Mortgage repurchase claims could prove to be costly for Wells Fargo & Co. (WFC). According to its quarterly filing with the Securities and Exchange Commission, its losses might exceed the recorded mortgage repurchase liability by as much as $2.6 billion, up 13% from the prior quarter. However, the company said that this loss estimate is reasonably possible but does not represent a probable loss.

As a matter fact, Wells Fargo is experiencing increasing demand for mortgage repurchases from government sponsored entities (GSEs) Fannie Mae and Freddie Mac, related to loans made from 2006 to 2008.

Notably, Wells Fargo’s total reserves for mortgage repurchase requests stood at $1.8 billion at the end of June. This represents an increase from $1.4 billion recorded at the end of March. The company has made provisions of $669 million in the second quarter of 2012, up 56% sequentially and significantly ahead of the provisions of $242 million recorded a year ago.

The Backstory

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 total financial system. In several situations, the legitimacy of the mortgages as well as the documents was ambiguous. The mortgage originators did not exercise 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 can demand buybacks by the seller of the security.

Others in the Same Pool

Not only is Wells Fargo suffering from this mortgage mess and experiencing higher repurchases requests, other companies such as First Horizon National Corp. (FHN) and PNC Financial Services Group Inc. (PNC) are witnessing similar increases in buyback demands. These companies have substantially beefed up their reserves for the rising demands and consequently their second quarter 2012 results bore the brunt.

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

Our Take

We believe that increasing demands for mortgage buybacks would remain a headwind in the quarters ahead for Wells Fargo. However, we believe that over the long term, investors should not be disappointed with their investments in Wells Fargo given its diverse geographic and business mix, which enables it to sustain consistent earnings growth.

Going forward, we believe that strategic acquisitions will help expand Wells Fargo’s business and improve its profitability. The company is also capitalizing on the deleveraging activities of European banks.

Though a tepid economic recovery, a low interest rate environment as well as regulatory issues would continue to remain as overhangs, we believe that given its solid profitability potential, the company can efficiently manage this mortgage repurchase issue.

Wells Fargo currently retains a Zacks #3 Rank, which translates into a short-term Buy rating. Considering the fundamentals, we also maintain a Neutral recommendation on the stock.

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