Give me honourable enemies rather than ambitious ones

Mint – Blain’s Morning Porridge  - February 25 2014

Give me honourable enemies rather than ambitious ones, and I’ll sleep more easily by night

Have we moved into a new market phase? Sure, the news is dominated by uncertainty about Ukraine, concerns on China and EM, and there are more than a few Cassandras shouting about asset bubbles… but generally, the underlying market going feels firm.

Last week we were market outliers – far more enthusiastic about global growth prospects than most of the street. Most commentators weren’t expecting much, while we held out some hope for positive surprises from the three prongs of:  North American trade - NAFTA, global trade and coordination - G20 and Pacific trade - Singapore TPP meeting. Unfortunately only G20 delivered any kind of push, with NAFTA proving a damp squib and the TPP meeting ending without agreement.

The thing is – it doesn’t seem to matter these hopes under-delivered. Markets haven’t been surprised, and have taken negative news in their stride. Stock markets remain positive. This morning stocks have shrugged off poor data and moved higher. Corporate credit spreads are back in at tight levels.

Excuse me if I go rain on the parade, but it all feels a bit complacent. I remind readers of rule 8 – “markets will seek to inflict the maximum amount of pain on the maximum amount of players.”    

From the macro, let us return to the micro to try and figure out what has been going on in the Austian town of Klagenfurt… 

Hypo Alpe Adria (HAA) never ceases to surprise. Yesterday Moody’s downgraded the bank’s covered bonds because of the “lack of transparency towards their future positioning in case of HAA’s resolution”. The bank itself is now chasing former owners and executives for the return of €50m of “special dividends” paid prior to its sale to Bayerische Landesbank. The bank says they “falsified” the bank’s 2007 balance sheet.

HAA is a fascinating saga on so many levels. Yet, despite rumours of imminent bad bank take-out, a possible coercive tender offer, the uncertain slide in bond prices, unparalleled stupidity, and the fact that unhappy Austrian tax payers are furious it’s still a mess after they have sunk over €4.8bn into the bank for no apparent gain.. HAA bonds may still be a hold/add.

New bail-in rules and ending “too-big-too-fail” bank culture should have put HAA into resolution years ago. But no - the Austrian government agreed to nationalise the bank in 2009 and guarantee much of its debt. Underlying the decision was the importance of the bank to its region, meaning its importance for local politicians (then holding up a coalition national government). Politics and banks remains a concern across Europe that shows no sign of going away.

Now we have unprecedented conflict at the highest levels of Austrian finance and politics:

Central banker, and ECB stalwart, Ewald Nowonty, has said the bank should be protected by the state to avoid damaging Austria’s financial reputation. Following the resignation of bank head Klaus Liebscher last week – who was put in to resolve the crisis – Nowonty will now be overseeing the bank’s future.

Yet, finance minister Michael Spindelegger is on record saying investors who’ve speculated by buying discounted HAA paper should be burnt. He is playing to his political audience of Austrian voters, staggered by the unending costs of sustaining HAA.

There was serious behind the scenes conflict between Spindelegger (trying to score political points) and Liebscher (trying to do his job). In his resignation Liebscher warned about the political opportunism of punishing bondholders as likely to cause “international investors to raise doubts about Austria and its reputation as a financial centre”.

It really doesn’t help that central banker Nowotny is also blaming HAA auditors for failing to spot the ongoing problems. He said: “I believe the main problem was simply that many of the balance sheets weren't right and the valuations weren't right…that is a process where the central role lies with the auditors." Auditors: take note when valuing the “held in the banking book assets” of banks across Europe.

Unfortunately, it’s not a simple case of just honouring guarantees. Austrian state guarantees will no doubt be honoured, but the Austrian Lander of Carinthia has given a “deficiency guarantee” over €15bn of debt, meaning it will pay only when all other avenues are exhausted. However, Carinthia is all but bankrupt itself. There is no mechanism for the Austrian state to assume the Carinthian guarantee. But if Carinthia goes bust, then the Austrian Federal Constitution envisages the Federal government and other Lander would discuss a basis for “mutual consideration.” (Article 42(5) of the constitution since you ask.)

Messy.

And there is the red herring of going back and suing Germany’s Bayerische Landesbank. When it realised the scale of losses and the political mess around the bank it simply walked away. Spindelegger has got the idea he can force them to pony up cash – despite the fact the bank itself now admits the 2007 numbers were wrong?

What are the likely outcomes? The lack of resolution and ministerial level conflict at the heart of the HAA saga is now seriously damaging Austria’s financial reputation. To simply guarantee all the debt will placate investors, but royally upset Europe. The most likely alternative to simply paying off investors is to haircut the questionable debt around 33% via a coercive tender offer – even though Austria currently has no bail-on legislation. Hedge funds are bound to game such an offer – making it even messier.

We don’t think it’s a binary toss-up. More like heads you win, tails you may lose 33%. We reckon the likelihood is the Austrians simply make the problem disappear without further damaging their financial system. It doesn’t say much for the European regional bank systems. However…we might be being over enthusiastic.. again.

Worrying news from Scotland. One of the great hopes for Alex Salmond’s independent Scotland will be its world class financial sector. Yet this morning I read some the largest firms including Baillie Gifford, Standard Life and others are making “prudent preparations”. We understand contingency plans are being made to address points such as the absence of currency union, the threat the SNP may target higher tax payers, lack of double tax treaties, and a potential talent drain to England. The easy answer is to move south.

Time to buy property in Newcastle? 

 

Bill Blain

0207 786 3877

[email protected]

[email protected]

 

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