What tune will

Household International

(HI) - Get Report

CEO William Aldinger whistle on the way to the bank -- "Fool Britannia" or "Mad Dog's an Englishman"?

Both apply after Thursday's announcement that the U.K.'s

HSBC

(HBC)

intends to acquire Household in a deal valued at $13 billion. There is a strong history of Europeans overpaying for struggling U.S. franchises, and this could easily turn out to be the best example yet.

Though the deal is being struck at a price well above Household's Wednesday close, the $29 price tag is far below recent highs and thus constitutes a resounding victory for the skeptical investors who have been betting against Household since it was trading above $50, just six months ago. Thursday afternoon, Household jumped 21% to $27.29 and HSBC slipped 4.5% to $53.55.

The transaction comes at a difficult time for Household. In October, it agreed to pay a whopping $484 million to settle with regulators over allegations that it had used deceptive lending practices. And just three weeks later it surprised the market by issuing $900 million of stock to boost its capital.

Nervousness over Household's prospects had pushed up the cost of its borrowing to uncomfortable levels and there was talk that a growing number of bad loans would force it to take a large credit charge in the fourth quarter.

Bye
Bidding adieu to HI stock

Portales Partners' Bill Ryan, an analyst who has been bearish on Household since it was trading in the high $50s, sees the deal as an act of desperation. "You don't raise $900 million of stock and then go out and sell yourself if there is no problem." (Portales doesn't do underwriting and Ryan rates Household a hold, but had previously advised clients to sell the stock.)

And there are two main problems with Household: credit quality and lending practices. The '90s boom wasn't just about telecom and tech; there was also a bubble in financial services, and one of the most affected segments was subprime, which is lending to people of impaired creditworthiness at very high interest rates.

Household focuses on subprime customers. It took only a moderate slowdown in economic growth to cause a spike in bad loans at subprime lenders because their borrower selection had been so poor in the boom. At Household, past-due loans in its home equity loan portfolio, its chief business, were 3.26% of the portfolio at the end of September, up a lot from 2.74% in the year-earlier period.

And these numbers were probably understated by a practice that Household uses a lot called re-aging, which is allowing distressed borrowers to skip payments and remain current. Skeptics have long anticipated that Household would need to take a large credit charge to recognize losses in its re-aged loan book. On a Thursday conference call, Household said there would be a charge to conform its accounts to HSBC's, but didn't specify credit issues.

Other Problems

For the past two years, Household has been bombarded by allegations that it was using aggressive and deceptive lending practices, so it was no surprise when it decided to settle with regulators in October. However, it was feared that revenue and earnings would be hurt once certain sales practices were stopped, as happened at credit card lender

Providian

( PVN) after large settlements.

With borrowing costs higher, bad loans rising and the prospect of slower revenues, Household's future was arguably bleak and a sale made sense. But why so soon after a large offering? Real problems with funding is the only halfway decent answer at this point. Indeed, the yields on Household's debt went up after falling just after the stock deal was done.

As for HSBC, it isn't buying Household at distressed levels. Sure, seven times earnings is low, but 1.6 times book value is certainly not cheap. And if Household does book a big credit provision in the fourth quarter, that book value ratio could be even higher. Sure, Britannia ruled the waves, but good luck reining in all the sharks that operate in Household's lending branches.