Lloyds Banking Group Faces Bleak Outlook In Ailing UK Economy

Faced with the U.K. banking sector's largest exposure to an ailing economy, Lloyds TSB Group PLC (LYG) and HBOS PLC (HBOS.LN) may not be in a mood to celebrate the official completion of their tie-up.

At 0800 GMT Monday, HBOS officially de-lists from the London Stock Exchange while Lloyds TSB changes its name to Lloyds Banking Group. It will still trade under the LLOY ticker in London.

While Lloyds Banking will have a competitive advantage in its domestic market, most observers agree this isn't a good time to be so exposed to the U.K.

Lloyds Banking will have a 28% share of U.K. mortgages, 27% of commercial real-estate loans and 25% of credit cards.

"The prognosis for the U.K. economy in 2009 remains poor, with economic activity contracting and property price declines entrenched," Keefe, Bruyette & Woods analysts said in a note.

KBW said capital adequacy will remain a focus this year, and while banks should be able to withstand a fairly sharp correction, "it is too early to conclusively rule out further equity issuance, particularly at Lloyds Banking Group given its U.K. focus and credit deterioration, which is evident within the HBOS portfolio."

After HBOS on Dec. 12 unveiled a significant acceleration in impairment charges in October and November, analysts cut already low expectations for Lloyds Banking.

Credit Suisse analysts said the group's combined core Tier 1 ratio - the level of equity held against losses on risky assets - will be at 6.2% at end-2008, and that it will drop further in the next two years as HBOS losses mount.

"On our stress test, combined ratio falls towards 4% which we do not think the market will tolerate. In other words, we believe the capital position of Lloyds Banking Group will come under increased scrutiny from here."

Credit Suisse had also predicted that Lloyds Banking would post a modest GBP167 million pretax profit in 2008 but after HBOS' December announcement, that was cut to a loss of GBP3.64 billion. For 2009, estimates were cut to a loss of GBP994 million from an estimated profit of GBP2.34 billion.

Analysts agree Lloyds Banking could bolster capital and improve profit through disposals and planned synergies, but KBW notes that prevailing market conditions could make disposals especially difficult. Case in point is Royal Bank of Scotland Group PLC (RBS), which has been trying to sell its insurance operations since last spring.

If Lloyds Banking fails to generate profit this year to finance buying back U.K. government-held preference shares, it won't be in a position to start paying dividends to investors.

That too will make trading in the share even less attractive, early signs of which can be seen in average trading volumes that have halved since the acquisition of HBOS and when ensuing capital increases were announced.

Lloyds Banking will have to balance the need to pare down losses and improve the quality of its loan book while the government as 43%-owner puts pressure on the industry to keep lending to stimulate the economy.

"The consequence of such ownership is, as yet, unknown, but with a contraction in the availability of credit likely to exacerbate the economic slowdown, it seems likely that further intervention will come. We would view the imposition of credit terms as a negative," KBW said.

At 1254 GMT, Lloyds' share was trading down 2.5 pence, or 2.1% at 114.7 pence. In the last year, the share has shed 72% of its value.

Company Web site: www.lloydstsb.com

-By Ragnhild Kjetland; Dow Jones Newswires; +44 207 842 9 268; ragnhild.kjetland@dowjones.com

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