SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 for the quarter ended September 30, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 for the transition period from _______________ to
___________________.
Commission File Number: 001-16581
SOVEREIGN BANCORP, INC.
(Exact name of Registrant as specified in its charter)
Pennsylvania 23-2453088
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1500 Market Street, Philadelphia, Pennsylvania 19103
(Address of principal executive offices) (Zip Code)
Registrant's telephone number: (215) 557-4630
2000 Market Street, Philadelphia, Pennsylvania 19103
(Former name, former address and former fiscal year, if changed since last
report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 12, 2002
- --------------------------- --------------------------------
Common Stock (no par value) 261,202,696 shares
FORWARD LOOKING STATEMENTS
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward-looking statements made by or on behalf of Sovereign
Bancorp, Inc. ("Sovereign"). Sovereign may from time to time make
forward-looking statements in Sovereign's filings with the Securities and
Exchange Commission (including this Quarterly Report on Form 10-Q and the
Exhibits hereto), in its reports to shareholders (including its 2001 Annual
Report) and in other communications by Sovereign, which are made in good faith
by Sovereign, pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Some of the disclosure communications by
Sovereign, including any statements preceded by, followed by or which include
the words "may," "could," "should," "pro forma," "looking forward," "will,"
"would," "believe," "expect," "anticipate," "estimate," "intend," "plan,"
"strive," "hopefully," "try," "assume" or similar expressions constitute
forward-looking statements.
These forward-looking statements include statements with respect to
Sovereign's vision, mission, strategies, goals, beliefs, plans, objectives,
expectations, anticipations, estimates, intentions, financial condition, results
of operations, future performance and business of Sovereign, including
statements relating to:
- growth in cash earnings, operating earnings, net income, shareholder
value and internal tangible equity generation;
- growth in earnings, operating earnings and cash earnings per share;
- return on equity;
- return on assets;
- efficiency ratio;
- Tier 1 leverage ratio;
- annualized net charge-offs and other asset quality measures;
- fee income as a percentage of total revenue;
- ratio of tangible equity to assets;
- book value and tangible book value per share; and
- loan and deposit portfolio compositions, employee retention,
customer retention, asset quality and reserve adequacy.
These forward-looking statements, implicitly and explicitly, include the
assumptions underlying the statements. Although Sovereign believes that the
expectations reflected in these forward-looking statements are reasonable, these
FORWARD LOOKING STATEMENTS
(continued)
statements involve risks and uncertainties which are subject to change based on
various important factors (some of which are beyond Sovereign's control). The
following factors, among others, could cause Sovereign's financial performance
to differ materially from its goals, plans, objectives, intentions,
expectations, forecasts and projections (and the underlying assumptions)
expressed in the forward-looking statements:
- the strength of the United States economy in general and the
strength of the regional and local economies in which Sovereign
conducts operations;
- the effects of, and changes in, trade, monetary and fiscal policies
and laws, including interest rate policies of the Board of Governors
of the Federal Reserve System;
- inflation, interest rate, market and monetary fluctuations;
- Sovereign's ability to successfully integrate any assets,
liabilities, customers, systems and management personnel Sovereign
acquires into its operations and its ability to realize related
revenue synergies and cost savings within expected time frames;
- Sovereign's timely development of competitive new products and
services in a changing environment and the acceptance of such
products and services by customers;
- the willingness of customers to substitute competitors' products and
services and vice versa;
- the impact of changes in financial services policies, laws and
regulations, including laws, regulations and policies concerning
taxes, banking, capital, liquidity, proper accounting treatment,
securities and insurance, and the application thereof by regulatory
bodies and the impact of changes in and interpretation of generally
accepted accounting principles;
- technological changes;
- changes in consumer spending and savings habits;
- terrorist attacks in the United States or upon United States
interests abroad, or armed conflicts relating to these attacks;
- armed conflicts involving the United States military;
- regulatory or judicial proceedings;
- changes in asset quality; and
- Sovereign's success in managing the risks involved in the foregoing.
FORWARD LOOKING STATEMENTS
(continued)
If one or more of the factors affecting Sovereign's forward-looking
information and statements proves incorrect, then its actual results,
performance or achievements could differ materially from those expressed in, or
implied by, forward-looking information and statements. Therefore, Sovereign
cautions you not to place undue reliance on any forward-looking information and
statements.
Sovereign does not intend to update any forward-looking information and
statements, whether written or oral, to reflect any change. All forward-looking
statements attributable to Sovereign are expressly qualified by these cautionary
statements.
Operating earnings and cash earnings which are included and defined
herein, and the related ratios using these measures are not a substitute for
other financial measures determined in accordance with generally accepted
accounting principles. Because all companies do not calculate these measures in
the same fashion, these measures as presented may not be comparable to other
similarly titled measures of other companies.
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 2002
and December 31, 2001 6
Consolidated Statements of Operations for the three-month
and nine-month periods ended September 30, 2002 and 2001 7
Consolidated Statement of Stockholders' Equity for
the nine-month period ended September 30, 2002 9
Consolidated Statements of Cash Flows for the nine-month
periods ended September 30, 2002 and 2001 10
Notes to Consolidated Financial Statements 11 - 23
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 24- 44
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 44
Item 4. Controls and Procedures 44
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 45
SIGNATURES 46
CERTIFICATIONS 47 - 48
EXHIBITS INDEX 49
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
September 30, December 31,
2002 2001
------------ ------------
(in thousands, except
per share data)
ASSETS
Cash and amounts due from
depository institutions $ 1,236,040 $ 907,279
Investment securities:
Available-for-sale 11,067,631 9,581,679
Held-to-maturity
(fair value approximates $722,922 and $883,208
at September 30, 2002 and December 31, 2001,
respectively) 704,750 883,437
Loans (including loans held for sale
at approximate fair value of
$304,749 and $308,950 at September 30, 2002
and December 31, 2001, respectively) 22,472,806 20,399,584
Allowance for loan losses (295,259) (264,667)
------------ ------------
Net loans 22,177,547 20,134,917
------------ ------------
Premises and equipment 280,615 251,587
Accrued interest receivable 183,773 183,913
Goodwill, net of accumulated amortization 1,025,292 954,688
Core deposit intangibles, net of
accumulated amortization 362,885 389,216
Bank owned life insurance 756,518 724,242
Other assets 1,768,112 1,463,880
------------ ------------
TOTAL ASSETS $ 39,563,163 $ 35,474,838
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits and other customer accounts $ 26,535,901 $ 23,297,574
Borrowings 3,117,483 2,678,764
Long-term debt 5,997,397 6,261,006
Advance payments by borrowers
for taxes and insurance 14,738 20,943
Other liabilities 589,226 409,542
------------ ------------
TOTAL LIABILITIES 36,254,745 32,667,829
------------ ------------
Company-obligated mandatorily redeemable
preferred securities of subsidiary trust
holding junior subordinated debentures of
Sovereign ("Trust Preferred Securities") 397,442 404,136
------------ ------------
Minority interests 200,268 200,392
------------ ------------
STOCKHOLDERS' EQUITY
Common stock; no par value; 400,000,000 shares
authorized; 265,372,495 shares issued at
September 30, 2002 and 252,386,163 shares
issued at December 31, 2001 1,576,354 1,416,267
Warrants 91,500 91,500
Stock options 7,617 --
Unallocated common stock held by the Employee
Stock Ownership Plan at cost;
3,626,414 shares at September 30, 2002
and 4,247,873 shares at December 31, 2001 (23,177) (30,945)
Treasury stock at cost; 218,680 shares at
September 30, 2002 and 108,792 shares at
December 31, 2001 (2,027) (515)
Unearned compensation - Restricted stock (4,228) (6,272)
Accumulated other comprehensive income/(loss) 69,619 (33,135)
Retained earnings 995,050 765,581
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 2,710,708 2,202,481
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 39,563,163 $ 35,474,838
============ ============
See accompanying notes to consolidated financial statements.
-6-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three-Month Period Nine-Month Period
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(in thousands, except
per share data)
INTEREST INCOME:
Interest-earning deposits $ 915 $ 796 $ 3,833 $ 1,650
Investment securities:
Available-for-sale 161,094 157,893 460,430 385,092
Held-to-maturity 11,472 16,272 37,356 53,721
Interest and fees on loans 350,862 388,380 1,043,327 1,260,331
---------- ---------- ---------- ----------
TOTAL INTEREST INCOME 524,343 563,341 1,544,946 1,700,794
---------- ---------- ---------- ----------
INTEREST EXPENSE:
Interest on deposits
and other customer accounts 119,420 165,530 346,725 579,625
Interest on borrowings and
other debt 107,373 126,991 331,737 344,546
---------- ---------- ---------- ----------
TOTAL INTEREST EXPENSE 226,793 292,521 678,462 924,171
---------- ---------- ---------- ----------
NET INTEREST INCOME 297,550 270,820 866,484 776,623
Provision for loan losses 38,000 22,000 110,500 65,100
---------- ---------- ---------- ----------
NET INTEREST INCOME AFTER PROVISION FOR
LOAN LOSSES 259,550 248,820 755,984 711,523
---------- ---------- ---------- ----------
NON-INTEREST INCOME:
Consumer banking fees 47,743 37,619 130,549 116,531
Commercial banking fees 24,976 21,575 71,281 57,602
Mortgage banking revenues 4,245 20,307 20,320 56,378
Capital markets revenue 4,436 2,330 9,581 8,226
Bank owned life insurance 10,722 10,296 31,655 29,963
Miscellaneous income 5,367 2,636 13,519 39,793
---------- ---------- ---------- ----------
TOTAL FEES AND OTHER INCOME 97,489 94,763 276,905 308,493
---------- ---------- ---------- ----------
Gain on investment securities and
related derivatives transactions 12,668 4,412 37,075 17,508
---------- ---------- ---------- ----------
TOTAL NON-INTEREST INCOME 110,157 99,175 313,980 326,001
---------- ---------- ---------- ----------
GENERAL AND ADMINISTRATIVE EXPENSES:
Compensation and benefits 91,460 78,069 269,729 236,786
Occupancy and equipment expenses 54,716 50,025 154,987 155,645
Technology expense 17,494 17,780 51,849 52,568
Outside services 12,210 12,394 36,293 40,947
Other administrative expenses 31,445 33,215 94,199 95,002
---------- ---------- ---------- ----------
TOTAL GENERAL AND ADMINISTRATIVE EXPENSES 207,325 191,483 607,057 580,948
---------- ---------- ---------- ----------
-7-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(continued)
Three-Month Period Nine-Month Period
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
(in thousands, except
per share data)
OTHER EXPENSES:
Amortization of intangibles,
including goodwill in 2001 $ 20,003 $ 32,556 $ 60,695 $ 101,420
Trust Preferred Securities and
other minority interest expense 15,313 14,676 46,776 43,750
Merger-related and integration charges -- -- 15,871 --
Non-solicitation expense -- 98,809 -- 243,241
Restructuring expense -- -- -- 8,500
---------- ---------- ---------- ----------
TOTAL OTHER EXPENSES 35,316 146,041 123,342 396,911
---------- ---------- ---------- ----------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEM 127,066 10,471 339,565 59,665
Income tax provision 33,927 1,855 90,664 9,755
---------- ---------- ---------- ----------
Income before extraordinary item 93,139 8,616 248,901 49,910
Extraordinary item - Debt extinguishment
(net of tax of $3,526 - 2001) -- -- -- (6,549)
---------- ---------- ---------- ----------
NET INCOME $ 93,139 $ 8,616 $ 248,901 $ 43,361
========== ========== ========== ==========
EARNINGS PER SHARE:
Basic
Income before extraordinary item $ .36 $ .03 $ .97 $ .20
Extraordinary item -- -- -- (.03)
---------- ---------- ---------- ----------
NET INCOME $ .36 $ .03 $ .97 $ .17
========== ========== ========== ==========
Diluted
Income before extraordinary item $ .33 $ .03 $ .90 $ .20
Extraordinary item -- -- -- (.03)
---------- ---------- ---------- ----------
NET INCOME $ .33 $ .03 $ .90 $ .17
========== ========== ========== ==========
DIVIDENDS DECLARED PER COMMON SHARE $ .025 $ .025 $ .075 $ .075
========== ========== ========== ==========
See accompanying notes to consolidated financial statements.
