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.
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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 strengthen 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."
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