WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- --- EXCHANGE ACT OF 1934
For the quarter ended September 30, 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 November 16, 1998
--------------------------- --------------------------------
Common Stock (no par value) 159,398,550 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.
-2-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 1998
and December 31, 1997 4
Consolidated Statements of Operations for the three-month
and nine-month periods ended September 30, 1998 and 1997 5 - 6
Consolidated Statement of Stockholders' Equity for
the nine-month period ended September 30, 1998 7
Consolidated Statements of Cash Flows for the nine-month
periods ended September 30, 1998 and 1997 8
Notes to Consolidated Financial Statements 9 - 23
Item 2. Management's Discussion and Analysis of
Results of Operations and Financial Condition 24 - 38
PART II. OTHER INFORMATION
Item 6. Reports on Form 8-K 39
PART III. FINANCIAL DATA SCHEDULE 40 - 41
SIGNATURES 42
-3-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
1998 1997
------------- ------------
(Unaudited) (Note)
(in thousands, except
per share data)
ASSETS
Cash and amounts due from
depository institutions $ 648,342 $ 238,623
Interest-earning deposits 155,833 17,314
Loans held for sale (approximate fair
value of $220,304 and $310,750 at
September 30, 1998 and December 31, 1997,
respectively) 220,057 310,678
Investment securities available-for-sale 5,716,720 1,956,262
Investment securities held-to-maturity
(approximate fair value of $2,225,033
and $3,446,863 at September 30, 1998
and December 31, 1997, respectively) 2,170,253 3,416,451
Loans 11,334,820 11,324,122
Allowance for loan losses (135,882) (116,823)
Premises and equipment 88,878 92,273
Real estate owned 17,974 12,009
Accrued interest receivable 213,832 108,029
Goodwill and other intangible assets 443,930 126,332
Other assets 622,065 170,185
------------ ------------
TOTAL ASSETS $ 21,496,822 $ 17,655,455
============ ============
LIABILITIES
Deposits $ 12,369,323 $ 9,515,294
Borrowings:
Short-term 5,287,886 5,455,894
Long-term 2,263,783 1,407,749
Advance payments by borrowers
for taxes and insurance 25,523 41,847
Other liabilities 274,056 57,904
------------ ------------
TOTAL LIABILITIES 20,220,571 16,478,688
------------ ------------
Corporation-obligated mandatorily redeemable
capital securities of subsidiary trust holding
solely subordinated debentures of Sovereign
Bancorp, Inc. ("Trust Preferred Securities") 129,029 128,972
------------ ------------
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; 163,733,638 shares issued at
September 30, 1998 and 147,216,301 shares
issued at December 31, 1997 639,315 523,327
Unallocated common stock held by the Employee
Stock Ownership Plan at cost;
4,611,132 shares at September 30, 1998 and
5,984,934 shares at December 31, 1997 (31,194) (37,211)
Treasury stock at cost; 8,721 shares at
September 30, 1998 and 13,210 shares at
December 31, 1997 (132) (185)
Accumulated other comprehensive income 15,026 18,944
Retained earnings 524,207 446,644
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 1,147,222 1,047,795
------------ ------------
TOTAL LIABILITIES, MINORITY INTERESTS
AND STOCKHOLDERS' EQUITY $ 21,496,822 $ 17,655,455
============ ============
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, plus additions necessary to reflect
Sovereign's February 28, 1998 acquisition of ML Bancorp, Inc. ("ML Bancorp") and
Sovereign's July 31, 1998 acquisitions of Carnegie Bancorp ("Carnegie") and
First Home Bancorp, Inc. ("First Home"), which were each accounted for as a
pooling-of-interests, 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 Nine-Month Period
Ended September 30, Ended September 30,
---------------------- -----------------------
1998 1997 1998 1997
-------- -------- -------- --------
(in thousands, except per share data)
Interest income:
Interest on interest-earning deposits $ 2,029 $ 1,366 $ 5,360 $ 3,815
Interest and dividends on investment
securities available-for-sale 85,396 30,155 187,806 78,372
Interest and dividends on investment
securities held-to-maturity 38,345 74,235 148,053 216,833
Interest and fees on loans 215,998 199,313 656,521 566,889
-------- -------- -------- --------
Total interest income 341,768 305,069 997,740 865,909
-------- -------- -------- --------
Interest expense:
Interest on deposits 112,893 99,801 319,230 281,608
Interest on borrowings 107,628 95,949 317,614 267,515
-------- -------- -------- --------
Total interest expense 220,521 195,750 636,844 549,123
-------- -------- -------- --------
Net interest income 121,247 109,319 360,896 316,786
Provision for loan losses (1) 7,001 20,329 20,961 34,925
-------- -------- -------- --------
Net interest income after provision for
possible loan losses 114,246 88,990 339,935 281,861