-8-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(unaudited)
(in thousands)
Common
Shares Out- Common Stock Retained
standing Stock Warrants options Earnings
-------- ----- -------- --------- --------
Balance, December 31, 2001 247,470 $ 1,416,267 $ 91,500 $ -- $ 765,581
Comprehensive income:
Net income -- -- -- -- 248,901
Other comprehensive income,
net of tax:
Change in unrealized net
investment gains, net
of reclassification
adjustments -- -- -- -- --
Change in accumulated
losses on derivatives,
net of reclassification
adjustments -- -- -- -- --
Total comprehensive income -- -- -- -- --
Acquisition of Main
Street Bancorp 11,367 148,578 -- -- --
Contingent purchase payout
Network Leasing 166 7 -- -- --
Exercise of stock options 1,124 7,761 -- -- --
Stock option expense -- -- -- 7,617 --
Stock issued under
Dividend Reinvestment
Plan and Employee Stock
Purchase Plan 236 3,037 -- -- --
Dividends paid on
common stock -- -- -- -- (19,432)
Stock repurchased (71) -- -- -- --
Stock issued 55 140 -- -- --
Vesting and allocation of
shares of restricted stock plan 182 -- -- -- --
Termination of Employee
Stock Ownership Plan 621 564 -- -- --
------- ----------- ----------- ----------- -----------
Balance,
September 30, 2002 261,150 $ 1,576,354 $ 91,500 $ 7,617 $ 995,050
======= =========== =========== =========== ===========
Unearned Accumulated Total
Compensation Unallocated Other Stock-
Treasury Restricted Common Stock Comprehensive holders'
Stock Stock Held by ESOP Income/(Loss) Equity
----- ----- ------------ ------------- ------
Balance, December 31, 2001 $ (515) $ (6,272) $ (30,945) $ (33,135) $ 2,202,481
-----------
Comprehensive income:
Net income -- -- -- -- 248,901
Other comprehensive income,
net of tax:
Change in unrealized net
investment gains, net
of reclassification
adjustments -- -- -- 190,767 190,767
Change in accumulated
losses on derivatives,
net of reclassification
adjustments -- -- -- (88,013) (88,013)
-------
Total comprehensive income -- -- -- -- 351,655
-------
Acquisition of Main
Street Bancorp (3,116) -- -- -- 145,462
Contingent purchase payout
Network Leasing 1,993 -- -- -- 2,000
Exercise of stock options -- -- -- -- 7,761
Stock option expense -- -- -- -- 7,617
Stock issued under
Dividend Reinvestment
Plan and Employee Stock
Purchase Plan -- -- -- -- 3,037
Dividends paid on
common stock -- -- -- -- (19,432)
Stock repurchased (922) -- -- -- (922)
Stock issued 604 -- -- -- 744
Vesting and allocation of
shares of restricted stock plan (71) 2,044 -- -- 1,973
Termination of Employee
Stock Ownership Plan -- -- 7,768 -- 8,332
----------- ----------- ----------- ----------- -----------
Balance,
September 30, 2002 $ (2,027) $ (4,228) $ (23,177) $ 69,619 $ 2,710,708
=========== =========== =========== =========== ===========
See accompanying notes to consolidated financial statements.
-9-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine-month Period
Ended September 30,
-------------------
2002 2001
---- ----
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 248,901 $ 43,361
Adjustments to reconcile net income to
net cash provided by operating activities:
Provision for loan losses 110,500 65,100
Deferred taxes (28,671) (15,436)
Depreciation and amortization 101,465 116,722
Net amortization of investment
securities and loan premiums 15,356 9,281
Gain on sale of investment
securities and related derivatives (37,075) (17,508)
(Gain)/loss on real estate owned 116 (63)
(Gain)/loss on sale of fixed assets 484 (1,032)
Loss on the retirement of Bancorp debt -- 10,075
Restricted stock and stock option expense 9,661 --
Net change in:
Loans held for sale 4,201 136,742
Accrued interest receivable 5,195 15,315
Other assets and bank owned life insurance (462,154) (434,819)
Other liabilities 155,986 107,180
----------- -----------
Net cash provided by operating activities 123,965 34,918
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities:
Available-for-sale 5,455,065 5,077,130
Proceeds from repayments and maturities of
investment securities:
Available-for-sale 1,841,286 1,154,374
Held-to-maturity 182,755 223,276
Purchases of investment securities:
Available-for-sale (8,156,190) (8,646,108)
Held-to-maturity (834) (1,224)
Proceeds from sales of loans 1,986,329 2,972,234
Purchase of loans (1,522,652) (1,930,918)
Net change in loans other than purchases and sales (1,834,234) (451,591)
Proceeds from sales of premises and equipment 6,053 24,785
Purchases of premises and equipment (25,494) (10,664)
Proceeds from sale of real estate owned 13,820 5,271
Cash received from acquired bank, net of cash paid 207,704 --
----------- -----------
Net cash used in investing activities (1,846,392) (1,583,435)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase/(decrease) in deposits
and other customer accounts 1,980,278 (1,238,781)
Net increase in borrowings 438,719 1,809,427
Net increase/(decrease) in long-term debt (300,593) 722,952
Proceeds from senior secured credit facility
and senior and subordinated notes -- 525,000
Repayments of senior secured credit facility
and senior and subordinated notes (50,000) (590,000)
Net decrease in advance payments by
borrowers for taxes and insurance (6,205) (6,848)
Repurchases of Trust Preferred Securities (11,460) --
Cash dividends paid to stockholders (19,432) (18,494)
Proceeds from issuance of common stock 11,509 153,961
Termination of ESOP 7,768 --
Other net changes in treasury stock 604 (3,041)
----------- -----------
Net cash provided by financing activities 2,051,188 1,354,176
----------- -----------
Net change in cash and cash equivalents 328,761 (194,341)
Cash and cash equivalents at beginning of period 907,279 959,643
----------- -----------
Cash and cash equivalents at end of period $ 1,236,040 $ 765,302
=========== ===========
SUPPLEMENTAL DISCLOSURES:
Income taxes paid $ 142,293 $ 33,387
Interest paid $ 662,657 $ 915,346
Non cash transaction:
On March 8, 2002, Sovereign Bancorp, Inc. issued 11,367,000 shares as partial
consideration for the acquisition of Main Street Bancorp, Inc. (see footnote
12).
See accompanying notes to consolidated financial statements.
-10-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Amounts in thousands except share data, unless otherwise noted)
(1) BASIS OF PRESENTATION AND ACCOUNTING POLICIES
Basis of Presentation
The accompanying financial statements of Sovereign Bancorp, Inc. and
Subsidiaries ("Sovereign" or the "Company") include the accounts of the parent
company, Sovereign Bancorp, Inc. and its wholly-owned subsidiaries: Sovereign
Bank, Sovereign Delaware Investment Corporation, Sovereign Capital Trust I,
Sovereign Capital Trust II, Sovereign Capital Trust III, MBNK Capital Trust I
and ML Capital Trust I. All intercompany balances and transactions have been
eliminated in consolidation.
These financial statements have been prepared by the Company, without
audit, pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in conformity with accounting principles generally
accepted in the United States have been condensed or omitted pursuant to such
rules and regulations. However, in the opinion of management, the accompanying
consolidated financial statements reflect all adjustments necessary to present
fairly the consolidated balance sheet, statements of operations and cash flows
for the periods indicated, and contain adequate disclosure to make the
information presented not misleading. It is suggested that these consolidated
financial statements be read in conjunction with the Company's latest annual
report on Form 10-K.
The preparation of these financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes. Actual results could differ
from those estimates. Certain amounts in the financial statements of prior
periods have been reclassified to conform with the presentation used in current
period financial statements. These reclassifications have no effect on net
income.
The results of operations for any interim periods are not necessarily
indicative of the results which may be expected for the entire year.
Sovereign adopted the expense recognition provisions of Statement of
Financial Accounting Standards No. 123 (SFAS No. 123) "Accounting for Stock
Based Compensation" in the third quarter for options granted in 2002 as
discussed in a later section of these footnotes.
-11-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(2) EARNINGS PER SHARE
Basic earnings per share is calculated by dividing income before
extraordinary items and net income by the weighted average common shares
outstanding, excluding options and warrants. The dilutive effect of options and
warrants is calculated using the treasury stock method for purposes of weighted
average dilutive shares.
The following table presents the computation of earnings per share for the
periods indicated.
Three-Month Period Nine-Month Period
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
-------- -------- -------- ---------
CALCULATION OF INCOME FOR
BASIC AND DILUTED EPS:
Income before extraordinary item $ 93,139 $ 8,616 $248,901 $ 49,910
Extraordinary item, after tax -- -- -- (6,549)
-------- -------- -------- ---------
Net income $ 93,139 $_ 8,616 $248,901 $ 43,361
======== ======== ======== =========
WEIGHTED AVERAGE SHARES OUTSTANDING:
Weighted average basic shares 261,015 246,922 257,506 243,792
Dilutive effect of:
Warrants 17,356 14,062 17,165 9,038
Average stock options 2,636 2,439 2,628 2,019
-------- -------- -------- ---------
Weighted average diluted shares 281,007 263,423 277,299 254,849
======== ======== ======== =========
EARNINGS PER SHARE:
Basic
Income before extraordinary item $ .36 $ .03 $ .97 $ .20
Extraordinary item, after tax -- -- -- (.03)
-------- -------- -------- ---------
Net income $ .36 $ .03 $ .97 $ .17
======== ======== ======== =========
Diluted
Income before extraordinary item $ .33 $ .03 $ .90 $ .20
Extraordinary item, after tax -- -- -- (.03)
-------- -------- -------- ---------
Net income $ .33 $ .03 $ .90 $ .17
======== ======== ======== =========
-12-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(3) INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The following table presents the composition and fair value of investment
securities available-for-sale at the dates indicated:
September 30, 2002
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 29,155 $ 403 $ 76 $ 29,482
Corporate debt and
asset-backed securities 885,347 44,561 6,311 923,597
Equities (1) 1,048,865 5,680 160 1,054,385
State and municipal
securities 29,282 603 -- 29,885
Mortgage-backed securities:
U.S. government agencies 6,100,420 181,822 71 6,282,171
Non-agencies 2,671,221 77,000 110 2,748,111
----------- ----------- ----------- -----------
Total investment securities
available-for-sale $10,764,290 $ 310,069 $ 6,728 $11,067,631
=========== =========== =========== ===========
December 31, 2001
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 23,109 $ 93 $ 23 $ 23,179
Corporate debt and
asset-backed securities 322,813 5,357 14,310 313,860
Equities (1) 790,391 2,631 160 792,862
State and municipal
securities 22,452 1,942 2 24,392
Mortgage-backed securities:
U.S. government agencies 6,625,498 34,371 33,828 6,626,041
Non-agencies 1,783,485 23,062 5,202 1,801,345
----------- ----------- ----------- -----------
Total investment securities
available-for-sale $ 9,567,748 $ 67,456 $ 53,525 $ 9,581,679
=========== =========== =========== ===========
(1) Equity investments consist principally of FHLB, FHLMC, and FNMA common and
preferred stock.
