Why Zions Bancorporation Flunked the Stress Test

If you're a shareholder of Zions Bancorporation (NASDAQ: ZION  ) , then there's a good chance you're irritated at the Utah-based bank. At the end of last week, investors learned it was the only major bank to fail this year's regulatory stress test.

The purpose of the annual examine is to ensure that bank holding companies like Zions have enough capital to withstand "highly stressful operating environments and be able to continue operations, maintain ready access to funding, meet obligations to creditors and counterparties, and serve as credit intermediaries."

The Federal Reserve determines this by assuming a number of adverse economic scenarios and then modeling the impacts on the participating bank's balance sheets and profitability.

While every bank that underwent the test experienced deep hypothetical losses that eroded their capital bases, none was hit as hard as Zions. Under the most extreme economic scenario modeled by the Fed, Zions saw its Tier 1 common capital ratio fall from 10.5% of risk-weighted assets all the way down to 3.5%, which is below the 5% regulatory minimum.

Indeed, even seemingly riskier investment banks like Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) fared better. Goldman Sachs' Tier 1 common capital ratio dropped from 14.2% down to 6.8%, and Morgan Stanley's went from 12.6% to 6.1%.

So, here's the question: Why did Zions come up short?

The answer to this lies in its loan portfolio. As you can see in the chart above, 90% of Zions' capital losses derived from loan loss provisions -- these are what a bank sets aside to cover bad loans. And more specifically, commercial real estate (CRE) loans alone accounted for 54% of total losses.

It's important to note in this regard that CRE loans by nature are one of the riskiest categories of bank loans. Under the stress test's "severely adverse" scenario, the Fed predicted that 8% of all CRE loans would have to be written off by the lenders. This compares to a 5% loss rate for general commercial loans and 6% for residential mortgages.

On top of this, there's reason to believe that the quality of Zions' CRE portfolio is worse than its competitors. I say this because Comerica also has a proportionally large CRE portfolio, accounting for an analogous 20% of its total loans, but it still sailed through the stress test.

And herein lies the issue for Zions' shareholders. If the latter is indeed true, it's an ominous sign, as a banker's greatest responsibility is to underwrite good loans. Consequently, if Zions isn't doing that, then investors should beware.

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  • Report this Comment On March 29, 2014, at 7:48 PM, hanover67 wrote:

    A bank's commercial real estate loans are usually secured, with a loan-to-value ratio of 70% or less, and the bank may also have cross guarantees of the borrowers with additional collateral. Many banks in the Western states have a relatively large R/E portfolio, as opposed to working capital, inventory, and other type borrowing base formulae.

    I think Zion's is a well-run bank, but one should look at the bank's classified loans, other real estate owned (OREO), and any other impaired assets as a matter of course. this information is usually contained in the Annual Report.

  • Report this Comment On April 18, 2014, at 3:34 PM, djson1 wrote:

    I think to be fair to some of these banks like Zions, it should be noted that it's not that they underwrote bad loans, necessarily, but that when they acquired large portfolios via acquisitions in the past 5 years, they were stuck with "adopting" these secondary and tertiary loans/relationships. So, that means, they have to dump all these "bad" acquired loans.

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