Austrian Banks Likely Next Domino in European Debt Crisis

At around 3 a.m. in Austria last Friday, as Londoners slumbered and New Yorkers trolled their city's bars and restaurants, an alarm roused the firemen of Vienna's main firehouse.

Across a tourist-favored plaza in central Vienna, less than 30 meters away from the firehouse, the former headquarters of Bank Austria were up in flames. Armed with hoses, the feuerwehrmänner fought the fire engulfing the 192-year-old neo-Classical building well into the daylight.

Like that gilded bank building, the wider Austrian banking system is ablaze -- singed not only by the heat of the Eurozone sovereign debt crisis, but also by the immolation of an Eastern European asset bubble the banks had been underwriting for a decade. Stumbling, contradictory guidance from the management of the banks has not helped, and a stalling Austrian economy is only likely to make things worse.

Truth and Consequences

Austria's banking sector is dominated by four main banks. Erste Group Bank (Vienna:EBS) and Raiffeisen Bank International AG (Vienna:RBI) are the main home teams, competing with smaller Österreichische Volksbanken AG. UniCredit Bank Austria AG, a unit of Italian financial powerhouse Unicredit S.p.A. (Milan:UCG) is also a major player.

When the European Banking Authority released the results of its annual stress tests in July this year, the leading institutions, shy of ÖVAG, passed with flying colors. But that rubber stamp of approval from the European Union quickly wore off.

On October 10, Erste Bank announced it had not accounted for its exposure to sovereign debt defaults during the stress tests. Instead of the €0 in exposure to government debt it had previously revealed, it was actually holding €2.8 billion ($3.7 billion) in credit default swap risk against sovereign debt (in other words, Erste was insuring that amount of government bonds against default). The exposure had already cost the bank €460 million, the bank noted. And, of course, it would cost much more if the situation in Europe worsened.

And the bad news kept piling on from there.

Four days later, ÖVAG announced it would be reporting an annual loss of between €900 million to €1.05 billion "depending on the development of the markets."

A few weeks after that, the European Banking Authority that had given a clean bill of health to Erste and Raiffeisen just a few months earlier was giving those banks a grim prognosis. RZB, the parent company of Raiffeisen Bank, would need to raise €1.9 billion by next year to meet capital requirements (that amount has since grown to €2.5 billion). Erste's own hole was €750 million and ÖVAG's recent losses had only added to its previously acknowledged shortfalls. The amount needed to plug Bank Austria's financing gap was reported under the wider €7.4 billion parent UniCredit S.p.A. needs to raise.

The day after news of the latest capital shortfalls began to arise, Erste Bank reported a third-quarter loss of €1.49 billion. Bank Austria followed a few weeks later, reporting on Nov. 14 that massive goodwill writedowns weighed year-to-date earnings to €4.5 million versus €723.5 million in the prior-year period.

Four days later, rating agency Moody's placed Bank Austria's debt on watch for a downgrade, on top of a previous downgrade on Oct. 6.

Raifeissen Bank reports quarterly earnings Thursday, but the Vienna equity market isn't holding its breath. Shares of Raifeissen Bank have dropped to as low as €14.60, close to historical lows of €14 for the bank and a far cry from the €40-range seen for most of 2010 and 2011. Erste Group Bank has also reached new bottoms, trading as low as €10.40 from a range of between €30 and €35.

Shares of ÖVAG are thinly traded on the Börse Stuttgart and are also at historical lows, while Bank Austria's Italian parent UniCredit has dropped to historical lows of 69 euro-cents on the Milan Stock Exchange, from about €2 earlier in the year.

Little Boxes on a Budapest Hillside

Billion-euro losses, capital holes and rock-bottom stock prices aside, the real horror is coming from a much larger, much costlier and much more unique phenomenon: the collapse of an asset balloon in neighboring Hungary and Romania that the Austrian banks had been pumping up for much of the past decade.

To understand how badly the banks were in on it, all that's needed is 35 seconds of time and access to YouTube.

In a recently uncovered Hungarian TV ad dating from 2007, Raiffeisen Bank unabashedly advertises its loans services to a demographic other lenders may have avoided in the past... the less than credit-worthy applicant.