-13-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(4) INVESTMENT SECURITIES HELD-TO-MATURITY
The following table presents the composition and fair value of investment
securities held-to-maturity at the dates indicated:
September 30, 2002
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 1,705 $ 60 $ -- $ 1,765
State and municipal
securities 2,192 28 -- 2,220
Mortgage-backed securities:
U.S. government agencies 696,687 18,429 311 714,805
Non-agencies 4,166 23 57 4,132
----------- ----------- ----------- -----------
Total investment securities
held-to-maturity $ 704,750 $ 18,540 $ 368 $ 722,922
=========== =========== =========== ===========
December 31, 2001
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 1,905 $ 55 $ -- $ 1,960
State and municipal
securities 4,128 35 2 4,161
Mortgage-backed securities:
U.S. government agencies 872,154 9,851 10,144 871,861
Non-agencies 5,250 47 71 5,226
----------- ----------- ----------- -----------
Total investment securities
held-to-maturity $ 883,437 $ 9,988 $ 10,217 $ 883,208
=========== =========== =========== ===========
-14-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(5) COMPOSITION OF LOAN PORTFOLIO
The following table presents the composition of the loan portfolio by type
of loan and by fixed and adjustable rates at the dates indicated:
September 30, 2002 December 31, 2001
------------------------- -------------------------
Amount Percent Amount Percent
------ ------- ------ -------
Commercial real estate loans $ 3,873,405 17.2% $ 2,987,747 14.6%
Commercial and industrial loans 4,849,320 21.6 4,506,198 22.1
Other 1,101,790 4.9 1,069,658 5.3
----------- ----------- ----------- -----------
Total Commercial Loans 9,824,515 43.7 8,563,603 42.0
----------- ----------- ----------- -----------
Home equity loans 4,747,791 21.1 3,756,621 18.4
Auto loans 3,174,409 14.2 2,880,449 14.1
Other 205,556 .9 193,692 .9
----------- ----------- ----------- -----------
Total Consumer Loans 8,127,756 36.2 6,830,762 33.4
----------- ----------- ----------- -----------
Residential Real Estate Loans 4,520,535 20.1 5,005,219 24.6
----------- ----------- ----------- -----------
Total Loans $22,472,806 100.0% $20,399,584 100.0%
=========== =========== =========== ===========
Total Loans with:
Fixed rate $12,821,989 57.1% $12,875,742 63.1%
Variable rate 9,650,817 42.9 7,523,842 36.9
----------- ----------- ----------- -----------
Total Loans $22,472,806 100.0% $20,399,584 100.0%
=========== =========== =========== ===========
Loans are recorded net of loan origination fees, direct origination costs
and discounts and premiums purchased. Components of recorded balances are as
follows at the dates indicated:
September 30, 2002 December 31, 2001
------------------ -----------------
Principal value $22,387,360 $20,341,303
Direct origination costs, net
of deferred loan fees 38,078 35,584
Purchase premiums, net of discounts 47,368 22,697
----------- -----------
Total Loans $22,472,806 $20,399,584
=========== ===========
Loans to related parties include loans made to certain officers,
directors and their affiliated interests. At September 30, 2002 and December
31, 2001, loans made by Sovereign Bank to these parties totaled $32.0 million
and $20.1 million, respectively and loans made by Sovereign Bancorp, Inc. to
executives totaled $8.3 million and $8.2 million, respectively.
-15-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(6) DEPOSIT PORTFOLIO COMPOSITION
The following table presents the composition of deposits and other
customer accounts at the dates indicated:
September 30, 2002 December 31, 2001
------------------------------------- ------------------------------------------
Weighted Weighted
Average Average
Account Type Amount Percent Rate Amount Percent Rate
------ ------- ---- ------ ------- ----
Demand deposit accounts $ 4,379,088 17% --% $ 3,910,171 17% --%
NOW accounts 6,067,386 23 1.58 4,162,169 18 0.87
Savings accounts 3,020,468 11 1.35 2,985,464 13 1.44
Money market accounts 5,792,529 22 2.01 4,992,163 21 1.73
Retail certificates 6,951,130 26 3.39 6,985,397 30 4.14
Jumbo certificates 325,300 1 2.44 262,210 1 3.04
----------- --- ----------- ---
Total Deposits $26,535,901 100% 1.87% $23,297,574 100% 1.99%
=========== === ==== =========== === ====
(7) BORROWINGS
The following table presents information regarding borrowings with
original maturities of up to one year at the dates indicated:
September 30, 2002 December 31, 2001
--------------------- ----------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- ---- ------- ----
Federal funds purchased $ -- --% $ 452,002 1.75%
Securities sold under
repurchase agreements 467,483 1.40 297,741 1.45
FHLB advances 2,650,000 1.81 1,929,021 3.08
---------- ----------
Total Borrowings $3,117,483 1.75% $2,678,764 2.67%
========== ==== ========== ====
(8) LONG-TERM DEBT
Long-term debt with original maturities greater than one year consisted of
the following:
September 30, 2002 December 31, 2001
------------------- ---------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- ---- ------- ----
Securities sold under
repurchase agreements $ 155,000 4.71% $ 155,000 4.71%
FHLB advances 3,892,688 5.36 4,105,929 5.28
Senior secured credit facility 175,000 4.56 225,000 5.72
Asset-backed floating rate notes 821,000 2.20 821,000 2.51
Senior and subordinated notes 953,709 9.67 954,077 9.92
---------- ----------
$5,997,397 5.57% $6,261,006 5.63%
========== ==== ========== ====
The weighted-average interest rate, including the effect of qualifying
derivative hedging contracts, on long-term debt at September 30, 2002 and
December 31, 2001 was 5.57% and 5.63%, respectively.
-16-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(9) COMPREHENSIVE INCOME
The following table presents the components of comprehensive income, net
of related tax, for the periods indicated:
Three-month Period Nine-Month Period
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
---- ---- ---- ----
Net income $ 93,139 $ 8,616 $ 248,901 $ 43,361
Cumulative effect of change in
accounting principle related
to adoption of SFAS No. 133 -- -- -- (9,951)
Change in accumulated losses
on derivatives (43,142) (92,318) (88,013) (89,465)
Change in unrealized gains on
investment securities
available-for-sale 128,180 138,809 214,742 137,160
Less reclassification adjustment:
Derivatives -- (9,550) -- (9,550)
Investments available-for-sale 8,120 12,409 23,975 20,954
--------- --------- --------- ---------
Comprehensive income $ 170,057 $ 52,248 $ 351,655 $ 69,701
========= ========= ========= =========
Accumulated other comprehensive income/(loss), net of related tax,
consisted of net unrealized gains on securities of $198.3 million and net
accumulated losses on derivatives of $128.7 million at September 30, 2002 and
net unrealized gains on securities of $7.5 million and net accumulated losses on
derivatives of $40.6 million at December 31, 2001.
(10) DERIVATIVES
Sovereign uses derivative instruments as part of its interest rate risk
management process, to manage risk associated with its mortgage banking
activities, and to assist its commercial banking customers with their risk
management strategies. On January 1, 2001, the Company adopted SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities".
Sovereign's primary market risk is interest rate risk. Management uses
derivative instruments to mitigate the impact of interest rate movements on the
value of certain liabilities, assets and on probable forecasted cash flows.
These instruments primarily include interest rate swaps that have underlying
interest rates based on key benchmark indices. The nature and volume of the
derivative instruments used to manage interest rate risk depend on the level and
type of assets and liabilities on the balance sheet and the risk management
strategies for the current and anticipated interest rate environment.
-17-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
Fair Value Hedges. Sovereign has entered into pay-variable receive-fixed
interest rate swaps to hedge changes in fair values of certain brokered CDs and
senior notes, including $400 million notional amount interest rate swaps entered
into in May 2002. Sovereign includes all components of each derivatives gain or
loss in the assessment of hedge effectiveness. For the three and nine-months
ended September 30, 2002 and September 30, 2001, no hedge ineffectiveness was
required to be recognized in earnings associated with fair value hedges.
Cash Flow Hedges. Sovereign hedges cash flow variability related to
variable-rate liabilities, specifically FHLB advances, through the use of
pay-fixed, receive variable interest rate swaps. Sovereign includes all
components of each derivatives gain or loss in the assessment of hedge
effectiveness. For the three and nine-months ended September 30, 2002 and 2001,
no hedge ineffectiveness was required to be recognized in earnings associated
with cash flow hedges. Gains and losses on derivative instruments reclassified
from accumulated other comprehensive income to earnings are included in the
caption in the Statement of Operations, in which the hedged cash flows are
recorded. During the nine months ended September 30, 2002, the Company
terminated $1.4 billion of pay-fixed interest rate swaps that were hedging the
future cash flows on $1.4 billion of FHLB advances resulting in a loss of $26.5
million (after-tax). The loss will continue to be deferred in accumulated other
comprehensive income and will be reclassified into earnings as the future cash
flows occur unless it becomes probable that the forecasted transactions will not
occur. As of September 30, 2002, Sovereign expects approximately $46.7 million
of the deferred net after-tax loss on derivative instruments included in
accumulated other comprehensive income to be reclassified to earnings during the
next twelve months.
Other Derivative Activities. Sovereign's derivative activities may also
include derivative instruments not included in SFAS No. 133 hedge relationships
such as interest rate swaps, interest rate futures, forward sales, mortgage
banking loan commitments, foreign exchange futures, and fixed income options in
accordance with Sovereign's investment policy. This policy is periodically
reviewed and updated by management and is approved by Sovereign Bank's Board of
Directors. Those derivatives are used by Sovereign for risk management purposes
and to facilitate the risk management strategies of its customers.
Net gains generated from derivative instruments executed with customers
are included as capital markets revenue on the income statement and totaled $5.5
million for the nine-months ended September 30, 2002 compared with $4.2 million
for the nine-months ended September 30, 2001.
(11) GOODWILL AND CORE DEPOSIT INTANGIBLE ASSETS
The Company adopted Statement of Financial Accounting Standards No. 142 -
Goodwill and Other Intangible Assets ("SFAS No. 142") and discontinued
amortizing goodwill effective January 1, 2002. Under SFAS No. 142 goodwill and
indefinite lived intangible assets are no longer amortized but are reviewed
annually for impairment. Separable intangible assets that are deemed to have a
finite life continue to be amortized over their useful lives. No impairment
charges were required to be recorded as a result of adoption of this statement.
If an impairment loss is determined in the future, the loss will be reflected in
expense in the statement of operations in the period in which impairment is
determined. The Company's primary intangible assets include goodwill, which is
deemed to have an indefinite life, and core deposit intangibles, which is deemed
to have a finite life and is amortized using an accelerated method over the
estimated lives of the existing deposit relationship acquired, but not exceeding
10 years.
-18-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
The estimated aggregate amortization expense related to core deposit
intangibles for each of the five succeeding calendar years ending December 31,
is:
Calendar Remaining
Year Recorded Amount
Year Amount To Date To Record
---- ------ ------- ---------
2002 $80,274 $60,695 $19,579
2003 73,835 -- 73,835
2004 66,856 -- 66,856
2005 57,945 -- 57,945
2006 51,047 -- 51,047
The following table reflects the components of intangible assets:
Gross Carrying Accumulated
Amount Amortization
----------------------------- -----------------------------
September 30, December 31, September 30, December 31,
2002 2001 2002 2001
---- ---- ---- ----
Non-amortized intangible
assets:
Goodwill $1,156,945 $1,086,341 $ 131,653 $ 131,653
Amortized intangible assets:
Core Deposit Intangibles 642,543 608,179 279,658 218,963
The following table reflects the pro forma results of operations as if
SFAS No. 142 had been adopted as of January 1, 2001:
Three-months ended Nine-months ended
September 30, September 30,
------------------ -----------------
2002 2001 2002 2001
---- ---- ---- ----
Reported income before
extraordinary item $ 93,139 $ 8,616 $ 248,901 $ 49,910
Add back goodwill amortization,
net of tax -- 7,547 -- 21,798
---------- ---------- ---------- ----------
Pro forma income before
extraordinary item $ 93,139 $ 16,163 $ 248,901 $ 71,708
========== ========== ========== ==========
Pro forma net income $ 93,139 $ 16,163 $ 248,901 $ 65,159
========== ========== ========== ==========
Reported diluted EPS before
extraordinary item $ .33 $ .03 $ .90 $ .20
Add back goodwill amortization,
net of tax -- .03 -- .09
---------- ---------- ---------- ----------
Pro forma diluted EPS before
extraordinary item $ .33 $ .06 $ .90 $ .29
========== ========== ========== ==========
Pro forma diluted EPS $ .33 $ .06 $ .90 $ .26
========== ========== ========== ==========
-19-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(12) PURCHASE OF MAIN STREET BANCORP, INC. ("MAIN STREET")
On March 8, 2002 Sovereign completed the purchase of Main Street, a
commercial bank holding company headquartered in Reading, Pennsylvania, and the
results of Main Street's operations are included in the accompanying financial
statements subsequent to the purchase date. Collectively, Main Street
shareholders elected to receive approximately 85% of the purchase price in
Sovereign common stock and 15% in cash. Sovereign issued 11.4 million shares of
common stock, net of Sovereign's shares held by Main Street, valued at $145.5
million and made cash payments of $31.5 million to acquire and convert all
outstanding Main Street shares and pay associated fees. The value of the common
stock was determined based on the average price of Sovereign's shares over the
ten day period preceding closing as provided in the purchase agreement. The
acquisition enhanced Sovereign's market share throughout its existing service
area in eastern Pennsylvania.
