Austria's folly and Juncker's madness
Earlier this week, Austria’s “Independent Commission of Inquiry for the Transparent Investigation of the Events Surrounding the Hypo Group Alpe‐Adria (HGAA)” reported its findings. They make grim reading. Hypo Alpe Adria’s story is a sleazy saga of corruption, moral hazard, duplicity and incompetence by the various actors involved. And it has important lessons for policymakers now – including the new President of the European Commission, Jean-Claude Juncker.
Juncker recently revealed a package of measures intended to increase investment across the EU. To encourage private investors to risk their funds he committed 5bn EUR from the European Investment Bank and provided a guarantee of 16bn EUR from the EU budget backed by funds already committed to other investment initiatives (so no new funds). This is supposed to enable leveraged investment of up to 315bn EUR, nearly all of it using funding from private sources. Unsurprisingly, his proposal was met with a decidedly lukewarm response. Wolfgang Munchau said it "reminded him of a synthetic CDO”, those highly-leveraged and ultimately worthless instruments that contributed to the 2008 financial crisis. And The Economist described it as “laughably inadequate”.
Inadequate it may well be. But there is a much bigger issue. Juncker’s proposal calls on EU Member States both to provide additional capital to this initiative and to support local investment. And he encourages them to use what he calls “financial innovation” to enable them to fund investment without putting sovereign finances at risk:
A particularly effective way to increase the impact of the Funds is to use financial instruments in the form of loans, equity and guarantees, instead of traditional grants. These instruments are relatively new to many public authorities, but they have a great potential and proven ability to deliver where they exist. In the context of this Plan, Member States should commit to increase significantly their use of innovative financial instruments in key investment areas such as SME-support, energy efficiency, Information and Communication Technology, transport and R&D support. This would achieve at least an overall doubling in the use of financial instruments under the European Structural and Investment Funds for the programming period from 2014 to 2020.
Guarantees, loans and equity stakes are new to sovereigns, are they?
Oh no they aren’t. If there is one thing that the HGAA saga tells us, it is that sovereigns are only too familiar with guarantees, loans and equity injections for pork barrel projects. Actually we knew this already, from the Spanish banking disaster, but it is worth reminding ourselves of it again.
The Land of Carinthia, a sub-sovereign state of Austria, provided unlimited guarantees to its friendly local bank to encourage it to provide investment funding for all manner of initiatives. Yes – unlimited. The inquiry into the failure of HGAA concluded that the risks taken on by Carinthia were “incalculable due to its liability for all future obligations”. In fact the liabilities exceeded Carinthia’s GDP every year from 2004 to 2011. At their peak, in 2007, they amounted to 23bn EUR.
So, armed with those unlimited guarantees, the bank went on a spending spree. It expanded massively in the Balkans as well as contributing funding to the Governor of Carinthia’s pet projects. And in an extraordinary demonstration of moral hazard in practice, Carinthia allowed it to do this, because the revenues from HGAA’s investments flattered its own finances. From the inquiry’s report:
The dramatic increase of the liability as a consequence of the unchecked growth led to higher revenues for the Land in form of guarantee commissions paid by HBInt and HBA;apart from that, the Land also received dividends…..
The risks arising from the expansion inherent to the Land’s liability were obvious and ultimately no longer sustainable for Carinthia. This constituted a clear case of moral hazard: the Land apparently reckoned that, should the risk materialise, the Federation (Republic of Austria) would step in. It therefore saw no reason to reduce the risk and to forego possible income. What is true for the Land also applies to HBInt. The bank too saw no need to restrict growth since – due to the liability of the Land – it was able to refinance itself at favourable conditions, and the amount of the guarantee commission did not adequately reflect the risk….
Of course, such rapid expansion reduced HGAA’s capital, and in 2005 it considered an IPO to raise capital. But the IPO was abandoned when HGAA’s involvement in high-risk swap transactions was revealed. The Austrian financial watchdog moved in, and senior executives were prosecuted for balance sheet fraud – the first of several such prosecutions. In 2006, short of capital and facing heavy losses, HGAA sought a buyer.
