April 21 (Bloomberg) -- Stress tests on the 19 largest U.S. banks are increasingly focusing on the quality of loans they made after finding wide variations in underwriting standards, a regulatory official said.

Supervisors concluded that banks’ lending practices need to be given as much weight as macroeconomic scenarios in determining the health of each bank, the official said. The approximately 200 examiners poring over the banks’ portfolios have found widely differing standards for mortgages and other loans, the person said.

The expanded criteria for the stress tests will make it easier for regulators to separate out vulnerabilities caused by bad management from those stemming from broader economic factors. Treasury Secretary Timothy Geithner has said he’s prepared to make management changes in any firms requiring “exceptional” amounts of fresh taxpayer funding.

“There was a heavy assumption” that soaring loan defaults in recent months were caused by the recession, said Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington. “If they find out that these were business decisions, that, in an odd way, is probably a good sign because you can fix this. There are very hard lessons to be learned.”

Geithner told an oversight panel today that “the vast majority of banks have more capital than they need.”

Methodology Paper

The official’s remarks provide insight into the release April 24 on the regulator’s methodology for the tests. The person also said the tests don’t amount to solvency judgments, noting that estimates of each bank’s losses over the coming two years won’t necessarily equal the amount of new capital it needs to raise.

The goal of the reviews is to keep the major financial institutions lending over the next two years, and to determine how much capital they might need should the economic downturn worsen. Assumptions about capital will be forward-looking, the official said.

Supervisors will take into account how much capital each company now has, the ability to retain earnings over the next few years, access to private capital in the future and how aggressively they have already written down some assets.

Fed Takes Lead

Federal Reserve officials are coordinating the exams, dedicating a staff of about 140 people to the effort. All told about 200 regulatory officials are involved, with information percolating up from front-line bank examiners.

While the tests are a central element of the Obama administration’s financial rescue plan, the Treasury charged the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., and Office of Thrift Supervision to conduct them.

Some of the findings on how portfolio quality varied will be revealed April 24 when supervisors release the white paper on the methodology. Final results of the tests will be released May 4. No decision has been made yet on how to publish the results, with some regulators concerned about a lack of uniformity in the releases if each firm discloses its own results, the official said.

Firms found to need more capital will be given six months to raise it, with the first option to attempt to raise it from the private market. Taxpayer funding will be made available from the Treasury’s $700 billion Troubled Asset Relief Program.

The Treasury is also open to converting its current preferred shares into common equity, a step that would boost capital levels and reduce banks’ interest payments.

‘Quality of Capital’

“What’s important is not just the overall level of capital, but the quality of capital, including the amount of tangible common equity,” Geithner said in testimony before a panel appointed by Congress to oversee the Troubled Asset Relief Program.

Bank of New York Mellon Corp., the world’s biggest custody bank, reported that its first-quarter earnings fell 51 percent, more than analysts had estimated, to $370 million. The U.S. injected $3 billion in preferred stock and warrants into the New York-based company in October and the firm each quarter pays a portion of a 5 percent annual dividend on the preferred shares.

The stress-test methodology paper will discuss what supervisors describe as a propensity for loss among loan portfolios. Some categories of lending, such as credit cards, are highly correlated with macroeconomic data such as rising unemployment.

Repayment Ability

More variance might be expected in other kinds of assets, such as commercial real estate or mortgages, where assumptions about clients’ ability to repay played a larger role. There, default rates have soared on some products because they were originated with little regard for a borrowers’ underlying payment ability.

U.S. regulators failed to prevent the plunging credit standards that surrounded the home-lending boom earlier this decade. They also underestimated how the housing shock would reverberate through the financial system, tightening credit, and worsening overall economic conditions.

In a review of the crisis, Phillip Swagel, former assistant Treasury secretary of economic policy, said Treasury and Fed officials in 2007 began to separately look at how foreclosures were linked to economic conditions such as the unemployment rate and housing prices.

“The prediction we made at an interagency meeting in May 2007 was that we were nearing the worst of it in terms of foreclosure starts,” Swagel wrote in a March 30 Brookings Institution paper. Officials forecast “the inventory of foreclosed homes would build throughout 2007, but that the foreclosure problem would subside after a peak in 2008.”

Underlying Mortgages

“What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007,” said Swagel, who noted that the Federal Deposit Insurance Corp. staff did point out loan quality issues. “The problems were baked into the mortgage at origination in a way not present before 2005.”

Foreclosure rates on subprime mortgages soared to 13.7 percent in the fourth quarter of 2008, up from 8.65 percent the same quarter a year earlier, according to the Mortgage Bankers Association. Mortgage delinquencies increased to 7.9 percent of all loans in the final three months of last year, the highest level in records going back to 1972.

Geithner announced the stress tests in February, including two economic scenarios. Under the assessments’ “more adverse” scenario, the unemployment rate is seen rising to 10.3 percent in 2010 from 8.5 percent currently.

Growing Pool

Bank of America Corp., the largest U.S. lender by assets, fell the most in almost two months of New York trading April 20 after putting aside $6.4 billion to cover a growing pool of uncollectible loans. Kenneth D. Lewis, chief executive officer of the Charlotte, North Carolina-based bank said unpaid loans are rising because of the weak economy and higher unemployment.

Bank of America is one of the 19 firms, along with Citigroup Inc., Capital One Financial Corp., GMAC LLC and regional lenders including Keycorp and Regions Financial Corp.

Goldman Sachs Group Inc. and JPMorgan Chase & Co. have said they plan to return the taxpayer funds they’ve received under the TARP.

“It is vitally important that our financial system emerge from this crisis stronger and that actions the government takes to stabilize the financial system do not sustain the weak at the expense of the strong,” Geithner said in his opening remarks before the oversight panel today.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: April 21, 2009 16:32 EDT