As previously indicated, asset growth is slowing and the rate of deposit growth is targeted to outstrip that for assets in 2008. We are achieving substantially better pricing on new lending in our key markets and, as a result, the decline in the net interest margin seen in 2007 is expected to moderate in 2008. We anticipate relatively stable and potentially improving margins in 2009

- BTL book grown by 13% in first five months to £30bn

- BTL arrears grown by 41% (by value)

- Self cert arrears up 22% while other (includes CCJ) +20%
- repossessions (unallocated) +51%

- in contrast mainstream arrears are up just 7%

The average LTV on the impaired book is 69% for the specialist mortgages, up from 66%, while mainstream is at 55%.

Our estimates assume 43bp impairment on the Specialist mortgage book in 2009e which increasingly looks too low given the pace of growth in arrears and outlook for house prices. Our revised estimates for Bradford & Bingley are 66bp on its specialist book for 2009E and historically HBOS has incurred a higher impairment partly reflecting its greater exposure to Self Cert within the mix.

We will revise estimates fully after the conference call but the sensitivity is that 100bp impairment (compared to 43bp) on the specialist book would lower our 2009E EPS for HBOS by 5.3p (XR).

Retail margin is similar to H2 2007 (159bp) and is expected to remain stable through the year (Caz 2008E: 156bp). HBOS expects good growth in net interest income (Caz 2008E: -2%). Around 1/3rd of the mortgage book is expected to reprice this year, benefiting asset spreads.

Impaired mortgage loans increased 17% since Dec07 to £4,953m. Our estimates assume the mortgage charge rises from 3bp (H207) to 11bp in 2008E.

The arrears rate on mainstream mortgages has increased 10bp to 143bp, and on specialist loans it is up 50bp to 309bp. BTL arrears are 159bp (Dec: 128bp) and self-cert are 395bp (Dec: 318bp). The BTL figure is lower than B&B (185bp) but self-cert is higher (B&B: 359bp).
Unsecured credit quality is stable.

There is little commentary on exposure to housebuilders other than to say HBOS operates mainly in the “niche” market segments and “debt safety is underpinned by collateral values including landbanks”.

The value of the investment portfolio has increased by £800m to £4.8bn, primarily due to new investments but is also net of £200m write-downs (including £0.1bn against housebuilders, which we estimate is c.50% of the total invested in this sector) and some positive revaluations.

International
The business is trading in line with management’s expectations.
Impairment is rising across all three businesses: Australia (higher interest rates), Ireland (in line with management’s expectations) and ENA (from a low base). We expect impairment to rise 80% in 2008.

Treasury
P&L write-downs have increased by £58m since the IMS on 29 April to £1,028m (Q1: £970m, Caz 2008E: £1,470m).

Outlook
HBOS expects a “resilient” performance, but weighted more towards the second half of the year.

Comment
The update on treasury is reassuring in terms of write-downs, although there is no additional detail on where the write-downs have been taken. Current trading is broadly in line with expectations, although rising impairment trends will remain the focus for investors – it is notable, for instance, that self cert arrears are higher than at B&B. In our view, impairment is rising more rapidly than management had indicated at Corporate, although consistent with our estimates at this stage.

Value of debt in arrears in the specialist mortgage book (equally split between self cert and Buy to Let, 26% of total mortgage book) has risen to 3.09% end of May v 2.59% end December – looks like the self cert were performing much worse than Buy to Let. But doesn’t strike me as surprising.

Writedowns -Since last statement on 29 April 2008, the negative fair value adjustments Treasury Trading Book taken through the Income Statement have increased by just £58m to £1,028m and the adjustments through equity have actually reduced. Much more detail in the Appendix which I haven’t been through yet.

For loans to finance specific commercial property investments where HBOS is the sole lender, which accounts for around two thirds of our UK property investment lending, the collateral comprises around 9,000 properties and 24,000 units, of which 95% by value are let. The largest 50 tenants account for 28% of the annual rental income. As at 31 March 2008, the indexed LTV for this portfolio was approximately 65%. We think share prices of listed commercial property sector is implying further large falls in commercial property values, but as yet defaults have not yet happened. HBOS disclosure shows how diversified their portfolio.

Lending and investment in the housebuilding sector at the end of May 2008 totalled £4.2bn (Dec 2007 £4.0bn), of which £3.5bn was provided in senior debt, £0.3bn in mezzanine, £0.3bn in loan stock and £0.1bn in equity finance. This last number seems low given they were buying companies such as Tulloch, Crest Nicholson, McCarthey and Stone.

First bank to talk about a “modest” rise in unemployment Repeats guidance that margin decline in 2008 should be lower than the 9bp seen last year. Longer term, company looks forward to relatively stable and potentially improving margins in 2009.

Analyst thoughts

Our Rec is BUY, HBOS trading on 0.81x tangible book 08F (including rights issue). Shares have been bouncing all over the place down -54% Year to Date (versus -28% dilution from rights issue and scrip dividend) but has bounced 25% since it fell through the rights price. Nothing in the statement jumps out at us as overly negative or unexpected, our recommendation is BUY, very hard to call what the stock does through the rights period though.
NH: and finally this is from MF Global

The outlook for the rest of 2008 is:
- a slower economy & rising unemployment
- low interest rates, but little scope for further reductions
- 9% fall in house prices
- gradually rising corporate bad debts
- slower asset growth, which means lower costs 2008, lower revenues 2009

HBoS is guiding for better times thereafter:
- higher margins on new lending
- no more treasury write-offs
But there is plenty of time for the economy to deteriorate faster than expected and mean that H2 is a disappointment
as well Mortgage arrears are 16% higher than December, but it is the message of higher corporate bad debt that concerns
us most, because this is where the £100s of millions of extra charges could come from

When HBoS was a pure lender to venture capital, now head of corporate Peter
Cummings wondered why HBoS was not investing in equity as well because that is
where the big profits were