U.S. Bancorp ( USB - Analyst Report ) plans to boost its mortgage repurchase reserves in the fourth quarter of 2012. The decision comes on the heels of Freddie Mac’s increase in its repurchase requests. The company conveyed this information to investors at Goldman Sachs Group Inc.’s ( GS - Analyst Report ) financials services conference yesterday, according to a Reuters report.

Government sponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae have already made repurchase demand on mortgages written between 2005 and 2008. However, last Friday, Freddie Mac informed lenders that it would initiate repurchase demands on mortgages generated in 2004.

Therefore, to meet the increased repurchase demands, U.S. Bancorp deemed it fit to beef up its reserve level. It would adversely impact its earnings by one to two cents in the fourth quarter.

The Back Story

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

When banks sell mortgage-backed securities to investors and GSEs, there is a clause that can force a bank to buyback 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 from the seller of the security.

In fact, a number of Wall Street Big banks have suffered severe losses for costs associated with such activities. PNC Financial Services Group Inc. ( PNC - Analyst Report ) and Bank of America Corp. ( BAC - Analyst Report ) too have experienced increased demands for mortgage repurchases from the GSEs.

In Conclusion

Currently, U.S. Bancorp is expected to report earnings of 75 cents per share in the fourth quarter. Though this elevation in repurchase reserve would slightly hurt the company’s earnings in the fourth quarter, we believe that given its solid financial position, the company can efficiently handle this mortgage repurchase issue and make adequate reserves.

U.S. Bancorp also boasts an attractive core franchisee and diverse revenue stream that helped it achieve strong performance in the past years. Solid capital position and increase in lending activities augur well. Yet, regulatory issues along with the expectation of a continued low interest rate environment are likely to limit the stock’s upside potential in the upcoming quarters.

Currently, U.S. Bancorp shares maintain a Zacks #2 Rank, which translates into a short-term Buy recommendation. As the repurchase issue is expected to impact the company’s earnings, downward estimate revisions might surface in the near term and affect the Zacks Rank.