What was HBOS doing?

Lloyds Banking Group's first half results are witness to the quite astonishing risks taken by HBOS, the bank that Lloyds agreed to buy and rescue - in very controversial circumstances - in the autumn of last year.

It was HBOS's business loans - many of them property related - which contributed most of a £9.7bn charge for debts that are going bad in Lloyds's so-called wholesale division.

And it comes on top of a £9.3bn charge that was incurred in the second half of last year.

So that's £19bn of charges for loans to companies that are turning sour during just one year of recession.

Those losses represent 8% of all loans and advances in that area of activity.

Wow.

And to be clear, this is not a newfangled, new age loss on impenetrable financial products such as collateralised debt obligations.

This is an old-fashioned failure to kick the tyres properly when lending to hotel groups, property developers and investors who in the 1950s would have been called spivs.

The former members of HBOS's board doubtless feel chastened - and the current members of Lloyds's board must surely regret their failure to conduct a proper investigation, what's known as due diligence, of what they were buying,

Here's the better news for Lloyds shareholders and perhaps troubling news for taxpayers - most of these poor quality loans are now being insured by us, by taxpayers, under the Asset Protection Scheme, so future losses will be ours, not the banks.

Lloyds' management is still putting a brave face on the takeover of HBOS.

It says that eliminating duplicated costs in the two banks will yield additional profits of £1.5bn a year by the end of 2011.

Which may be delightful for the bank's owners (taxpayers, again, through a 43% stake that will rise to 62%), but is simply another way of saying that many thousands of employees are losing their jobs.

One other concern is that the bank remains very dependent on funding from taxpayers and from wholesale providers who have proved to be unreliable.

The best way of seeing this dependence is that there is a £223bn gap between Lloyds' loans and advances and its customer deposits, or the non-wholesale loans to the bank which tend to be more stable.

Some of this gap may be closed over the next five years by Lloyds' decision to run off some £140bn of loans to customers.

And there is already evidence that Lloyds is shrinking its balance sheet.

Which is probably the prudent thing to do. Although this reduction in lending risks bringing the bank into conflict with the government over whether it is fulfilling a pledge as a state-rescued bank to increase the supply of loans to homebuyers and also to business.

These results indicate that it is making good on the mortgage promise.

On loans to companies, Lloyds claims to be doing its bit - but that appears to be at odds with a 9% reduction to £198bn in the value of its loans and advances to corporate customers over just the past six months.

Finally, a bit of good news: putting the bad debts to one side, the banking operations owned by this sprawling group - Lloyds, Halifax, Bank of Scotland, inter alia - are still churning out the revenues much as they've done for decades.

This is a group that will generate enormous profits as and when we're through the recession.

As for when the recovery will come, Lloyds believes that bad debts may have peaked, which is earlier in the economic cycle than is normal for banks.

Lloyds will however generate a loss for the year as a whole and the bank expects only a slow economic recovery in 2010.

But the day will dawn - sooner than seems credible right now - when it'll be the magnitude of the profits being generated by this Tesco-size market leader in retail financial services that will be sparking controversy, rather than the horror of its losses.

Update, 10:16:

Lloyds - or rather the Halifax bit of Lloyds - has revised its forecast for what will happen to house prices this year from a fall of 15% to a much smaller fall of 7% or less.

This matters to Lloyds, as the UK's largest provider of mortgages (and, of course, to millions of home owners).

This new forecast may turn out to be too bearish, in that the cumulative fall in its own figures for the first seven months of the year is just 1%.

Next year it expects house prices to be flat or to rise just a fraction.

Also, it is pretty bullish on its ability to increase its income, or top line: it is predicting high single digit percentage growth in revenues within a couple of years - which, if costs can be contained, would generate very significant incremental profits.

In fact - and this may worry Lloyds staff fearful of losing their jobs, it is promising to reduce costs as a percentage of income by two percentage points every year for as far as the eye can see.

Finally, Lloyds has asked me to point out - in case it's unclear - that it did conduct due diligence on HBOS, but not as much as would have been ideal if there weren't important deadlines to meet.