The German publicly-owned Landesbank BayernLB was only too pleased to oblige, believing that HGAA was a “strategic fit” for its expansion plans and the swap losses could be accommodated. In May 2007 BayernLB bought a majority stake in HGAA for 1.625bn EUR plus, apparently, a football sponsorship worth 2.5m EUR. But by the end of the year it was clear it had been sold a pup. BayernLB was forced to inject 500m EUR of new capital to keep HGAA afloat. Though there was a get-out for BayernLB: the guarantees provided by the Land of Carinthia continued under its ownership. According to the inquiry, this meant that:
when HBInt needed fresh capital because
of a sharp increase of write‐downs, BayernLB could call on the responsibility
of the Republic of Austria, even though HBInt was now the Austrian subsidiary
of a Bavarian bank.
Austrian taxpayers were still on the hook.
Despite two capital injections, HGAA continued to expand under BayernLB’s ownership until September 2008. At that point, the wheels came off, as they did for so many banks then. In December 2008, HGAA was forced to ask the Republic of Austria for a capital injection of 1.45bn EUR. Bizarrely, the Austrian Central Bank concluded that HGAA was “not distressed”. As a result, the Austrian government provided new capital to HGAA at public expense. But by July 2009 it was clearly in distress as asset value adjustments and increased provisions wiped out its capital. It was nationalized in December 2009.
But the saga does not end there. And what happened next raises serious questions about the competence of EU member state governments to handle complex financial instruments.
At the point of nationalization, BayernLB replaced its capital stake in HGAA with an equivalent liquidity injection which – surprise, surprise – was guaranteed by the Land of Carinthia. By doing so, it avoided losses amounting to several billion euros. Why on earth did the Austrian authorities handling the nationalization agree to this? It appears that they believed, firstly, that Carinthia would remain liable for all HGAA’s debts even after nationalization, and secondly, that the Republic of Austria was entirely responsible for HGAA’s resolution even though HGAA’s beneficial owner was the Free State of Bavaria. Meanwhile, BayernLB – which had the sense to seek legal advice, unlike the Austrians - used every means at its disposal to pull the wool over the eyes of the inexperienced Austrian officials. The inquiry concludes:
“The responsible decision‐makers of the Federation took the nationalisation decision without a sufficient information basis. Neither did they establish the facts in an appropriate manner, nor did they sufficiently examine the legal framework conditions. The Austrian negotiators were therefore unable to develop alternative scenarios which could have formed a counterweight to the strategy of BayernLB and of the Free State of Bavaria. The opposite party was hence able to decisively determine the course and the outcome of the negotiations.”
Five years later, the status of BayernLB’s Carinthian-guaranteed loans to HGAA is still disputed in the courts. Austria claims that they should be regarded as equity and the guarantees cannot be allowed to stand: the Free State of Bavaria is equally insistent that the guarantees should be honoured and the loans repaid. The HGAA saga is by no means over.
But what struck me from this report was the sheer naivety of the government officials involved. They were like children playing with fireworks. The instruments they were handling blew up in their faces and they were badly burned. And Juncker wants government officials to do MORE of this sort of thing?
There is a worrying tendency at the moment for public officials worried about deficits and debt/gdp ratios to hide public liabilities off the balance sheet. But the HGAA saga should sound an alarm about this practice. The Carinthian guarantees were all off-balance sheet – but collectively, they were enough to bankrupt Carinthia, which as a sub-sovereign must balance its books. In fact they were sufficient to place the finances of Austria itself under considerable strain, as well as setting up a nasty spat between Austria and Germany with EU-wide implications. And it is painfully evident that government officials lack the expertise to understand the legal and financial implications of the complex financial instruments involved. The ease with which BayernLB’s experts could deceive Austrian government officials is frightening.
This is no way to do public investment. We should be keeping public investment ON the balance sheet, where the risks can be seen and properly managed, not sweeping it under the carpet and pretending it doesn’t exist. Juncker’s call for EU member states to make greater use of “innovative financial instruments” is madness.