* 890 mln euros in state-backed subordinated debt affected
* Austria seeks 800 mln euro contribution from BayernLB
* Federal guarantee on Hypo debt unaffected (Adds comments from government officials, bankers, market reaction)
By Michael Shields and Angelika Gruber
VIENNA, June 11 Austria broke new ground for debt markets on Wednesday by deciding to annul 890 million euros ($1.21 billion) of subordinated Hypo Alpe Adria debt guaranteed by the bank's home province of Carinthia.
The move aims to ensure that investors - not just taxpayers who have pumped more than 5 billion euros into Hypo so far - share wind-down costs for the stricken lender, officials said.
"Bailing in" junior bondholders in ailing banks in Europe is not new, but imposing losses on holders of debt with an official guarantee has credit rating agencies and investors worried about the reliability of state backing for debt in Austria.
Standard & Poor's put seven Austrian banks on CreditWatch negative on Tuesday because of the government's plan, following Moody's downgrades of Hypo debt on similar concerns.
"There will be a massive loss of confidence. To what extent this will spread to Austria as a place to do business and to the Vienna stock exchange is the big question and big worry," one Austrian institutional investor said on condition of anonymity.
But the blue-chip ATX market index was down only 1.2 percent by 1215 GMT, while 10-year government bond spreads widened slightly to around 31 basis points over German Bunds.
Finance Minister Michael Spindelegger said the move should be no surprise as the government had flagged in March when it ruled out letting Hypo go bust that subordinated Hypo creditors would take a hit.
"What was promised then is being fulfilled now," he told reporters after the cabinet signed off on the draft law, which could take effect by August once parliament approves it in July.
He stressed that the federal government would honour its 1 billion euro guarantee on Hypo junior debt.
The draft legislation means Hypo would also not repay 800 million out of 2.3 billion euros in cash contributed by German regional bank BayernLB when Austria had to nationalise it in 2009 to save it from collapse. BayernLB had no comment.
Hypo has refused to repay the 2.3 billion, saying it should be treated as equity rather than debt until it is back on its feet.
Hitting Hypo creditors is a risk that the coalition government is willing to take to avoid deepening a public furore over its handling of the country's worst-ever financial crisis.
In fact, Austria sees the case as a chance to change assumptions of implicit federal backing for all guarantees from the provinces, forcing investors to look more closely at the credit quality of each region.
Austria's legislation, drawn up by the finance and justice ministries and outside experts, is based on a 2001 European Commission directive on reorganising and liquidating banks, so it should be solid ground to counter expected lawsuits by investors, government officials said.
It does not touch the state guarantees, but simply eliminates the underlying Hypo liability, the officials said.
Austrian constitutional law experts have questioned whether expropriating investors outside of a formal insolvency procedure will stand up in court.
Insurer Uniqa, which faces a 34 million euro hit on Hypo debt, said it was considering a lawsuit. Vienna Insurance Group could take a 50 million euro hit.
In London, market participants were divided on whether Austria's move would affect the broader market. There was a muted reaction in credit spreads and credit default swaps.
"While it won't be good for the bonds in question, I struggle to see the applicability to the broader market unless you have banks in similar situations, which is not the case," said a senior debt capital markets banker.
"This is not a systemic issue. What it says though it that there is less and less appetite for taxpayers to be exposed to losses in these institutions," he added.
A bond syndicate banker was less sanguine.
"Changing the law like they did in Ireland or Holland is one thing. Changing the law to get out of a guarantee is completely different. A guarantee is a guarantee and you have to ask what it's worth if governments can turn around and just revoke them," he said.
Austria is also going after holders of non-voting capital in the bank and wants a 500 million-euro contribution from Carinthia as well, which the local government is resisting.
Austria's draft law also sets up a "bad bank" to wind down assets at Hypo, whose breakneck expansion at home and in the Balkans pushed it to the brink of insolvency.
It is selling off its Balkans network and will put its Italian banking unit - which is barred from doing new business under an EU-approved bailout plan - into a new holding company. ($1 = 0.7345 euros) (Aditional reporting by Helene Durand in London and Andreas Kroener in Frankfurt; editing by Tom Pfeiffer)