Jeremy Warner's Outlook: HBOS shares wobble amid concern over US bailout fund

It is not just the financial markets praying that Congress gets a move on and approves Hank Paulson's proposed $700bn bail-out of Wall Street. Our own Prime Minister's future is riding on it too, for as doubts mounted yesterday over whether US Congressmen would vote the emergency funding through, or whether it would do any good even if they did, HBOS's share price took another pounding – raising questions over whether the rescue takeover by Lloyds TSB would actually proceed if financial conditions got any worse.

With HBOS shares down nearly 14 per cent yesterday, the discount on Lloyds TSB's all-stock offer widened to a startling 17 per cent, suggesting real concern in markets over the deal's deliverability. The renewed assault on bank share prices took place despite last week's ban on short trading and – according to some mischievous hedge fund managers still infuriated by the FSA's actions – might even have been accentuated by it.

This is because in the event of real, as opposed to short, selling pressure, there are now no short positions to be closed out to provide buying support. Whatever. The old concerns over HBOS's funding position have returned and are again undermining the share price, notwithstanding the Lloyds bid. Some of the anomaly in the HBOS share price is explained by the fact that the markets are not behaving rationally at the moment. Alternatively, the price may now be driven more by recessionary concerns than the immediate funding crisis.

Personally, I find it almost inconceivable Lloyds would pull out, though one of the lessons of this crisis is not to speak too soon. Things previously thought inconceivable have occurred repeatedly as the storm strengthened. Yet there are a number of reasons for being a little more optimistic on this occasion. One is that Lloyds is just gagging for the deal. The opportunity to acquire such a dominant position in the UK market is a once-in-a-century event. Missing it simply because markets were having another dark night of the soul is not something Sir Victor Blank, the Lloyds TSB chairman, would do lightly. Hell would need to freeze over before he were even willing to contemplate it.

Nor is this just an ordinary deal between two commercial organisations where force majeure might indeed seem a reasonable excuse for cancellation. The Prime Minister has staked much of his claim to being the right person to see Britain through the crisis on the success of this transaction. If it were now to fail and HBOS collapsed into national ownership, his political fightback would be in tatters. Gordon Brown, too, is going to move hell and high water to make sure it happens.

Then, finally, there is what to my mind is the near certainty that the Paulson package will go through, despite yesterday's understandable grandstanding by members of the US Senate Banking Committee. In cross-examining the Treasury Secretary Mr Paulson and the Federal Reserve chairman Ben Bernanke, they were bound to express fury at the idea that the US taxpayer is being forced to pick up the tab for the recklessness on Wall Street.

The euphoric reaction of markets last Friday to news of the fund was certain to wear off once traders realised that there is quite a difference between saying you are going to do something and actually doing it. Yet by creating a renewed sense of crisis this week, the markets have almost certainly ensured swift congressional approval. The markets have got Congress over a barrel. Once Mr Paulson had said his plan was the only way of saving America from severe recession, there was no option but to go through with it. To remove the bailout now would create mayhem.

All the same, for sheer theatre, it is worth watching a replay of yesterday's congressional hearing. It is hard to exaggerate the sense of anger and bewilderment that senators expressed at being asked to fund the consequences of so much private risk with public debt. Mr Bernanke expressed the hope that, held to maturity, most of the bad debts now being nationalised would repay the taxpayer in full and might even yield a profit – but he refused to give any such guarantees.

In all the furore over the exposure being taken on by US taxpayers, everyone has forgotten the proportionately even bigger risk that has been acquired by the public sector here in Britain. Reasonable progress seems to have been made in the Northern Rock run-off, reducing the taxpayers' liability to perhaps no more than £75bn of the original £110bn mortgage book. But as this liability falls, the risk acquired through the Special Liquidity Scheme, which the Chancellor, Alistair Darling, admits has already swelled to well in excess of £100bn, continues to rise.

Admittedly the SLS is not a nationalisation of mortgage debt, as proposed in the US, but only a long-term borrowing facility for banks. Even so, the taxpayer is no less on the hook for the risk, so you could argue that the cost to the public purse of the credit crisis is, as a percentage of GDP, already a great deal higher than in the US.

No wonder the Prime Minister is so desperate to see Lloyds TSB's take-over of HBOS consummated. If he were forced to take HBOS on to his own books as well, it would be the end of private sector banking as we know it. In such circumstances, we might just as well all be banking through National Savings.

Wall Street spills its troubles onto Main Street

What happens on Wall Street stays on Wall Street. As the weight of commentary warning of recession or even depression grows, it would certainly be nice to think so.

Over the past few weeks, this reassuring theory – that Wall Street is a world largely divorced from Main Street – has acquired some interesting converts. One is Joseph Stiglitz, the Nobel prize-winning economist who is something of a hero among anti-globalisation campaigners. He has depicted Wall Street as no more than a giant casino, whose removal from the landscape would have little impact on anyone outside inveterate gamblers. Maybe it's good to have a casino in your midst, but its wider economic impact is likely to be limited and nobody would much miss it if it were bombed.

Another is Jim O'Neill, the chief economist at Goldman Sachs, though his articulation of the theory is a more nuanced and qualified affair which depends on the counterweight being provided to declining US consumption by continued growth in the developing world and, more crucially still, on the proposed policy response in the US being voted through.

The lesson of previous crises, he points out, is that Wall Street can indeed be isolated from Main Street given the correct cocktail of public policy. In the absence of such policies, the outcome is likely to be far less benign. Bottom line, Mr O'Neill thinks that if you are going to have a serious banking crisis, this is the time to have one, with the rest of the world economy relatively stable and strong.

Can it be right that the travails of Wall Street are going to have little effect? The idea is a seductive one, but while it may contain an element of truth, in practice it is almost certainly wrong. What is true is that much of the explosive growth in credit markets of the past 10 years is an illusion, in that one credit instrument has been piled on top of another in a process of multiple duplication which, while no doubt very good for fees and bonuses, may not have expanded the pool of available credit as much as was generally thought. Strip these layers away and nobody suffers, other than the fools who have bought into them.

Unfortunately, the reality is a more brutal one which cannot but help have a very damaging effect on the supply of credit to the wider economy. As the bad debts mount, financial institutions are forced to deleverage and contract their balance sheets. In simple terms, that means reducing the amount of available credit.

This is already apparent in mortgage markets, where the supply of finance has all but dried up completely. On both sides of the Atlantic, there is now growing evidence of the same phenomenon spreading from financials and housing to other sectors of the economy, with even quite big companies experiencing difficulty with overnight funding, and some smaller firms finding their overdraft facilities restricted or cut back.

Almost as worrying, industries as diverse as retail, leisure and manufacturing are taking on a siege mentality. Business leaders are switching their priorities from expansion to survival. Budgets are being slashed and capital spending projects suspended. Headcount reduction will follow shortly. Policymakers may be able to keep the worst consequences of Wall Street's folly off Main Street, but it seems unlikely they will succeed in entirely insulating it.