Jeremy Warner's Outlook: With HBOS under renewed attack, forced takeover may be the solution

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The Independent Online

Notwithstanding yesterday's trouncing of the Halifax Bank of Scotland (HBOS) share price, and the separate downgrade by credit rating agencies, Britain's largest mortgage bank cannot and will not be allowed to fail. Some £258bn in retail deposits tells you exactly why not.

The effect on the UK economy of such a collapse would be catastrophic, making what happened with Northern Rock look like a vicar's tea party by comparison. Nor would the Government's beefed-up deposit insurance arrangements be capable of coping with failure on such a scale.

An already weakened banking system would be unable to fund the payout, which in any case is essentially uninsurable for any of the UK's big five deposit takers. In such circumstances, the taxpayer would have to pick up the tab. To prevent fiscal and economic Armageddon, the authorities would therefore need to act well before the bomb went off. Even nationalisation, à la Northern Rock, would seem preferable to failure.

Yet it would also be an extraordinarily bad outcome. Policymakers at the Treasury and the Financial Services Authority will already be examining the options against the still unlikely but ever more possible eventuality of the speculators getting their way and succeeding in bringing HBOS to its knees.

Dennis Stevenson, HBOS's chairman, will be going through the exact same thought process. There was a palpable sense of fear in markets yesterday, with interbank lending rates showing their biggest rise in seven years as markets came to terms with the collapse of Lehman and the possible failure of AIG. Far from easing, the funding famine is becoming ever more acute. As Lehman's remaining positions in mortgage-backed securities are dumped on markets, there will be further "marks" on HBOS's holdings of these instruments.

Should Lord Stevenson, like John Thain at Merrill Lynch, fold his tent and sell the bank now while he still can? He must be starting to think so. Or should he hold to the old saying that it is always darkest just before the dawn and trust to a return in confidence?

On traditional investment yardsticks, the shares look a screaming buy at a near 50 per cent discount to book value. Following the recent £4bn rights issue, HBOS's core, tier-one capital ratio at a relatively "safe" 6.5 per cent is also better than any of its UK rivals, bar HSBC.

Such was the panic yesterday that the FSA went so far as to issue a statement confirming that, "as HBOS has already stated, it has a strong capital base and continues to fund itself satisfactorily". Unfortunately, such reassurances seem powerless before the flood. Once confidence goes, you can have all in the way of capital and liquidity cushions you like, but if depositors withdraw their money or the markets refuse to lend then you are in trouble.

The immediate concern is that HBOS has a bigger funding issue than it admits to. What we do know is that approximately £164bn of wholesale funding falls due within the next year. This is actually lower than the funding programme faced by Barclays and Royal Bank of Scotland, but it is also mainly mortgage funding, for which at present there are virtually no takers, and much of it may be within the next three months.

As things stand, HBOS can in extremis utilise the Government's special liquidity scheme (SLS) to address any potential funding gap. Unfortunately, this comes to an end in October, with the SLS's planned replacement facility unable to provide the same degree of funding support. In such circumstances, the Government may have to consider extending the SLS.

Yet the more permanent solution, if things deteriorate any further, would be to engineer a reinforcing merger or takeover. Given the paucity of likely buyers, this might require a Treasury guarantee.

It would also require the suspension of normal competition rules, for only already substantial players in the UK banking and mortgage market would be interested – HSBC, Lloyds TSB and Santander, the latter newly emerged from its acquisition of Alliance & Leicester.

Yet to the Government, the resulting job losses and shrinkage in competition might seem preferable to being landed with £650bn of mortgage funding, not to mention the commercial lending and private equity stakes that would also come with the bank. Just to put this in context, Northern Rock was "only" £100bn.

All this may seem alarmist conjecture, but we live in alarming times and the FSA will already have a plan A, B, C, and D in place if the pins start to fall.

Vince Cable, the Liberal Democrat Treasury spokesman, is right to demand that short selling of bank shares should be outlawed. The speculators have hugely added to the atmosphere of panic around banking stocks. Because banks depend on public and market confidence for their existence, the hedge funds threaten to bring about a self-fulfilling prophecy. Is there no safe haven for your money any longer? Well perhaps Northern Rock, which is nationalised and therefore already underwritten by the taxpayer, to judge by the growing volume of deposits it has attracted over the last few weeks.

Yet to ban short selling won't solve the problem. Yesterday's carnage was in any case as much caused by panic and forced selling as short selling. HBOS won't be allowed to fail, but it's looking ever more possible it won't survive the financial maelstrom as an independent company. One of its rivals may be about to pick up the bargain of the century, for, once this is all over, HBOS will again be recognised for what it is – a highly valuable property.

Barclays cherry picks from the Lehman carcass

One bank that definitely won't be buying HBOS is Barclays, or not unless it is strong-armed by the authorities into participating in lifeboat support. Instead, its focus remains on expansion in overseas markets and on Wall Street.

Bob Diamond, head of Barclays Capital, seems to have finally got his way in persuading his board to allow him to grow bigger in American investment banking.

This might seem a ludicrous time to be embarking on such an adventure, with Wall Street apparently in meltdown, yet, by picking up the remnants of Lehman's New York securities and advisory business, Mr Diamond seems to have found a low-risk way of establishing Barclays as a major player in American investment banking at a bargain-basement price.

We'll have to await today's details, but on the face of it he's got a steal, even though Barclays will have to raise a little equity to satisfy Financial Services Authority concerns that, regardless of the apparent bargain, this is hardly the time to go shopping.

In any case, for Barclays this is a much better outcome than what was being talked about last week, when Mr Diamond was seriously trying to buy the whole shebang, including all the toxic, legacy "assets".

Without US Treasury guarantees, that was never really an option. The Bank of England and the FSA wouldn't have allowed it even if Mr Diamond thought it possible. As it was, the idea that Lehman could be salvaged by a bank with an even weaker capital position than its own was plainly ridiculous.

Yet having been forced to back off, Barclays now appears to have landed on its feet. by ending up with the core American investment banking business minus the crud. As I say, there was no statement last night, but that didn't stop Mr Diamond announcing to downcast Lehman staff that they now had a partner that offered the possibility of becoming one of the globe's bulge-bracket investment banks.

Unfortunately, the same salvation has not yet been offered to Lehman's 4,500 UK staff, though some will no doubt be cherry- picked for the new venture. In adversity, there is always opportunity for the brave and willing. Despite the storm, Barclays is intent on seizing it.