Bank collapse in Austria brings debt in Eastern Europe center stage

In the links yesterday, I pointed to an FT article detailing the Austrian government’s nationalization of the insolvent bank Hypo Group Alpe Adria (HGAA). The financial institution, which has 40 billion Euros in assets, is the country’s sixth largest bank. But, in relative terms, this is a very large bankruptcy – using GDP at purchasing power parity, an American HGAA would have assets of $2.5 trillion, larger than any of the American banks. So, this is a very big deal and it points to renewed risks in banking and the possibility of contagion.

HGAA is considered a subsidiary of the troubled German state-controlled bank of Bavaria BayernLB.  Just last month BayernLB pointed to trouble when it reported a huge loss over 1 billion Euros for the second quarter running. The trouble: HGAA.

The FT reported at the time that:

HGAA would report a significant loss for the year and a capital injection for its subsidiary would be unavoidable, BayernLB said. The bank warned it would take a goodwill impairment charge at the end of the year on the value of its HGAA investment.

“Increased risk provisions and the expected impairment at HGAA will weigh significantly on… earnings in the fourth quarter. It is not yet possible to quantify it exactly, but it can be expected that as a result of these effects, the group will report a loss of well over €1bn,” BayernLB said in a statement.

The problems are the latest sign of how Germany’s Landesbanken – regionally owned public banks – have been thrown off course by risky attempts to boost profits by diversifying away from their core regional lending activities. BayernLB lost more than €5bn last year after writedowns on its huge stock of toxic assets, forcing it to seek a bail-out from the Bavarian regional government.

The bank’s purchase of HGAA in 2007 is already the subject of an inquiry by Germany state prosecutors, who are considering whether the former chief executive of the German bank committed a breach of trust by paying too high a price for HGAA.

Along with other Landesbanken, including HSH Nordbank and WestLB, BayernLB is reducing the scale of some of its foreign ventures. Michael Kemmer, chief executive, said the “more focused business model” was improving the bank’s performance.

This is what is commonly known as reckless lending and it happened in spades during the boom in Eastern Europe. Most of the actors are banks in Scandinavian and German-speaking countries.  HGAA was most exposed to the former nations of Hapsburg empire, with the Balkans in first place on that list.  The purchase of HGAA by BayernLB even after a global housing bubble had popped needs investigation and reminds me of the flyer taken by Hypo Real Estate in Ireland via its purchase of Depfa. And the fact that two large German institutions increased international exposure into Austria, the Balkans, and Ireland at the top of the market demonstrates the laxity in banking regulation globally.

The fact that the HGAA bankruptcy is happening now should remind you of the Dubai situation again.  When the crisis there first struck I talked about exogenous shocks and contagion, saying:

But now that Dubai is back in the news, I have looked back in my archives to see what (if any) links I have had on the situation in the country. The last two were in April about developers defaulting and in May about an S&P debt downgrade. Since then – as the global equity markets have turned up – nothing.

What does this tell me? First and foremost, it hints at the fragility of this recovery and the real risk exogenous shocks pose.  We are barely recovering now and a lot of debt and unemployment put us at stall speed, making the risk posed by events of this nature that much greater.

More importantly, however, the Dubai World events underline the unpredictability of exogenous shocks. All of these potential crisis situations — dollar carry trade unwind, debt crisis in the Baltics, oil price spike, an unexpected surge in interest rates, war in the Middle East — are still there lurking in the background. We don’t see coverage in the press on them everyday, but they are still there.

I have been optimistic about the near-term prospects for the global economy in large part due to the myriad pro-cyclical effects of recovery. Longer-term, however, there are some serious obstacles to a sustainable recovery.  This is not a garden-variety recession and recovery. It is a recession within a longer-term depression.  And while we are in a technical recovery, I believe much of the fundamental problems which triggered this downturn are still there, lurking. The debt troubles at Dubai World bring this point home.

[emphasis added]

The first signs of Dubai contagion popped up in Greece and Ireland because of similarities to Dubai regarding mountainous sovereign debt problems. Now that we have this rather large bankruptcy in Austria, we can talk about further contagion. Looking back in my archives at Austria this time, it has been a long time since I have discussed the banking situation in Austria.  It was most critical in the December 2008 to March 2009 time frame when we were in serious crisis mode.  Below are the posts I wrote relating to that topic.

• Is this Austrian real estate company a canary in the coalmine? – Dec 2008
• Austrian banks have emerging-market financial exposure that is 70% of GDP – Jan 2009
• The Eurozone and the spectre of banking collapse – Jan 2009
• Peer Steinbrueck says Germany might bail out the Austrians – Feb 2009
• The European problem – Feb 2009
• While Rome Burns – Feb 2009
• EU planning 200 billion euro package for Eastern Europe – Feb 2009
• The EU promises to bail out eurozone members – Mar 2009

That’s it! As with the situation in Dubai, it was radio silence until the Dubai World panic.  The most telling statement in these posts is this one which comes via the Vancouver Sun about comments by International Economy magazine’s David Smick:

Internationally, Smick said export-dependent developing countries, and the western banks that financed their growth, are particularly vulnerable.

“If too many of these emerging markets go down, the IMF (International Monetary Fund) lacks the necessary resources to mount rescue operations,” writes Smick, author of the 2008 book The World Is Curved: Hidden Dangers to the Global Economy.

“To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria’s GDP is only $370 billion.”

As in the U.S., the critical thing in Eastern Europe is maintenance of asset prices underpinning this financial exposure. There is zero chance Austria will survive a further collapse in asset values in Eastern Europe without EU or IMF support.  This is the major reason central banks are flooding the system with liquidity.

Now, if the Dubai contagion does result in renewed weakness in asset prices, then I may have to eat my words about how unlikely it is that Ireland or Greece leave the Eurozone. My comments from last January on Ambrose Evan-Pritchard’s Euroscepticism are still my thinking today:

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

Update: No post on banking in Austria is ever complete without reference to Creditanstalt’s 1931 bankruptcy as the trigger event for the global banking crisis which gave the Great Depression its ‘greatness.’