Investors rushed to dump HBOS shares yesterday, while big City players paid higher premiums to insure themselves against Britain’s biggest savings institution going bust.

In a torrid day for Britain’s biggest mortgage and savings institution, its shares collapsed by as much as 41 per cent at one point, ending the day down 22 per cent. That followed an 18 per cent decline on Monday.

Statements from both HBOS and the main City regulator, the Financial Services Authority, that the bank was sound, strong and well funded, failed to placate worried investors.

A colossal 368 million shares changed hands, seven times as many as on an average day, as investors bailed out and hedge funds bet that the share price would fall further. But perhaps the more sinister price movement was in the arcane world of credit default swaps – basically contracts protecting the holder against a company failing.

HBOS is the biggest private savings institution in Britain with £258 billion of ordinary deposits and 15 million savers. While almost all banks have been targeted by worried shareholders since the collapse of Lehman Brothers, HBOS has been hit much harder than any others in Britain. Standard & Poor’s, the agency that assesses the financial strength of thousands of companies, added to its woes yesterday by saying HBOS was “less well positioned to manage the deteriorating operating environment” than its peers.

In a report downgrading the bank’s credit rating S&P pointed to its exposure to higher risk specialist and buy-to-let mortgages. It also said that the bank had been more willing than others to make bigger loans relative to a property’s value and pointed to its greater than average dependence on funding from the wholesale markets. The downgrade – by just one notch to A-plus – was modest, putting HBOS on the same level as Nationwide Building Society, which is regarded as a very safe home for savings. S&P added that HBOS was supported by its strong British franchise, a track record of efficiency and a well-diversified business line.

Deposits at HBOS are regarded by financial experts as safe because the Government has hinted, though never explicitly stated, that it would guarantee depositors of any British institution in trouble, as it did with Northern Rock last September.

However, bankers and regulators are acutely aware of how quickly panic can spread. In March HBOS was plagued by a false rumour that it had gone to the Bank of England for emergency funding, sparking a brief downward move in its share price then.

“The danger is that it can become a self-fulfilling prophecy,” Alex Potter, a banking analyst with Collins Stewart, said. He added that while HBOS was facing difficulties, the sell-off was seriously overdone and he advised investors to buy the shares at these levels.

An HBOS spokesman said the bank was winning new deposits and there was no evidence of customers withdrawing their money any more than usual. HBOS raised £4 billion from shareholders in July to beef up its balance sheet, but it has continued to be plagued by worries that it is somehow less solid than some of its peers.

In particular, traders worry that when Lehman’s more toxic assets are sold by the administrators, that will cut the value of other banks’ holdings. By law they have to value their assets at the prevailing market price. HBOS owns asset-backed securities last valued at £37 billion, of which £6.6 billion depend ultimately on the creditworthiness of poor Americans and those with impaired credit histories.

Another concern has been HBOS’s dependence on the wholesale markets to fund its mortgage lending. These markets have seized up partly during the credit crunch, yet the bank still needs to raise as much as £128 billion gross in the next quarter. However, it has about £60 billion in liquid assets and can expect to collect £30 billion in normal loan repayments, leaving it with a much more manageable £40 billion still to find, Mr Potter said.

Other traders have more doubts. One said: “HBOS has an enormous amount of exposure to the UK mortgage market, where prices are under pressure. The rest of its loans are to small and medium enterprises, which are struggling, and it’s been feeding heavily at the trough of private equity, which is also not what it used to be.

“The amount of loans it has outstanding is almost twice what it has in deposits. It has wholesale funding that it has to roll over at what are likely to be much higher prices, and it needs that funding just to stand still. So it’s either got to shrink rapidly or its margins are going to be hit.”

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