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 June 30, 1998
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: 34-16533
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.)
1130 Berkshire Boulevard, Wyomissing, Pennsylvania 19610
- -------------------------------------------------- ---------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number: (610) 320-8400
N/A
---------------------------------------
(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 August 18, 1998
------------ ------------------------------
Common Stock (no par value) 148,131,154 shares
FORWARD LOOKING STATEMENTS
Except for historical information, this report may be deemed to contain
"forward looking" statements. Sovereign Bancorp, Inc. ("Sovereign") desires to
avail itself of the Safe Harbor provisions of the Private Securities Litigation
Reform Act of 1995 (the "Act") and is including this cautionary statement for
the express purpose of availing itself of the protection afforded by the Act.
Examples of forward looking statements include, but are not limited to
(a) projections of or statements regarding future earnings, net interest income,
other income, earnings or loss per share, asset mix and quality, growth
prospects, capital structure and other financial terms, (b) statements of plans
and objectives of Sovereign or its management or Board of Directors, (c)
statements of future economic performance, and (d) statements of assumptions,
such as economic conditions in Sovereign's market areas, underlying other
statements and statements about Sovereign or its businesses. Such forward
looking statements can be identified by the use of forward looking terminology
such as "believes," "expects," "may," "intends," "will," "should,"
"anticipates," or the negative of any of the foregoing or other variations
thereon or comparable terminology, or by discussion of strategy.
No assurance can be given that the future results covered by the
forward-looking statements will be achieved. Such statements are subject to
risks, uncertainties, and other factors which could cause actual results to
differ materially from future results expressed or implied by such
forward-looking statements. Important factors that could impact Sovereign's
operating results include, but are not limited to, (i) the effects of changing
economic conditions in Sovereign's market areas and nationally, (ii) credit
risks of commercial, real estate, consumer and other lending activities, (iii)
significant changes in interest rates, (iv) changes in federal and state banking
laws and regulations which could impact Sovereign's operations, (v) funding
costs, and (vi) other external developments which could materially affect
Sovereign's business and operations.
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at June 30, 1998
and December 31, 1997 4
Consolidated Statements of Operations for the three-
month and six-month periods ended June 30, 1998 and 1997 5 - 6
Consolidated Statement of Stockholders' Equity for
the six-month period ended June 30, 1998 7
Consolidated Statements of Cash Flows for the six-month
periods ended June 30, 1998 and 1997 8
Notes to Consolidated Financial Statements 9 - 22
Item 2. Management's Discussion and Analysis of
Results of Operations and Financial Condition 23 - 37
PART II. OTHER INFORMATION
Item 6. Reports on Form 8-K 38
PART III. FINANCIAL DATA SCHEDULE 39 - 40
SIGNATURES 41
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
1998 1997
-------- ------------
(Unaudited) (Note)
(in thousands, except
per share data)
ASSETS
Cash and amounts due from
depository institutions $ 367,044 $ 219,143
Interest-earning deposits 123,342 14,502
Loans held for sale (approximate fair
value of $306,879 and $310,440 at
June 30, 1998 and December 31, 1997,
respectively) 306,230 310,368
Investments available-for-sale 4,732,105 1,795,060
Investment and mortgage-backed securities
held-to-maturity (approximate fair value
of $2,283,689 and $3,238,197 at June 30,
1998 and December 31, 1997, respectively) 2,258,552 3,209,966
Loans 10,072,949 10,756,785
Allowance for possible loan losses (111,398) (110,251)
Premises and equipment 78,555 85,194
Real estate owned 10,968 10,631
Accrued interest receivable 126,306 102,043
Goodwill and other intangible assets 123,346 125,816
Other assets 759,319 166,514
----------- -----------
TOTAL ASSETS $18,847,318 $16,685,771
=========== ===========
LIABILITIES
Deposits $ 9,341,861 $ 8,856,651
Borrowings:
Short-term 5,819,782 5,320,498
Long-term 2,206,656 1,309,591
Advance payments by borrowers
for taxes and insurance 47,088 41,431
Other liabilities 264,972 53,442
----------- -----------
TOTAL LIABILITIES 17,680,359 15,581,613
----------- ----------
Corporation-obligated mandatorily redeemable
capital securities of subsidiary trust holding
solely subordinated debentures of Sovereign
Bancorp, Inc. ("Trust Preferred Securities") 129,007 128,972
----------- -----------
STOCKHOLDERS' EQUITY
Preferred stock; no par value; $50 liquidation
preference; 7,500,000 shares authorized;
1,996,467 shares issued and outstanding
at December 31, 1997 - 96,276
Common stock; no par value; 200,000,000 shares
authorized; 152,401,920 shares issued at
June 30, 1998 and 136,833,840 shares issued
at December 31, 1997 591,181 481,159
Unallocated common stock held by the Employee
Stock Ownership Plan at cost;
4,611,132 shares at June 30, 1998 and
5,984,934 shares at December 31, 1997 (31,194) (37,211)
Treasury stock at cost; 8,721 shares at June 30,
1998 and 13,210 shares at December 31, 1997 (149) (185)
Accumulated other comprehensive income 18,347 18,680
Retained earnings 459,767 416,467
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 1,037,952 975,186
----------- -----------
TOTAL LIABILITIES, MINORITY INTERESTS
AND STOCKHOLDERS' EQUITY $18,847,318 $16,685,771
=========== ===========
See accompanying notes to consolidated financial statements.
Note: The balance sheet at December 31, 1997 is taken from Sovereign's audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.
4
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
------------------------ ---------------------
1998 1997 1998 1997
--------- --------- --------- -------
(in thousands, except
per share data)
Interest income:
Interest on interest-earning deposits $ 1,890 $ 1,023 $ 3,236 $ 2,233
Interest and dividends on investment
and mortgage-backed securities
available-for-sale 62,517 22,505 96,848 42,730
Interest and dividends on investment
and mortgage-backed securities
held-to-maturity 45,578 73,885 103,347 137,641
Interest and fees on loans 203,695 173,637 416,010 343,891
--------- --------- --------- ---------
Total interest income 313,680 271,050 619,441 526,495
--------- --------- --------- ---------
Interest expense:
Interest on deposits 97,652 86,528 192,561 168,280
Interest on borrowings 104,895 86,518 203,148 166,060
--------- --------- --------- ---------
Total interest expense 202,547 173,046 395,709 334,340
--------- --------- --------- ---------
Net interest income 111,133 98,004 223,732 192,155
Provision for possible loan losses (1) 7,000 3,200 13,500 14,100
--------- --------- --------- ---------
Net interest income after provision for
possible loan losses 104,133 94,804 210,232 178,055
--------- --------- --------- ---------
Other income:
Other loan fees and service charges 3,097 1,707 5,983 3,336
Deposit fees 5,678 4,861 11,058 9,199
Mortgage banking gains 6,697 4,912 11,572 9,175
Gain on sale of loans and investment
and mortgage-backed securities
available-for-sale 3,005 1,311 6,456 1,584
Miscellaneous income 6,191 1,730 11,899 3,541
--------- --------- --------- ---------
Total other income 24,668 14,521 46,968 26,835
--------- --------- --------- ---------
General and administrative expenses:
Salaries and employee benefits 26,305 25,408 54,791 48,402
Occupancy and equipment expenses 11,436 6,807 23,542 15,596
Outside services 10,158 5,895 16,477 11,420
Deposit insurance premiums 1,089 1,124 2,173 2,199
Advertising 2,323 1,996 4,167 4,062
Other administrative expenses 7,589 8,314 17,987 16,517
--------- --------- --------- ---------
Total general and administrative expenses 58,900 49,544 119,137 98,196
--------- --------- --------- ---------
5
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(continued)
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
------------------ ----------------
1998 1997 1998 1997
--------- --------- --------- -------
(in thousands, except
per share data)
Other operating expenses:
One-time, merger-related charge (1) - - $ 39,529 $ 7,955
Amortization of goodwill and other intangibles 3,185 3,193 6,340 6,337
Trust Preferred Securities expense 3,048 3,590 6,427 5,015
Real estate owned (gain)/loss, net (47) 237 (122) 515
---------- --------- ---------- ---------
Total other operating expenses 6,186 7,020 52,174 19,822
--------- --------- --------- ---------
Income before income taxes 63,715 52,761 85,889 86,872
Income tax provision 22,769 19,978 31,916 34,015
--------- --------- --------- ---------
Net Income (1)(2) $ 40,946 $ 32,783 $ 53,973 $ 52,857
========= ========= ========= ========
Net Income Applicable to Common Stock $ 40,946 $ 31,221 $ 52,477 $ 49,732
========= ========= ========= =========
Earnings per share (2)(3) $ .27 $ .23 $ .36 $ .37
========= ========= ========= =========
Dividends per share (3) $ .020 $ .036 $ .036 $ .071
========= ========= ========= =========
(1) Results for the six-month period ended June 30, 1998 include a one-time,
merger charge of $39.5 million ($25.8 million after-tax) related to
Sovereign's acquisition of ML Bancorp during the first quarter of 1998.
Results for the six-month period ended June 30, 1997 include a one-time,
merger charge of $15.9 million ($10.7 million after-tax) related to
Sovereign's acquisition of First State Financial Services, Inc. ("First
State") during the first quarter of 1997 of which $7.9 million (pre-tax) is
classified as provision for possible loan losses.
