Lloyds’ Credit Rating Cut

Today (Tuesday), Moody’s slashed the long-term credit rating on Lloyds Banking Group plc (LYG) to A1 from Aa1, citing “the high level of troubled and higher risk exposures within HBOS, which Moody’s considers will weaken the profitability and capital adequacy of the overall group, as well as the very significant operational challenge of integrating a larger and weaker bank into the group.” Lloyds announced the completion of the acquisition of HBOS plc, a UK bank almost twice as large as Lloyds with over £650 billion in assets, on January 19, 2009.

This follows Lloyds’ announcement late last week of a significant increase in the pretax loss at HBOS for the full-year 2008. Lloyds now expects HBOS’s pretax loss to be about £10 billion on a statutory basis and an £8.5 billion loss on an underlying basis (before nonrecurring items), largely due to a £4 billion negative impact from market dislocation from falling market valuations and a roughly £7 billion bad debt impairment charge in the HBOS corporate division. This is up £1.6 billion from its November 2008 bad debt estimate, reflecting acceleration in the deterioration of the UK economy and a more conservative provisioning methodology consistent with that used by Lloyds.

Separately, Lloyds TSB is expected to report statutory pretax earnings of £1.3 billion and an underlying pretax profit (before nonrecurring items) of £2.4 billion in 2008. This is a bit below our pretax estimate of £2.5 billion for Lloyds on a stand-alone basis.

Lloyds estimates that the Core Tier 1 capital ratio at December 31, 2008 will be 6.0-6.5% and that the Tier 1 capital ratio will exceed 9.0%.

Lloyds is expected to report 2008 full-year results on February 27.

We have a Hold recommendation on LYG shares. The current Zacks rank is 3, indicating no clear directional pressure on the stock. In morning trading, LYG shares are down over 22% from Friday’s close of $3.80.

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