What now for HSBC as bank counts cost of its sub-prime US acquisition?

HSBC's shareholders could be forgiven for regarding 2006 as an annus horribilis.

This most distinguished of banks finished the year as a stock market dog with the unwanted title of worst performing bank in the FTSE 100. In fact, it was the only one to finish in negative territory. That made it one of the three worst performing banks in Europe and one of the worst performing banks in the world.

No wonder Michael Taylor, the retiring head of equities at Threadneedle Investments, described HSBC chairman Stephen Green - who stands to lose more than £1m in bonuses as a result of the poor performance - as being "asleep at the wheel".

Threadneedle was quick to disavow the comments, insisting they were Mr Taylor's "personal view". But while his public criticisms have not been repeated, others have also been expressing concern, albeit privately.

The furore was started at the beginning of last month by what was seen as a decidedly downbeat trading statement in the run-up to the bank's forthcoming results.

A spokesman for HSBC insisted yesterday that things were going well, pointing to the "record" profits achieved at the half-year. But in its trading statement, HSBC complained loudly about the rapid growth of IVAs - an easier form of bankruptcy - hitting its figures in the UK, while admitting its US mortgage business had got into a bit of a mess.

The investment bank also had a disappointing third quarter. It all left a poor impression, taking the gloss off the company's Asian businesses, which are still doing rather well.

Some, including Mr Taylor, would rather HSBC focused more on the East, and wonder what the bank was doing involving itself in a "trailer park" deal to buy the controversial sub-prime lender Household International in 2003 from where those US difficulties hail. Household cost HSBC $14.8bn in a deal that raised many eyebrows. At only just over seven times earnings, it looked like a steal.

But there is no such thing as a free lunch and part of the reason for the low price was that Household had just stumped up half a billion dollars to settle charges of engaging in predatory lending. The credit ratings agencies were also voicing all sorts of concerns.

Analysts from Schroder Salomon Smith Barney called the acquisition the "riskiest in HSBC's history" at the time. They may yet be proved right.

With the release of the trading statement, it emerged that some of the US borrowers that patronise Household were defaulting on secondary mortgages within six months of taking them out.

The bank said yesterday that it had taken action to correct the problem - chiefly by being a bit more cautious about who it lends money too ("tightening our underwriting criteria" in bankspeak). But the damage was done.

The difficulties at the corporate, investment banking and markets division have to be put in context - HSBC has been building up the division and the third quarter of 2005 was a blockbuster.

But the division has also been hit by some high-profile departures. Last year John Studzinski, hired to turn HSBC into a top 10 deal adviser, left to join private equity firm Blackstone. He was swiftly followed by David Livingstone, head of investment banking for Europe, Middle East and Africa.

The bank remains outside the top 10 both in Europe and globally, while figures from Thompson Financial show it does not even make the top 20 in the all-important US market.

This most frugal of institutions has never been entirely comfortable with the business, with its eye-popping bonuses and highly paid jetset bankers travelling in the lap of luxury while previous chairman Sir John Bond famously flew economy class around Europe.

To be fair, much of the blame for the shares' rotten record over the last year cannot be laid at the doors of HSBC's executives.

James Eden, analyst at Dresdner Kleinwort, points out the bank has suffered badly as a result of the weakness of the US dollar. That is because most of the bank's profits are made either in dollars or in dollar-linked currencies due to its substantial businesses in the US, Canada, Mexico and Hong Kong.

The greenback has fallen sharply against the pound this year, meaning HSBC's earnings are worth much less in sterling, translating into a lower share price.

"Two-thirds of the earnings are in dollars and if you think that the dollar has fallen 10 per cent, that translates into a fall in the shares of more than 6 per cent," Mr Eden says.

But he also says the acquisition of Household fundamentally changed the character of the bank. "Before that deal HSBC was very much a deposit-collecting institution, which made it unlike most other banks. Household changed its profile, making it look much more like a normal bank. Because it is now much more involved in lending, the business is seen as cyclical, much more linked to the rest of the economy. Some of the premium the share price used to enjoy has therefore been eroded," he says.

Household is also a sub-prime lender. Its clients are the sort of people with poor credit histories. It means they pay higher interest rates than their less financially strained neighbours.

When times are good, a business like Household can be phenomenally profitable. But interest rates have been rising in the US, and the economy has now started to slow.

People in the "sub-prime" category are the first to suffer when this happens, and that has fed through into HSBC's figures.

HSBC produced a statement in response to Mr Taylor's criticisms, hailing the 154 per cent total return produced by Mr Green since becoming chief executive in June 2003. The trouble is, with the exception of Royal Bank of Scotland, every other British bank did better.

But a spokesman insisted that much of the criticism faced by the company was unfair, and based on misconceptions about its business. "We made record profits in the first half of the year and we are still pretty positive." he said.

"We seem to have fallen back to our UK peers [in terms of the share price] but I think that some of that doesn't take into account the spread of our businesses when compared to them.

"We have long thought that some of the newsflow around HSBC is a little too influenced by what is happening in the UK, such as the UK credit story. We also think that, perhaps, the market isn't pricing in the spread of our businesses. There is a story the market is missing and we will be endeavouring to put that right."

Earlier this year Mr Green, an Anglican lay preacher, loudly complained about the UK corporate tax regime, going as far as to suggest that HSBC could quit the UK.

It is going too far to suggest that nobody would miss it. But the bank certainly has issues that need to be addressed, beyond a simple misunderstanding of its business.

Until it does, this one-time jewel in Britain's corporate crown will continue to look tarnished.