The purchase price was allocated to the assets and liabilities acquired of
Main Street based on fair value as of March 8, 2002 (dollars in millions):
Assets
Investments $ 305.9
Loans:
Commercial 527.0
Consumer 152.7
Residential 165.6
--------
Total loans 845.3
Less allowance for loan losses (14.9)
--------
Total loans, net 830.4
Federal funds and cash 239.3
Premises and equipment, net 26.0
Other real estate owned 0.8
Prepaid expenses and other assets 14.9
Core deposit intangible 34.4
Goodwill 69.6
--------
Total assets $1,521.3
========
Liabilities
Deposits:
Core $ 700.6
Time 554.6
--------
Total deposits 1,255.2
Borrowings and long-term debt 86.9
Other liabilities 23.7
Trust preferred securities 10.0
--------
Total liabilities $1,375.8
========
In connection with the Main Street acquisition, Sovereign recorded charges
against its earnings for the three-month period ended March 31, 2002 and the
nine-month period ended September 30, 2002 for an additional loan loss provision
of $6.0 million pre-tax ($3.9 million net of tax) to conform Main Street's
allowance for loan losses to Sovereign's reserve policies and for merger related
expenses of $15.9 million pre-tax ($10.3 million net of tax).
These merger-related expenses include the following:
Community grants $ 1,000
Branch and office consolidations 11,338
Account conversion and other 3,533
--------
$ 15,871
========
-20-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(13) STOCK BASED COMPENSATION
Sovereign adopted the expense recognition provisions of SFAS No. 123
"Accounting for Stock Based Compensation" for stock based employee compensation
awards during the third quarter ending September 30, 2002. Management made this
election since it believes, in light of recent events, it is the preferable
method of accounting in this area. Sovereign continues to account for all
options granted prior to January 1, 2002 in accordance with the intrinsic value
model of APB Opinion No. 25, "Accounting for Stock Issued to Employees."
Sovereign estimates the fair value of option grants issued subsequent to January
1, 2002 using a Black-Scholes option pricing model and expenses this value over
the vesting periods as required in SFAS No. 123. Reductions to compensation
expense associated with forfeited options are recorded in the period that the
forfeitures occur.
The recognition transition provisions of SFAS No. 123 require that it be
applied to all awards granted at the beginning of the fiscal year in which the
statement is first applied. Previously reported results for the quarters ended
June 30, 2002 and March 31, 2002 have been adjusted in accordance with the
existing transition provisions of SFAS No. 123. As a result of this accounting
change, Sovereign recorded non-cash after-tax charges as additional compensation
expense of $2.1 million and $1.5 million for the three-month periods ended June
30, 2002 and March 31, 2002, respectively. The net income and fully-diluted
earnings per share impacts of adopting this statement were $2.0 million and
$0.01 for the three-months ended September 30, 2002 and $5.6 million and $0.02
per share for the nine-months ended September 30, 2002.
The fair values for the 2002 option grants were estimated at the date of
grant using a Black-Scholes option pricing model based on the following
assumptions:
Expected volatility 34.60% - 38.30%
Expected life in years 6
Stock price on the date of grant $12.77 - $15.10
Exercise price $12.77 - $15.10
Weighted average exercise price $12.84
Weighted average fair value $5.28
Expected dividend yield .66% - .78%
Risk-free interest rate 3.37% - 5.05%
Vesting period in years 1 - 3
The following tables reflect the impact resulting from the adoption of
SFAS No. 123 on our financial results for the first and second quarters:
June 30, 2002 June 30, 2002
(dollars in millions, except per share amounts) As Reported As Adjusted
----------- -----------
Other assets $ 1,425.4 $ 1,426.7
Total assets 38,237.8 38,239.1
Retained earnings 912.1 910.0
Stockholders' equity 2,540.6 2,541.9
Compensation and benefits 89.5 92.3
Net income 92.4 90.3
Diluted EPS $0.33 $0.32
Weighted average diluted shares (in millions) 282.2 281.2
-21-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(13) STOCK BASED COMPENSATION (continued)
March 31, 2002 March 31, 2002
(dollars in millions, except per share amounts) As Reported As Adjusted
----------- -----------
Other assets $ 1,376.8 $ 1,377.4
Total assets 36,833.4 36,834.0
Retained earnings 826.3 824.8
Stockholders' equity 2,402.9 2,403.4
Compensation and benefits 83.9 86.0
Net income 66.9 65.4
Diluted EPS 0.25 0.24
Weighted average diluted shares (in millions) 269.9 269.0
Since SFAS No. 123 has not been applied to awards granted in prior years,
the reported results of prior periods are not comparable. The impact to our
reported annual results for 2001 and 2000 is disclosed in footnote 16 in our
annual report filed on Form 10-K. If Sovereign had adopted SFAS No. 123 when
this pronouncement was originally issued, net income for the three-month and
nine-month periods ended September 30, 2002 would have been further reduced by
$0.3 million and $4.8 million.
(14) RECENT ACCOUNTING PRONOUNCEMENTS
In April 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 145, "Rescission of FASB Statements No. 4, No. 44 and No. 64, Amendment
of FASB Statement No. 13, and Technical Corrections." This statement rescinds
SFAS No. 4, "Reporting Gains and Losses from Extinguishments of Debt," and SFAS
No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The
statement requires gains and losses from debt extinguishments to be classified
as income from operations rather than as extraordinary items. The Company will
adopt this statement on January 1, 2003.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." This statement addresses the
accounting for costs associated with disposal activities covered by SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets", and with
exit and restructuring activities previously covered by Emerging Issues Task
Force ("EITF") Issue No. 94-3 "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity". This statement
nullifies EITF No. 94-3 in its entirety and requires that a liability for all
costs be recognized when the liability is incurred. This Statement also
establishes a fair value objective for initial measurement of the liability. The
statement will be applied prospectively to exit or disposal activities initiated
after December 31, 2002.
In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain
Financial Institutions, an amendment of SFAS No. 72 and SFAS No. 144 and FASB
Interpretation No. 9." This Statement addresses the financial accounting and
reporting for the acquisition of all or part of a financial institution that
does not qualify as a business combination. The
-22-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(14) RECENT ACCOUNTING PRONOUNCEMENTS (continued)
acquisition of all or part of a financial institution that meets the definition
of a business combination shall be accounted for by the purchase method in
accordance with SFAS No. 141, "Business Combinations". Since Sovereign has
accounted for all of its previous bank acquisitions as business combinations,
identifying core deposit intangibles separate from goodwill, the adoption of the
pronouncement has no impact on our financial position or results of operations.
-23-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS
General
Net income, including special charges discussed below, was $248.9 million,
or $.90 per share, for the nine-month period ended September 30, 2002, as
compared to $43.4 million, or $.17 per share, for the same period in 2001.
Operating earnings, as defined below, for 2002 increased 23% to $263.1 million,
or $.95 per share, as compared to $213.5 million, or $.84 per share, for 2001.
Cash earnings, as defined below, for the nine-month period ended September 30,
2002 increased 10% to $311.4 million, or $1.12 per share, up from $282.7
million, or $1.11 per share, for the same period in 2001.
Operating earnings exclude certain special items for 2002 and 2001.
Special charges for the nine months ended September 30, 2002 and 2001 were $14.2
million and $170.2 million, respectively, after tax, and are outlined in the
Reconciliation of Net Income to Operating and Cash Earnings table on the
following page. Cash earnings are operating earnings excluding the net effects
of amortization of intangible assets, stock option expense, and ESOP-related
expense.
Cash return on average equity and cash return on average total assets,
excluding special charges discussed above, were 16.90% and 1.12% for the
nine-month period ended September 30, 2002 compared to 18.01% and 1.11% for the
same period in 2001.
Effective January 1, 2002, the Company ceased to amortize goodwill in
accordance with SFAS No. 142 (see Note 11 in Notes to Consolidated Financial
Statements). Had SFAS No. 142 been applied as of January 1, 2001, net income and
operating earnings in the prior year would have increased by $7.5 million and
$21.8 million for the three-months ended and the nine-months ended September 30,
2001, respectively.
In the third quarter of 2002, Sovereign adopted the expense recognition
provisions of SFAS No. 123 "Accounting for Stock Based Compensation". See Note
13 in Notes to Consolidated Financial Statements for a discussion of the current
year impact resulting from the adoption of this statement.
Critical Accounting Policies
Our significant accounting policies are described in Note 1 to the
December 31, 2001 consolidated financial statements filed on Form 10-K. The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses, and disclosure of contingent assets and liabilities.
Actual results could differ from those estimates. We have identified accounting
for the allowance for credit losses, securitizations, and goodwill as our most
critical accounting policies and estimates in that they are important to the
portrayal of our financial condition and results, and they require management's
most difficult, subjective or complex judgments as a result of the need to make
estimates about the effect of matters that are inherently uncertain. These
accounting policies, including the nature of the estimates and types of
assumptions used, are described throughout this Management's Discussion and
Analysis and the December 31, 2001 Management's Discussion and Analysis filed on
Form 10-K.
-24-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Reconciliation of Net Income to Operating and Cash Earnings
(In thousands, except per share data - all amounts are after tax)
Three-month Period Nine-Month Period
Ended September 30, Ended September 30,
------------------------------------- -------------------------------------
Total Per Share Total Per Share
------------------------------------- -------------------------------------
2002 2001 2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ---- ---- ----
Net income as reported $ 93,139 $ 8,616 $ .33 $ .03 $248,901 $ 43,361 $ .90 $ .17
Loss on the early extinguish-
ment of debt -- -- -- -- -- 6,549 -- .03
Main Street Bancorp acquisition:
Merger-related and
integration costs -- -- -- -- 10,316 -- .04 --
Provision for loan losses -- -- -- -- 3,900 -- .01 --
Restructuring expense -- -- -- -- -- 5,525 -- .02
Non-solicitation expense -- 64,226 -- .25 -- 158,106 -- .62
-------- -------- -------- -------- -------- -------- -------- --------
Operating earnings $ 93,139 $ 72,842 $ .33 $ .28 $263,117 $213,541 $ .95 $ .84
Amortization of intangibles $ 13,545 $ 21,811 $ .05 $ .08 $ 40,851 $ 67,872 $ .14 $ .27
Stock option expense 2,020 -- .01 -- 5,583 -- .02 --
ESOP expense 641 367 -- -- 1,817 1,249 .01 --
-------- -------- -------- -------- -------- -------- -------- --------
Cash earnings $109,345 $ 95,020 $ .39 $ .36 $311,368 $282,662 $ 1.12 $ 1.11
======== ======== ======== ======== ======== ======== ======== ========
Weighted average
diluted shares 281,007 263,423 277,299 254,849
-25-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
CONSOLIDATED AVERAGE BALANCE SHEET / TAX EQUIVALENT NET INTEREST MARGIN ANALYSIS
NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2002 AND 2001
(in thousands)
2002 2001
----------------------------------------- ------------------------------------------
Tax Equivalent Yield/ Tax Equivalent Yield/
Average Balance Interest Rate Average Balance Interest Rate
--------------- -------- ---- --------------- -------- ----
EARNING ASSETS
INVESTMENTS $ 10,906,552 $ 513,151 6.28% $ 8,553,457 $ 447,908 6.99%
LOANS:
Commercial loans 9,304,899 419,063 5.98% 8,184,335 488,406 7.94%
Consumer loans 7,580,167 386,394 6.82% 6,546,256 389,475 7.95%
Residential loans 4,690,543 241,530 6.87% 6,681,947 386,215 7.71%
------------ ------------ ---- ------------ ------------ ----
Total loans 21,575,609 1,046,987 6.47% 21,412,538 1,264,096 7.87%
Allowance for loan losses (285,155) -- -- (254,676) -- --
------------ ------------ ---- ------------ ------------ ----
NET LOANS 21,290,454 1,046,987 6.55% 21,157,862 1,264,096 7.96%
------------ ------------ ---- ------------ ------------ ----
TOTAL EARNING ASSETS 32,197,006 1,560,138 6.46% 29,711,319 1,712,004 7.69%
Other assets 4,932,536 -- -- 4,473,873 -- --
------------ ------------ ---- ----------- ------------ ----
TOTAL ASSETS $ 37,129,542 $ 1,560,138 5.60% $34,185,192 $ 1,712,004 6.68%
============ ============ ==== =========== ============ ====
FUNDING LIABILITIES
DEPOSITS:
Core deposits $ 17,446,256 $ 149,798 1.15% $15,200,070 $ 229,025 2.01%
Time deposits 7,460,509 196,926 3.53% 8,447,117 350,601 5.54%
------------ ------------ ---- ------------ ------------ ----
TOTAL DEPOSITS 24,906,765 346,724 1.86% 23,647,187 579,626 3.28%
------------ ------------ ---- ------------ ------------ ----
BORROWED FUNDS:
FHLB advances 6,046,948 227,971 4.98% 5,832,735 232,593 5.26%
Repurchase agreements 549,499 9,652 2.32% 485,439 15,273 4.15%
Other borrowings 1,967,891 94,114 6.36% 1,327,571 96,680 9.72%
------------ ------------ ---- ------------ ------------ ----
TOTAL BORROWED FUNDS 8,564,338 331,737 5.13% 7,645,745 344,546 5.96%
------------ ------------ ---- ------------ ------------ ----
TOTAL FUNDING LIABILITIES 33,471,103 678,461 2.70% 31,292,932 924,172 3.93%
Other liabilities 1,194,881 -- -- 793,102 -- --
------------ ------------ ---- ------------ ------------ ----
TOTAL LIABILITIES 34,665,984 678,461 2.60% 32,086,034 924,172 3.84%
STOCKHOLDERS' EQUITY 2,463,558 -- -- 2,099,158 -- --
------------ ------------ ---- ------------ ------------ ----
TOTAL LIABILITIES
AND STOCKHOLDERS' EQUITY $ 37,129,542 $ 678,461 2.43% $ 34,185,192 $ 924,172 3.60%
============ ============ ==== ============ ============ ====
NET INTEREST INCOME $ 881,677 $ 787,832
============ ============
NET INTEREST SPREAD (1) 3.17% 3.08%
==== ====
NET INTEREST MARGIN (2) 3.66% 3.55%
==== ====
(1) Represents the difference between the yield on total assets and the cost
of total liabilities and stockholders' equity.
