June 12 (Bloomberg) -- HBOS Plc, Britain's biggest mortgage bank, said U.K. profit margin and market share fell in the first half as a decision to cut rates for some customers backfired.

HBOS stock dropped the most in three months after the Edinburgh-based company said its share of the domestic home-loan market may fall to about 8 percent from 21 percent in 2006. The margin on loans will decline from 1.78 percentage points, HBOS Finance Director Phil Hodkinson said on a call with analysts today.

Chief Executive Officer Andrew Hornby, who took over in August, had to reverse his strategy of lowering rates for HBOS mortgage holders and raising costs for new customers. The bank lost its competitive edge as the total value of U.K. home loans rose 11 percent from a year ago to 1.1 trillion pounds ($2.17 trillion).

``It was quite a radical move which didn't work,'' said Mike Trippitt, a London-based analyst at Oriel Securities in London. ``They are having to price more competitively and get the thing back in balance,'' said Trippitt, who cut his rating on the stock to ``reduce'' from ``buy.''

Shares of HBOS fell 3.6 percent to 1,031 pence in London. They are down 8.9 percent this year, valuing the bank at about 38.6 billion pounds. The nine-member FTSE All-Share Banks Index is down 1.7 percent.

``We have seen stronger competition and greater margin erosion in the mortgage market than we were expecting,'' Hodkinson said.

Choking Off Demand

Though U.K. house prices have more than tripled in the last decade and are still rising, a series of four interest-rate increases in Britain since August has started to choke off demand for mortgages. Barclays Plc, Alliance & Leicester Plc and Nationwide Building Society responded by cutting prices and increasing their shares of the market.

HBOS decided last year to pay brokers higher fees to encourage existing customers to stay with the bank. It also cut prices for customers waiting to refinance and raised rates for new customers.

The plan ``has not deliver the anticipated benefits,'' driving away more new borrowers than forecast and failing to retain enough HBOS customers. The bank is ``confident'' it can recapture a 15 percent to 20 percent market share in the second half after reversing last year's pricing plan and ``refining'' broker incentives, Hodkinson said.

``After a slower first quarter for net lending, we are now seeing an improved performance, having taken corrective action in the second quarter,'' HBOS said. The bank how has a ``much stronger pipeline'' of loans, Hodkinson said.

`Lower Margin Business'

Full-year pretax profit will meet analysts' estimates as HBOS increases corporate lending and insurance sales, it said today. Since taking over as CEO from James Crosby last August, Hornby, 40, has added branches in the U.K. and pushed consumer banking growth in Ireland and Australia. Pretax profit excluding one-time charges will increase 8 percent to about 6 billion pounds, or 110.8 pence a share, in line with analysts' median estimate, the bank said.

HBOS is seeking to recapture market share in home loans by cutting rates, Trippitt said. ``I would expect it to be a lower margin business in 2008.''

The overall credit environment continues to remain ``robust'' and unsecured loans are close to their peak, HBOS said today. While consumer bad loans will rise in this year's first half from the second half of 2006, delinquencies from unsecured lending will be lower in the second half, Hodkinson said.

Growth at HBOS's corporate banking unit was ``strong'' and credit quality remains benign in the unit, though the bank is ``cautious in this late stage of the cycle,'' it said. The insurance and investment division is making ``good progress'' in the first five months of the year, HBOS also said.

`Smelling of Roses'

``I don't think management have exactly come out of this smelling of roses,'' Collins Stewart analyst Alex Potter said in an interview today. HBOS lacks the overseas diversity that helps peers including Royal Bank of Scotland Group Plc and Barclays Plc, he said. ``The bigger strategic question is where is HBOS going to be in two years,'' said Potter, who rates the stock ``buy.''

HBOS's underlying pretax profit, which excludes accounting charges under International Financial Reporting Standards, was 5.54 billion pounds, or 100.5 pence a share, in 2006.

The bank bought back 262 million pounds of its own stock for cancellation, it said today. HBOS plans to buy back about 500 million pounds of stock this year, compared with 982 million pounds in shares in 2006.

To contact the reporter on this story: Ben Livesey in London blivesey@bloomberg.net

Last Updated: June 12, 2007 13:25 EDT