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In stress tests, Fed may have inflated grades for TARP banks

March 21, 2012: 5:00 AM ET

Fed's Ben Bernanke

UPDATE, March 27

For two banks that have yet to repay government bailout funds, the Federal Reserve's stress test was easier than for rivals.

FORTUNE -- The Federal Reserve appears to have class favorites.

Analysts say two banks, Regions Financial (RF) and Zions Bancorp. (ZION), received better grades in last week's stress tests than they deserved. One possible reason: Regions and Zions have yet to repay the bailout money they got from the government's Troubled Asset Relief Program - money the government seems increasingly eager to get back. Collectively, the two banks owe $4.9 billion to the government - more than any of the other mostly small 361 banks still in the program - or about a third of the TARP funds still owed by banks. And that, analysts say, may have affected how the Fed graded the two banks.

MORE: Where the stress test failed

Analysts thought a likely outcome of the stress test was that Regions and Zions would be told by the Fed that they had failed and would have to raise more capital. Instead, Regions and Zions passed the test, receiving better grades than many of their larger rivals, and were given the green light to repay government funds, which both banks now say they will do by the end of the year. Shares of Regions and Zions have risen more than other bank stocks since the test, up 10% and 16%, respectively, indicating investors were surprised by the results as well.

"Both companies received a pass in terms of the rigor of the test and getting out of TARP itself," says Todd Hagerman, an analyst who follows bank stocks at brokerage firm Sterne Agee & Leach. "The numbers for losses looked generous for those two banks."

The Fed said all the banks in the stress test were evaluated equally. Last week, Regions CEO Grayson Hall said he was pleased with the outcome of the Fed's stress test and that it "demonstrates the strength of our company." Zions said that even under the Fed's extreme stress test scenario - a rise in the unemployment rate to 13%, a 50% drop in stock prices, and a more than 20% decline in home prices - that the bank's capital had remained well above what the Fed required.

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But for Zions that result appears to be based on the fact that the Fed approved a loan loss estimate that was roughly half of the rate that was applied to other banks. Zions was not subject to the same stress test as Citigroup (C), Bank of America (BAC) and others. That's because it's not one of the nation's 19 largest banks. As part of the stress test, though, the Fed asked Zions and 10 other banks with more than $50 billion in assets to submit their estimates of how they would do under the Fed's stressed economic scenario. The Fed tested those projections and then passed or failed the banks based on its calculations. The Fed declined to make the details of the stress test of Zions and the other smaller banks public. Says Fed spokeswoman Barbara Hagenbaugh, "The Fed did not rubber stamp the results."

Nonetheless, it appears the Fed was more lenient with Zions than with other banks. Last month, Zions told analysts it projected that $1.7 billion, or 4.5% of its loans, would go unpaid under the Fed's stress scenario. That's significantly lower than average 8.1% loan loss estimate that the Fed used to determine whether the nation's 19 largest banks had enough capital or not. Go with Zion's estimate, which it appears the Fed did, and the bank comes out of the stress test with 60% more capital than is required. A pass. But if the Fed had applied the same loan loss ratio to Zions that it did on average to the other banks, Zions' stress test would have shown that the bank has 30% less capital than it needs, meaning it would have failed.

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Regions appears to have gotten a similarly light treatment. The overall loan loss projection for Regions, which is one of the nation's 19 largest banks, was in line with the average for other banks. But much of the bank's loan portfolio is concentrated in the Southeast, which has been hit hard by the housing bust, and where analysts expect loan loses to be higher than average.

In fact, Regions might already not have enough capital to cover its portfolio. As Bloomberg columnist Jonathan Weil has noted, Regions' recent financial statements said that the bank would have to take an $8 billion loss if the bank were forced to sell all of its loans today. Regions, however, only has $7.6 billion in capital to cover those losses, or $400 billion less than it needs. Meaning no stress test is required. Regions already fails.

"The administration seems to want to have as much of the bank bailout fund repaid by November," says analyst Hagerman. "I think that played into how the Fed looked at the TARP banks."

UPDATE: Zions CEO submitted this letter to the editor after FORTUNE's article was published. A Zions spokesperson said the bank did not originally respond to FORTUNE's requests for comments because the bank was in the middle of an offering.

Stephen Gandel's article, "In stress tests, Fed may have inflated grades for TARP banks," suggests that the Fed may have had its eyes half shut when evaluating the capital strength of my firm, Zions Bancorporation, in a hypothetical severely stressed economic environment. Mr. Gandel's comments about Zions Bancorporation missed the mark in some fundamentally important ways.

 First, Zions Bancorporation's loan losses as a percentage of average loans over the past four years have been better than the combined record chalked up by all large publicly traded banks by a wide margin; our annual average loss rate through the crisis and its aftermath was 1.90%, compared to 2.51% for large bank loan portfolios in general. And that's despite the fact that we had a disproportionate share of exposure in some of the nation's toughest markets, including Nevada, Arizona and SouthernCalifornia. We also had approximately twice the exposure of other banks to the hard-hit real estate construction and development sector. Our exposure to such loans, with their higher risk and potential loss content, has decreased by two thirds since the beginning of the crisis, substantially reducing our futurerisk profile.

At the same time, we've strengthened one of the strongest core deposit franchises in the industry, and maintained one of the strongest net interest margins among all large banks. Furthermore, Zions Bancorporation has also raised substantial capital since the financial crisis began. From 2008 through the end of 2012, we raised new common equity equal to 124% of our TARP investment, and preferred equity equal to 47% of TARP.  That compares to the median values of 52% and 40%, respectively, for capital raises by other banks that have exited TARP prior to 2012.

 It should also be noted that the sole Wall Street "analyst" that Mr. Gandel references in his comments about Zions Bancorporation is Todd Hagerman of Sterne Agee & Leach. Mr. Hagerman, in the days leading up to the release of the stress test results, had recommended that his clients sell short Zions shares, believing that we would have to issue $600 million of additional common equity (recently revised downward from his estimate of $1 billion). Mr. Hagerman's view was a clear outlier among the more than two dozen sell-side analysts that cover my company.  Given that clients heeding his recommendation would have suffered a substantial loss from the recent strength in the stock following the Fed's announcement, one might conclude that Mr. Hagerman has ample reason to pin the blame on the Fed's alleged flawed analysis, rather than his own.

 Harris H. Simmons

Chairman, President and CEO

Zions Bancorporation

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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