(2) Results for the six-month periods ended June 30, 1998 and 1997 include the
one-time, merger-related charges described in Note 1 above. Excluding the
one-time, merger-related charges, net income for the six-month periods
ended June 30, 1998 and 1997 was $79.8 million and $63.6 million,
respectively and diluted earnings per share for the same periods were $.53
and $.44, respectively.
(3) Per share amounts have been adjusted to reflect all stock dividends and
stock splits.
See accompanying notes to consolidated financial statements.
6
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(in thousands)
Common Preferred
Shares Shares Common Preferred Retained Treasury
Outstanding Outstanding Stock Stock Earnings Stock
----------- ----------- -------- --------- -------- ---------
Balance, December 31, 1997 130,836 1,996 $481,159 $ 96,276 $416,467 $ (185)
Net income - - - - 53,973 -
Exercise of stock options 1,108 - 4,768 - - -
Cash in lieu of fractional shares - - (45) - - -
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan 121 - 2,098 - - -
Dividends paid on common stock - - - - (4,949) -
Dividends paid on preferred stock - - - - (1,496) -
Treasury stock repurchase (10) - - - - (127)
Treasury stock sale 12 - - - - 163
Other comprehensive income -
unrecognized income on investment
and mortgage-backed securities
available-for-sale, net of tax - - - - - -
Conversion of Preferred stock 14,342 (1,996) 96,270 (96,270) - -
Redemption of Preferred stock - - - (6) - -
Allocation of shares under Employee
Stock Ownership Plan 1,373 - 9,293 - - -
Adjustment for ML Bancorp's
different fiscal year end - - - - (4,228) -
Other - - (2,362) - - -
--------- -------- -------- --------- -------- --------
Balance, June 30, 1998 147,782 - $591,181 $ - $459,767 $ (149)
========= ======== ======== ========= ======== ========
Accumulated Total
Unallocated Other Stock-
Common Stock Comprehensive Holders'
Held by ESOP Income Equity
------------ ------------- ----------
Balance, December 31, 1997 $ (37,211) $ 18,680 $ 975,186
Net income - - 53,973
Exercise of stock options - - 4,768
Cash in lieu of fractional shares - - (45)
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan - - 2,098
Dividends paid on common stock - - (4,949)
Dividends paid on preferred stock - - (1,496)
Treasury stock repurchase - - (127)
Treasury stock sale - - 163
Other comprehensive income -
unrecognized income on investment
and mortgage-backed securities
available-for-sale, net of tax - 459 459
Conversion of Preferred stock - - -
Redemption of Preferred stock - - (6)
Allocation of shares under Employee
Stock Ownership Plan 6,017 - 15,310
Adjustment for ML Bancorp's
different fiscal year end - (792) (5,020)
Other - - (2,362)
---------- --------- -----------
Balance, June 30, 1998 $ (31,194) $ 18,347 $1,037,952
========== ========= ==========
See accompanying notes to consolidated financial statements.
7
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six-Month Period
Ended June 30,
1998 1997
---- ----
(in thousands)
Cash Flows from Operating Activities:
Net income $ 53,973 $ 52,857
Adjustments to reconcile net income to net cash provided
by operating activities:
Provision for possible loan losses and deferred taxes 12,603 32,942
Depreciation 6,058 4,934
Amortization 3,842 49,012
Gain on sale of loans, investment and
mortgage-backed securities and real estate owned (6,578) (4,947)
Allocation of Employee Stock Ownership Plan 15,310 1,538
Net change in:
Loans held for sale 4,138 (79,079)
Accrued interest receivable (24,263) (8,848)
Prepaid expenses and other assets (554,789) (11,298)
Other liabilities 209,273 92,400
----------- -----------
Net cash (used)/provided by operating activities $ (280,433) $ 129,511
----------- -----------
Cash Flows from Investing Activities:
Proceeds from sales of investment and mortgage-backed
securities available-for-sale 765,877 65,234
Proceeds from repayments and maturities of investment
and mortgage-backed securities:
Available-for-sale 274,090 97,538
Held-to-maturity 1,325,756 447,661
Purchases of investment and mortgage-backed securities:
Available-for-sale (4,008,225) (483,768)
Held-to-maturity (335,174) (1,201,946)
Proceeds from sales of loans 8,211 10,749
Purchase of loans (322,725) (448,561)
Net change in loans other than purchases and sales 937,575 284,359
Proceeds from sales of premises and equipment 12,915 7,895
Purchases of premises and equipment (12,444) (7,364)
Proceeds from sale of real estate owned 9,319 9,436
Net cash received in business combinations -- (9,495)
Other, net (4,228) (4,996)
----------- -----------
Net cash used by investing activities (1,349,053) (1,233,258)
----------- -----------
Cash Flows from Financing Activities:
Net increase in deposits 429,156 395,261
Net increase in short-term borrowings 118,113 731,375
Proceeds from long-term borrowings 1,333,000 19,838
Net increase in advance payments by
borrowers for taxes and insurance 5,657 10,031
Cash dividends paid to stockholders (6,550) (12,131)
Proceeds from issuance of common stock 6,821 3,550
Proceeds from issuance of preferred stock -- (3,963)
Redemption of preferred stock (6) --
Issuance of treasury stock 36 9,165
----------- -----------
Net cash provided by financing activities 1,886,227 1,153,126
----------- -----------
Net change in cash and cash equivalents 256,741 53,348
Cash and cash equivalents at beginning of period 233,645 151,270
----------- -----------
Cash and cash equivalents at end of period $ 490,386 $ 204,618
=========== -----------
Reconciliation of Cash and Cash Equivalents to Consolidated
Balance Sheets:
Cash and amounts due from depository institutions $ 367,044 $ 180,075
Interest-earning deposits 123,342 24,543
----------- -----------
Cash and cash equivalents at end of period $ 490,386 $ 204,618
=========== ===========
Supplemental Disclosures:
Income tax payments totaled $30.9 million for the six-month period ended June
30, 1998 and $31.6 million for the same period in 1997. Interest payments
totaled $406.3 million for the six-month period ended June 30, 1998 and $323.9
million for the same period in 1997. Noncash activity consisted of mortgage or
whole loan sales of $394.5 million for the six-month period ended June 30, 1998
and $140.0 million for the same period in 1997; reclassification of long-term
borrowings to short-term borrowings of $436.0 million for the six-month period
ended June 30, 1998 and $524.0 million for the same period in 1997; and
reclassification of mortgage loans to real estate owned of $7.5 million for the
six-month period ended June 30, 1998 and $11.4 million for the same period in
1997.
See accompanying notes to consolidated financial statements.
8
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) GENERAL
The accompanying financial statements of Sovereign Bancorp, Inc. and
Subsidiaries ("Sovereign") include the accounts of the parent company, Sovereign
Bancorp, Inc. and its wholly-owned subsidiaries: Sovereign Bank, Sovereign
Capital Trust I, ML Capital Trust I and ML Bancorp of Delaware. All material
intercompany balances and transactions have been eliminated in consolidation.
These financial statements have been prepared in accordance with the
instructions for Form 10-Q and therefore do not include certain information or
footnotes necessary for the presentation of financial condition, results of
operations, stockholders' equity, and cash flows in conformity with generally
accepted accounting principles. However, in the opinion of management, the
consolidated financial statements reflect all adjustments (which consist of
normal recurring accruals) necessary for a fair presentation of the results for
the unaudited periods. The preparation of these financial statements in
conformity with generally accepted accounting principles 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.
The financial statements for all periods presented include the
consolidated accounts of ML Bancorp, Inc. ("ML Bancorp") which was acquired on
February 28, 1998 in a transaction accounted for under the pooling-of-interests
method of accounting (see Note 9 "Acquisitions" hereof). The results of
operations for the six-month period ended June 30, 1998 are not necessarily
indicative of the results which may be expected for the entire year. The
consolidated financial statements should be read in conjunction with Form 10-K
for the year ended December 31, 1997, and the audited consolidated financial
statements, restated for the merger of ML Bancorp, Inc. filed on Form 8-K dated
June 23, 1998.
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(2) EARNINGS PER SHARE
The following table presents the computation of earnings per share based
on the provisions of Statement of Financial Accounting Standard ("SFAS") No. 128
for the periods indicated (in thousands, except per share data). For additional
information with respect to SFAS No. 128, see Note 10 "Accounting Changes"
hereof.
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
------------------- -------------------
1998 1997 1998 1997
---- ---- ---- ----
Basic Earnings Per Share:
Net income attributable to
common stock(1) $ 40,946 $ 31,221 $ 52,477 $ 49,732
-------- -------- -------- --------
Average basic shares outstanding
at end of period (3) 140,369 126,563 136,058 126,157
======== ======== ======== ========
Basic earnings per share (2) (3) $ .29 $ .25 $ .39 $ .39
======== ======== ======== ========
Diluted Earnings Per Share:
Net income (1) $ 40,946 $ 32,783 $ 53,973 $ 52,857
-------- -------- -------- --------
Average diluted shares outstanding
at end of period (3) 147,533 140,931 146,753 140,525
Dilutive effect of average stock
options, net of shares assumed to
be repurchased under the treasury
stock method (3) 2,947 3,617 3,128 3,690
-------- -------- -------- --------
Total average diluted shares
Outstanding at end of period (3) 150,480 144,548 149,881 144,215
======== ======== ======== ========
Diluted earnings per share (2)(3) $ .27 $ .23 $ .36 $ .37
======== ======== ======== ========
(1) Results for the six-month period ended June 30, 1998 include a one-time,
merger charge of $25.8 million (after-tax) related to Sovereign's
acquisition of ML Bancorp during the first quarter of 1998. Results for the
six-month period ended June 30, 1997 include a one-time, merger charge of
$10.7 million (after-tax) related to Sovereign's acquisition of First State
during the first quarter of 1997.
