* Law forces losses on some junior creditors despite guarantees
* Needs to pass upper house as well, and be signed by president
* Former Hypo owner BayernLB faces 800 million euro hit (Adds details from parliamentary debate, context)
By Michael Shields and Angelika Gruber
VIENNA, July 8 (Reuters) - The lower house of Austria’s parliament approved legislation on Tuesday that would wipe out the claims of some subordinated creditors of nationalised lender Hypo Alpe Adria, despite guarantees from its home province, entering uncharted territory for debt markets.
The government insists its move, which still needs the approval of the upper house and the president’s signature, is a one-off step to ensure that Hypo’s investors help to pay to wind down a bank that has cost 5.5 billion euros ($7.5 billion) in public aid so far.
The step is in line with European bank bail-in rules that take effect in 2016 that ensure taxpayers alone no longer shoulder the burden of propping up or killing off ailing banks.
But ratings agencies, senior bankers and the International Monetary Fund warn that Vienna has set a dangerous precedent, which may undermine confidence in other state guarantees that underpin billions of euros in debt.
“The situation with Hypo Alpe reflects badly on the Austrian banking system as a whole,” said Dierk Brandenburg, a senior bank credit analyst at Fidelity.
“It creates uncertainty in the system, as investors will be thinking: ‘If they can change the rules once like this, what’s to stop them doing it again?'”
The law is likely to face legal challenges from investors including insurers and pension funds who hold the bonds.
Nevertheless, Austria sold 1 billion euros in bonds on Tuesday amid solid demand, including a 10-year deal at an average yield of 1.497 percent, which Finance Minister Michael Spindelegger said was a record low.
The coalition government has faced a public furore over the mounting costs of dismantling Hypo, which Austria had to nationalise in 2009 to avoid a collapse that would have sent a shock wave across the region.
In Tuesday’s debate, opposition parties complained the law did not go far enough to bail in Hypo investors. They said Austria should have let the bank go bust, an option that the government ruled out in March as too risky.
Letting Hypo go under would have bankrupted the province of Carinthia, whose unaffordable guarantees on Hypo’s debt helped to fuel a decade of breakneck expansion at home and abroad that pushed the lender to the brink of insolvency.
Instead, Austria aims to impose losses on holders of around 890 million euros of Hypo debt guaranteed by Carinthia, and seize another 800 million from former Hypo owner BayernLB of Germany.
The legislation also sets up a “bad bank” that will absorb billions of euros’ worth of Hypo assets to be wound down over years. The move will boost Austria’s state debt to nearly 80 percent of gross domestic product, and nearly double the budget deficit to 2.7 percent of GDP this year.
Hypo is selling off its Balkan banking network under a break-up mandated by the European Commission. Spindelegger said a deal could wrap up within weeks.
Austrian President Heinz Fischer says the legislation needs a thorough legal review before he signs it.
Carinthia - which made millions by selling its Hypo stake to BayernLB - is fighting government demands that it contribute around 500 million euros to Hypo’s costs. ($1 = 0.7331 Euros) (Additional reporting by Aimee Donnellan in London; Editing by Georgina Prodhan and Kevin Liffey)