A Billion Here, A Billion There …

A Billion Here, A Billion There …

We always wondered a bit why the Austrian government was so eager to adopt the EU’s bail-in law (a.k.a. the Bank Recovery and Resolution Directive) one year earlier than demanded by the EU Commission. What was the rush? Well, now we know. Last year, the decision to wind down the former Hypo Alpe Adria (HAA) “in an orderly manner” helped push Austria’s government debt above 87% of GDP – a level perilously close to what has so far in many cases proved to be the point of no return.

 Heta Asset Resolution, formerly Hypo Alpe Adria International: The situation is hopeless, but it isn’t serious …

Image credit: fmh

This decision was not exactly unanimously welcomed in Austria, but the government found itself between a rock and a hard place. Credit rating agencies are busy downgrading banks across euro-land, as government support assumptions are revised in light of the EU’s bail-in directive. Austria’s banks however have come under special scrutiny. This has of course absolutely nothing to do with the country’s government sometimes appearing to be sympathetic to evil Uncle Vlad in Moscow (it signed the South Stream agreement and occasionally one of its representatives will bemoan the utter uselessness of the sanctions regime). Honni soit qui mal y pense!

5-year CDS spreads on two large Austrian banks: Erste Group, one of the better run outfits (its management e.g. had the eminently good sense to sell its Ukraine business in 2012) and Raiffeisen, the international arm of which has recently been under great pressure as large losses in its Eastern European divisions have piled up. The market may actually be a bit too sanguine about the latter

There are in fact more than enough legitimate reasons to be wary of the creditworthiness of some of Austria’s banks. Among the reasons why they have suffered especially from the credit agencies’ wrath is their large exposure to Central and Eastern Europe (great during boom times, but a millstone in times of crisis), as well as the shenanigans surrounding the aforementioned HAA.

The HAA problem in a nutshell: the state of Carinthia, one of Austria’s federal provinces, had liberally garnished the bank’s bonds with deficiency guarantees. Both its senior debt and a portion of its subordinated debt was thus immunized against default – or so it seemed. Unfortunately, Carinthia never had the money to actually pay out on its guarantees, which amount to a multiple of its annual budget. The credit rating agencies complained that since the guarantor was evidently unable to pay, they would very closely scrutinize how the federal government handled the question of these guarantees.

The government thereupon attempted a compromise solution: the subordinated creditors would be bailed in, and their guarantees were declared worthless by law (a special law for the wind-down of HAA was actually adopted). However, in order to placate the rating agencies and save at least a small shred of the reputation of provincial governments, it was decided to honor commitments to senior creditors in full. This proved a costly decision, as HAA wasn’t just a normal bank insolvency case. Rather, it was a total catastrophe.

Not surprisingly, there are suspicions that a sizable portion of the bank’s lending activities in South-Eastern Europe was actually fraudulent. The government has tried its best not to let any too detailed information about the bank’s assets emerge, but some have leaked out anyway. A certain Mr. Pointner, who regularly publishes such details on his website, has been threatened (along with his ISP) with draconian legal measures by the bank’s legal successor Heta. He has happily ignored these threats so far and keeps posting whatever he learns about the bank’s former activities.

The steep decline in the value of the HAA’s assets was already quite stunning before the most recent revelations. It looked as though the bank had simply thrown billions into a black hole – it was money evaporation on a truly grand scale. Since it is known it inter alia did business with the Macedonian drug mafia(presumably for money laundering purposes), it is not too far-fetched to assume that a lot of money was simply stolen. Add to this the fact that even the legitimate business of the bank was apparently characterized by atrociously bad lending decisions, and the end result is said money evaporation. As the saying goes, the bank’s funds were basically Corzined.

Aaaaand it’s Gone! Marking Assets to Market

In recent months the bank’s assets were once again reviewed, after the sale of one of its subsidiaries unexpectedly resulted in the disappearance of a few billions in previously stated book value. HAA’s board apparently determined the valuation of assets on its balance sheet in a manner that seemed politically opportune following its nationalization, rather than employing strict accounting principles.

