Jeremy Warner's Outlook: Banking crisis enters grimmer phase as HBOS rights issue heads for underwriters

The banking crisis seems to be entering a second, even grimmer, phase with the more conventional bad-debt experience associated with a banking downturn taking over from where the original credit crunch left off.

Banking crises normally follow a well-worn pattern. As interest rates rise to choke off inflationary pressures, borrowers find it increasingly difficult to service and repay debt. Defaults rise, and so too do bad debts. Credit becomes restricted, crimping economic growth which in turn leads to yet more defaults and so on.

The curiosity of this particular crisis is it began the other way around, with the core problem occurring not among the borrowers but with funding among the lenders. Bankers became mistrustful of the debts their counterparties had taken on and stopped lending to one another.

This in turn caused a credit squeeze, which is now coming home to roost in the real economy with falling house prices, plunging confidence and reduced activity. To date, the climb in conventional bad-debt experience, in Britain and Europe at least, has been relatively modest.

True, there have been some horrendous losses on mortgage-backed securities, leveraged loans, monolines and all the other exotic inventions of modern credit markets. These might be counted as merely old-fashioned bad-debt experience in modern, global form.

All of a sudden, it transpired that the likes of HBOS, an assumed staid old mortgage bank of the ultra-conservative building society tradition, had through international securities markets being dabbling in sub-prime lending in the American badlands. Yet in the real, domestic economy, the bedrock of the British banking system, defaults have remained subdued even as the credit crunch raged.

Until now, that is. The second phase of the banking crisis referred to above is when we enter that point of the cycle when conventional lending begins to default too. Again, the evidence of this is so far not that great, but, with now fast-falling house prices, and the growing probability of bad debts in construction and housebuilding, there is a certain inevitability about it which is playing straight into the hands of short-selling hedge funds.

Bank shares suffered another pummelling yesterday as fears over the state of the UK housing market and the wider economy took hold. Alarmingly, shares in HBOS plummeted through the price of the proposed £4bn rights issue, which means that, unless things recover, the issue will get left with the underwriters.

HBOS dashed out a statement to say nothing had changed since the company announced the rights issue in April. This should at least mean underwriters are unable to wriggle off the hook, as they did with Bradford & Bingley, where a profits warning in the midst of the rights process allowed them to reprice the issue. There can be no such double-dealing with HBOS.

Both the two lead underwriters, Morgan Stanley and Dresdner Kleinwort, are hardly in great shape themselves, so we have to hope that they've managed robustly to sub-underwrite in the normal way. If not, there really is trouble in store. HBOS can hardly pull the plug now, having said it needs the money to see it through the downturn.

HBOS has been notably more cautious about the economic outlook than any of its rivals, and it is also very heavily exposed to the troubled UK housing market. To deprive HBOS of the capital it seeks might trigger a rerun of the insolvency rumours which afflicted the bank a couple of months back. Regulators were so shocked by this attack on the integrity of a major bank they announced a full-scale market-abuse inquiry to root out the perpetrators. As it happens, the share price was then more than double what it is now, so, however malicious and dangerous the rumours, they were bang on the money in terms of predicting the likely trajectory of the share price.

In the meantime, a rights issue, which began life as deeply discounted and therefore so safe that it scarcely justified the underwriting fee, now looks a complete goner. Once the shares sink through the underwritten price, they rarely recover in time for the issue to close. Short sellers have won the battle, and cleaned up accordingly.

UK banking shares have sunk so low that they now seem fully to discount not just a downturn or even a mild recession, but one of the really serious, all-embracing, economic contractions involving high levels of bankruptcy and unemployment. Who knows? Maybe this is the way to bet. Yet it still doesn't feel quite right, notwithstanding the fact that the world has plainly changed for the major banks with earnings likely to be impaired for possibly years to come.

Bank stocks may be mispriced, but that doesn't yet mean they have hit rock-bottom. The point of capitulation, where those investors who cannot afford to sit out the cycle give up on trying to recapture past gains and sell, may not yet have been reached. Perhaps regrettably, there are still lots of short sellers out there making hay from all the turmoil. The effect of all this short selling is further to exaggerate the overshoot in the share price.

Prolonged short selling cannot occur without stock lending. Banks have been revealed as so completely out of control, with one arm not knowing what the other is doing, it would come as no surprise to learn the fund management arms of the banks that are suffering the most are among the prime stock lenders to the hedge funds making all the mischief. I've no evidence for this, but regrettably it seems only too plausible.