(2) Results for the six-month periods ended June 30, 1998 and 1997 include the
one-time, merger-related charges described in Note 1 above. Excluding the
one-time, merger-related charges, basic earnings per share for the
six-month periods ended June 30, 1998 and 1997 were $.58 and $.48,
respectively and diluted earnings per share for the same periods were $.53
and $.44, respectively.
(3) All per share data have been adjusted to reflect all stock dividends and
stock splits.
10
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(3) INVESTMENT AND MORTGAGE-BACKED SECURITIES AVAILABLE-FOR-SALE
The following table presents the composition and fair value of
investments available-for-sale at the dates indicated: (dollars in thousands)
June 30, 1998
-------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
--------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 32,803 $ - $ 5 $ 32,798
Equity securities 728,164 24,133 475 751,822
Other securities 20,500 - - 20,500
Mortgage-backed Securities:
FHLMC 158,061 1,163 285 158,939
FNMA 54,405 973 47 55,331
GNMA 374,510 568 34 375,044
Collateralized mortgage
obligations 3,333,659 6,985 2,973 3,337,671
---------- --------- --------- ----------
Total investment and
mortgage-backed securities
available-for-sale $4,702,102 $ 33,822 $ 3,819 $4,732,105
========== ========= ========= ==========
December 31, 1997
--------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
--------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 19,988 $ 2 $ - $ 19,990
Equity securities 631,692 18,768 39 650,421
Other securities 32,873 4,391 298 36,966
Mortgage-backed Securities:
FHLMC 403,913 3,184 375 406,722
FNMA 198,719 1,597 375 199,941
GNMA 247,149 1,498 554 248,093
Collateralized mortgage
obligations 218,113 747 179 218,681
Other securities 14,295 9 58 14,246
---------- --------- --------- ----------
Total investment and
mortgage-backed securities
available-for-sale $1,766,742 $ 30,196 $ 1,878 $1,795,060
========== ========= ========= ==========
11
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(4) INVESTMENT AND MORTGAGE-BACKED SECURITIES HELD-TO-MATURITY
The following table presents the composition and fair value of
investment and mortgage-backed securities held-to-maturity at the dates
indicated: (dollars in thousands)
June 30, 1998
--------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
--------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 21,368 $ 105 $ 5 $ 21,468
Corporate securities 1,000 16 - 1,016
Other securities 59,043 4,341 108 63,276
Mortgage-backed Securities:
FHLMC 305,743 6,338 498 311,583
FNMA 181,852 3,060 348 184,564
GNMA 347,421 7,249 1 354,669
RTC - - - -
Private issues 90,426 719 165 90,980
Collateralized mortgage
obligations 1,251,699 5,656 1,222 1,256,133
---------- --------- --------- ----------
Total investment and
mortgage-backed securities
held-to-maturity $2,258,552 $ 27,484 $ 2,347 $2,283,689
========== ========= ========= ==========
December 31, 1997
---------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
--------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 39,483 $ 136 $ 430 $ 39,189
Corporate securities 1,050 24 - 1,074
Other securities 51,797 3,832 150 55,479
Mortgage-backed Securities:
FHLMC 350,775 7,447 445 357,777
FNMA 220,265 3,603 397 223,471
GNMA 392,312 8,309 - 400,621
RTC 411 - 1 410
Private issues 119,350 963 82 120,231
Collateralized mortgage
obligations 2,034,523 8,038 2,616 2,039,945
---------- ---------- ---------- ----------
Total investment and
mortgage-backed securities
held-to-maturity $3,209,966 $ 32,352 $ 4,121 $ 3,238,197
========== ========== ========== ===========
12
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: (dollars
in thousands)
June 30, 1998 December 31, 1997
-------------------- -------------------
Amount Percent Amount Percent
------ ------- ------ -------
Residential real estate loans $ 5,554,671 55.1% $ 6,400,715 59.5%
Residential construction loans
(net of loans in process of
$77,087 and $46,523, respectively) 97,162 1.0 134,926 1.2
----------- ---- ----------- ----
Total Residential Loans 5,651,833 56.1 6,535,641 60.7
----------- ---- ----------- ----
Multi-family loans 93,672 .9 106,108 1.0
Commercial real estate loans 446,111 4.4 458,786 4.3
Commercial loans 420,159 4.2 302,515 2.8
Automotive floor plan loans 307,046 3.1 279,757 2.6
----------- ---- ----------- ----
Total Commercial Loans 1,266,988 12.6 1,147,166 10.7
----------- ---- ----------- ----
Automobile loans 1,541,452 15.3 1,548,383 14.4
Home equity loans 1,067,785 10.6 1,003,404 9.3
Loans to automotive lessors 254,919 2.5 267,033 2.5
Student loans 276,547 2.8 190,440 1.8
Credit cards -- -- 54,887 .5
Other 13,425 .1 9,831 .1
----------- ---- ----------- ----
Total Consumer Loans 3,154,128 31.3% 3,073,978 28.6%
----------- ---- ----------- ----
Total Loans $10,072,949 100.0% $10,756,785 100.0%
=========== ===== =========== =====
Total Loans with: (1)
Fixed rates $ 4,317,698 42.9% $ 4,181,538 38.9%
Variable rates 5,755,251 57.1 6,575,247 61.1
----------- ----- ----------- -----
Total Loans $10,072,949 100.0% $10,756,785 100.0%
=========== ===== =========== =====
(1) Loan totals do not reflect the impact of off-balance sheet interest rate
swaps used for interest rate risk management as discussed in "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Loan Portfolio."
13
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(6) DEPOSIT PORTFOLIO COMPOSITION
The following table presents the composition of deposits at the dates
indicated: (dollars in thousands)
June 30, 1998 December 31, 1997
--------------------------- ----------------------
Weighted Weighted
Average Average
Account Type Amount Percent Rate Amount Percent Rate
------------ ------ ------- -------- ------ ------- -----
Demand deposit accounts $ 751,000 8.1% - % $ 547,394 6.2% - %
NOW accounts 822,309 8.8 1.62 671,228 7.6 1.28
Savings accounts 1,888,359 20.2 2.94 1,777,603 20.1 2.90
Money market accounts 896,583 9.6 4.21 802,438 9.0 4.06
Retail certificates 4,513,122 48.3 5.51 4,490,948 50.7 5.53
Jumbo certificates 470,488 5.0 5.50 567,040 6.4 5.78
---------- ----- ---- ---------- ----- ----
Total Deposits $9,341,861 100.0% 4.08% $8,856,651 100.0% 4.22%
========== ===== ==== ========== ===== ====
(7) BORROWINGS
The following table presents information regarding borrowings at the
dates indicated: (dollars in thousands)
June 30, 1998 December 31, 1997
----------------- ------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- -------- ------- --------
Securities sold under
repurchase agreements $1,138,547 5.70% $1,022,100 5.67%
FHLB advances 6,705,092 5.66 5,419,838 5.93
Other borrowings 182,799 6.06 188,151 5.88
---------- ------ ---------- ------
Total Borrowings $8,026,438 5.68% $6,630,089 5.89%
========== ====== ========== ======
14
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(8) INTEREST RATE EXCHANGE AGREEMENTS
Amortizing and non-amortizing interest rate swaps are generally used to
convert fixed rate assets and liabilities to variable rate assets and
liabilities and vice versa. Interest rate caps are primarily used to limit the
exposure from the repricing and maturity of liabilities. Interest rate floors
are primarily used to limit the exposure from repricing and maturity of assets.
Interest rate caps and floors are also used to limit the exposure created by
other interest rate swaps. In certain cases, interest rate caps and floors are
simultaneously bought and sold to create a range of protection (interest rate
corridors) against changing interest rates while limiting the cost of that
protection. The following table presents information regarding interest rate
exchange agreements at the dates indicated: (dollars in thousands)
June 30, 1998
-------------
Weighted
Average
Notional Book Estimated Maturity
Amount Value Fair Value In Years
---------- ----- ---------- ---------
Amortizing interest rate swaps:
Pay variable-receive fixed (1) $ 181,894 $ - $ 1,710 3.8
Pay fixed-receive variable (2) 191,250 - (11) .8
Non-amortizing interest rate swaps:
Pay fixed-receive variable (4) 3,350,000 - (5,665) 4.4
Interest rate caps/floors(5) 1,200,000 8,599 (915) 3.5
---------- -------- ----------
$4,923,144 $ 8,599 $ (4,881)
========== ======== ==========
December 31, 1997
-----------------
Weighted
Average
Notional Book Estimated Maturity
Amount Value Fair Value In Years
-------- ----- ---------- --------
Amortizing interest rate swaps:
Pay variable-receive fixed (1) $ 602,116 $ - $ 1,436 2.8
Pay fixed-receive variable (2) 208,761 - (9) 1.3
Non-amortizing interest rate swaps:
Pay variable-receive fixed (3) 28,499 - (561) 2.7
Pay fixed-receive variable (4) 2,750,000 - (9,290) 2.3
Interest rate caps/floors (5) 1,200,000 9,963 (4,434) 4.0
---------- -------- ----------
$4,789,376 $ 9,963 $ (12,858)
========== ======== ==========
15
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(1) The weighted average pay rate was 5.68% and 5.58% and the weighted average
receive rate was 6.86% and 5.97% at June 30, 1998 and December 31, 1997,
respectively.
