Feb. 28 (Bloomberg) -- HBOS Plc, Britain's biggest mortgage lender, said profitability may decline in 2007, driving the shares to their biggest drop in more than three years.

Net income rose 26 percent in the second half of 2006, to 2.12 billion pounds ($4.15 billion), or 54.6 pence a share, from 1.68 billion pounds, or 42.2 pence a share, a year earlier, based on full-year earnings published by the company today.

HBOS shares plunged 4.6 percent after the bank, owner of Halifax and Bank of Scotland, said lending margins will decline this year as peers including Barclays Plc and Nationwide Building Society compete to win mortgage customers with lower rates. Chief Executive Officer Andy Hornby has focused on corporate banking and insurance to reduce reliance on home loans.

``With rising interest rates in the U.K., concerns over subprime lending on both sides of the Atlantic and margin pressure in 2007 due to the highly competitive market, it comes as no surprise that'' the shares are falling, said Rupert Cecil, who helps manage $13.4 billion as the head of U.K. equities at Kleinwort Benson in London. ``The stock has had an unbelievable run since May of last year.''

U.K. Insolvencies

Personal insolvencies are at record levels in the U.K. as rising interest rates and energy costs have squeezed household incomes. Concern over earnings growth at banks increased after HSBC Holdings Plc said on Feb. 7 it is setting aside $1.76 billion to cover potential U.S. mortgage losses in 2006, 20 percent more than analysts estimated. The Bank of England has raised interest rates three times since August, to a five-year high of 5.25 percent to contain inflation.

HBOS's net interest margin, the difference between the interest it pays of deposits and what it earns on loans, last year fell to 178 basis points from 180 basis points in 2005. A basis point is one hundredth of 1 percent.

Net interest margin at the retail bank fell to 1.78 percent from 1.84 percent on home-loan pricing pressure. The bank's mortgage-market share rose to 17 percent in 2006 from 14 percent a year earlier.

``We anticipate some further margin decline in 2007,'' Hornby said in a statement.

HBOS shares lost 52 pence to 1,081 pence in London, the biggest drop since Oct. 22, 2003. The stock has added 20 percent since May.

Corporate Banking

HBOS's pretax profit from corporate banking rose 20 percent to 905 million pounds. Insurance and investment profit also rose 20 percent, to 294 million pounds. Retail banking profit climbed 3 percent 1.23 billion pounds. Bad debts increased 3.8 percent to 878 million pounds, compared with a median estimate of 971 million pounds from a survey of six analysts.

In the retail bank, ``growth is a bit lackluster,'' said Mike Trippitt, an analyst at Oriel Securities Ltd. in London. ``Topline growth in retail isn't what it was.'' He has a ``buy'' rating on the shares.

Second-half non interest revenue in the retail bank fell 6.4 percent to 669 million pounds on falling sales of so-called payment-protection insurance sold on unsecured loans. Revenue was also cut by caps imposed on credit-card default fees last by the Office of Fair Trading last April, the bank said. Net interest revenue rose 3.7 percent to 2.14 billion pounds. Margins at the corporate unit rose 3.7 basis points to 2.22 percent and margins fell 16 basis points at its international operation.

Lending Growth

Lending growth this year is expected to be at or slightly above the level achieved in 2006, Hornby said. ``The mortgage market and the corporate market have been really resilient,'' Hornby said in a telephone interview, referring to the bank's bad debts charge. Both markets are ``likely to stay really resilient'' in 2007, he added.

The sale of HBOS's U.S. car-finance unit in December will mean a pretax gain of 180 million pounds, the company said at the time. Last year the company set aside a 95 million-pound provision for compensation related to customer complaints over the bank's sale of endowment, or insurance-related mortgages.

HBOS plans to buy back about 500 million pounds of stock this year, the company said in December. It bought back 982 million pounds in shares in 2006.

Full-year pretax profit was 5.71 billion pounds, more than the 5.46 billion-pound median estimate from 19 analysts surveyed by Bloomberg.

The bank appointed Compass Group Plc CEO Richard Cousins as a non-executive director, it said in a separate statement today. The appointment will take effect from March 1.

To contact the reporter on this story: Ben Livesey in London at blivesy@bloomberg.net; Jon Menon in London at jmenon1@bloomberg.net

Last Updated: February 28, 2007 12:32 EST