Did the Fed Tamper With Stress Test Grades for Two TARP Banks?

Although the Fed proudly announced last week that a “majority of the biggest U.S. banks met ‘supervisory expectations for capital adequacy,'” some analysts believe the final grades for two banks were inflated.

Regions Financial and Zions Bancorp. received better grades in last week's stress tests than they deserved, according to a recent CNN Money report by Stephen Gandel.

Why would the Fed mess with the grades?

“One possible reason: Regions and Zions have yet to repay the bailout money they got from the government's Troubled Asset Relief Program [TARP] - money the government seems increasingly eager to get back,” Gandel writes.

Well, wait a minute. How much TARP money do these two banks owe?

According to Gandel, the two banks owe about $4.9 billion. That’s more than the other 361 banks still in the program (or about a third of the TARP funds still owed by banks).

“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,” Gandel writes.

“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,” he adds.

Of course, the Fed claims all banks were evaluated equally. In fact, according to the results of the stress test, Zions would have no problem retaining enough capital should any of the scenarios outlined by the Feds come to pass.

But there seems to be something wrong with this claim. Gandel explains:

...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, Bank of America 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.

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 percent of its loans, would go unpaid under the Fed's stress scenario. That's significantly lower than average 8.1 percent 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 percent 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 percent less capital than it needs, meaning it would have failed.

And it appears Regions was given a break as well.

“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,” according to CNN Money. “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,” the report adds.

Which is to say, if Regions were forced to sell all of its loans today, it would suffer an $8 billion dollar loss. But seeing as how Regions "only has $7.6 billion in capital to cover those losses," or $400 million less than it needs, this means the bank flunks the stress test automatically.

All of this supports the idea that the Fed may have toyed with the final grades because it's eager to have that $4.9 billion in TARP money repaid.

"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."