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.

15 COMMENTS

  1. Good article.

    Frank, what is your view on Nomura’s ability to do transactions with the collateral? Do you think they can issue credit-linked notes to investors on the back of holding the 6% ’22 (potentially hedging the risk and earning fees in the process) or that they can’t actually touch the collateral at all? Moreover, you mention that the value of the bonds might drop and the republic may face a margin call. But these bonds have never traded in the market, so where is the quote for that valuation going to come from? And then again, it goes back to my initial question, what ability may Nomura have to do transactions with the collateral? If the terms of the transaction allow for it, they may sell some of those in the market (effectively being short on these) but then they would have to hand them back in 3 years’ time…So…

    I agree that details are scarce. But don’t think other central banks in the world would provide much more details about some of their trades either…This is a separate topic though.

    By the way, I love the “dibujo libre” reference…Took me back in time quite a few years! Refreshing.

    • Thanks! What Nomura can do with the collateral will depend on the fine print of the agreement. I suspect that Nomura (or the actual investors behind this deal) will NOT be able to sell the bonds into the market during the three years. That’s the impression I got from the Reuters piece, which states that BCV officials don’t want to dump more paper into the bond market. However, the agreement might have some clauses that allow the 6% 22s to be sold under certain conditions, like a failed margin call, or a drop in value of x%, for example. We don’t know at this point.

      Pricing the bond isn’t too tough because the Pdvsa 6% 2024 bond is almost identical. It just matures two years later. And you have the rest of the yield curve with which to infer pricing. Any valuation would be inexact, but as long as a specific formula is stipulated in the contract, I don’t see that being a problem.

      • I agree. Yes you can price it, and in fact you can find pricing for it (currently ~43% from two sources), however, there are no trades at that price and I don’t think there has ever been one (presumably because the BCV was holding them all along). So I would argue that it is not a reliable source of pricing for the purposes of enforcing a margin call unless it becomes a widely trade bond (which probably won’t happen because as you mentioned, the BCV officials’ initial is not to dump the paper into the bond market).

        What seems clear to me is that the reason why this bond started being quoted back in March’16 (back in the times when Bloomberg released the embarrassing article about a mysterious bond which in fact was no mystery as Bloomberg themselves had previously published an article on this bond when it was issued) has something to do with the actual swap. Perhaps some regulatory requirement or an operating requirement so that the transaction can take place. Who knows…

  2. Excellent piece, Muci.

    Following on the speculation regarding the likely form of the deal, I suspect that Nomura would seek to hedge its exposure to the repo through two (probably not mutually-exclusive ways):

    1. Hedge credit risk (via buying CDS / selling CLN to hedge funds for example)

    2. Hedge mark-to-market risk (via a clause in said CLNs that ensures Nomura transfers the price risk of the bonds in case a particular threshold is breached).

    I’m imagining a structure on which Nomura can deliver the bonds to the risk-taking party at an agreed-upon price in case shit hits the fan.

    We are deep into The Big Short territory here, that’s all we can be sure at this point…

    • “We are deep into The Big Short territory here, that’s all we can be sure at this point…”

      Look, I’m far from a finance guy but not entirely ignorant of that world either. By the time I stop understanding even the broad outline of what the government is doing, I have to agree we really are deep into The Big Short territory…

  3. Yet another reason to take those criminals out of power as soon as possible, by any means necessary.

    Also, about this part:

    “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.”

    The AN would do something useful broadcasting this piece of law, instead of making the sterile and useless statements they have been doing for the past year.

    • Understand that law firms have been getting a lot of questions from offshore and or international financial entities regarding validity of public financial transactions lacking in National Assembly approval ….and that so far responses from these firms have been almost universally dubious ……!!

      Apparently govt officials are recognizing privately , that the lack of an AN approval is hindering the regimes search for new financial resources from many prospective lenders…..

  4. Why not just pay GRZ the settlement funds & costs $240 M to obtain the mining data asap.Rush to get mines in operations,use future gold as payment to satisfy the bond holders.I realize it is a race produce gold before they default.They,errored in their ways & now must realize produce gold @ $200 all in costs make it viable.Ven.. can not rely on just oil as their only source of income.If they come clean with GRZ,Other international companies will also take the risk & invest in Ven.. too.

    • Mining is controllod by pranes and corrupt military oficials, to give mining to ANY company in a formal sense is asking for plomo, thats a risk a normal company would be scared of. It’s like Africa and blood diamonds

  5. Who, in his right mind, would accept bonds of dubious legality from a country sliding on the express lane to the status of failed state?

  6. A favourable forecast of oil prices is key for Pdvsa or Govts ability to obtain any additional financing , after Opec decided to lower production to increase prices these have risen , specially after it appeared this january that Opec countries were indeed sticking to their production reduction deal , it now appears that opec production has fallen this january not because all Opec members were abiding by the deal but because the Saudis were lowering their production beyond their formal commitments to make the market believe that the deal was a success …… The actual fact of the matter is that other countries have not been lowering their production as promised and that Saudis sacrifice of revenue resulting from their lowering their production more than expected is something that hurts their finances badly and which they cannot sustain for more than a couple of months. this means that in a few months time production will rise again and force a fall in oil prices to somthing closer to their former levels …this is bound to make any future Venezuelan financing less attractive , much riskier than perhaps expected…..!! Lets not forget the big debt payments due this april , where the money is going to come from to make these payments is a mistery ….april is the month to watch . and if somehow payment is made …the next bit hurdle is next october …..!! were in for a wild joyride for sure …!!

  7. […] The government’s attempt to source creative financing backfired, as it looks like whomever was on the other side of the negotiating table got scared by the uproar in the international community of the move. It was just too brazen: striking an elected branch of government in such circumstances. In fact, according to opposition MP Rafael Guzmán, that was precisely the reason Japanese investment bank Nomura scrapped its alleged plans for a multi-billion repo operation with the Central Bank. […]

Leave a Reply