Jeremy Warner's Outlook: Lloyds holds all the cards as HBOS seeks shelter from financial hurricane

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The Independent Online

As trailed in these columns yesterday, so life-threatening has the situation at Halifax Bank of Scotland (HBOS) become that it has been forced to seek a rescue takeover by one of its UK rivals.

Even more astonishing, so desperate is the UK Government to avoid another Northern Rock that it appears ready to suspend normal competition laws to allow a smooth and swift takeover that will end up giving Lloyds TSB a dominant market position in mortgages, deposit taking, small business lending, life assurance and much else besides. It will also cost tens of thousands of job losses and hundreds of branch closures.

Out of necessity has been born capitulation of quite breathtaking proportions. A year ago, such an apparently uncompetitive merger would have been thought completely out of the question.

In the early "Noughties", Lloyds TSB had been in effect prevented by the Competition Commission from acquiring Abbey National, which is a much smaller mortgage bank than HBOS. That set the doctrine for banking takeovers thereafter. The competition authorities were clear: no more major consolidation of UK banking.

The humiliation of UK competition policy is almost by the by compared with that of HBOS, which has set itself up as the consumer's friend, able to keep the banking sector honest by offering cut-throat competition to the extortionate charging of the big four legacy banks.

Now the plucky upstart is about to be taken out by one of its erstwhile sparring partners. The deal finally agreed last night was, in the circumstances, a comparatively generous all-stock bid, valuing HBOS at 232p a share. Sir Victor Blank, the Lloyds TSB chairman, could probably have got Britain's largest mortgage bank for less. Yet speed was of the essence and Lloyds TSB couldn't spend time haggling over the price.

Having admitted to the Lloyds TSB talks, the genie was out of the bottle. The situation must have been truly dire to have opened such a negotiation, and, if the talks failed, the bank would have been finished. There were lots of people taking their money out of HBOS yesterday, as well as lots of retail investors dumping their HBOS shares. Value was walking out the door. Last night's agreement ought to stem the outflow.

Even so, many HBOS shareholders, particularly those who underwrote the recent £4bn rights issue at 275p a share, will be furious. Lloyds TSB is getting HBOS for less than half book value, which to many will seem a steal. There's potential for a shareholder revolt, despite HBOS's obvious need for a deal.

Over the past two weeks, conditions in financial markets have grown infinitely worse. The storm has reached hurricane force, with bail-outs for Fannie Mae, Freddie Mac and AIG, the collapse of Lehman Brothers, the rescue takeover of Merrill Lynch and interbank money market rates soaring off the scale. HBOS had no option but to seek shelter. The well-capitalised and conservatively run Lloyds TSB is just the ticket.

There is still potential for the deal to founder on anti-trust issues. Though there is a willingness in Government to see this takeover happen, to the extent that the Prime Minister is already nakedly attempting to present himself as the chief deal-maker, it is not obvious the competition rules can so easily be suspended.

There are three grounds on which it might be possible. One is that the law does allow for anti-competitive takeovers if they can be presented as saving the company from closure or insolvency. Separately, the national interest could be cited to overcome normal anti-trust vetting. The Office of Fair Trading also has an over-riding duty to protect consumers, and there is little doubt that, if this takeover doesn't happen, HBOS customers might be exposed to catastrophic loss.

Even so, rival banks will be spitting tacks at the prospect of being so comprehensively leapfrogged. They would much prefer a situation where HBOS was taken into public ownership, and then broken up with the assets sold widely, rather in the manner proposed for AIG in the United States. But another state-funded bail-out just before the Labour Party conference is just what the Prime Minister doesn't want. Despite the likely jobs destruction, a clean private-sector takeover looks far preferable.

By most accounts, talks only properly began on Tuesday. This followed a Citigroup-hosted dinner at Spencer House on Monday night at which the Prime Minister, Gordon Brown, first suggested to Sir Victor that he should do his bit for UK plc by taking the HBOS problem out of the equation.

By this stage, Dennis Stevenson, chairman of HBOS, had already come to the view that, in order to protect his customers, he needed to partner with someone bigger.

Sir Victor could hardly believe his ears. He was being offered a once-in-a-lifetime opportunity to bring about the biggest banking consolidation ever seen on these shores. Yet the risks are high. The UK economy is heading into possibly deep recession, as banks everywhere shrink their lending, and consumer and business confidence plummets.

The potential for rising defaults in the mortgage market is one thing. Through Bank of Scotland, HBOS has also expanded aggressively into commercial property and business lending. In addition, there is a substantial private equity portfolio.

None of these loans or equity positions has yet been written down to any significant degree. That happy process has yet to begin. HBOS also quite plainly faces a funding crunch, which, even with Lloyds standing behind it, will be extraordinarily difficult to overcome.

The Government extended its special liquidity scheme for a further three months yesterday, but Lloyds may need more in the way of Government funding to bridge the gap. The last thing Sir Victor wants to do is put his own bank at risk by acquiring the problems of others.

Yet this was a once-in-a-lifetime opportunity for Sir Victor and his chief executive, Eric Daniels. Despite the dangers, it was one they found impossible to resist. What's more, the consequences of not rescuing HBOS would have been disastrous for the entire UK economy and therefore its banking system as a whole. This is financial drama and brinkmanship of truly epic proportions.

AIG has become embroiled in the crisis

With so much theatre going on among the British constituents of the credit crunch, I've managed to neglect comment on the extraordinary saga of AIG, the insurance goliath that was bailed out by the US Treasury on Tuesday night. This was meant to be a crisis among banks, not insurers, so how come AIG found itself in the eye of the storm, and how come also the federal authorities felt obliged to bail it out with taxpayers' money?

AIG has always been a provider of quite exotic forms of insurance, so, when the opportunity to start insuring lenders against the risk of credit default came along, it grabbed it with both hands, and is today one of the largest players in the world in "credit default swaps" (CDS), with some $440bn of the stuff. In the good times, credit default is comparatively rare, so AIG made hay.

Then rates of default started to creep up, prompting an eventual downgrade of AIG's own credit rating. This in turn triggered demands for more capital to support the contracts. At the same time, it decreased the value of the hedges to those who had bought them, as with a credit downgrade there was more chance AIG wouldn't be able to honour its side of the bargain.

If the credit insurance is viewed as unsafe, that makes the credit itself less safe, requiring banks to make further writedowns and raise more capital, which right now they need like a hole in the head. The whole construct is so self-evidently dangerous, it is a wonder it was ever allowed. Certainly it needed to be propped up by the US Treasury. Had the company gone down, it would have triggered multiple defaults right through the financial system.

For the founding father of AIG, Maurice "Hank" Greenberg, it's a humbling sign-off to a lifetime of corporate empire-building, even though he was forced out a number of years ago after allegations of accounting irregularities. For the time being, the company survives, but the plan is to break it up and sell it off piecemeal. As for Mr Greenberg's personal fortune, nearly all of it in AIG stock once valued at more than $3bn, that's gone. Nor can he blame his successors for his misfortune. The big push into the CDS market took place under his watch, when it seemed like money for old rope. Vanitas vanitatum et omnia vanitas. All is vanity.