The result of the review was that another estimated EUR 5.1bn. to 8.7 bn. have to be written down. It seems Heta was simply getting close to the point where it was running out of money to service debt redemptions. The Austrian supervisory authority has now taken over the entity, and its first act was to impose a moratorium on payments in line with the new bank resolution directive. However, it craftily didn’t file for the bankruptcy of the clearly insolvent company.

The reason for this is that a bankruptcy of Heta would be shortly followed by the bankruptcy of the state of Carinthia, as the guarantees on Heta’s bonds are only triggered if Heta actually goes bankrupt. No bankruptcy filing, no legal way of demanding payment of the guarantees. Neat, isn’t it? Meanwhile, there don’t even exist any legal provisions for the bankruptcy of a federal state in Austria, so it is evidently considered the kind of mess the government would rather avoid.

An HAA perpetual bond issued in 2004 is trading at EUR 1.14 these days (down 98.86%)

Austria’s government, in line with the new bank resolution law, has resolved to no longer fund Heta’s shortfalls, which is actually a wise decision. Why should taxpayers continually bail out those who have voluntarily and foolishly lent money to overstretched fractionally reserved banks? This means however that senior creditors, regardless of their “guarantees”, will now be “bailed in” as well. An avalanche of law suits is certain to swamp Austrian courts shortly.

What strikes us as even more interesting here though is why such a big additional asset impairment has occurred. According to reports in Austrian newspapers (see e.g. here – as far as we can tell, this is reasonably intelligible when using the Google translation function), one of the major reasons for the additional write-downs were huge losses on the CHF-denominated loans HAA has extended in Eastern Europe. These assets were on the books with a value of €2 billion, which has now been restated to a mere €300 million – a loss of 85%.

If there is such a big problem with CHF loans specifically, one is left wondering what the situation for other banks is. Readers may recall that when Raiffeisen International recently went on a PR offensive to calm the nerves of rattled investors, it stated quite clearly that it didn’t expect its CHF assets to become a big nuisance, in spite of the SNB’s decision to chuck the CHF-euro peg. Evidently though, the Swissy has become a rather big problem for Heta.

We are therefore asking ourselves to what extent this is symptomatic of CHF- denominated lending to Eastern Europe more generally. If other banks were forced to take similarly sized write-downs on their CHF exposure in Eastern Europe, the numbers would become rather formidable (see some previous thoughts on the topic: “The Fat Lady is Clearing Her Throat” and “Poland’s Government to Reset Swiss Franc Mortgages”).

Potemkin Village

An important point is that the wind-down entity Heta is now valuing its assets according to their actual market value. In other words, something that banks as a rule are no longer doing since the 2008 crisis, namely marking assets to market, has just been done in this case.

This indirectly tells us something about the fact that the global banking system – and especially the European banking system – remains at least in part a Potemkin village of largely fictitious values. Naturally, if all assets are carried to maturity (the assumption being made in the absence of marking them to market) and debtors actually pay up, then there is no problem. However, all of this highly dependent on market confidence. The very moment concerns about the true market value of assets on bank balance sheet are resurfacing, the current happy “nothing can go wrong” consensus will evaporate as fast as HAA’s assets.

How fortunate then that true money supply growth in the euro area has accelerated to more than 11% year-on-year as of January 2015, according to a just released ECB update:

Euro area M1 (= currency and demand deposits = TMS), with the y/y growth rate in blue

Reality usually takes a backseat when the money spigot is open this wide (note that this still doesn’t include the purchases of the newest ECB “QE” program!). However, such huge money supply growth is certainly not without its pitfalls – it simply allows the underlying problems to fester and grow without anyone noticing, as more and more capital malinvestment is piling up. It can also not be continued forever, as that would eventually lead to a loss of confidence in the currency itself.

Conclusion:

The system is probably in far worse shape than is currently widely assumed. The ongoing collapse in the value of the former HAA’s assets seems to us symptomatic of a more general problem. When and under what circumstances it will become more clearly visible we cannot say – but we are certainly taking the HAA revelations as another warning sign.

Charts by: Bloomberg, ECB