(2) The weighted average pay rate was 6.87% and 6.87% and the weighted average
receive rate was 6.77% and 6.80% at June 30, 1998 and December 31, 1997,
respectively.
(3) The weighted average pay rate was 7.28% and the weighted average receive
rate was 6.75% at December 31, 1997.
(4) The weighted average pay rate was 5.60% and 5.89% and the weighted average
receive rate was 5.69% and 4.47% at June 30, 1998 and December 31, 1997,
respectively.
(5) The strike price range was 5.25% - 9.00% at June 30, 1998 and 5.25% - 7.50%
at December 31, 1997.
The following table summarizes by notional amounts the activity of
Sovereign's interest rate exchange agreements: (dollars in thousands)
Balance Balance
December 31, Maturities/ June 30,
1997 Additions Amortization Terminations 1998
----------- ----------- ------------ ------------ -------
Amortizing interest $ 810,877 $ - $ 48,722 $ 389,011 $ 373,144
rate swaps
Non-amortizing interest
rate swaps 2,778,499 1,300,000 100,000 628,499 3,350,000
Interest rate
caps/floors 1,200,000 - - - 1,200,000
---------- ---------- ---------- ----------- ----------
$4,789,376 $1,300,000 $ 148,722 $ 1,017,510 $4,923,144
========== ========== ========== =========== ==========
At June 30, 1998, Sovereign's balance sheet included a net deferred loss
of $753,000 related to interest rate exchange agreements terminated in September
1997 and January 1998 which were originally accounted for as hedges. Of this net
deferred loss, $364,000 will amortize into interest expense during the remainder
of 1998 and $389,000 will amortize into interest expense in 1999.
Net interest income resulting from interest rate exchange agreements
includes $3.4 million of income and $2.5 million of expense for the six-month
period ended June 30, 1998.
16
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(9) ACQUISITIONS
On August 3, 1998, Sovereign announced the completion of its
acquisitions of Carnegie Bancorp ("Carnegie") and First Home Bancorp, Inc.
("First Home"). Carnegie, a $424 million commercial bank holding company
headquartered in Princeton, New Jersey, operated seven branches throughout
central New Jersey and one in Pennsylvania. First Home, a $523 million savings
bank holding company headquartered in Pennsville, New Jersey, had one principal
operating subsidiary which operated ten branches in Salem, Gloucester and Camden
counties, New Jersey and New Castle County, Delaware.
In accordance with the merger agreements, Carnegie common stock
shareholders received 2.022 shares of Sovereign common stock in exchange for
each share of Carnegie common stock and First Home common stock shareholders
received 1.779 of Sovereign common stock in exchange for each share of First
Home common stock. As a result of these two mergers, Sovereign issued
approximately 10.9 million new shares of common stock.
Both transactions were tax-free to Sovereign, Carnegie, and First Home
shareholders. The mergers were each treated as a pooling-of-interests for
financial accounting purposes; as such, in future filings, all prior periods of
Sovereign will be restated to reflect the balances and activity of Carnegie and
First Home. Sovereign also recorded a one-time, merger-related charge of
approximately $11 to $13 million (after-tax) as a result of the transactions,
which will be reflected in Sovereign's third quarter of 1998 earnings. Pro forma
information has not been presented due to immateriality.
On February 28, 1998, Sovereign acquired ML Bancorp, a $2.4 billion
bank holding company headquartered in Villanova, Pennsylvania. ML Bancorp's
principal operating subsidiary, Main Line Bank, operated 29 branch offices
located in the suburbs of Philadelphia, Pennsylvania. The transaction added
loans, deposits and stockholders' equity to Sovereign of $1.04 billion, $989.5
million and $173.1 million, respectively. In accordance with the merger
agreement, ML Bancorp shareholders received 1.944 shares of Sovereign common
stock in exchange for each share of ML Bancorp common stock. Approximately 24.6
million new shares of Sovereign common stock were issued in connection with the
transaction. The transaction was tax-free to ML Bancorp and ML Bancorp
shareholders, and was accounted for as a pooling-of-interests.
17
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
The results of operations previously reported by the separate
enterprises and the combined amounts presented in the accompanying consolidated
financial statements are summarized below:
Years Ended December 31,
1997 1996
---- -----
Net interest income
Sovereign $340,849 $304,121
ML Bancorp (1) 59,568 54,179
-------- --------
Combined $400,417 $358,300
======== ========
Net income:
Sovereign $ 77,640 $ 70,139
ML Bancorp (1) 16,548 13,810
-------- -------
Combined $ 94,188 $ 83,949
======== ========
- --------------------
(1) Reflects ML Bancorp's results of operations for the eleven-month period
ended February 28, 1998 and for the year-ended March 31, 1997,
respectively.
Prior to the combination, ML Bancorp's fiscal year end was March 31,
and accordingly, Sovereign's consolidated results of operations for the
twelve-month period ended December 31, 1997 include ML Bancorp's results of
operations for the eleven-month period ended February 28, 1998. Consequently, a
net decrease to Sovereign's stockholders' equity of $5.0 million has been made
to reflect ML Bancorp's activity for the two-month period ended February 28,
1998. That activity consisted of net income of $4.2 million and a net change in
accumulated other comprehensive income of $792,000. ML Bancorp's total interest
income, net interest income and net income for the two-month period ended
February 28, 1998 was $28.0 million, $11.6 million and $4.2 million,
respectively. Sovereign's consolidated results of operations for the three-month
and six-month periods ended June 30, 1997 include ML Bancorp's results of
operations for the three-month and six-month periods ended September 30, 1997.
On April 27, 1998, Sovereign announced its planned acquisition of 95
branch offices, approximately $2.3 billion in commercial bank deposits and
approximately $800 million in commercial and consumer loans throughout
Pennsylvania and New Jersey from CoreStates Financial Corp. ("CoreStates") and
First Union Corporation ("First Union"). This transaction, which will be
accounted for as a purchase of assets, is subject to certain regulatory
approvals and is expected to close during the third quarter of 1998.
18
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(10) ACCOUNTING CHANGES
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which is required to be adopted
in years beginning after June 15, 1999. SFAS No. 133 permits early adoption as
of the beginning of any fiscal quarter after its issuance. Sovereign expects to
adopt SFAS No. 133 effective January 1, 2000. SFAS No. 133 will require
Sovereign to recognize all derivatives on the balance sheet at fair value.
Derivatives that are not hedges must be adjusted to fair value through income.
If the derivative is a hedge, depending on the nature of the hedge, changes in
the fair value of derivatives will either be offset against the change in fair
value of the hedged assets, liabilities, or firm commitments through earnings or
recognized in other comprehensive income until the hedged item is recognized in
earnings. The ineffective portion of a derivative's change in fair value will be
immediately recognized in earnings. Sovereign has not yet determined what the
effect of SFAS No. 133 will be on the earnings and financial position of
Sovereign.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." SFAS No. 131 requires that public
companies report certain information about operating segments in complete sets
of financial statements of the company and in condensed financial statements of
interim periods issued to shareholders. It also requires that public companies
report certain information about their products and services, the geographic
areas in which they operate, and their major customers. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997. Sovereign is
currently evaluating the impact SFAS No. 131's additional disclosure
requirements are expected to have on its consolidated financial statements.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." Sovereign adopted SFAS No. 130 on January 1, 1998. The overall
objective of SFAS No. 130 is to provide new rules for the reporting and display
of comprehensive income and its components; however, the adoption of this
statement had no impact on Sovereign's net income or stockholders' equity. SFAS
No. 130 requires unrealized gains or losses on Sovereign's available-for-sale
securities and foreign currency translation adjustments, which prior to adoption
were reported separately in stockholders' equity, to be included in other
comprehensive income. Prior year financial statements have been restated to
conform to the provisions of SFAS No. 130.
19
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
The following table presents the components of comprehensive income,
net of related tax, based on the provisions of SFAS No. 130 for the periods
indicated: (dollars in thousands)
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
------------------ ----------------
1998 1997 1998 1997
---- ---- ---- ----
Net income $ 40,946 $ 32,783 $ 53,973 $ 52,857
Unrealized (losses) gains on
securities arising during the year 9,378 6,773 2,629 10,228
Less reclassification adjustment (1) - - 2,170 -
-------- -------- -------- -------
Net unrealized gain recognized
in other comprehensive income 9,378 6,773 459 10,228
-------- -------- -------- --------
Comprehensive income (2) $ 50,324 $ 39,556 $ 54,432 $ 63,085
======== ======== ======== ========
(1) Sovereign has not calculated the reclassification adjustment for the
six-month period ended June 30, 1997.
(2) Excluding one-time, merger-related charges, comprehensive income for the
six-month periods ended June 30, 1998 and 1997 was $80.3 million and $73.8
million, respectively.
Accumulated other comprehensive income, net of related tax, at June 30,
1998 and December 31, 1997 consisted of net unrealized gains on securities of
$18.3 million and $18.7 million, respectively.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share."
This statement supersedes APB Opinion No. 15, "Earnings per Share" and FASB
Statement No. 85, "Yield Test for Determining whether a Convertible Security Is
a Common Stock Equivalent." The overall objective of SFAS No. 128 is to simplify
the calculation of earnings per share and achieve comparability with the
recently issued International Accounting Standard No. 33, "Earnings Per Share."
