Why Zions Bancorporation Flunked the Stress Test

Here's why Zions Bancorporation failed the stress test while investment banks like Goldman Sachs and Morgan Stanley sailed on through.

Mar 27, 2014 at 8:07PM

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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?

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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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John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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