Just as we think things are getting stable in the rest of the world, Austria has fallen into a strange situation. There was a bank, Heta. It failed. Six years ago.
And when it did, its bonds were guaranteed by the province, Carinthia, which now has to pay back around 11 billion euros worth (Bloomberg) After years of status quo, the province has offered 75 cents on the Euro for the senior bonds (and 30 cents on the junior bonds) to the creditors. Meaning, people who’ve given them 100 euros should settle for 75.
Tower in Carinthia
Except they’re not happy. Carinthia gave a guarantee, one that the Austrian government too said was as good as sovereign debt, and therefore they should make good that obligation, say the creditors, which are largely German banks. They’ve rejected the deal, and the group that’s vocally done so owns 5.5 billion euros worth of bonds which can stymie any forced deal (which needs 2/3rd or more of bondholders to accept).
Apparently, Hans Joerg Schilling, the Austrian FM, has tried to sweeten the deal by offering bondholders Austrian bonds that mature in eighteen years at a discount. The Zero Coupon bonds currently would trade at a yield of 1%, which means a price of about 82 cents to the dollar (since you don’t get paid interest, it’s built into the price). The bondholders are being given an option to buy at 75 cents.
So people that are owed EUR 100 by Heta, which are supposedly fully guaranteed by Carinthia, get EUR 75 only. Then they have to invest that $75 into 18 year bonds freshly issued. These bonds CURRENTLY trade at 82 cents, but obviously if you bring in so 11 billion EUR of such bonds into the market, they will not trade at anywhere close. The trading price of 82 cents is based on a 1% interest rate – for 18 years. If they trade at 1.4% instead, that’s a price of 75 cents instead.
(A deep discount bond trades at lower than face value. If I wanted to borrow for a year at 10%- I could do two things. take Rs. 100 and pay Rs. 110 after a year, or, take Rs. 90.9 and return Rs. 100 after a year. The first one is a regular bond with interest paid out. The second is a deep discount bond of Rs. 100 that I allow someone to buy at Rs. 90.9. The more years you have remaining in the bond, the lower the price is, to reflect the interest over the larger time period).
Or, they could keep the bonds for 18 years to recover 100% of their money. This sounds very stupid – to wait for another 18 years to just get back what you should be getting now!
Our View: Fraud Moral Hazard, and Sovereign Reassessment
Deutsche Bank and others are taking the view that this is a default. The default means that they get to attach Carinthia’s assets – not just Heta’s – after the default, since Carinthia is a guarantor. Unfortunately, though, this will go through courts, and by the time this is resolved, more time (and lost interest for that time) will pass.
Why would banks not accept this? After all 75 cents is greater than zero, or having to wait for a long process. And it’s greater than the 50 cents they have to value these bonds at today, because the ECB has told them that’s the valuation now, and if they recover more it’s a gain.
The answer is: Whoa, what happens to my other bonds if we do accept. If this acceptance becomes a precedent, all close-to-bankrupt but apparently sovereign guarantees will offer 75 cents to the dollar or 18 year discounted bonds, and that means banks will have to write down a lot more. Earlier, Banks were the recipients of moral hazard – i.e. if we bail them out, they will think they are invincible and do even more stupid things – and now they are backing off from deals because they don’t want to be on the other side of moral hazard. That’s rich. But that’s banking for you – as hypocritical as you can imagine. And many times, more.
Our base view is this: If you can’t print your own currency, your sovereign risk is much higher than what we think of as “sovereign”. And then, if you’re just implying sovereign guarantees, you have FULL risk. Indian rupee debt is sovereign. There is no way India can be forced to default of rupee debt. But Indian banks – even the public sector ones – can default on their bonds. The government’s “implicit” guarantee is simply not going to protect bondholders. And indeed, the government has been a defaulter even when people assumed it had guaranteed a bond. If the Indian “sovereign” risk isn’t beyond risk, then there is no way that you will say “low risk” bonds for an Austrian bank, guaranteed by an Austrian province, which is only implicitly guaranteed by the government of Austria, which cannot even print Euros by force because it’s part of a union of multiple countries.
The markets are underpricing risk severely, and the Euro is the biggest example of where sovereign risk is going to suddenly become high-risk from now on. Heta is just the beginning.
