costly and temporary.

Just last November, PDVSA borrowed dollars at an implicit interest rate of 21.7% when it swapped 2017 bonds for a new 2020 bond, guaranteed by a 50.1% stake in CITGO. A month later, Venezuela pledged the remaining 49.9% of CITGO to Russia for a $1.5 billion loan.

Add 50.1% to 49.9% and you’ll find that CITGO is now 100% mortgaged.

If sold at 40% of face value, the PDVSA 2022 bond would have an implicit interest rate of around 26% (which, if you’re keeping score, is horrific). If the Central Bank is not selling the bonds on the market, it probably thinks it can secure an interest rate of 26% or lower with Nomura’s repo. Still, the Central Bank has basically no leverage at the moment, so Venezuela will have to pay up if it wants the billion dollars: 12% a year, 18% a year, who knows? Again, without more information, it’s hard to tell.

Rest assured that it’s a terrible deal for Venezuela, though.

Venezuela’s counterparts will likely extract a “legality premium” from Venezuela to compensate for heightened risk.

This transaction won’t get congressional approval because the National Assembly is as good as dissolved. This, again, is unfortunate, because Article 312 of Venezuela’s 1999 constitution is clear: “The state will not recognize debts other than those contracted by legitimate state bodies, in accordance with the law.” I’m no lawyer, but from Nomura’s point of view, there’s a risk that future National Assemblies will say this repo agreement amounts to new debt, declare it illegal, and establish that payment of the PDVSA 6% 2022 bonds illegal by extension.

This suggests Venezuela’s counterparts will likely extract a “legality premium” from Venezuela to compensate for heightened risk, meaning the whole thing will be even more costly for Venezuela.

At this time, we don’t know what legal protections the Central bank would get if it (A) defaulted on the repo agreement in three years, or (B) if the value of the pledged bonds dropped below some critical threshold in the contract, say, $1 billion.

If Nomura simply keeps the bonds if the government doesn’t pay up (case A), then the government will have essentially received a meager $1 billion and have to pay $3 billion in five years (plus interest). The cashflows of this situation are either identical or slightly worse than selling PDVSA’s mystery 2022 bonds today at 40% of their face value: it means Venezuela issues debt at an atrocious (minimum of) 26% in dollars.

But it gets worse. Market insiders tell us that Venezuela could face a kind of “margin call” if the value bonds in the repo drop below a certain level. We won’t know for sure until we see the fine print, but is the kind of guarantee an intelligent investor in a deal of this kind would seek. In this scenario, if bond prices tank, Venezuela would have to hand over more bonds to be repurchased at a later date. If Venezuela failed to meet a margin call (i.e. hand over more bonds), it could be a default of the repo contract, which would have the same effects as described above.

This financing arrangement is dangerous and stupid.

If Venezuela gets a margin call and does hand over more bonds, it puts more assets on the line and risks making the consequences of a subsequent default on the repo contract even worse. In other words, it risks issuing more debt and making the atrocious 26% implicit interest rate described before yet more ludicrous.

It’s a mess.

This financing arrangement is dangerous and stupid. Venezuela’s economy is grinding to a halt under the weight of suicidal economic policy and a crushing external debt. Taking on new, crushingly expensive debts to kick the can down the road is senseless.

But who are we kidding? The status quo is firmly entrenched. Venezuela is in for at least two years of Chavista macroeconomic adjustment and more travesties like this repo are a near certainty. These guys are just warming up. Just wait to see what else they think up in 2017-2018.