-------- -------- -------- --------
Other income:
Loan fees and service charges 2,945 1,333 7,748 2,111
Deposit fees 6,523 5,415 18,170 15,134
Mortgage banking gains 5,201 5,154 18,211 17,238
Gain on sale of loans and investment
securities available-for-sale 6,262 1,330 12,846 2,921
Miscellaneous income 4,815 1,817 16,787 5,488
-------- -------- -------- --------
Total other income 25,746 15,049 73,762 42,892
-------- -------- -------- --------
General and administrative expenses:
Salaries and employee benefits 30,166 25,446 89,811 78,556
Occupancy and equipment expenses 13,767 12,907 40,113 30,435
Outside services 11,823 6,428 31,258 18,269
Deposit insurance premiums 1,150 1,090 3,440 3,399
Other administrative expenses 9,500 11,102 31,106 34,282
-------- -------- -------- --------
Total general and administrative expenses 66,406 56,973 195,728 164,941
-------- -------- -------- --------
-5-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(continued)
Three-Month Period Nine-Month Period
Ended September 30, Ended September 30,
---------------------- ------------------------
1998 1997 1998 1997
-------- ------- --------- --------
(in thousands, except per share data)
Other operating expenses:
One-time, merger-related charges (1) 10,860 21,303 $ 50,389 $ 29,258
Amortization of goodwill and other intangibles 4,950 3,383 11,347 9,711
Trust Preferred Securities expense 3,051 3,543 9,478 8,558
Real estate owned (gain)/loss, net (243) 180 (256) 757
-------- ------- --------- --------
Total other operating expenses 18,618 28,409 70,958 48,284
-------- ------- --------- --------
Income before income taxes 54,968 18,657 147,011 111,528
Income tax provision 20,178 9,439 54,227 45,460
-------- ------- --------- --------
Net Income (1)(2) $ 34,790 $ 9,218 $ 92,784 $ 66,068
======== ======= ========= ========
Net Income Applicable to Common Stock $ 34,790 $ 7,658 $ 91,288 $ 61,384
======== ======= ========= ========
Earnings per share (2)(3) $ .22 $ .06 $ .58 $ .43
======== ======= ========= ========
Dividends per share (3) $ .020 $ .022 $ .063 $ .097
======== ======= ========= ========
- ----------
(1) Results for the three-month and nine-month periods ended September 30, 1998
include a one-time, merger charge of $10.9 million ($7.8 million after-tax)
related to Sovereign's acquisitions of Carnegie and First Home during the
third quarter of 1998. Results for the nine-month period ended September
30, 1998 also 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 three-month and nine-month
periods ended September 30, 1997 include a one-time, merger charge of $38.3
million ($25.9 million after-tax) related to Sovereign's acquisition of
Bankers Corp. ("Bankers") during the third quarter of 1997 of which $17.0
million (pre-tax) is classified as provision for loan losses. Results for
the nine-month period ended September 30, 1997 also 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 loan losses.
(2) Results for the three-month and nine-month periods ended September 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
three-month and nine-month periods ended September 30, 1998 and 1997 were
$42.8 million and $126.6 million and $35.3 million and $102.8 million,
respectively and earnings per share for the same periods were $.27 and $.79
and $.23 and $.67, 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 141,218 1,996 $523,327 $ 96,276 $446,644 $(185)
Net income -- -- -- -- 92,784 --
Exercise of stock options 1,973 -- 9,457 -- -- --
Cash in lieu of fractional shares -- -- (63) -- -- --
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan 206 -- 3,393 -- -- --
Dividends paid on common stock -- -- -- -- (9,497) --
Dividends paid on preferred stock -- -- -- -- (1,496) --
Treasury stock repurchase (16) -- -- -- -- (210)
Treasury stock sale 18 -- -- -- -- 263
Other comprehensive income -
unrecognized income on investment
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, September 30, 1998 159,114 -- $639,315 $ -- $524,207 $(132)
========= ====== ======== ======= ======== =====
Accumulated Total
Unallocated Other Stock-
Common Stock Comprehensive Holders'
Held by ESOP Income Equity
------------ ------------- --------
Balance, December 31, 1997 $(37,211) $18,944 $1,047,795
Net income -- -- 92,784
Exercise of stock options -- -- 9,457
Cash in lieu of fractional shares -- -- (63)
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan -- -- 3,393
Dividends paid on common stock -- -- (9,497)
Dividends paid on preferred stock -- -- (1,496)
Treasury stock repurchase -- -- (210)
Treasury stock sale -- -- 263
Other comprehensive income -
unrecognized income on investment
securities available-for-sale, net of tax -- (3,126) (3,126)
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, September 30, 1998 $(31,194) $15,026 $1,147,222
======== ======= ==========
See accompanying notes to consolidated financial statements.
