LONDON (Reuters) - An emergency fund-raising by HBOS <HBOS.L>, Britain's biggest home lender, flopped as investors took just 8.3 percent of the shares, leaving underwriters trying to sell almost 3.8 billion pounds of shares that are currently under water.

The two lead underwriters in the rights issue, Morgan Stanley (SPU - news) <MS.N> and Dresdner Kleinwort <ALVG.DE>, on Monday sold 1.2 billion pounds of the leftover or "rump" shares. They are now stuck with the remaining stock, leaving each with shares worth 1.3 billion pounds.

HBOS (LSE: HBOS.L - news) raised 4 billion pounds from the rights issue -- the 11th biggest ever -- but the troubled fund-raising has left one of the biggest blocks of shares with investment banks since the privatisation of oil major BP <BP.L> flopped in the middle of a stock market crash in 1987.

HBOS is the latest European bank to raise capital to repair its balance sheet and brace for a tough economic outlook.

Its shareholders signed up to buy just 124 million shares in the fund-raising after the market price of its shares fell below the offer price of 275 pence amid worries about UK banks' prospects as the economy falters.

"The obvious reason (for the low demand) is the shares spent much of the time leading up to cut-off under water," said Richard Hunter, head of UK equities at brokerage Hargreaves Lansdown (LSE: HL.L - news) .

"But it's also investors taking a view on the UK property market, which is a decision for the steeliest investors given where we are ... there's a risk aversion," Hunter added.

Morgan Stanley and Dresdner sold a further 443 million shares on Monday at 275p during a "rump" placing, whereby they sought buyers at or above the rights issue offer price. In the final phase, the "stick," they can sell shares to subordinate underwriters or hold on to the shares.

HBOS shares sagged 6.2 percent to 264.5p as dealers said the prospect of a big stock sale hurt, threatening to be an overhang for the shares for some time. Other banks rallied for a fourth straight day on optimism that U.S. and European banks are through the worst of their write-downs.

LEFT WITH THE SHARES?

A poor take-up of less than a quarter of HBOS shareholders had been expected after the stock's collapse in recent months. The offer had been priced at a 45 percent discount when announced on April 29.

Morgan Stanley and Dresdner are estimated to have commitments for about 40 percent of their holdings, which would leave each of them with about 280 million shares, or a 5 percent stake worth 770 million pounds.

On paper, based on closing prices on Monday, the banks would each have a gross loss of about 22 million pounds on the transaction. Public investors, though, don't know Morgan (MGHL.PK - news) 's actual basis cost.

A person familiar with the transaction said the actual impact on Morgan Stanley has been offset by hedging and sub-underwriters. It is possible the firm may even end up with a financial gain on the transaction and potential upside of the shares.

The net result may not be material to third-quarter results, the source said. Notably, Morgan Stanley has not filed with UK regulators to signify ownership of more than 3 percent of HBOS shares.

A regulatory filing on Monday showed Morgan Stanley had taken a short position relating to 2.34 percent of HBOS shares at the end of last week.

A Morgan Stanley spokesman said HBOS "is a sound bank with diverse income" and that the U.S. bank's due diligence and management of risk left it "comfortable" with its HBOS stake.

Dresdner said it was under no pressure to sell shares and it saw value in the stock.

The extent to which the underwriters can find long-term buyers could dictate how the stock overhang affects HBOS's share price, as that would mop up extra supply. HBOS stock, meanwhile, is trading at about two-thirds of its book value, well below the valuations awarded to other British banks.

Meanwhile many hedge funds and other speculators sold HBOS shares short in anticipation of buying it back now, so they will also absorb stock.

"There were a large number of hedge funds who shorted the stock with the intention of buying it back off the underwriters at a discount and it looks like they're going to get their way," said James Hamilton, analyst at Numis Securities.

HBOS said that from its perspective "we've raised 4 billion pounds of capital, which means we will now be one of the most strongly capitalised banks. That's where we want to be at a time when the economic outlook is darkening," said Shane O'Riordain, a bank spokesman.

He noted the fund-raising took place "in the middle of a fierce financial storm".

HBOS said it expects the fund-raising to lift its core Tier 1 capital to the "upper end" of its targeted 6 percent to 7 percent by the end of this year, above most European peers.

Britain's rights issue process now faces scrutiny, as HBOS rivals Royal Bank of Scotland (LSE: 91ID.L - news) <RBS.L> and Bradford & Bingley (LSE: BB.L - news) <BB.L> also had a turbulent time during fund-raisings. Regulators have set up a working party to assess and report this year on the efficiency of the process.

(Additional reporting by Joe Giannone in New York and Douwe Miedema in London; Editing by David Cowell/Erica Billingham/Braden Reddall)