(2) Represents taxable equivalent net interest income divided by average
interest-earning assets
-26-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Net Interest Income
Net interest income for the three-month and nine-month periods ended
September 30, 2002 was $297.6 million and $866.5 million compared to $270.8
million and $776.6 million for the same periods in 2001. This increase was
attributable to an increase in the average balance of earning assets,
principally investments, and improvements of 3 and 11 basis points in net
interest margin for the three-month and nine-month periods ended September 30,
2002, respectively, over the same periods in 2001. Net interest margin was 3.62%
and 3.66% for the three-month and nine-month periods ended September 30, 2002
compared to 3.59% and 3.55% for the same periods in 2001. Net interest margin
has contracted from the prior two quarters in 2002, due to the flattening of the
yield curve, the continued repricing of short duration consumer and commercial
loans, a competitive deposit pricing environment and the sale of longer duration
mortgage-backed securities. Although market interest rates declined in 2002, the
Company's net interest margin expanded compared to the prior year as a
significant portion of the growth in earning assets was funded by lower cost
core deposits.
Interest on investment securities and interest earning deposits was $173.5
million and $501.6 million for the three-month and nine-month periods ended
September 30, 2002 compared to $175.0 million and $440.5 million for the same
periods in 2001. The average balance of investment securities was $10.9 billion
with an average tax equivalent yield of 6.28% for the nine-month period ended
September 30, 2002 compared to an average balance of $8.6 billion with an
average yield of 6.99% for the same period in 2001.
Interest and fees on loans were $350.9 million and $1.0 billion for the
three-month and nine-month periods ended September 30, 2002 compared to $388.4
million and $1.3 billion for the same periods in 2001. The average balance of
loans was $21.6 billion with an average yield of 6.47% for the nine-month period
ended September 30, 2002 compared to an average balance of $21.4 billion with an
average yield of 7.87% for the same period in 2001. Average balances of
commercial and consumer loans in 2002 increased $1.1 billion and $1.0 billion as
compared to 2001 primarily due to loan originations and the Main Street
acquisition. Average residential loans declined $2.0 billion primarily due to
scheduled payments and prepayments, and a residential loan sale, offset by
residential loan purchases. These changes in loan balances are consistent with
Sovereign's strategy to emphasize commercial and consumer lending. The decrease
in loan rates is due to declining market interest rates and the aforementioned
shift in the components of the loan portfolio, which now includes more variable
rate and shorter maturity assets.
Interest on deposits was $119.4 million and $346.7 million for the
three-month and nine-month periods ended September 30, 2002 compared to $165.5
million and $579.6 million for the same periods in 2001. The average balance of
deposits was $24.9 billion with an average cost of 1.86% for the nine-month
period ended September 30, 2002 compared to an average balance of $23.6 billion
with an average cost of 3.28% for the same period in 2001. The increase in the
balance of deposits is due to the success of product initiatives to grow core
deposits and the Main Street acquisition. The decrease in average cost year to
year is due primarily to declining market interest rates.
-27-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Interest on borrowed funds was $107.4 million and $331.7 million for the
three-month and nine-month periods ended September 30, 2002 compared to $127.0
million and $344.5 million for the same periods in 2001. The average balance of
borrowings was $8.6 billion with an average cost of 5.13% for the nine-month
period ended September 30, 2002 compared to an average balance of $7.6 billion
with an average cost of 5.96% for the same period in 2001. Wholesale borrowings
are currently an attractive source of funding.
On November 6, 2002, the Federal Open Market Committee decided to lower
its target for the federal funds rate by 50 basis points to 1 1/4 percent. Based
on our current asset and liability position, as well as existing commitments, we
do not expect that this action will have a material adverse impact on our net
interest margin in the fourth quarter of 2002 or in the early part of 2003.
Provision for Loan Losses
The provision for loan losses is based upon credit loss experience and on
the estimation of losses inherent in the current loan portfolio. The provision
for loan losses for the three-month and nine-month periods ended September 30,
2002 was $38.0 million and $110.5 million, respectively compared to $22.0
million and $65.1 million for the same periods in 2001.
The increase in the provision over 2001 was based on several factors:
- One large commercial loan totaling $17.1 million was charged off in
the amount of $15.5 million in the first and second quarter. The
remaining balance on this loan has been collected.
- In the first quarter, a $2.3 million charge-off was taken associated
with the sale of $20.5 million in non-performing residential
mortgages.
- A $6.0 million provision was taken relative to the Main Street
acquisition.
- An increase in non-accrual commercial loans during each quarter, due
to the current overall environment which remains less than
favorable.
- Loan growth of 10% from December 31, 2001 has also contributed to
the increase in the current year provision compared with the prior
year.
Over the last few years, through several strategic acquisitions and
internal restructuring initiatives, Sovereign has diversified its lending
efforts and increased its emphasis on providing its customers with small
business loans and an expanded line of commercial and consumer products, such as
middle market asset-based lending and automobile loans. As a result of the
increased risk inherent in these loan products and as Sovereign continues to
place emphasis on commercial business and consumer lending in future periods,
management will regularly evaluate Sovereign's loan portfolios, and its
allowance for loan losses, and will adjust the loan loss allowance as is
necessary.
-28-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign's net charge-offs for the nine-month period ended September 30,
2002 were $94.8 million and consisted of charge-offs of $122.3 million and
recoveries of $27.5 million. This compared to net charge-offs of $64.4 million
consisting of charge-offs of $88.6 million and recoveries of $24.2 million for
the nine-month period ended September 30, 2001. The increased level of
charge-offs was driven by the events discussed above.
The following table presents the activity in the allowance for possible
loan losses for the periods indicated:
Nine-month Period Ended September 30,
2002 2001
---- ----
Allowance, beginning of period $264,667 $256,356
Charge-offs:
Residential 4,957 6,999
Commercial 64,836 31,684
Consumer 52,509 49,891
-------- --------
Total Charge-offs 122,302 88,574
-------- --------
Recoveries:
Residential 353 2,145
Commercial 3,551 1,203
Consumer 23,613 20,879
-------- --------
Total Recoveries 27,517 24,227
-------- --------
Charge-offs, net of recoveries 94,785 64,347
Provision for possible loan losses 110,500 65,100
Main Street's allowance
for loan losses 14,877 --
-------- --------
Allowance, end of period $295,259 $257,109
======== ========
Non-Interest Income
Total non-interest income was $110.2 million and $314.0 million for the
three-month and nine-month periods ended September 30, 2002 compared to $99.2
million and $326.0 million for the same periods in 2001. Excluding securities
and related derivatives transactions, total fees and other income for the
three-month and nine-month periods ended September 30, 2002 were $97.5 million
and $276.9 million as compared to $94.8 million and $308.5 million for the same
periods in 2001.
Consumer banking fees were $47.7 million and $130.5 million for the
three-month and nine-month periods ended September 30, 2002 as compared to $37.6
million and $116.5 million for the same periods in 2001. Average core deposit
balances have grown 14.78% over the past year due primarily to the success of
recent product initiatives. The increases in consumer banking fees of $10.1
million and $14.0 million for the three-month and nine-month periods ended
September 30, 2002 are attributed to the increase in the number of core deposit
accounts and balances, as well as new fee products.
Commercial banking fees were $25.0 million and $71.3 million for the
three-month and nine-month periods ended September 30, 2002 as compared to $21.6
million and $57.6 million for the same periods in 2001. This increase of $3.4
million and $13.7 million was primarily due to higher loan volumes, increased
market share and increased cash management fee income.
Mortgage banking revenue was $4.2 million and $20.3 million for the
three-month and nine-month periods ended September 30, 2002, respectively, as
compared to $20.3 million and $56.4 million for the same periods in 2001. The
principal components of mortgage banking revenues included gains from the sale
of mortgage
-29-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
loans, servicing fees, amortization of mortgage servicing rights and changes in
the valuation allowance related to mortgage servicing rights. The reduction in
revenues during the three-month period ended September 30, 2002 compared with
the corresponding period in the preceding year resulted primarily from a decline
in gains on loan sales by $7.5 million to $14.3 million and an increase in the
valuation allowance associated with mortgage servicing rights of $7.4 million.
The reduction in revenues during the nine-month period ended September 30, 2002
compared with the corresponding period in the preceding year resulted primarily
from a decline in gains on loan sales by $38.4 million to $21.8 million. Our
remaining mortgage servicing right capitalized asset was approximately $51
million at September 30, 2002.
Capital markets revenues totaled $4.4 million and $9.6 million for the
three-month and nine-month periods ended September 30, 2002 compared with $2.3
million and $8.2 million for the same periods in 2001. The reason for the
increase from the prior year is due to increases in our customer base.
Miscellaneous income was $5.4 million and $13.5 million for the
three-month and nine-month periods ended September 30, 2002 compared to $2.6
million and $39.8 million for the same periods in 2001. The nine months ended
September 30, 2001 included a $28.1 million gain related to the sale of branches
located in southern New Jersey, Delaware and eastern Pennsylvania.
Gain on investment securities and related derivatives transactions were
$12.7 million and $37.1 million for the three-month and nine-month period ended
September 30, 2002 compared to $4.4 million and $17.5 million for the same
periods in 2001. The Company repositioned its investment portfolio with the sale
of $2.0 billion of investment securities during the third and first quarter,
resulting in gains of approximately $16.7 million and $20.0 million,
respectively. The three-month period ended September 30, 2002 includes a charge
of $4.0 million related to losses associated with CRA and venture capital equity
investments. These investments have a book value of $23 million at September 30,
2002.
General and Administrative Expenses
General and administrative expenses for the three-month and nine-month
periods ended September 30, 2002 were $207.3 million and $607.1 million,
respectively, compared to $191.5 million and $580.9 million for the same periods
in 2001, representing increases of $15.8 million and $26.2 million. The
three-month period ended September 30, 2002 includes approximately $3.0 million
of losses associated with sub-leasing facilities. Compensation costs increased
due to insourcing of certain technology services, the 2002 impact of expensing
stock options under SFAS No. 123 (see Note 13 in the Notes to Consolidated
Financial Statements), and the Main Street acquisition. Expense reduction
initiatives have favorably impacted occupancy and outside services.
Other Expenses
Other expenses were $35.3 million and $123.3 million for the three-month
and nine-month periods ended September 30, 2002 compared to $146.0 million and
$396.9 million for the same periods in 2001. The nine-month period ended
-30-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
September 30, 2001, includes $243.2 million of expense related to payments under
the non-solicitation provisions of the New England Acquisition (defined below).