SFAS No. 128 is effective for all periods ending after December 15, 1997.
Under SFAS No. 128, primary earnings per share has been replaced with
basic earnings per share. Basic earnings per share is calculated by dividing
income available to common stockholders by the weighted average common shares
outstanding, excluding options, warrants, and convertible securities from the
calculation.
Under SFAS No. 128, fully diluted earnings per share has been renamed
diluted earnings per share. Income available to common stockholders is adjusted
for the assumed conversion of all potentially dilutive securities. In
calculating diluted earnings per share, the dilutive effect of options and
warrants continues to be calculated using the treasury stock method. However,
unlike the calculation of fully diluted earnings per share, the treasury stock
method is applied using the average market price for the period rather than the
higher of the average market price or the ending market price. The dilutive
20
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
effect of convertible debt or preferred stock continues to be calculated using
the if-converted method. Sovereign adopted SFAS No. 128 in December 1997 and
accordingly, the calculation of primary and fully diluted earnings per share for
current and prior periods has been presented and where appropriate, restated to
conform to the provisions of SFAS No.
128.
(11) RECENT DEVELOPMENTS
On July 1, 1998, Sovereign entered into a $10 million strategic
investment in Mego Mortgage Corporation ("Mego"). Mego is a national home equity
lender specializing in high loan to value lending, based in Atlanta, Georgia.
The terms of the stock purchase agreement call for Sovereign to invest $10
million in Mego Series A Convertible Preferred stock. The preferred stock is
mandatorily convertible into Mego common stock after two years, or earlier at
Sovereign's option after six months. This investment establishes Sovereign as a
strategic partner, owning about 9% of Mego on a converted basis. Separately, a
private investor and City Holdings, a West Virginia headquartered bank holding
company, have each agreed to invest $10 million in Mego.
This strategic partnership enables Sovereign to explore the high income
generating consumer finance market without incurring the inherent risks
associated with a start up of a new division or a purchase of an existing
company. This transaction also provides Sovereign with a method to generate
referral income from customers who would not otherwise qualify for a Sovereign
loan product under Sovereign's conservative underwriting criteria and other
mutually beneficial relationships with Mego.
Preferred Stock. On April 16, 1998, Sovereign announced that it would
redeem all outstanding shares of its 6 1/4% Cumulative Convertible Preferred
Stock, Series B on May 15, 1998 at a redemption price of $52.188 per share plus
the dividends payable on May 15, 1998. On this date, dividends on shares of
Series B Preferred Stock ceased to accrue.
Holders of Series B Preferred Stock who converted such shares on May
15, 1998 received shares of common stock of Sovereign issuable upon conversion
of Series B Preferred Stock and were entitled to receive the quarterly dividend
payable on the Series B Preferred Stock. Holders of Series B Preferred Stock who
converted such shares prior to the Redemption Date received shares of common
stock of Sovereign issuable upon conversion of Series B Preferred Stock, but
were not entitled to receive the quarterly dividend payable on the Series B
Preferred Stock. Holders of Series B Preferred Stock who did not convert such
shares on or prior to the Redemption Date received the Redemption Price of
$52.188 per share, plus all accrued and unpaid dividends through the Redemption
Date of $.78125 per share, but did not receive any shares of common stock of
Sovereign issuable upon conversion of Series B Preferred Stock. Accordingly, the
planned redemption by Sovereign resulted in virtually all of preferred
shareholders exercising their right to convert their preferred shares into
Sovereign common stock and 14.3 million common shares were issued as a result of
the transaction.
21
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Impact of Year 2000. The Year 2000 Issue is the result of computer
programs being written using two digits rather than four to define the
applicable year. Any of Sovereign's computer programs that have time-sensitive
software may recognize a date using "00" as the year 1900 rather than the year
2000. This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.
Based on a continuing assessment, Sovereign has preliminarily
determined that it, or third party vendors with which Sovereign contracts, will
be required to modify or replace portions of software and hardware so that
computer systems will function properly with respect to dates in the year 2000
and thereafter. Sovereign presently believes that with modifications or
replacements to existing software and hardware and conversions to new software
and hardware, the Year 2000 Issue will not pose significant operational problems
for its computer systems. However, if such modifications and conversions are not
made, or are not completed timely, the Year 2000 Issue could have a material
impact on the operations of Sovereign.
Sovereign is initiating an ongoing program of formal communications
with all of its significant suppliers and large customers to determine the
extent to which Sovereign's interface systems are vulnerable to those third
parties' failure to remediate their own Year 2000 Issues. However, there can be
no guarantee that the systems of other companies on which Sovereign's systems
rely will be timely converted and would not have an adverse effect on
Sovereign's systems or operations.
Sovereign will utilize both internal and external resources to
reprogram, or replace, and test the software and hardware for Year 2000
modifications. Sovereign anticipates completing the Year 2000 project prior to
any anticipated impact on its operating systems. Sovereign estimates that the
expenses associated with the Year 2000 project for 1998 may cost in the $5
million to $10 million range, although this estimate is subject to change. The
total cost of the Year 2000 project is anticipated to be funded through
operating cash flows and expensed as incurred.
The costs of the project and the time table on which Sovereign believes
it will complete the Year 2000 modifications are based on management's best
estimates, which were derived utilizing numerous assumptions of future events,
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved and actual results could differ materially from
those anticipated. Specific factors that might cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in this area, the ability to locate and correct all relevant computer codes, and
similar uncertainties.
Although Sovereign believes that the program outlined above should be
adequate to address the Year 2000 Issue, there can be no assurance to that
effect.
22
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
RESULTS OF OPERATIONS
General
Net income for the three-month period ended June 30, 1998 was $40.9
million, an increase of 25% when compared to net income of $32.8 million for the
same period in 1997. Diluted earnings per share for the three-month periods
ended June 30, 1998 and 1997 were $.27 and $.23, respectively.
Net operating income for the six-month period ended June 30, 1998 was
$79.8 million, an increase of 26% when compared to net operating income of $63.6
million for the same period in 1997. Diluted operating earnings per share for
the six-month periods ended June 30, 1998 and 1997 were $.53 and $.44,
respectively. These amounts exclude a one-time, merger-related charge of $25.8
million (after-tax) for Sovereign's acquisition of ML Bancorp, Inc. ("ML
Bancorp") during the first quarter of 1998. Operating results for the six-month
period ended June 30, 1997 exclude a one-time, merger charge of $10.7 million
(after-tax) related to Sovereign's acquisition of First State Financial
Services, Inc. ("First State") during the first quarter of 1997.
Reported net income for the six-month periods ended June 30, 1998 and
1997, including the impact of the one-time, merger-related charges discussed
above was $54.0 million and $52.9 million, respectively and diluted earnings per
share for the same periods was $.36 and $.37, respectively. All per share
amounts presented have been adjusted to reflect all stock dividends and stock
splits.
Return on average equity and return on average total assets, excluding
the one-time, merger-related charges discussed above were 16.36% and .92%,
respectively, for the six-month period ended June 30, 1998 compared to 14.62%,
and .84%, respectively, for the same period in 1997. Average equity to average
total assets for the six-month period ended June 30, 1998 and 1997 was 5.61% and
5.75%, respectively.
Net Interest Income
Net interest income for the three-month and six-month periods ended
June 30, 1998 was $111.1 million and $223.7 million compared to $98.0 million
and $192.2 million for the same periods in 1997. This increase is attributable
to an increase in average balances resulting from internal growth and
Sovereign's acquisition of Fleet Financial Group Inc.'s ("Fleet") Automobile
Finance Division ("AFD") in September 1997. Sovereign's net interest margin (net
interest income divided by average interest-earning assets) for the three-month
and six-month periods ended June 30, 1998 was 2.74% and 2.80% compared to 2.79%
and 2.69% for the same periods in 1997.
Interest on interest-earning deposits for the three-month and six-month
periods ended June 30, 1998 was $1.9 million and $3.2 million compared to $1.0
million and $2.2 million for the same periods in 1997. The average balance of
interest-earning deposits was $52.8 million with an average yield of 12.34% for
the six-month period ending June 30, 1998 compared to an average balance of
$34.5 million with an average yield of 12.89% for the same period in 1997.
23
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The high yields on Sovereign's interest-earning deposits are the result of a
contractual arrangement whereby a third-party vendor performed check processing
and reconcilement functions for Sovereign's disbursement accounts. Under the
agreement, the vendor is required to pay Sovereign interest on disbursed funds
during the two to three day float period, effectively producing interest income
with no corresponding asset balance. This agreement will continue to favorably
impact the yield on Sovereign's interest-earning deposits in 1998 and future
years.
Interest on investment and mortgage-backed securities available-for-sale
was $62.5 million and $96.8 million for the three-month and six-month periods
ended June 30, 1998 compared to $22.5 million and $42.7 million for the same
periods in 1997. The average balance of investment and mortgage-backed
securities available-for-sale was $2.94 billion with an average yield of 6.87%
for the six-month period ended June 30, 1998 compared to an average balance of
$1.31 billion with an average yield of 6.71% for the same period in 1997.
Interest on investment and mortgage-backed securities held-to-maturity
was $45.6 million and $103.3 million for the three-month and six-month periods
ended June 30, 1998 compared to $73.9 million and $137.6 million for the same
periods in 1997. The average balance of investment and mortgage-backed
securities held-to-maturity was $2.81 billion with an average yield of 7.37% for
the six-month period ended June 30, 1998 compared to an average balance of $3.89
billion with an average yield of 7.09% for the same period in 1997.
