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Moody's Investors Service, a rating arm of Moody’s Corp. (MCO - Analyst Report), downgraded the rating outlook of First Horizon National Corporation (FHN - Analyst Report) and its subsidiaries. Moody’s downgraded the senior unsecured debt rating of First Horizon to Baa3 from Baa2.

Additionally, the baseline credit assessment (BCA) of First Tennessee Bank – the primary banking subsidiary – was lowered to baa2 from baa1. However, the standalone bank financial strength rating (BFSR) of First Tennessee Bank was affirmed at C-. Therefore, the long-term deposit rating of First Tennessee Bank was downgraded to Baa2 from Baa1, whereas the short-term deposit rating was affirmed at Prime-2.

Why the Downgrade?

The rating agency is concerned with First Horizon’s obstacles to reach heightened profitability, primarily from the company’s legacy mortgage banking business. Recently, the company signed an agreement in principle with Fannie Mae (FNMA), settling certain legacy representation and warranty repurchase obligations related to loans originated from 2000 to 2008.
 
As a result, in the quarter ended Sep 30, 2013, First Horizon reported loss per share of 45 cents, accounting for the negative impact of 64 cents per share (after tax) due to the addition of $200 million to the repurchase reserve.

Although, a substantial part of the repurchase reserve was related to a still awaiting settlement with Fannie Mae, the company’s repurchase expense will continue to remain an overhang on its financials. Notably, from 2009, First Horizon’s cumulative repurchase provision equals 50% of its pre-provision pre-tax income (excluding repurchase provisions).

The rating agency is also concerned about the company’s weak credit quality. First Horizon has a significant exposure to problem loan categories such as national home equity loans. The asset quality of the company remains affected by its hefty run-off loan portfolio, which constitutes roughly 20% of total loans. Further, more than half of the company’s problem loans are from the run-off portfolio.

As of Sep 30, 2013, the company’s non-performing assets (including loans past due 90 days or more and all restructured loans) was 5.7% of loans plus other real estate owned. Even though, the company is gradually winding down its non-strategic loan portfolio, it will continue to be a drag on its credit quality for some time.

Favorable Outlook

On a positive note, Moody’s upgraded the outlook on First Horizon to Stable from Negative. This was based on the parent company’s efforts to strengthen its core retail banking franchise in Tennessee. Additionally, the rating agency was impressed with the company’s healthy capital position, which will help counter the hazards of mortgage-related charges in the future.

Our Viewpoint

As downgrades in ratings affect investors’ confidence in the company and its creditworthiness in the market, First Horizon’s endeavor to lower its exposure to problem loans appear impressive to us. The company also aims to control costs and improve long-term profitability by strengthening its core Tennessee banking franchise.
 
Nevertheless, regulatory issues and the likely persistence of low interest rates could limit the stock’s upside potential in the quarters ahead.

First Horizon currently carries a Zacks Rank #4 (Sell). A Southeast bank we prefer is American National Bankshares Inc. (AMNB - Snapshot Report), which carries a Zacks Rank #1 (Strong Buy).
 

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