UPDATE 3-Austria finally rules out letting lender Hypo go bust
* Govt to create wind-down unit for ailing state bank
* Seeks contributions from Carinthia, subordinated creditors
* Balkans banking network may be sold this year (Adds details on subordinated debt, participation capital)
By Michael Shields and Angelika Gruber
VIENNA, March 14 (Reuters) - Austria will not let ailing state lender Hypo Alpe Adria go bust, Finance Minister Michael Spindelegger said on Friday, ending months of uncertainty that had unsettled financial markets and touched off a political storm.
Vienna will instead create a "bad bank" for 18 billion euros ($25 billion) of Hypo assets while pressing its home province of Carinthia and holders of subordinated debt to contribute to the costs.
"There were many reasons to seriously consider insolvency, but in the end the risks were incalculable," Spindelegger told a news conference.
If Austria had let a bank with a balance sheet worth nearly 9 percent of economic output fail, it could have been the biggest jolt to the euro zone since Cyprus hit savers in 2013 to avoid collapse.
The bank's senior bonds gained four points in the secondary market, while Austrian sovereign debt showed little reaction.
"The Austrian government has, as expected, backed away from a threat to impose losses on senior bondholders in Hypo Alpe-Adria. Bonds are up sharply, and the news should also be positive for other Austrian banks that have been affected by the speculation," analysts at Creditsights said.
The government demanded that Carinthia - whose generous debt guarantees forced the state to take over Hypo in 2009 after its breakneck expansion at home and in the Balkans drove it to the brink of ruin - chip in at least 500 million euros.
It also wants holders of 1.9 billion euros worth of subordinated debt to contribute to wind-down costs, Spindelegger and central bank Governor Ewald Nowotny said.
Holders of 1.1 billion in non-voting participation capital - more than 1 billion state-owned but also 55 million at a Carinthia state holding company and 9 million at insurer Grazer Wechselseitige - will also get drawn in, they said.
Nowotny, who had lobbied hard against letting Hypo go bust or forcing losses on Hypo bondholders, was asked about the treatment of investors who own 1 billion euros worth of subordinated Hypo debt with federal guarantees.
"Federal guarantees will of course be honoured," he told a news conference, while adding: "This is a matter where appropriate negotiations and regulation will be done to achieve this effect."
Carinthia guarantees another 890 million euros worth of such subordinated bonds and notes. A finance ministry spokesman said details about how to bail in these creditors were under discussion and may require specific legislation.
Carinthia Governor Peter Kaiser said the province - which would have been dragged under as well had Hypo gone bust - would contribute to the costs but he did not say to what extent.
Creating a "bad bank" relieves Hypo's chronic need for fresh capital but will also push up state debt more than 5 percentage points to above 80 percent of economic output, and drive up the budget deficit by around 1.2 percentage points this year.
That will leave a rump business comprising its Balkans banking network that Nowotny said could be sold this year, ahead of a mid-2015 deadline set by the European Commission.
The 18 billion euros destined for the bad bank includes toxic loans, leases and real estate but also more than 4 billion in liquid assets. The idea is to wind the assets down over many years via the vehicle, which will not have a banking license and thus not need to meet minimum capital rules for lenders.
Unlike Germany's bad bank model for troubled lenders, the new Austrian wind-down unit will not have state guarantees.
Talks on reaching a settlement with former Hypo owner BayernLB - which has 2.3 billion euros frozen at Hypo and has a say on major strategic decisions at Hypo since the 2009 nationalisation - would start soon, Spindelegger added.
Austria this week authorised a quick capital injection even though the exact amount Hypo needs is not yet known. Hypo's board was due to meet on Friday to discuss the matter.
Hypo Alpe Adria has already got 4.8 billion euros in state aid since 2008 and needs more to be able to meet minimum capital requirements when it finalises its 2013 results.
($1 = 0.7180 Euros) (Aditional reporting by Aimee Donnellan in London, editing by Mark Heinrich)