Interest and fees on loans were $203.7 million and $416.0 million for
the three-month and six-month periods ended June 30, 1998 compared to $173.6
million and $343.9 million for the same periods in 1997. The average balance of
loans was $10.64 billion with an average yield of 7.85% for the six-month period
ended June 30, 1998 compared to an average balance of $9.14 billion with an
average yield of 7.54% for the same period in 1997. The increases in the average
balance of loans and in the interest and fees on loans are primarily due to
Sovereign's AFD acquisition in September 1997 and continued growth in
Sovereign's commercial lending division.
Interest on deposits was $97.7 million and $192.6 million for the
three-month and six-month periods ended June 30, 1998 compared to $86.5 million
and $168.3 million for the same periods in 1997. The average balance of deposits
was $9.18 billion with an average cost of 4.23% for the six-month period ended
June 30, 1998 compared to an average balance of $8.23 billion with an average
cost of 4.12% for the same period in 1997.
Interest on borrowings was $104.9 million and $203.1 million for the
three-month and six-month periods ended June 30, 1998 compared to $86.5 million
and $166.1 million for the same periods in 1997. The average balance of
borrowings was $7.06 billion with an average cost of 5.72% for the six-month
period ended June 30, 1998 compared to an average balance of $5.63 billion with
an average cost of 5.91% for the same period in 1997. The increase in the
average balance of borrowings is the result of balance sheet growth being
partially funded by borrowings.
24
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Provision for Possible Loan Losses
The provision for possible loan losses for the three-month and
six-month periods ended June 30, 1998 was $7.0 million and $13.5 million,
respectively. This compares to provision for possible loan losses of $3.2
million and $14.1 million for the same periods in 1997. Results for the
six-month period ended June 30, 1997 includes $7.9 million of reserves taken
during the first quarter of 1997 as part of the one-time, merger charge related
to Sovereign's acquisition of First State in February 1997. These additional
reserves were taken as a result of Sovereign's conservative approach with
respect to an aggressive workout plan for certain non-performing assets acquired
from First State. Excluding this one-time, merger-related charge, Sovereign's
loan loss provision increased by 118% from $6.2 million for the six-month period
ended June 30, 1997 to $13.5 million for the same period in 1998.
Over the past two years, 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 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 small
business and consumer lending in 1998 and future years, management will
continually evaluate its loan portfolio and record additional loan loss reserves
as is necessary. For additional information with respect to Sovereign's asset
quality, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Loan Portfolio."
During the six-month period ended June 30, 1998, Sovereign charged-off
$19.8 million of loans compared to $7.5 million for the same period in 1997.
This increased level of charge-offs for the six-month period ended June 30, 1998
was partially off-set by recoveries of $5.2 million, resulting in net
charge-offs of $14.5 million for 1998. This compares to recoveries of $1.7
million and net charge-offs of $5.8 million for the same period in 1997.
Sovereign's increased level of charge-offs for 1998 is primarily the result of
increased consumer loan charge-offs, the majority of which are related to
Sovereign's newly acquired AFD portfolio. Historically, non-residential lending
will typically result in higher charge-off levels than other types of lending;
however, recoveries and income potential will also be greater.
25
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The following table presents the activity in the allowance for possible
loan losses for the periods indicated: (dollars in thousands)
Six-Month Period Ended June 30,
1998 1997
---- ----
Allowance, beginning of period $ 110,251 $ 67,422
Charge-offs:
Residential 3,336 4,305
Commercial Real Estate - 542
Commercial 252 1,436
Consumer 16,174 1,173
--------- ---------
Total Charge-offs 19,762 7,456
--------- ---------
Recoveries:
Residential 525 427
Commercial Real Estate 5 1,056
Commercial 120 160
Consumer 4,598 46
--------- ---------
Total Recoveries 5,248 1,689
--------- ---------
Charge-offs, net of recoveries 14,514 5,767
Provision for possible loan losses 13,500 14,100
Other 2,161 (1,351)
--------- ----------
Allowance, end of period $ 111,398 $ 74,404
========= =========
Other Income
Other income was $24.7 million and $47.0 million for the three-month
and six-month periods ended June 30, 1998 compared to $14.5 million and $26.8
million for the same periods in 1997.
Other loan fees and service charges were $3.1 million and $6.0 million
for the three-month and six-month periods ended June 30, 1998 compared to $1.7
million and $3.3 million for the same periods in 1997. The increase in other
loan fees and service charges is directly attributable to fees earned on
Sovereign's AFD portfolio which was acquired in September 1997. Other loan fees
and service charges result primarily from Sovereign's loan servicing portfolio.
Sovereign serviced $8.53 billion of its own loans and $6.19 billion of loans for
others at June 30, 1998 compared to $7.10 billion of its own loans and $6.15
billion of loans for others at June 30, 1997.
26
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Deposit fees were $5.7 million and $11.1 million for the three-month
and six-month periods ended June 30, 1998 compared to $4.9 million and $9.2
million for the same periods in 1997. This increase is primarily the result of
an increase in the number of Sovereign's transaction accounts and a larger
retail customer base over the last year.
Mortgage banking gains were $6.7 million and $11.6 million for the
three-month and six-month periods ended June 30, 1998 compared to $4.9 million
and $9.2 million for the same periods in 1997. Mortgage banking gains have
increased as interest rates have declined and loan volumes have accelerated in
1998 compared to 1997.
Gains on sales of loans and investment and mortgage-backed securities
available-for-sale were $3.0 million and $6.5 million for the three-month and
six-month periods ended June 30, 1998 compared to $1.3 million and $1.6 million
for the same periods in 1997. This increase is primarily attributable to gains
of $2.4 million resulting from the liquidation of $477.1 million of investment
and mortgage-backed securities acquired from ML Bancorp during the first quarter
of 1998 and a net gain of $2.8 million resulting from the sale of Sovereign's
credit card portfolio during the second quarter of 1998.
Miscellaneous income was $6.2 million and $11.9 million for the
three-month and six-month periods ended June 30, 1998 compared to $1.7 million
and $3.5 million for the same periods in 1997. This increase is primarily due to
Sovereign's investment in Bank Owned Life Insurance ("BOLI") which was made
during the first quarter of 1998 and increased inter-change income resulting
from growth in the number of Sovereign's debit cards and credit cards over the
last year.
General and Administrative Expenses
Total general and administrative expenses were $58.9 million and $119.1
million for the three-month and six-month periods ended June 30, 1998 compared
to $49.5 million and $98.2 million for the same periods in 1997. The ratio of
general and administrative expenses to average assets for the three-month and
six-month periods ended June 30, 1998 was 1.30% and 1.36% compared to 1.30% and
1.32% for the same periods in 1997. Sovereign's efficiency ratio (all general
and administrative expenses as a percentage of net interest income and recurring
non-interest income) for the three-month and six-month periods ended June 30,
1998 was 44.4% and 45.3% compared to 44.5% and 45.2% for the same periods in
1997.
27
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Other operating expenses were $6.2 million and $52.2 million for the
three-month and six-month periods ended June 30, 1998 compared to $7.0 million
and $19.8 million for the same periods in 1997. Results for the six-month period
ended June 30, 1998 include one-time, merger charges of $39.5 million related to
Sovereign's acquisition of ML Bancorp during the first quarter of 1998. Expenses
included as part of the one-time charge were human resources related costs and
other expenses, including investment banker fees and legal expenses. Results for
the six-month period ended June 30, 1997 include one-time, merger charges of
$8.0 million.
Income Tax Provision
The income tax provision was $22.8 million and $31.9 million for the
three-month and six-month periods ended June 30, 1998 compared to $20.0 million
and $34.0 million for the same periods in 1997. The effective tax rate for the
three-month and six-month periods ended June 30, 1998 was 35.7% and 37.2%
compared to 37.9% and 39.2% for the same periods in 1997. The higher than usual
effective tax rate for the six-month periods ended June 30, 1998 and 1997 is
primarily attributable to certain non-deductible expenses incurred in
conjunction with Sovereign's acquisitions during each of these periods.
FINANCIAL CONDITION
Loan Portfolio
Sovereign's loan portfolio at June 30, 1998 was $10.1 billion compared
to $10.8 billion at December 31, 1997. This slight decrease is primarily due to
a decline in Sovereign's residential mortgage loan portfolio of approximately
$414 million resulting from the refinance environment and Sovereign's lessened
emphasis on portfolio lending.
Continuing its transition to a mortgage banking franchise, during the
six-month period ended June 30, 1998, Sovereign closed $903.4 million of first
mortgage loans of which approximately 88% were fixed rate and sold in the
secondary market. This compares to first mortgage loan closings of $988.0
million and approximately 38% of fixed rate loans for the same period in 1997.
Over the past two years, Sovereign has increased its emphasis on
commercial and consumer loan originations. As a result, during the six-month
period ended June 30, 1998, Sovereign closed $364.7 million of commercial loans
compared to $76.4 million of commercial loans during the same period in 1997.
This increase is due to strong business loan demand in Sovereign's market area
resulting from a strong economy and the recently completed acquisition of
CoreStates by First Union.
Sovereign closed $832.3 million of consumer loans during the six-month
period ended June 30, 1998 compared to $344.7 million of consumer loans during
the same period in 1997. This increase is primarily the result of Sovereign's
newly acquired AFD which originated $329.5 million of indirect auto loans during
the six-month period ended June 30, 1998.