The ad's punchline: "We don't care about your monthly wage. The only thing that matters is the property's value."

Suicidal lending standards on subprime loans are of course nothing new. But Raiffeisen and its Austrian competitors went even further than that, denominating these Hungarian loans in Swiss franc rather than the local fiorint, adding another level of risk to the loans -- if the Swiss franc suddenly rose against the Hungarian fiorint, tens of thousands would see their loan payments rise overnight.

Which is exactly what happened. Runaway inflation, fueled in no small part by the housing bubble the banks were promoting, caused a deterioration in the value of the local currency. From a time in the middle of 2008 when 141 fiorints could buy one Swiss franc, the cost of francs ballooned up to 254 fiorints, meaning a loan made to a homeowner in Debrecen in that time frame is now about 80.1 percent higher in cost. The €5.4 billion in franc-denominated loans given out by Erste, Raiffeisen and Bank Austria were now in peril.

The situation was similar in neighboring Romania, where ÖVAG went in head-first, opening 300 branches and setting plans in motion to open 250 more. Erste Bank and Austria Bank also have a significant presence in that country.

"They Can Go To Hell"

The deteriorating condition of the Eastern European mortgage market began having an effect almost immediately after the fiorint started losing value to the franc, but the severity of the issue was lost in the general chaos that prevailed in the last few months of 2008, following the collapse of Lehman Brothers. In the middle of the crisis, Austria approved a €100 billion bailout of its banks.

For more than a year after that, Eastern European home-owners defaulted on their loans. The banks took the hits, but foreign lending, particularly in Romania, was still good.

But then Hungary moved the goal post.

On Sept. 19, the government passed a bill allowing Hungarians with loans denominated in Swiss francs to pay off balances at an artificial exchange rate of 180 fiorints, 20 percent less than the actual exchange rate when the bill was passed (the discount is even larger today).

"It tells foreign banks that they can go to hell," Daniel Bebesy, an asset manager at Budapest Investment Management, told Bloomberg News, in a phone interview, the day the bill was passed.

And hell it has been indeed. After vowing to fight the legislation, threatening a credit freeze, and playing down the impact the new situation will have on their balance sheets, they have been reduced to taking massive "one-time" goodwill losses.

All Quiet on the Home Front

Now comes the collapse of the Austrian banks' last hopes -- continued lending in Romania and economic growth at home.

Austrian economic growth turned negative in September for the first time since 2010. An 18-month streak of increasing employment has come to a dead stop.

Furthermore, a cycle of expansionary monetary policy in Romania that began Tuesday with a rate cut is likely to further devalue the leu, and hence make franc-denominated loans less attractive.

In a wider sense, too, Austria is in peril of being swallowed by the larger eurozone crisis. Even though AAA-rated Austria is viewed by markets as one of the three strongest economies in Europe, it is decidedly the weakest of the strongest.

Too Little, Too Late

Some action is being taken. Tuesday, the country extended the short-selling ban various European nations have used to protect the stocks of financial companies being traded in their exchanges. Austrian regulators have also stepped up requirements on their banks, effectively forcing them to turn off the spigot on Hungarian loans and making them agree to early adoption of capital requirement rules other European banks won't have to abide by until 2019.

The banks have also extended their legal challenge to the Hungarian foreign-loan-repayment scheme, filling a complaint with the EU.

Yet many of the measures have the appearance of leaders struggling to close the proverbial barn door after the horse is out. The European Commission handling the complaint, for example, has given the government of Hungary ten weeks to respond, by which time the bulk of the repayment-scheme would have been completed.

Winter of Discontent

If Austria takes a turn for the worse, all bets are off. In lowering a country-wide credit risk assessment it had assigned to Austria's banking industry in early November, Standard & Poor's said it was worried Austria would not be able to fund the needs of its banks' international units in a bailout.

The possibility of a bailout is also in question because the funds might just not be there -- the banks have not repaid the monies from the bailout in 2008 and currently hold assets in excess of the national GDP.

As Viennese news sources reported last week, no one was injured in the Austria Bank fire. But there is no news what the carnage might be from the inferno in the banking sector. The winters are cold in Vienna and, when the blaze threatens to grow, the pipes might be frozen.