The 1st of March the Financial Market Authority of Austria imposed a moratorium on the debt repayments of a “bad” Austrian bank, HETA. Despite having been largely ignored by the media, like the butterfly flapping its wings, this decision is setting off storms well beyond the Austrian mountains.

Where do “bad banks” get born?

HETA was born from a rib of the Hypo Group Alpe Adria (Hypo). Hypo is (or better, was) the 5th largest bank in Austria. It was based in the Austrian Lander of Carinthia and until 2007 it was majority-owned by the Government of Carinthia. In May 2007 Carinthia sold the majority stake to BaynerLB a German Bank, owned by the Lander of Bavaria, for EUR 1.6 Bn.

BaynerLB investment in Hypo turned out to be as wise as buying the Titanic on the 13th of April 1912, the day before it sank. Hypo was an overblown bank that between 2000 and 2007 had pursued an aggressive expansion in the south and east of Europe. Its balance sheet went from slightly more than EUR 5 Bn in 2000 to over EUR 30 Bn at the end of 2006 and increased again, under German control, to over EUR 43 Bn before going belly up in 2008. In other words, the balance sheet of the bank increased by 760% in less than 8 years. The size of its activities at their peak equalled some 15% of Austria’s GDP. The last small positive profit was posted in 2006 and as of 2007 the bank was already losing money.

More than half of Hypo lending activities took place in Italy, Slovenia, Croatia, Bosnia and Serbia. The reckless lending practices coupled with the unfolding of the financial crisis meant that the share of non-performing loans held by Hypo skyrocketed and the bank, soon after being acquired by BayernLB, needed a recapitalization of about EUR 2.1 Bn, which were provided by the German mother company.

As losses began to pile up, BayernLB was forced to abandon ship. The German bank sold to the Austrian State its stake for a symbolic amount of 1 euro in 2009, effectively making more than EUR 3 Bn losses in just 2 years of ownership. The Austria Government nationalized Hypo by purchasing the remaining shares and then started restructuring the bank. It is estimated that about EUR 5.5 billion of public money have since been pumped into the bank but this did not prevent its total collapse which was acknowledged in 2014 with the establishment of HETA, a bad bank supposed to wind down Hypo impaired assets.

HETA is now managing what is optimistically estimated to be 19 EUR billion of former Hypo’s assets. While two branches of the former Hypo Group have been sold already.

More “idiots from Düsseldorf”

And just when you think it could not get any worse, it actually did. At the end of February an asset evaluation review of HETA was concluded and the results revealed additional losses of about EUR 7 to 8 billion which would require additional capital injections. The Austrian Government refused to provide the funding to HETA and this triggered the decision of the Austrian Financial Market Authority (FMA) to impose a halt to HETA debt repayments. The decision affects some EUR 11 Bn of HETA debt and the moratorium on repayment should last until May 2016.

The decision of the FMA has for the time being spared the Carinthia’s regional Government from going bust. The Lander is, as a matter of fact, legally obliged to guarantee a large portion of the bank’s liabilities, estimated at around EUR 10 Bn. Given that the Lander’s yearly budget is slightly more than EUR 2 Bn, should the guarantee be activated it would bankrupt the region and require the intervention of the Austrian federal government.

The FMA move therefore is shifting the losses onto HETA’s creditors that appear to be mainly placed in Germany. Local and national German banks are estimated to have a combined exposure to HETA of about EUR 4.5 Bn with none other than BayernLB exposed for more than EUR 2 Bn. It is worth noting that almost all the concerned German institutions are publicly-owned creating an additional layer of contingent liabilities for the German taxpayers.

But this is not all. The refusal of the Austrian government to foot another bill and the consequent action of FMA may be seen by the general public as sensible way to lift the burden from ordinary taxpayers. This “bail-in” of the creditors is foreseen by the new EU legislation on banks resolution but it is frowned upon by the banking sector. The reason is simple: without State guarantees many of today’s European stressed banks may be viewed as increasingly shaky by investors which could start withdrawing their money, hence reinforcing the vicious circle.

Moody’s, the rating agency, reacted to the FMA provisions by downgrading the ratings of other Austrian banks which are backed by State’s guarantees, now more theoretical than ever. This could involve up to EUR 50 Bn of liabilities held by Austrian institutions, according to Barclays. Moody’s also downgraded the ratings of the government of Carinthia and will most probably review downwards the ratings of the intricate network of German banks and Landers which are heavily exposed to the Austrian banking sector.

For example, there is small but important mortgage institute in Düsseldorf, Düsseldorfer Hpyothekenbank, with a core capital of about EUR 233 Mn that is owed by HETA something around EUR 348 Mn. The bank has lending activities for about EUR 11 Bn. The Fitch rating agency has given the bank the lowest possible grade above insolvency.

This brings to mind the answer that an American investment banker gave to financial journalist Michael Lewis when asked: “Who was on the other side? Who was the idiot?” (ie. who was buying your dodgy financial products, such as the subprime-backed obligations). “Stupid Germans. Idiots from Düsseldorf” was the reply.

The elephant in the room

The story of the collapsing Austrian bank tells us something really important: the losses are here to stay. If they will be allocated to the public sector, taxpayers will foot the bill via bail out. If they will be forced onto the creditors, via bail-in, the chain reaction will be unpredictable, it may bring down other financial institutions and it will bear eventually once again on State’s budgets which are always, implicitly or explicitly, liable for their financial institutions.

In this newsletter we have often insisted on the need to look at the European economy as one inextricable web of feedback loops. Unlike many other commentators we have carefully avoided morality tales where virtuous countries are opposed to vicious ones. This time is no different. The massive exposure of Austrian and German banks to “peripheral” EU countries is nothing else than the financial counterpart of the huge trade imbalances that have developed prior to the crisis in the EU, and in the Eurozone in particular and which we have extensively covered in previous articles.

By creating a narrative whereby some countries have been blamed for their profligacy while others praised for their rigour, the European policies have forced all of the adjustment only on the deficit countries, under the illusion that it would have been sufficient to ignore the elephant in the room to make it disappear.

Today the elephant is back with a vengeance.