The sale of structured notes: What the Government giveth, the Government taketh away

July 31, 2008

According to today’s El Nacional, the Government has now extended the period for local banks to sell their structured notes for an additional 60 days, as the deadline of August 14th. is fast approaching. I understand that the El Nacional news is not precisely correct, but rather the Government is looking at banks on a case by case basis and has given extensions to specific banks of 60 and 90 days.

Thus, what the Government ignorantly decided in May, ordering banks to sell these notes that had been in the balance sheets for months under the eyes of the Superintendent of Banks, has been delayed and postponed, as the Government realized the implications of what it was doing.

Recall that banks had these notes denominated in Bolivars, but which were backed with dollars and dollar denominated instruments, bought in the parallel swap market when the rate was much higher. Banks had been doing this to hide their foreign currency positions, which were essentially illegal, since the law limits banks to having 30% of their equity in foreign currency.

If the Government had forced the banks to sell the notes, losses would have been significant and in some cases some banks would have gone bankrupt. Furthermore, the Government did not realize initially that some of these notes were backed by Venezuelan Sovereign bonds, which would force prices of these bonds down at a time when the Government wanted then to firm up.

Thus, we have fallen into the limbo that I was afraid the Government would lead us to: The tough decisions have been postponed, some banks will limp along and the possibility of things getting worse is still there.

Let me explain myself:

There is definitely a problem, as some banks, if forced to sell the notes would not survive, unless their owners put up the money to recapitalize them.The solution is simple, you have to figure out which banks survive and which ones don’t and simply go to the owners and ask whether they are willing or not to put up their money. If the answer is yes, they survive, if not the Government has to take them over, but it is all resolved speedily, no rumors can start swirling around and the system will be ok.

Instead we are now going to delay action, looking at cases individually and opening the way for rumors to affect the financial system. Such rumors may arise from the fact that the Government itself forced the banks to quantify their losses as of June 30th. and those numbers will be available before the next 60 days are over.

But what is most ridiculous is how the whole affair has been handled. The Government allowed the notes to be set up, then it decides to force their sale and then, uups, it backtracks when it realizes the possible consequences. Which simply confirms that the country is being run by a bunch of amateurs.

Even more ironically, the extension of the period is reportedly the result of the technical advise of the Government’s archenemy the International Monetary Fund, which was called in to give technical advise on the subject. I think the IMF should have made a more forceful recommendation and hopefully it will not turn into a crisis.

In the end, the losses are currently manageable as the country’s financial system is small compared to GDP, the whole system is worth around US$ 10 billion based on their sale value. But such financial crisis have an important psychological factor and an impact that goes beyond the numbers. In the end, the banks that will not survive today will only survive if the parallel swap rate jumped sharply to the levels where they bought, an unlikely event in the next few months. Otherwise, their critical situation is as bad today as it will be in sixty or ninety days.

Maybe the Government simply would like to push the resolution beyond the November regional elections, proving once again that politics is above everything in this administration.On the other hand this may have had a different purpose in mind, like taking over the financial system and the Government has had a change of mind. For now…

Thus, the same Government that giveth the order to sell the notes, taketh it away to protect itself, in another almost comical chapter in the way the Chavez Government manages the country’s financial system.

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