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First Horizon National Corp. (FHN - Analyst Report) expects to incur charges of $272 million in the second quarter of 2012 for mortgage repurchase and pending litigation issues. The company will beef up its mortgage repurchases reserve by about $250 million to meet repurchase demands from two government-sponsored entities (GSEs), Fannie Mae and Freddie Mac.

This addition in mortgage repurchase reserve will be recorded as expense by First Horizon. At the end of the first quarter, the company’s reserves stood at $161 million. For meeting repurchase activity in the second quarter, around $60 million is expected to be realized by First Horizon as losses. Therefore, at the end of the second quarter, the company’s mortgage repurchase reserve is likely to stand at $351 million.

Considering the earnings charges and losses to be realized in the second quarter of 2012, the cumulative total of losses realized to date as well as reserves for First Horizon's mortgage repurchase exposure to the two GSEs is around $750 million. The remaining charges are for the company’s litigation issues.

Earlier in June, PNC Financial Services Group Inc. (PNC - Analyst Report) also announced that it will boost its residential mortgage repurchase reserves by around $350 million in the second quarter of 2012. The decision stemmed from the company’s experience of recently elevated levels of GSE-related repurchase demands. The mortgages were mostly originated by National City Corp., which was acquired in 2009.

In fact, a number of big Wall Street banks have suffered billions in losses for costs associated with such activities.  Besides First Horizon and PNC Financial, Bank of America Corp. (BAC - Analyst Report) is also experiencing increased demands for mortgage repurchases from the GSEs. The mortgages originated primarily from Countrywide Financial which Bank of America had purchased in 2008.

The Backstory

It was found in the aftermath of the real estate market collapse in 2008 and the financial crisis that mortgage and mortgage backed securities occupied a significant share of the total financial system. In several situations, the legitimacy of the mortgages as well as the documents was doubtful. The mortgage originators did not complete due diligence in several cases and also deliberately defrauded.

Now when banks sell mortgage-backed securities to investors and GSEs, there is a clause that can force a bank to buy back the securities in the event of fraudulent or faulty underwriting or origination of the underlying mortgage. Therefore, in cases of fraudulent and faulty origination documents, the holder of the mortgage-backed securities demands buybacks by the seller of the security.

In Conclusion 

We believe mortgage repurchase expense will continue to remain an overhang for First Horizon. While the company sold its mortgage origination and servicing platforms in 2008, it bears the liability for the conforming conventional mortgage loans purchased by the GSEs from First Horizon which were originated over many years till 2008.

Though the winding down of the non-strategic part of the loan portfolio bodes well, it will remain a drag on First Horizon's earnings going forward. A shrinking revenue base and regulatory issues, tepid economic recovery coupled with a low interest rate environment and mortgage exposure serves as headwinds for the company’s results.

Yet First Horizon’s endeavor to lower its exposure to problem loans is impressive. The company is also aiming at controlling costs, strengthening capital levels, and improving long-term profitability by focusing on growing its core Tennessee banking franchise, which would augur well going forward. Moreover, share buybacks give a boost to investors’ confidence in the stock.

First Horizon shares maintain a Zacks #3 Rank, which translates into a short-term Hold recommendation. Considering the fundamentals, we also maintain our long-term Neutral rating on the stock.

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