In 2000, Sovereign acquired certain businesses from Fleet Boston Financial as
more fully described in the 2001 Annual Report on Form 10-K, the "New England
Acquisition." Also during the nine-month period ended September 30, 2001,
Sovereign recorded an $8.5 million charge as the last element of a restructuring
initiative related to its company-wide restructuring announced in November of
2000. The restructuring, completed over the first quarter of 2001 and last
quarter of 2000, resulted in elimination of over 600 positions and the closure
of 14 in-store offices to consolidate efforts within our geographic footprint.
Merger-related and integration charges of $15.9 million ($10.3 million or $0.04
per share, net of tax) related to the Main Street acquisition were recorded in
the three-month period ended March 31, 2002. (See Note 12 to the Consolidated
Financial Statements). As of September 30, 2002, substantially all costs
incurred in connection with the restructuring activities have been incurred.
Results for the three-month and nine-month periods ended September 30,
2002 included amortization of core deposit intangibles of $20.0 million and
$60.7 million. Results for the three and nine month periods ended September 30,
2001 include $32.6 million and $101.4 million for amortization of goodwill and
core deposit intangibles. Effective January 1, 2002, the Company discontinued
goodwill amortization as a result of the adoption of Statement of Financial
Accounting Standard No. 142, "Goodwill and Other Intangible Assets" (See Notes
to Consolidated Financial Statements in Part I of this document). No impairment
charges were required to be recorded as a result of adoption of this statement.
Income Tax Provision
The income tax provision was $33.9 million and $90.7 million for the
three-month and nine-month periods ended September 30, 2002 compared to $1.9
million and $9.8 million for the same periods in 2001. The effective tax rate
for the three-month and nine-month periods ended September 30, 2002 was 26.7%,
compared to 17.7% and 16.3% for the same periods in 2001. The current year tax
rate differs from the statutory rate of 35% due to income from tax-exempt
investments and income related to bank-owned life insurance. The effective tax
rate for the 2001 quarters is lower than the current year rate due to the high
proportion of permanent tax differences, in relation to the low level of
recorded pretax income.
Extraordinary Item
In last year's reported results, Sovereign completed a $400 million term
and revolving credit facility with Bank of Scotland of which $350 million was
used to prepay an existing $350 million senior secured credit facility. In
connection with this transaction, Sovereign wrote-off $6.5 million net of tax
($10.1 million pretax) of deferred issuance costs remaining from the existing
line of credit. These costs were reflected net of tax as an extraordinary item
in accordance with generally accepted accounting principles.
-31-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
FINANCIAL CONDITION
Loan Portfolio
At September 30, 2002, commercial loans totaled $9.8 billion representing
44% of Sovereign's loan portfolio, compared to $8.6 billion or 42% of the loan
portfolio at December 31, 2001 and $8.3 billion or 41% of the loan portfolio at
September 30, 2001. The consumer loan portfolio (including home equity loans and
lines of credit, automobile loans, and other consumer loans) totaled $8.1
billion at September 30, 2002, representing 36% of Sovereign's loan portfolio,
compared to $6.8 billion or 33% of the loan portfolio at December 31, 2001 and
$6.8 billion or 33% of the loan portfolio at September 30, 2001. The increase in
the commercial and consumer portfolios is due to our increased emphasis on these
loan types, decreased emphasis on residential mortgage loans and the purchase of
Main Street Bancorp.
Residential mortgage loans decreased $484.7 million to $4.5 billion at
September 30, 2002 and now represent 20% of Sovereign's loan portfolio as
compared to $5.0 billion and 25% at December 31, 2001. The decrease is
consistent with the Company's strategy to de-emphasize this portfolio and
resulted from scheduled payments and prepayments and a sale of non-performing
residential loans, offset by residential loan purchases. At September 30, 2001
residential mortgage loans totaled $5.3 billion representing 26% of the loan
portfolio.
Non-Performing Assets
At September 30, 2002 Sovereign's non-performing assets increased by $32.0
million to $276.7 million compared to $244.7 million at December 31, 2001. This
increase is due to increases in non-performing commercial loans, offset by a
decline in residential non-performing loans as a result of the sale of certain
residential assets in the first quarter of 2002 and third and second quarter
declines in residential non-performing assets. Non-performing assets as a
percentage of total assets was .70% at September 30, 2002 and .69% at December
31, 2001. Sovereign generally places all commercial loans and residential loans
with loan to values greater than 50% on non-performing status at 90 days or
sooner, if management believes the loan has become impaired (unless return to
current status is expected imminently). All other loans continue to accrue until
they are 120 days delinquent, at which point they are either charged-off or
placed on non-accrual status and anticipated losses are fully reserved, unless
they are real estate loans evaluated to be well secured based on appraisals and
are in the process of collection. At 180 days delinquent, anticipated losses on
real estate loans are fully reserved or charged off.
-32-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The following table presents the composition of non-performing assets at
the dates indicated:
September 30, December 31,
2002 2001
---- ----
Non-accrual loans:
Commercial $ 127,418 $ 100,993
Commercial real estate 41,850 18,776
Consumer 31,066 28,032
Residential 53,919 76,737
---------- ----------
Total non-accrual loans 254,253 224,538
Restructured loans 1,087 1,280
---------- ----------
Total non-performing loans 255,340 225,818
Other real estate owned 14,128 12,076
Other repossessed assets 7,281 6,852
---------- ----------
Total non-performing assets $ 276,749 $ 244,746
========== ==========
Past due 90 days or more as to interest
or principal and accruing interest (1) $ 40,723 $ 54,599
Non-performing assets as a percentage
of total assets .70% .69%
Non-performing loans as a percentage
of total loans 1.14% 1.11%
Non-performing assets as a percentage of
total loans and real estate owned 1.23% 1.20%
Allowance for loan losses as a percentage
of total non-performing assets 106.7% 108.1%
Allowance for loan losses as a percentage
of total non-performing loans 115.6% 117.2%
(1) Includes consumer and residential loans of $39.8 million and $51.0 million
at September 30, 2002 and December 31, 2001, respectively.
Loans ninety (90) days or more past due and still accruing interest fell
by $13.8 million from December 31, 2001 to September 30, 2002. Ninety day
delinquencies fell in all three categories, residential by $8.3 million,
consumer by $2.8 million, and commercial by $2.7 million.
Potential problem loans (loans for which management has doubts as to the
borrowers ability to comply with present repayment terms, principally
commercial loans delinquent more than 30 days but less than 90 days, although
not currently classified as non-performing loans) amounted to approximately
$71.9 million and $120 million at September 30, 2002 and December 31, 2001,
respectively.
-33-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Allowance for Loan Losses
The following table presents the allocation of the allowance for loan
losses and the percentage of each loan type of total loans at the dates
indicated:
September 30, 2002 December 31, 2001
------------------ -----------------
% of Loans % of Loans
to to
Amount Total Loans Amount Total Loans
------ ----------- ------ -----------
Allocated allowance:
Commercial loans $188,472 44% $162,720 42%
Consumer loans 72,417 36 59,555 33
Residential real estate
mortgage loans 18,704 20 20,724 25
Unallocated allowance 15,666 n/a 21,668 n/a
-------- --- -------- ---
Total allowance for loan losses $295,259 100% $264,667 100%
======== === ======== ===
The adequacy of Sovereign's allowance for loan losses is regularly
evaluated. Management's evaluation of the adequacy of the allowance to absorb
loan losses takes into consideration the risks inherent in the loan portfolio,
past loan loss experience, specific loans which have loss potential, geographic
and industry concentrations, delinquency trends, economic conditions, the level
of originations and other relevant factors. Management also considers loan
quality, changes in the size and character of the loan portfolio, amount of
non-performing loans, delinquency trends, economic conditions and industry
trends when determining the allowance. Management believes the shift in loan
composition from residential into commercial and consumer brings higher inherent
risk.
Sovereign maintains an allowance for loan losses sufficient to absorb
inherent losses in the loan portfolio and believes the current allowance to be
at a level adequate to cover such inherent losses. The Company gives
consideration to other risk indicators when determining the appropriate
allowance level.
The allowance for loan losses consists of two elements: (i) an allocated
allowance, which is comprised of allowances established on specific loans, and
class allowances based on risk ratings, historical loan loss experience and
current trends, and (ii) unallocated allowances based on both general economic
conditions and other risk factors in the Company's individual markets and
portfolios, and to account for a level of imprecision in management's estimation
process.
The specific allowance element of the allocated allowance is based on a
regular analysis of criticized loans where internal credit ratings are below a
predetermined classification. This analysis is performed at the relationship
manager level, and periodically reviewed by the loan workout department. The
specific allowance established for these criticized loans is based on a careful
-34-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
analysis of related collateral value, cash flow considerations and, if
applicable, guarantor capacity.
The class allowance element of the allocated allowance is determined by an
internal loan grading process in conjunction with associated allowance factors.
These class allowance factors are updated as required and are based primarily on
actual historical loss experience, peer group loss experience, and projected
loss experience. While this analysis is conducted quarterly, the Company has the
ability to revise the class allowance factors whenever necessary in order to
address improving or deteriorating credit quality trends or specific risks
associated with a given loan pool classification.
Regardless of the extent of the Company analysis of customer performance,
portfolio evaluations, trends or risk management processes established, certain
inherent, but undetected losses are probable within the loan portfolio. This is
due to several factors including inherent delays in obtaining information
regarding a customer's financial condition or changes in their unique business
conditions; customer fraud, the judgmental nature of individual loan
evaluations, collateral assessments and the interpretation of economic trends;
volatility of economic or customer-specific conditions affecting the
identification and estimation of losses for larger non-homogeneous credits; and
the sensitivity of assumptions utilized to establish allocated allowances for
homogeneous groups of loans among other factors. The Company maintains an
unallocated allowance to recognize the existence of these exposures. These other
risk factors are continuously reviewed and revised by management where
conditions indicate that the estimates initially applied are different from
actual results.
A comprehensive analysis of the allowance for loan losses is performed by
the Company on a quarterly basis. In addition, a review of allowance levels
based on nationally published statistics is conducted on an annual basis. The
Company has an Asset Review Committee, which has the responsibility of affirming
allowance methodology and assessing the general and specific allowance factors
in relation to estimated and actual net charge-off trends. This Committee is
also responsible for assessing the appropriateness of the allowance for loan
losses for each loan pool classification at Sovereign.
Commercial Portfolio. The portion of the allowance for loan losses related
to the commercial portfolio has increased from $162.7 million at December 31,
2001 to $188.5 million at September 30, 2002. This increase is warranted by the
softening economy, the increase in non-performing and adversely classified loans
in this sector and the addition of loans in part due to the Main Street
acquisition.
Consumer Portfolio. The allowance for the consumer loan portfolio
increased from $59.6 million at December 31, 2001, to $72.4 million at September
30, 2002 due to increases in loan balances.
Residential Portfolio. The allowance for the residential mortgage
portfolio decreased from $20.7 million at December 31, 2001 to $18.7 million at
September 30, 2002. This change was due primarily to the reduction in size of
the overall residential portfolio.
-35-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Unallocated Allowance. The unallocated allowance for loan losses decreased
to $15.7 million at September 30, 2002 from $21.7 million at December 31, 2001.
Management continuously evaluates current economic conditions and loan portfolio
trends. However, this balance is subject to significant changes each reporting
period due to certain inherent but undetected losses that are probable within
the loan portfolio. This is due to several factors including delays in obtaining
information regarding a customer's financial condition or changes in their
unique business conditions; the judgmental nature of individual loan
evaluations, collateral assessments and the interpretation of economic trends;
volatility of economic or customer conditions and the sensitivity of assumptions
utilized to establish allocated allowances for homogeneous groups of loans among
other factors. Sovereign maintains an unallocated allowance to recognize the
existence of these exposures.
Investment Securities
Investment securities consist primarily of mortgage-backed securities,
U.S. Treasury and government agency securities, corporate debt securities and
stock in the Federal Home Loan Bank of Pittsburgh ("FHLB"), Freddie Mac and
Fannie Mae. Mortgage-backed securities consist of pass-throughs and
collateralized mortgage obligations issued by federal agencies or private label
issuers. Sovereign's mortgage-backed securities are generally either guaranteed
as to principal and interest by the issuer or have ratings of "AAA" by Standard
and Poor's and Moody's at the date of issuance. Sovereign purchases classes
which are senior positions backed by subordinate classes. The subordinate
classes absorb the losses and must be completely eliminated before any losses
flow through the senior positions. The effective duration of the total
investment portfolio at September 30, 2002 was 1.73 years.
