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Increase in reserves for government-sponsored entities (GSE) mortgage repurchases have resulted in First Horizon National Corp. (FHN - Analyst Report) reporting a loss in the second-quarter of 2012, following five consecutive quarters of profit.

First Horizon reported a loss available to common shareholders of $124.8 million or 50 cents per share, in line with the Zacks Consensus Estimate. The company had earned $30.5 million or 12 cents per share in the prior quarter and $20.0 million or 6 cents per share from continuing operations in the year-ago quarter.

Besides the increased provisions for mortgage buybacks, the company also made litigation-related accruals. As a result, First Horizon incurred a pre-tax charge of $272 million for GSE-related mortgage repurchase and litigation reserves. Together, the provisions resulted in a negative impact of 67 cents per share on the company’s earnings.

Revenue came in at $331.6 million, below the Zacks Consensus Estimate of $359 million. The revenue figure also fell 11% sequentially and 8% year over year. While net interest income remain relatively flat both sequentially and year over year, decline in non-interest income primarily pulled the revenue figure down.

Also, provision for loan losses reported an increase to $15 million from $8 million reported in the prior quarter and $1 million reported in the year-ago quarter.

Quarter in Detail

Net interest income was relatively flat both sequentially and year over year at $172.7 million. Net interest margin moved up 4 basis points (bps) sequentially to 3.16%. However, from the prior-year quarter, net interest margin reported a 4 bps decline.

Non-interest income slipped 24% sequentially and 18% year over year to $153.8 million. Non-interest expense increased 64% sequentially and 53% year over year to $527.2 million.

Period-end loans were up 1% both sequentially and year over year. Though total deposits fell 5% sequentially, it advanced 1% year over year.
 
Credit Quality

Credit trends continued to improve, but at a slower rate. Allowance for loan losses were down 7% sequentially and 39% year over year to $321.1 million. As a percentage of period-end loans on an annualized basis, allowance for loan losses were 1.98%, down 19 bps from the prior quarter and 128 bps year over year.

Net charge-offs were down 14% sequentially and 39% year over year to $40.0 million. As a percentage of average loans and on an annualized basis, net charge-offs were 1.01%, down 15 bps sequentially and 66 bps year over year.

Non-performing assets fell 9% sequentially and 38% year over year to $466.9 million. As a percentage of period-end loans plus foreclosed real estate and other assets, non-performing assets were 2.32%, down 24 bps sequentially and 177 bps year over year.

Evaluation of Capital

First Horizon’s capital ratios declined in the reported quarter. Tier 1 capital ratio decreased to 13.10% from 14.36% in the prior quarter and 14.39% in the year-ago quarter. Tangible common equity ratio fell 57 bps sequentially and 80 bps year over year to 8.13%. Also, book value came in at $8.92 per share, down from $9.42 per share in the prior quarter and $9.05 in the year-ago quarter.

Capital Deployment Update

On July 17, the board of directors of First Horizon approved a quarterly cash dividend of 1 cent per share. The dividend is payable on October 1 to common shareholders of record on September 14, 2012.

During the reported quarter, First Horizon bought back $36.9 million in shares. Following this, the company had $74.5 million available under its $200 million stock repurchase program.

The Mortgage Repurchase Reserve Issue

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 that were originated over many years till 2008.

Besides First Horizon, PNC Financial Services Group Inc. (PNC - Analyst Report) has also beefed up its residential mortgage repurchase reserves by a significant amount in the second quarter following the recently elevated levels of GSE-related repurchase demands.

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.

Our Viewpoint

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 along with a low interest rate environment and mortgage exposure serve 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 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.

Among First Horizon’s peers, both Regions Financial Corporation (RF - Analyst Report) and Synovus Financial Corp. (SNV - Analyst Report) will release their second-quarter 2012 earnings on July 24.

First Horizon retains its Zacks #3 Rank, which translates into a short-term Hold rating.

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