Black Swan 2: This Is "The Next Critical Chapter In The Austrian Banking System Story"

When it comes to the sweeping of (trillions of) toxic assets until such time as the ECB starts purchasing not only government bonds but equities, bank loans and really anything else that in a normal world would have some "mark to market" value, Europe had a ready answer: bad banks. A tradition which started with Switzerland and the semi-bailout of UBS during the great financial crisis, "bad banks" have been proposed every time there are a few hundred billion in bad assets that need to be swept away or otherwise removed from the the public eye.

In fact, it was just a few hours ago that Spain's economy minister praised the usefulness of bad banks, which have certainly seen their fair share of use in Spain over the past 5 years.


Yes, useful. Until you have a massive blow up like in Austria when several years of avoiding reality exploded in everyone's face when the Bad Bank meant to fix the mess left after the collapse of Hypo Alpe Adria itself became insolvent, after the horrendous state of its balance sheet could no longer be masked, and creditors were shocked to learn they would foot the bail out, or rather bail in costs thanks to massive debt writedowns.

And since there is never just one cockroach when it comes to hiding Europe's biggest financial problem, namely trillions in non-performing loans, the question always is: which cockroach is next?

For now the answer, thanks to the ECB's relentless intervention in all capital markets is hiding, but one proposal comes from Daiwa Capital Markets which suggests to take a long hard look at Austria's Pfandbriefbank Oesterreich AG.

Here is what Daiwa's Jakub Lichwa thinks:

  • A relatively low-profile entity in Austria – Pfandbriefbank Oesterreich AG (Pfandbriefbank) – is becoming the next critical chapter in the Austrian banking system story.
  • This all started with the capital shortfall disclosure by Heta Asset Resolution AG (Heta), which prompted the Austrian Financial Market Authority (FMA) to announce on 1 March 2015 a moratorium on Heta’s debt securities, including €10.2bn of senior unsecured bonds guaranteed by the State of Carinthia. Carinthia has indicated that it does not have either the resources or will to honour these guarantees, which should be activated upon the bail-in or insolvency of Heta. This has sparked investor uncertainty about the broader guarantee framework in Austria.
  • Given Pfandbriefbank’s exposure to Heta, that moratorium has a direct effect on Pfandbriefbank’s standalone ability to repay nearly €600mn of bonds due in June 2015. As things currently stand, these can only be repaid if Pfandbriefbank’s own guarantees are invoked. If they are not, that will further undermine guarantee mechanisms in Austria, and possibly beyond.
  • The Austrian regional mortgage banks have publicly announced their commitment on 4 March 2015 to adhere to these guarantees, although the current trading level of senior unsecured bonds (PFBKOS 2.875 07/17) does not imply investor confidence in these assurances.
  • Nevertheless, the PFBKOS 2.875 07/17 bond is currently quoted at around 95 (z-spread of 583bps), a significant discount from the 108 (z-spread of 2bps) level seen prior to the announcement of the Heta moratorium, reflecting investors’ increasing doubts about Austria’s guarantee mechanisms.
  • The reaction from the rating agencies to the Heta moratorium has been more sanguine, suggesting that they believe that Pfandbriefbank’s own guarantees will be honoured. S&P sees no immediate effect of the recent events on the two related Austrian entities it rates, while Moody’s placed Pfandbriefbank’s A2 rating on review earlier in March, but did not downgrade it.

Daiwa's conclusion, ironically, after correctly calculating where the next major capital shortfall will be, reverts to the logic of the original Heta Asset Resolution bondholders, and assumes that all shall be well, and that this time, the government will not let the bank fail because the downstream effects will reverberate even louder and with far more dire consequences. To wit:

We are inclined to agree with the rating agencies that these guarantees will ultimately be honoured.

Fine, but keep in mind: there are those FX carry traders who were inclined to agree that the SNB would never drop its EURCHF peg, and were promptly carted out feet first when it did. And then there were those bondholders who also thought they would never be bailed-in to rescue Austria's Bad Bank. They too lost at least half of their investment.

In fact, the number of cases where investors go all in on a bet that some official public authority will not let them down, appear to be spreading very fast in the past few months. Which is why for any bondholders still long Pfandbriefbank bonds, the time to exit the dance-off is be now. Because when another shock announcement follows and sleepy Pfandbriefbank announces it is the next casualty of Austria's completely unexpected black swan, you will have nobody to blame but yourselves.

Full Daiwa Note:

Pfandbriefbank - Not Another Heta?

DetailPfandbriefbank is an issuing vehicle for its member banks (including Heta – the wind up entity for Hypo Alpe Adria Bank), with total assets of €5.6bn as of end-FY14, and very limited equity, given its business profile. The funds raised by the entity are channeled to its members and therefore Pfandbriefbank relies on the payment of these claims to service its own liabilities.

This reliance is strengthened by the Pfandbriefstelle-Act and Article 92 of the Austrian Banking Act, according to which members of Pfandbriefbank and their respective liable public authorities (Gewährsträger) are jointly and severally liable for all obligations of Pfandbriefbank. In an event of default, recourse against any or all of the member institutes and their respective liable public authorities is possible.

The members include: Hypo Noe Gruppe Bank AG (-/A/-, by Moody’s/S&P/Fitch), Hypo NOE Landesbank AG (-/A/-), Vorarlberger Landes- und Hypothekenbank AG (A2 RuRd/-/-), Hypo Tirol Bank AG (Baa2 RuRd/-/-), Landes-Hypothekenbank Steiermark AG (-/-/-), Salzburger Landes-Hypothekenbank AG (-/-/-), Hypo-Bank Burgenland AG (-/-/-), Austrian Anadi-Bank AG (-/-/-), and Heta Asset Resolution AG (Ca/-/-).

Pfandbriefbank has funded its activities via the wholesale markets, although it has not issued any bonds since 2007.

Pfandbriefbank’s bonds came into focus at the beginning of March following the announcement of the moratorium on Heta’s liabilities, whereby the Austrian Financial Market Authority suspended the interest or principal payments on some of Heta’s liabilities until 31 May 2016, with a view to drawing up a resolution strategy by then. The moratorium included €10.2bn of senior unsecured bonds guaranteed by the Province of Carinthia. Carinthia has indicated that it does not have either the resources or will to honour these guarantees.

Pfandbriefbank carries €1.24bn of exposure to Heta, of which nearly €600mn will come due in June 2015. By this date, the guaranteeing member states will need to agree and extend liquidity support to Pfandbriefbank AG or €5.6bn of its liabilities could come due immediately.

The Austrian regional mortgage banks have publicly announced their commitment on 4 March 2015 to adhere to these guarantees, although the current trading level of senior unsecured bonds (PFBKOS 2.875 07/17) does not imply investor confidence in these assurances.

In recently published research, Moody’s stated that “honouring of the guarantee obligations for Pfandbriefbank has limited impact on the federal states' risk-bearing capacity”. This suggests that what is in doubt is the willingness of the guarantors to act in line with their statement of 4 March, rather than the financial capacity of the guarantors to honour their commitments.

To our mind, therefore, there is a fundamental difference between the case of Heta, where Carinthia’s guarantee obligations threatened to sink the state financially, and Pfandbriefbank, where the guarantee obligations for the states are much less onerous.

Given this, and the potential contagion impact on trust in other guarantee structures if these obligations were also reneged on, it would appear more likely than not that that the guarantees provided to Pfandbriefbank will indeed be honoured. The current price of Pfandbriefbank’s bonds does not reflect that.

* * *

Until it does of course.