28
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Sovereign's primary residential loan products are variable rate
mortgage loans on owner-occupied residential real estate. As a result, at June
30, 1998, 68% of Sovereign's total loan portfolio was secured by residential
real estate and 57% of the total loan portfolio was comprised of variable rate
loans. However, as a result of Sovereign's use of interest rate swaps for
interest rate risk management, at June 30, $191.3 million of intermediate
variable rate mortgage loans (loans with a five-year fixed rate period) have
effectively been converted to a variable rate loan over the fixed rate period.
At June 30, 1998, Sovereign's total loan portfolio included $5.55
billion of first mortgage loans secured primarily by liens on owner-occupied
one-to-four family residential properties. With its increased focus on
non-residential lending and the AFD acquisition, at June 30, 1998, Sovereign's
total loan portfolio also included $1.27 billion of commercial loans and $3.15
billion of consumer loans, including $1.54 billion of auto loans and $1.07
billion of outstanding home equity loans (excluding $389.0 million of additional
unused commitments for home equity lines of credit) secured primarily by second
mortgages on owner-occupied one-to-four family residential properties.
At June 30, 1998, Sovereign's non-performing assets were $101.3 million
compared to $98.6 million at December 31, 1997. Non-performing assets as a
percentage of total assets were .54% at June 30, 1998 compared to .59% at
December 31, 1997. Non-performing assets at June 30, 1998 included $11.0 million
of REO which is carried at lower of cost or estimated fair value less estimated
costs to sell. Sovereign places all loans 90 days or more delinquent (except
auto loans and loans guaranteed by the government or secured by deposit
accounts) on non-performing status. Sovereign's auto loans continue to accrue
interest until they are 120 days delinquent, at which time they are placed on
non-accrual status. At June 30, 1998, the allowance for possible loan losses as
a percentage of non-performing assets was 97.54% compared to 107.35% at December
31, 1997.
29
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
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: (dollars in thousands)
June 30, December 31,
1998 1997
-------- ------------
Non-Accrual Loans:
Past due 90 days or more
as to interest or principal:
Real estate related $ 59,564 $ 62,397
Other 17,322 18,208
Past due less than 90 days as to interest and principal:
Real estate related 547 555
Other 5,230 -
--------- --------
Total Non-Accrual Loans 82,663 81,160
Other 7,367 6,524
Restructured Loans 306 327
--------- --------
Total Non-Performing Loans 90,336 88,011
--------- --------
Real Estate Owned:
Real estate related 10,303 9,921
Other 665 710
--------- --------
Total Real Estate Owned 10,968 10,631
--------- --------
TOTAL NON-PERFORMING ASSETS $ 101,304 $ 98,642
========= ========
Past due 90 days or more as to
interest or principal and
accruing interest (1) $ 5,194 $ 6,672
Non-Performing Assets as a
percentage of Total Assets .54% .59%
Non-Performing Loans as a
percentage of Total Loans .87% .80%
Non-Performing Assets as a
percentage of Total Loans
and Real Estate Owned 1.02% .95%
Allowance for Possible Loan
Losses as a percentage of
Total Non-Performing Assets 97.54% 107.35%
Allowance for Possible Loan
Losses as a percentage of
Total Non-Performing Loans 109.39% 120.32%
30
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
(1) Represents student loans which are government-guaranteed and Sovereign
retains minimal risk of credit losses related to these loans.
The adequacy of Sovereign's allowance for possible loan losses is
constantly being evaluated. Management's evaluation of the adequacy of the
allowance to absorb potential future loan losses takes into consideration the
risks inherent in the loan portfolio, past loan loss experience, specific loans
which could have loss potential, geographic and industry concentrations,
delinquency trends, economic conditions and other relevant factors. At June 30,
1998, the allowance for possible loan losses was $111.4 million or 1.07% of
total loans compared to $110.3 million or 1.00% of total loans at December 31,
1997.
The following table presents the allocation of the allowance for
possible loan losses and the percentage of such allocation to each loan type for
the dates indicated: (dollars in thousands)
June 30, December 31,
1998 1997
Balance at End of ------------------- -------------
Period Attributable to Amount Percent Amount Percent
Residential real estate $ 29,388 26.4% $ 34,745 31.5%
Commercial real estate 6,382 5.7 19,368 17.6
Commercial 21,445 19.3 8,007 7.3
Consumer 38,982 35.0 23,097 20.9
Unallocated 15,201 13.6 25,034 22.7
-------- ----- -------- -----
Total $111,398 100.0% $110,251 100.0%
======== ===== ======== =====
Potential problem loans (consisting of loans as to which management has
serious concerns as to the ability of such borrowers to comply with present
repayment terms, although not currently classified as non-performing loans)
amounted to approximately $28.1 million at June 30, 1998 and consisted
principally of commercial real estate loans.
Sovereign encourages loan officers to follow specific procedures in the
early identification and collection of problem loans. If a loan becomes
seriously delinquent or the loan officer is not successful in the resolution of
the problem loan, the account is transferred to Sovereign's Asset Recovery Team.
At this time the account is analyzed for collateral values and the cash flows
available to repay the loan. If it is determined that there is a collateral
shortfall and insufficient cash flow to repay the debt, a reserve will be
established immediately based on this analysis. At any time during this process
and at the loan officer's discretion, the account may be placed on non-accrual
status. By following these procedures, losses are minimized on impaired loans.
31
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Impaired loans are summarized as follows (in thousands):
June 30, December 31,
1998 1997
-------- ------------
Impaired loans without a related reserve $ 15,890 $ 7,435
Impaired loans with a related reserve 29,863 12,153
--------- --------
Total impaired loans $ 45,753 $ 19,588
========= ========
Reserve for impaired loans $ 17,887 $ 5,325
========= ========
The average balance of impaired loans for the six-month periods ended
June 30, 1998 and 1997 was $46.0 million and $26.1 million, respectively.
Investment and Mortgage-backed Securities
Investment securities consist primarily of U.S. Treasury and government
agency securities, corporate debt securities and stock in the Federal Home Loan
Bank of Pittsburgh ("FHLB"). Mortgage-backed securities consist of collateral
mortgage obligations issued by FHLMC, FNMA, GNMA, RTC or private label issues.
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 Fitch at the date of issuance. The classes are backed by single
family residential loans which are primary residences geographically dispersed
throughout the United States. 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. Sovereign's strategy is to purchase classes which have an
average life of three years or less. The effective duration of the total
investment portfolio at June 30, 1998 was 1.7 years.
At June 30, 1998, total investment and mortgage-backed securities
available-for-sale were $4.73 billion compared to $1.80 billion at December 31,
1997 and investment and mortgage-backed securities held-to-maturity were $2.26
billion compared to $3.21 billion at December 31, 1997. For additional
information with respect to Sovereign's investment and mortgage-backed
securities, see Notes 3 and 4 in the Notes to Consolidated Financial Statements.
32
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Long-Lived Assets
In March 1995, the Financial Accounting Standards Board (?FASB?) issued
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed of", which requires impairment losses to be
recorded on long-lived assets used in operations when indicators of impairment
are present and the undiscounted cash flows estimated to be generated by those
assets are less than the assets' carrying amount. SFAS No. 121 also addresses
the accounting for long-lived assets that are expected to be disposed of.
Sovereign adopted SFAS No. 121 in the first quarter of 1996 and the effect of
adoption was not material.
Goodwill and Other Intangible Assets
Total goodwill and other intangible assets at June 30, 1998 were $123.3
million compared to $125.8 million at December 31, 1997. During the first
quarter of 1998, Sovereign added $5.5 million to goodwill as part of an
adjustment related to its AFD acquisition from Fleet in September 1997. This
adjustment, which is permitted during the one-year period following a
transaction, reflects a refinement of Sovereign's estimate of the fair market
value of the assets acquired and liabilities assumed as of the date of the
combination. This increase to goodwill was off-set by a reduction of $1.8
million taken as part of the one-time, merger-related charge during the first
quarter of 1998 and normal year-to-date amortization.
Deposits
Deposits are attracted from within Sovereign's primary market area
through the offering of various deposit instruments including NOW accounts,
money market accounts, savings accounts, certificates of deposit and retirement
savings plans.
Total deposits at June 30, 1998 were $9.34 billion compared to $8.86
billion at December 31, 1997. For additional information with respect to
Sovereign's deposit portfolio composition, see Note 6 in the Notes to
Consolidated Financial Statements.
Borrowings
Sovereign utilizes borrowings 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.
Another source of funds for Sovereign is reverse repurchase agreements. Reverse
repurchase agreements are short-term obligations collateralized by securities
fully guaranteed as to principal and interest by the U.S. Government or an
agency thereof.
33
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Total borrowings at June 30, 1998 were $8.03 billion of which $5.82
billion were short-term compared to $6.63 billion of which $5.32 billion were
short-term at December 31, 1997. This increase in borrowings is the result of
balance sheet growth being partially funded by borrowings. For additional
information with respect to Sovereign's borrowings, see Note 7 in the Notes to
Consolidated Financial Statements.
Through the use of interest rate swaps, $3.35 billion of FHLB advances
at June 30, 1998 have been effectively converted from variable rate obligations
to fixed rate obligations. In addition, at June 30, 1998, $1.2 billion of
borrowings have been protected from upward repricing through the use of interest
rate caps and floors.