Total investment securities available-for-sale were $11.1 billion at
September 30, 2002 and $9.6 billion at December 31, 2001. Investment securities
held-to-maturity were $704.8 million at September 30, 2002 compared to $883.4
million at December 31, 2001. For additional information with respect to
Sovereign's investment securities, see Notes 3 and 4 in the Notes to
Consolidated Financial Statements.
Goodwill and Core Deposit Intangible Assets
Goodwill increased by $70.6 million and the gross carrying amount of core
deposit intangibles increased by $34.4 million since December 31, 2001 primarily
due to the Main Street acquisition. Year-to-date core deposit intangible
amortization of $60.7 million has been recorded in 2002.
Deposits
Sovereign attracts deposits within its primary market area with an
offering of deposit instruments including demand accounts, NOW accounts, money
market accounts, savings accounts, certificates of deposit and retirement
savings plans.
Total deposits at September 30, 2002 were $26.5 billion compared to $23.3
billion at December 31, 2001. Sovereign continues to emphasize strategies to
grow core deposits and limit higher priced time deposits.
-36-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Borrowings
Sovereign utilizes borrowings (original maturities of up to one year) as a
source of funds for its asset growth and its asset/liability management.
Collateralized advances are available from the FHLB provided certain standards
related to creditworthiness have been met. Sovereign also utilizes reverse
repurchase agreements, which are short-term obligations collateralized by
securities fully guaranteed as to principal and interest by the U.S. Government
or an agency thereof, and federal funds lines with other financial institutions.
Total borrowings at September 30, 2002 and December 31, 2001 were $3.1 billion
and $2.7 billion, respectively. See Note 7 in the Notes to Consolidated
Financial Statements for additional information.
Long-Term Debt
Long-term debt (original maturities greater than one year) were $6.0
billion and $6.3 billion at September 30, 2002 and December 31, 2001,
respectively. See Note 8 in the Notes to Consolidated Financial Statements for
additional information.
Trust Preferred Securities
Sovereign has outstanding $397 million ($503 million par value) of
mandatorily redeemable trust preferred obligations that have stated maturities
ranging from 2027 through 2031 and have stated dividends of 7.50% to 9.875% of
par value.
As discussed in our 2001 annual report on Form 10-K in Note 12, Sovereign
has outstanding a preferred capital security (Trust Preferred II) and associated
warrants whose balance totaled $187.8 million and $91.5 million, respectively,
at September 30, 2002. Sovereign may elect to redeem the Trust Preferred II
securities and the warrants after November 20, 2002, if the value of Sovereign's
common stock on 20 trading days out of the preceding 30 consecutive trading days
and on the day the election is made exceeds $14.99.
Securitization Transactions
Securitization transactions contribute to Sovereign's overall funding and
regulatory capital management. These transactions involve periodic transfers of
loans or other financial assets to special purpose entities ("SPEs"). The SPEs
are either consolidated in or excluded from Sovereign's consolidated financial
statements depending on whether the transactions qualify as a sale of assets in
accordance with SFAS No. 140, "Transfers of Financial Assets and Liabilities"
("SFAS No. 140").
Unconsolidated Securitizations - In certain transactions, Sovereign has
transferred assets to SPEs qualifying for non-consolidation ("QSPE") and has
accounted for the transaction as a sale in accordance with SFAS No. 140.
Sovereign also has retained interests in the QSPEs. Off-balance sheet QSPEs had
$1.4 billion of debt related to assets that Sovereign sold to the QSPEs which is
not included in Sovereign's consolidated Balance Sheet at September 30, 2002.
Sovereign's retained interests in such QSPEs were $100.6 million at September
30,
-37-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
2002. Sovereign does not provide contractual legal recourse to third party
investors that purchase debt or equity securities issued by the QSPEs beyond the
credit enhancement inherent in Sovereign's subordinated interests in the QSPEs.
Securitizations Consolidated in Sovereign's Financial Statements - In a
transaction consummated in November 2001, the "November 2001 transaction",
Sovereign accessed the liquidity of international markets and transferred $957
million of indirect automobile loans to SPEs. The transaction is classified as a
financing under SFAS No. 140, and therefore the SPEs are consolidated in
Sovereign's financial statements in accordance with generally accepted
accounting principles. At September 30, 2002, Sovereign had $957 million of
indirect automobile loans, $821 million of debt and $64 million of minority
interest reflected on its Consolidated Balance Sheet related to consolidated
SPEs. See "Minority Interests" below.
Additionally, Sovereign will periodically sell qualifying mortgage loans
to FHLMC, GNMA, and FNMA in return for mortgage-backed securities issued by
those agencies. Sovereign reclassifies the net book balance of the loans sold to
such agencies from loans to investment securities held to maturity and available
for sale. For those loans sold to the agencies in which Sovereign retains
servicing rights, Sovereign allocates the net book balance transferred between
servicing rights and investment securities based on their relative fair values.
Minority Interests
Minority interests represent the equity value and earnings attributable to
that portion of consolidated subsidiaries which are owned by parties independent
of Sovereign. Earnings attributable to minority interests are reflected in trust
preferred securities and other minority interest expense on the Consolidated
Statements of Operations.
As part of the November 2001 transaction, Sovereign received $64 million
from the sale to outside investors of controlling ownership interests in SPEs
formed to issue debt and equity interests as parts of a financing transaction
which raised a total of $885 million for Sovereign. See "Securitization
Transactions" in the preceding sections of this document.
On August 21, 2000, Sovereign received approximately $140 million of net
proceeds from the issuance of $161.8 million of 12% Series A Non-cumulative
Preferred Interests in Sovereign Real Estate Investment Trust ("SREIT"), a
subsidiary of Sovereign Bank which holds primarily residential real estate
loans. The preferred stock was issued at a discount, which is being amortized
over the life of the preferred shares using the effective yield method. The
preferred shares may be redeemed at any time on or after May 16, 2020, at the
option of Sovereign subject to the approval of the OTS. Under certain
circumstances, the preferred shares are automatically exchangeable into
preferred stock of Sovereign Bank.
-38-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Termination of Employee Stock Ownership Plan
Sovereign discontinued in 2002, the employee stock ownership plan it
assumed upon acquisition of Peoples Bancorp Inc., in 1999. The Plan repaid debt
owed to Sovereign with the proceeds of unallocated Sovereign shares, which the
Plan sold. Shares allocated to active plan participants will be distributed to
those participants following approval of the Plan of Termination by the Internal
Revenue Service.
Bank Regulatory Capital
The Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA")
requires institutions regulated by the Office of Thrift Supervision (OTS) to
have a minimum leverage capital ratio equal to 3% of tangible assets and 4% of
risk-adjusted assets, and a risk-based capital ratio equal to 8% as defined. The
Federal Deposit Insurance Corporation Improvement Act ("FDICIA") requires OTS
regulated institutions to have a minimum tangible capital equal to 2% of total
tangible assets.
The FDICIA established five capital tiers: well-capitalized,
adequately-capitalized, undercapitalized, significantly undercapitalized and
critically undercapitalized. A depository institution's capital tier depends
upon its capital levels in relation to various relevant capital measures, which
include leverage and risk-based capital measures and certain other factors.
Depository institutions that are not classified as well-capitalized or
adequately-capitalized are subject to various restrictions regarding capital
distributions, payment of management fees, acceptance of brokered deposits and
other operating activities.
The OTS Order, as amended, applicable to the approval of the New England
Acquisition (the "OTS Order") requires Sovereign Bank to be "Well Capitalized"
and also to meet certain additional capital ratio requirements above the
regulatory minimums, and other conditions. Various agreements with Sovereign's
lenders also require Sovereign Bank to be "Well Capitalized" at all times and in
compliance with all regulatory requirements. To be "Well Capitalized," a thrift
institution must maintain a Tier 1 Leverage ratio of at least 5%, a Tier 1
risk-based capital ratio of 6% and total risk-based capital of 10%. Although OTS
capital regulations do not apply to savings and loan holding companies, the OTS
Order requires Sovereign to maintain certain Tier 1 capital levels.
At September 30, 2002 and December 31, 2001, Sovereign and Sovereign Bank
had met all quantitative thresholds necessary to be classified as
well-capitalized under regulatory guidelines and the OTS Order.
Federal banking laws, regulations and policies also limit Sovereign Bank's
ability to pay dividends and make other distributions to Sovereign Bancorp.
Sovereign Bank is required to give prior notice to the OTS before paying any
dividend. In addition Sovereign Bank must obtain prior OTS approval to declare a
dividend or make any other capital distribution if, after such dividend or
distribution, Sovereign Bank's total distributions to the Bancorp within that
calendar year would exceed 100% of its net income during the year plus retained
net income for the prior two years, Sovereign Bank would not meet capital levels
imposed by the OTS in connection with any order, including the OTS Order
applicable to the New England Acquisition completed in
-39-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
2000, as amended, or if Sovereign Bank is not adequately capitalized at the
time. In addition, OTS prior approval would be required if Sovereign Bank's
examination or CRA ratings fall below certain levels or Sovereign Bank is
notified by the OTS that it is a problem association or an association in
troubled condition. The following schedule summarizes the actual capital
balances of Sovereign Bank at September 30, 2002 and December 31, 2001 (in
thousands):
TIER 1 TIER 1 TOTAL
REGULATORY CAPITAL TANGIBLE LEVERAGE RISK-BASED RISK-BASED
CAPITAL TO CAPITAL TO CAPITAL TO CAPITAL TO
TANGIBLE TANGIBLE RISK ADJUSTED RISK ADJUSTED
ASSETS ASSETS ASSETS ASSETS
------------- ------------- ------------- -------------
Sovereign Bank at September 30, 2002:
Regulatory capital $ 2,791,640 $ 2,794,585 $ 2,695,770 $ 2,968,603
Minimum capital requirement (1) 758,941 2,656,500 1,117,940 2,934,593
------------- ------------- ------------- -------------
Excess $ 2,032,699 $ 138,085 $ 1,577,830 $ 34,010
============= ============= ============= =============
Capital ratio 7.36% 7.36% 9.65% 10.62%
Sovereign Bank at December 31, 2001:
Regulatory capital $ 2,464,222 $ 2,470,620 $ 2,368,893 $ 2,616,871
Minimum capital requirement (1) 685,584 2,399,545 979,792 2,571,955
------------- ------------- ------------- -------------
Excess $ 1,778,638 $ 71,075 $ 1,389,101 $ 44,916
============= ============= ============= =============
Capital ratio 7.19% 7.21% 9.67% 10.68%
(1) Minimum capital requirement as defined by OTS Regulations, or the OTS Order,
whichever is higher.
Liquidity and Capital Resources
Liquidity represents the ability of Sovereign to obtain cost effective
funding to meet the needs of customers, as well as Sovereign's financial
obligations. Sovereign's primary sources of liquidity include retail deposit
gathering, Federal Home Loan Bank (FHLB) borrowings, federal funds purchases,
reverse repurchase agreements and wholesale deposit purchases. Other sources of
liquidity include asset securitizations, liquid investment portfolio securities
and debt and equity issuances.
Factors which impact the liquidity position of Sovereign include loan
origination volumes, loan prepayment rates, maturity structure of existing
loans, core deposit growth levels, CD maturity structure and retention,
Sovereign's credit ratings, investment portfolio cash flows, maturity structure
of wholesale funding, etc. These risks are monitored and centrally managed. This
process includes reviewing all available wholesale liquidity sources. As of
September 30, 2002, Sovereign had $6.2 billion in available overnight liquidity
in the form of unused federal funds purchased lines, unused FHLB borrowing
capacity and unencumbered investment portfolio securities. Sovereign also
forecasts future liquidity needs and develops strategies to ensure that adequate
liquidity is available at all times.
Sovereign's holding company has the following major sources of funding to
meet its liquidity requirements: dividends and returns of investment from its
subsidiaries, a revolving credit agreement and access to the capital markets.
