Ally Financial Inc stepped up its defense against the Federal Reserve on Friday, after the central bank singled out the auto lender as the weakest of 18 major banks in a stress test meant to show whether they could survive a severe economic downturn and a stock market crash.

Ally, once the in-house lender for General Motors Co , was able to maintain a Tier 1 common capital ratio of only 1.5 percent in the scenario, compared with a minimum of 5 percent that the Fed requires. The Tier 1 common capital ratio is a measure of a bank's ability to withstand losses.

Ally's ratio was a lot worse than the other banks, which all exceeded the minimum, with the next lowest being Morgan Stanley at 5.7 percent.

Ally's test score suffered because the Fed appeared to count mortgage liabilities that the lender has been seeking to shed through the bankruptcy of its Residential Capital mortgage unit, a source familiar with the matter said.

The lender also said in a securities filing on Friday that its own stress test projected significantly smaller losses from auto loans than the Fed's review.

The Fed's examination came at a particularly tricky time for Ally because it's in the middle of a complex restructuring. Residential Capital has filed for bankruptcy, and the lender has reached agreements to sell international operations for $9.2 billion in proceeds, but some of the deals haven't closed yet.

The stress test results are yet another hurdle for Ally as it tries to refocus the company on U.S. auto lending and pay back taxpayers that propped it up during the financial crisis.

The lender needs the Fed's approval to make any payments to the Treasury, which owns 74 percent of its common equity.

Ally received $17.2 billion in bailouts during the financial crisis. It says it has paid back $5.9 billion, including dividends. Ally said it would have more than sufficient capital when the international sales are completed to repay a substantial amount of the Treasury's investment, pending Fed approval.

The U.S. Treasury did not immediately respond to a request for comment.

BETTER RESULTS ON ITS OWN TEST

In its own version of the test, Ally said it would have been at a Tier 1 common capital ratio of no lower than 5.7 percent. Its ratio could have been even higher - 7.6 percent - if the Fed would have counted $5.9 billion in preferred stock owned by the U.S. Treasury that the Fed is allowed to convert into common equity at its discretion.

The lender's response to the Fed was sharper than last year, when Ally also disputed the Fed's findings after it failed the test. It said on Thursday that the Fed's analysis was "fundamentally flawed."

Ally is in discussions with the Fed over what steps to take next, the source said. The lender said that it continues to have "strong capital levels and ample liquidity to support its automotive finance operations."

A senior Fed official said on Thursday that firms falling below the minimum capital level would be required to craft a plan to get to a stronger capital position.

A Fed spokeswoman declined to comment on Friday.

The Fed appeared to use the Ally preferred stock owned by the Treasury to calculate other capital ratios, which compared much more favorably to peers, the source said.

According to Friday's filing, Ally did not include financials for its mortgage unit in its company-run stress test and counted the $9.2 billion in proceeds from planned sales of international businesses. Ally said it did not know how the Fed reflected its mortgage unit and international sales in its results.

GOVERNMENT'S MAJORITY STAKE

In a research report, Kathleen Shanley, an analyst with bond research firm Gimme Credit, said it was not surprising that Ally was the only bank to fall below the capital minimum, given that it is majority owned by the government and mired in a dispute with creditors over its mortgage unit bankruptcy.

In its stress test, the Fed assumed $2.4 billion in losses over the two-year period from other consumer loans, which includes auto loans, for a loss rate of 4.9 percent. Shanley noted that rate was much higher than the current annualized industry charge-off rate of 0.73 percent, which has been lower than historical trends lately.

In its company-run stress test, Ally said its "other consumer loans" would have produced $1.4 billion in losses, for a loss rate of 2.7 percent.

Other banks have also disclosed company-run stress tests results that were rosier than the Fed's. The banks have noted that their tests are based on the company's experience with its own portfolios, while the Fed does not disclose details about its loss models.

(Reporting By Rick Rothacker in Charlotte, N.C.; Editing by Paritosh Bansal and Jan Paschal)