LIQUIDITY AND CAPITAL RESOURCES
Sovereign's banking subsidiaries are required under applicable federal
regulations to maintain specified levels of "liquid" investments in cash and
U.S. Treasury and other qualifying investments. Regulations currently in effect
require Sovereign's banking subsidiaries to maintain liquid assets of not less
than 5% of its net withdrawable accounts plus short-term borrowings. These
levels are changed from time to time by the OTS to reflect economic conditions.
The liquidity ratio of Sovereign Bank for June 30, 1998 was 45.4%.
Sovereign's primary financing sources are deposits obtained in its own
market area and borrowings in the form of securities sold under repurchase
agreements and advances from the FHLB. While the majority of Sovereign's
certificate of deposit accounts are expected to mature within a one year period,
historically, the retention rate has been approximately 70%. If a significant
portion of maturing certificates would not renew at maturity, the impact on
Sovereign's operations and liquidity would be minimal due to cash flows produced
by Sovereign's investment portfolio which currently approximate $125.0 million
per month. At June 30, 1998, Sovereign had $5.32 billion in unpledged
investments and mortgage-backed securities which could be used to collateralize
additional borrowings. Sovereign Bank can also borrow from the FHLB, subject to
required collateralization. Other sources of funds include operating activities,
repayments of principal on investment and mortgage-backed securities, repayment
of principal on loans and other investing activities.
For the six-month period ended June 30, 1998, cash and cash equivalents
increased $256.7 million. Net cash used by operating activities was $280.4
million for the six-month period ended June 30, 1998. Net cash used by investing
activities for the six-month period ended June 30, 1998 was $1.35 billion
consisting primarily of purchases of mortgage-backed securities which are
classified available-for-sale, partially offset by proceeds from sales and
repayments of investment and mortgage-backed securities. Net cash provided by
financing activities for the six-month period ended June 30, 1998 was $1.89
billion which includes an increase in deposits of $429.2 million and an increase
in proceeds from long-term borrowings of $1.33 billion.
34
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The Financial Institutions Reform, Recovery and Enforcement Act
("FIRREA"), requires the OTS to prescribe uniformly applicable capital standards
for all savings associations. These standards require savings associations to
maintain a minimum tangible capital ratio of not less than 1.5%, a minimum
leverage capital ratio of not less than 3% of tangible assets and not less than
4% of risk adjusted assets and a minimum risk-based capital ratio (based upon
credit risk) of not less than 8%. In all cases, these standards are to be no
less stringent than the capital standards that are applicable to national banks.
The OTS has issued a regulation that requires a minimum leverage capital
requirement of 3% for associations rated composite "1" under the OTS MACRO
rating system. For all other savings associations, the minimum leverage capital
requirement will be 3% plus at least an additional 100 to 200 basis points.
The Federal Deposit Insurance Corporation Improvement Act ("FDICIA"),
established five capital tiers: well capitalized, adequately capitalized, under
capitalized, significantly under capitalized and critically under capitalized. 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 are subject to various restrictions
regarding capital distributions, payment of management fees, acceptance of
brokered deposits and other operating activities.
At June 30, 1998, Sovereign Bank was classified as well capitalized and
in compliance with all capital requirements. Management anticipates that
Sovereign Bank will continue to be classified as well capitalized and will be in
compliance with all regulatory capital requirements.
The following table sets forth the capital ratios of Sovereign Bancorp
and Sovereign Bank and the current regulatory requirements at June 30, 1998:
Well
Sovereign Sovereign Minimum Capitalized
Bancorp (1) Bank Requirement Requirement
-------- --------- ----------- -----------
Stockholders' equity to
total assets 5.51% 5.86% None None
Tangible capital to tangible
assets 4.83 5.19 1.50% None
Leverage (core) capital to
tangible assets 5.71 5.36 3.00 5.00%
Leverage (core) capital to
risk adjusted assets 10.50 9.95 4.00 6.00
Risk-based capital to risk
adjusted assets 12.99 10.94 8.00 10.00
(1) OTS capital regulations do not apply to savings and loan holding companies.
These ratios are computed as if those regulations did apply to Sovereign
Bancorp.
35
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
ASSET AND LIABILITY MANAGEMENT
The objective of Sovereign's asset and liability management is to
identify, measure and control its interest rate risk in order to produce
consistent earnings that are not contingent upon favorable trends in interest
rates. Sovereign manages its assets and liabilities to attain a stable net
interest margin across a wide spectrum of interest rate environments. This is
attained by monitoring the levels of interest rates, the relationships between
the rates earned on assets and the rates paid on liabilities, the absolute
amount of assets and liabilities which reprice or mature over similar periods,
off-balance sheet positions and the effect of all of these factors on the
estimated level of net interest income.
There are a number of industry standards used to measure an
institution's interest rate risk position. Most common among these is the one
year gap which is the ratio representing the difference between assets,
liabilities and off-balance sheet positions which will mature or reprice within
one year expressed as a percentage of total assets. Using management's estimates
of asset prepayments, core deposit decay and core deposit repricing in its
computation, Sovereign estimates that its cumulative one year gap position was a
negative .24% at June 30, 1998.
Sovereign manages the one year interest rate gap within +/- 10%. A
positive gap position implies that the bank is asset sensitive which could cause
net interest income to decrease if interest rates fall. Conversely, a negative
gap position implies that the bank is liability sensitive which could cause net
interest income to decrease if interest rates rise. Sovereign manages the impact
to net interest income in a +200 basis point instantaneous parallel rate shock
environment to be within a 10% loss. At June 30, 1998, Sovereign estimates that
if interest rates rise by 200 basis points, net interest income would decrease
by $7.1 million or 1.29%.
Sovereign also utilizes income simulation modeling in measuring its
interest rate risk and managing its interest rate sensitivity. Income simulation
considers not only the impact of changing market interest rates on forecasted
net interest income, but also other factors such as yield curve relationships,
the volume and mix of assets and liabilities, customer preferences and general
market conditions.
Pursuant to its interest rate risk management strategy, Sovereign
enters into off-balance sheet transactions which 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. For additional information on
interest rate exchange agreements, see Note 8 in the Notes to Consolidated
Financial Statements.
36
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Amortizing and non-amortizing interest rate swaps are generally used to
convert fixed rate assets and liabilities to variable rate assets and
liabilities and vice versa. Sovereign utilizes amortizing interest rate swaps to
convert discounted adjustable rate loans to fixed rate for a period of time. The
amortization of the notional amount of the interest rate swaps are tied to the
level of an index such as the One Year Treasury Constant Maturity, LIBOR, or a
prepayment rate of a pool of mortgage-backed securities. In order for interest
rate swaps to achieve the desired objective, Sovereign selects interest rate
swaps that will have a high degree of correlation to the related financial
instrument. Sovereign generally utilizes non-amortizing swaps to convert fixed
rate liabilities to floating, and floating rate liabilities to fixed, to reduce
Sovereign's overall cost of funds.
Interest rate caps are generally used to limit the exposure from the
repricing and maturity of liabilities and interest rate floors are generally
used to limit the exposure from repricing and maturity of assets. Interest rate
caps and floors are also used to limit the exposure created by other interest
rate swaps. In certain cases, interest rate caps or floors are simultaneously
bought and sold to create a range of protection against changing interest rates
while limiting the cost of that protection.
Over the past two years, Sovereign has shifted its residential focus
from portfolio lending to mortgage banking. Accordingly, the majority of
Sovereign's fixed-rate loan originations are sold 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 means of hedging loans in the mortgage pipeline which are
originated for sale.
Sovereign's primary funding source is deposits obtained in its own
marketplace. Deposit programs at Sovereign are priced to meet management's
asset/liability objectives, while taking into account the rates available on
investment opportunities and also considering the cost of alternative funding
sources. Borrowings are also a significant funding source for Sovereign and have
primarily been in the form of securities sold under repurchase agreements and
advances from the FHLB. Since borrowings are not subject to the market
constraints to which deposits are, Sovereign uses borrowings to add flexibility
to its interest rate risk position.
37
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
PART II - OTHER INFORMATION
Items 1 through 5 are not applicable or the responses are negative.
Item 6 - Reports on Form 8-K.
Report on Form 8-K, dated June 23, 1998 (date of earliest event - June
23, 1998), contained Sovereign's 1997 Form 10-K restated to include
the merger of ML Bancorp, Inc. with and into Sovereign Bancorp, Inc.
ML Bancorp's Form 10-K was also presented.
Report on Form 8-K, dated April 20, 1998 (date of earliest event -
April 14, 1998), contained a press release announcing Sovereign's
expected earnings for the first quarter of 1998.
Report on Form 8-K, dated April 20, 1998 (date of earliest event -
April 15, 1998), contained a press release announcing the resignation
of Karl D. Gerhart as Sovereign's Chief Financial Officer and the
appointment of Dennis S. Marlo as Sovereign's new Chief Financial
Officer.
Report on Form 8-K, dated February 20, 1998 (date of earliest event -
January 20, 1998), contained a press release announcing Sovereign's
earnings for the year ended December 31, 1997.
Report on Form 8-K, dated February 19, 1998 (date of earliest event -
January 20, 1998), contained a press release announcing Sovereign's
earnings for the year ended December 31, 1997.
38
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 August 18, 1998 /s/ Dennis S. Marlo
-------------------------
Dennis S. Marlo
Chief Financial Officer
Date August 18, 1998 /s/ Mark R. McCollom
-------------------------
Mark R. McCollom
Chief Accounting Officer
39