Sovereign Bank may pay dividends to its parent subject to approval of the OTS,
as discussed above. Year-to-date Sovereign Bank declared and paid dividends to
the parent company of $140 million in 2002. Sovereign also has approximately
$900 million of availability under a shelf registration statement on file with
the Securities and Exchange Commission permitting ready access to the public
debt and
-40-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
equity markets. The OTS has approved payment of up to $160 million of additional
dividends throughout the remainder of 2002 as long as Sovereign and Sovereign
Bank comply with the covenants contained within their dividend approval request.
Cash and cash equivalents increased $328.8 million for 2002. Net cash
provided by operating activities was $124 million for 2002. Net cash used by
investing activities for 2002 was $1.8 billion and consisted primarily of the
purchase of investments of $8.2 billion, purchase of loans of $1.5 billion and
the net change in loans other than purchases and sales of $1.8 billion offset by
sales, repayments and maturities of investments of $7.5 billion and proceeds
from loan sales of $2.0 billion. Net cash provided by financing activities for
2002 was $2.1 billion which was primarily due to an increase in deposits.
Contractual Obligations and Commercial Commitments
Sovereign enters into contractual obligations in the normal course of
business as a source of funds for its asset growth and its asset/liability
management, to fund acquisitions, and to meet required capital needs. These
obligations require Sovereign to make cash payments over time as detailed in the
table below.
Contractual Obligations Payments Due by Period
(in thousands of dollars) ----------------------
Less than Over 1 yr Over 3 yrs Over
Total 1 year to 3 yrs to 5 yrs 5 yrs
----------- ----------- ----------- ----------- -----------
Borrowings $ 3,117,483 $ 3,117,483 $ -- $ -- $ --
Securities sold under
repurchase agreements 155,000 -- -- 155,000 --
FHLB advances 3,892,688 100,000 313,450 306 3,478,932
Other debt 1,949,709 50,380 525,071 553,258 821,000
Trust Preferred securities 502,500 -- -- -- 502,500
Certificates of deposit 7,508,889 5,576,910 1,674,658 170,351 86,970
Operating leases 780,775 105,092 291,732 95,334 288,617
----------- ----------- ----------- ----------- -----------
Total contractual cash
obligations $17,907,044 $ 8,949,865 $ 2,804,911 $ 974,249 $ 5,178,019
=========== =========== =========== =========== ===========
Certain of Sovereign's contractual obligations require Sovereign to
maintain certain financial ratios and to maintain a "well capitalized"
regulatory status. Sovereign has complied with these covenants as of September
30, 2002 and expects to be in compliance with these covenants for the
foreseeable future. However, if in the future Sovereign is not in compliance
with these ratios or is deemed to be other than well capitalized by the OTS, and
is unable to obtain a waiver from its lenders, the debt would be in default and
callable by Sovereign's lenders. Due to cross-default provisions in certain of
Sovereign's debt agreements, if more than $25 million of Sovereign's debt is in
default, $875 million of senior notes and the full amount of the senior secured
credit facility then outstanding will become due in full.
-41-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its customers
and to manage its own exposure to fluctuations in interest rates. These
financial instruments include commitments to extend credit, standby letters of
credit, loans sold with recourse, forward contracts and interest rate swaps,
caps and floors. These financial instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheet. The contract or notional amounts of these
financial instruments reflect the extent of involvement Sovereign has in
particular classes of financial instruments.
Sovereign's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit,
standby letters of credit and loans sold with recourse is represented by the
contractual amount of those instruments. Sovereign uses the same credit policies
in making commitments and conditional obligations as it does for on-balance
sheet instruments. For interest rate swaps, caps and floors and forward
contracts, the contract or notional amounts do not represent exposure to credit
loss. Sovereign controls the credit risk of its interest rate swaps, caps and
floors and forward contracts through credit approvals, limits and monitoring
procedures. Unless noted otherwise, Sovereign does not require and is not
required to pledge collateral or other security to support financial instruments
with credit risk.
Amount of Commitment Expiration Per Period
Total
Other Commercial Amounts Less than Over 1 yr Over 3 yrs
Commitments Committed 1 year to 3 yrs to 5 yrs Over 5 yrs
----------- --------- ------ -------- -------- ----------
Commitments to
extend credit $7,593,647 $4,668,988 $1,077,048 $ 361,055 $1,486,556
Standby letters of credit 885,102 295,743 171,995 396,837 20,527
Loans sold with recourse 16,870 -- -- -- 16,870
Forward contracts 1,106,037 1,101,037 5,000 -- --
---------- ---------- ---------- ---------- ----------
Total commercial
commitments $9,601,656 $6,065,768 $1,254,043 $ 757,892 $1,523,953
========== ========== ========== ========== ==========
Asset and Liability Management
Interest rate risk arises primarily through Sovereign's traditional
business activities of extending loans and accepting deposits. Many factors,
including economic and financial conditions, movements in market interest rates
and consumer preferences, affect the spread between interest earned on assets
and interest paid on liabilities. In managing its interest rate risk, Sovereign
seeks to minimize the variability of net interest income across various likely
scenarios while at the same time maximizing its net interest income and net
interest margin. To achieve these objectives, Sovereign works closely with each
business line in the company and guides new business flows. Sovereign also uses
various other tools to manage interest rate risk including wholesale funding
maturity targeting, investment portfolio purchase strategies, asset
securitization/sale, and financial derivatives.
-42-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Interest rate risk is managed centrally by the Treasury Group with
oversight by the Asset and Liability Committee. Management reviews various forms
of analysis to monitor interest rate risk including net interest income
sensitivity, market value sensitivity, repricing frequency of assets versus
liabilities and scenario analysis. Numerous assumptions are made to produce
these analyses including, but not limited to, assumptions on new business
volumes, loan and investment prepayment rates, deposit flows, interest rate
curves, economic conditions, and competitor pricing.
Sovereign simulates the impact of changing interest rates on its expected
future interest income and interest expense (net interest income sensitivity).
This simulation is run monthly and it includes nine different stress scenarios.
These scenarios shift interest rates up and down. Certain other scenarios shift
short-term rates up while holding longer-term rates constant and vice versa.
This scenario analysis helps management to better understand its short-term
interest rate risk and is used to develop proactive strategies to ensure that
Sovereign is not overly sensitive to the future direction of interest rates. At
September 30, 2002 and December 31, 2001, the general level of interest rates
represented a unique economic environment in which several of Sovereign's
declining interest rate simulation scenarios would not apply. At September 30,
2002, if interest rates dropped in parallel 100 basis points Sovereign estimates
that net interest income would fall 4.3%. Alternatively, if interest rates rose
in parallel 200 basis points, estimated net interest income would increase 6.6%
Sovereign also monitors the relative repricing sensitivities of its assets
versus its liabilities. Management attempts to keep assets and liabilities in
balance so that when interest rates do change, the net interest income of
Sovereign will not experience any significant short-term volatility as a result
of assets repricing more quickly than liabilities or vice versa. As of September
30, 2002, the one year cumulative gap was 7%, compared to 9% at December 31,
2001 indicating Sovereign could benefit from rising rates.
Finally, Sovereign calculates the market value of its balance sheet
including all assets, liabilities and hedges. This market value analysis is very
useful because it measures the present value of all estimated future interest
income and interest expense cash flows of the company. Net Portfolio Value (NPV)
is used to assess long-term interest rate risk. A higher NPV ratio indicates
lower long-term interest rate risk and a more valuable franchise. As of
September 30, 2002, the NPV as a percentage of the present value of assets was
9.61% as compared to 11.68% at December 31, 2001. Management reviews the
sensitivity of NPV to changes in interest rates. As of September 30, 2002, a 200
basis point rise in interest rates would increase the NPV ratio by 1.75% as
compared to 1.18% at December 31, 2001 and a 100 basis point decline in interest
rates would decrease the NPV ratio by .72% as compared to .45% at December 31,
2001.
Because the assumptions used are inherently uncertain, Sovereign cannot
precisely predict the effect of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to the timing,
magnitude and frequency of interest rate changes, the difference between actual
experience and the assumed volume and characteristics of new business and
behavior of existing positions, and changes in market conditions and management
strategies, among other factors.
-43-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Pursuant to its interest rate risk management strategy, Sovereign enters
into hedging transactions that involve interest rate exchange agreements (swaps,
caps, and floors) for interest rate risk management purposes. Sovereign's
objective in managing its interest rate risk is to provide sustainable levels of
net interest income while limiting the impact that changes in interest rates
have on net interest income.
Interest rate swaps are generally used to convert fixed rate assets and
liabilities to variable rate assets and liabilities and vice versa. Sovereign
utilizes interest rate swaps that have a high degree of correlation to the
related financial instrument. At September 30, 2002, Sovereign's principal
hedging transactions were to convert liabilities from floating rate to fixed
rate for interest rate risk management purposes.
As part of its mortgage banking strategy, Sovereign originates fixed rate
residential mortgages. It sells the majority of these loans to FHLMC, FNMA, and
private investors. The loans are exchanged for cash or marketable fixed rate
mortgage-backed securities which are generally sold. This helps insulate
Sovereign from the interest rate risk associated with these fixed rate assets.
Sovereign uses forward sales, cash sales and options on mortgage-backed
securities as a means of hedging loans in the mortgage pipeline that are
originated for sale.
To accommodate customer needs, Sovereign enters into customer-related
financial derivative transactions primarily consisting of interest rate swaps,
caps, and floors. Risk exposure from customer positions is managed through
transactions with other dealers.
Through the Company's capital markets, mortgage-banking and precious
metals activities, it is subject to trading risk. The Company employs various
tools to measure and manage price risk in its trading portfolios. In addition,
the Board of Directors has established certain limits relative to trading
positions and activities. The level of price risk exposure at any given point in
time depends on the market environment and expectations of future price and
market movements, and will vary from period to period.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Incorporated by reference from Part I, Item 2. "Management's Discussion
and Analysis of Results of Operations and Financial Condition - Asset and
Liability Management" hereof.
Item 4. Controls and Procedures
Within 90 days prior to the date of filing this report, an evaluation was
performed under the supervision and the participation of the Company's
management, including the principal executive officer and principal financial
officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures pursuant to Rule 13a-15. Based on that
evaluation, the Company's principal executive officer and principal financial
officer concluded that the Company's disclosure controls and procedures were
effective as of the date the Company completed its evaluation. There have been
no significant changes in the Company's internal controls or in other factors
that could significantly affect internal controls subsequent to the date the
Company completed its evaluation.
-44-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Items 1 through 5 not applicable or the responses are negative.
Item 6 - Exhibits and Reports on Form 8-K.
(a) Exhibits
(3.1) Articles of Incorporation, as amended and restated, of
Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit
3.1 to Sovereign's Registration Statement No. 333-86961-01 on
Form S-3)
(3.2) By-Laws of Sovereign Bancorp, Inc., as amended and restated
as of August 14, 2002.
(10.1) Employment agreement by and between Sovereign Bancorp, Inc.
and James J. Lynch dated September 16, 2002.
(99.1) Chief Executive Officer certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(99.2) Chief Financial Officer certification pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
On August 14, 2002, the Company filed a current report on Form 8-K dated
August 14, 2002, reporting information under Items 7 and 9.
-45-
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOVEREIGN BANCORP, INC.
(Registrant)
Date November 14, 2002 /s/Jay S. Sidhu
----------------------------------------
Jay S. Sidhu, Chairman,
Chief Executive Officer and President
(Authorized Officer)
Date November 14, 2002 /s/James D. Hogan
----------------------------------------
James D. Hogan
Chief Financial Officer
-46-
CERTIFICATIONS
I, Jay S. Sidhu, Chief Executive Officer of Sovereign Bancorp, Inc.,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Sovereign
Bancorp, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Jay S. Sidhu
-----------------------
Jay S. Sidhu
Chief Executive Officer
-47-
I, James D. Hogan, Chief Financial Officer of Sovereign Bancorp, Inc.,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Sovereign
Bancorp, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ James D. Hogan
-----------------------
James D. Hogan
Chief Financial Officer
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
EXHIBITS INDEX
(3.1) Articles of Incorporation, as amended and restated, of Sovereign
Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to
Sovereign's Registration Statement No. 333-86961-01 on Form S-3)
(3.2) By-Laws of Sovereign Bancorp, Inc., as amended and restated as of
August 14, 2002.
(10.1) Employment agreement by and between Sovereign Bancorp, Inc. and
James J. Lynch dated September 16, 2002.
(99.1) Chief Executive Officer certification pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
(99.2) Chief Financial Officer certification pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
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