-7-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine-Month Period
Ended September 30,
-----------------------------
1998 1997
----------- -----------
(in thousands)
Cash Flows from Operating Activities:
Net income $ 92,784 $ 66,068
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for possible loan losses and deferred taxes 15,443 57,618
Depreciation 10,368 9,213
Amortization 6,925 56,522
Gain on sale of loans, investment securities
and real estate owned (13,211) (8,948)
Allocation of Employee Stock Ownership Plan 15,310 2,547
Net change in:
Loans held for sale 90,621 (100,654)
Accrued interest receivable (107,454) (15,442)
Prepaid expenses and other assets (392,777) (81,426)
Other liabilities 214,224 138,058
----------- -----------
Net cash (used)/provided by operating activities $ (67,767) $ 88,556
----------- -----------
Cash Flows from Investing Activities:
Proceeds from sales of investment securities
available-for-sale 934,873 295,447
Proceeds from repayments and maturities of
investment securities:
Available-for-sale 620,740 199,478
Held-to-maturity 1,724,969 1,266,498
Purchases of investment securities:
Available-for-sale (5,328,899) (781,030)
Held-to-maturity (456,601) (1,259,596)
Proceeds from sales of loans 22,711 25,019
Purchase of loans (2,102,078) (2,664,675)
Net change in loans other than purchases and sales 1,997,327 536,730
Proceeds from sales of premises and equipment 13,131 9,039
Purchases of premises and equipment (21,909) (12,526)
Proceeds from sale of real estate owned 14,764 14,601
Net cash received in business combinations 0 (4,926)
Other, net (4,228) (4,996)
----------- -----------
Net cash used by investing activities (2,585,200) (2,380,937)
----------- -----------
Cash Flows from Financing Activities:
Assumption of deposits 1,906,041 --
Net increase in deposits 566,356 704,336
Net (decrease)/increase in short-term borrowings (661,446) 1,343,838
Proceeds from long-term borrowings 1,404,842 425,156
Net increase in advance payments by
borrowers for taxes and insurance (16,324) (3,395)
Cash dividends paid to stockholders (11,098) (19,795)
Proceeds from issuance of common stock 12,787 14,384
Redemption of preferred stock (6) --
Issuance of treasury stock 53 9,135
----------- -----------
Net cash provided by financing activities 3,201,205 2,473,659
----------- -----------
Net change in cash and cash equivalents 548,238 181,278
Cash and cash equivalents at beginning of period 255,937 174,450
----------- -----------
Cash and cash equivalents at end of period $ 804,175 $ 355,728
=========== ===========
Reconciliation of Cash and Cash Equivalents to
Consolidated Balance Sheets:
Cash and amounts due from depository institutions $ 648,342 $ 337,931
Interest-earning deposits 155,833 17,797
----------- -----------
Cash and cash equivalents at end of period $ 804,175 $ 355,728
=========== ===========
Supplemental Disclosures:
Income tax payments totaled $71.6 million for the nine-month period ended
September 30, 1998 and $45.3 million for the same period in 1997. Interest
payments totaled $598.9 million for the nine-month period ended September 30,
1998 and $518.0 million for the same period in 1997. Noncash activity consisted
of mortgage or whole loan sales of $708.1 million for the nine-month period
ended September 30, 1998 and $192.1 million for the same period in 1997;
reclassification of long-term borrowings to short-term borrowings of $563.0
million for the nine-month period ended September 30, 1998 and $664.2 million
for the same period in 1997; and reclassification of mortgage loans to real
estate owned of $13.5 million for the nine-month period ended September 30, 1998
and $18.5 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 and ML Capital Trust I. 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 which was acquired on February 28, 1998 and First Home which were
both acquired on July 31, 1998. These transactions were each accounted for under
the pooling-of-interests method of accounting (see Note 9 "Acquisitions"
hereof). The results of operations for the nine-month period ended September 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.
-9-
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 Nine-month Period
Ended September 30, Ended September 30,
------------------------ ------------------------
1998 1997 1998 1997
-------- -------- -------- --------
Basic Earnings Per Share:
Net income attributable to
common stock(1) $ 34,790 $ 7,658 $ 91,288 $ 61,384
-------- -------- -------- --------
Average basic shares outstanding
at end of period(3) 158,907 137,696 150,711 136,041
======== ======== ======== ========
Basic earnings per share(2)(3) $ .22 $ .06 $ .61 $ .45
======== ======== ======== ========
Diluted Earnings Per Share:
Net income(1) $ 34,790 $ 9,218 $ 92,784 $ 66,068
-------- -------- -------- --------
Average diluted shares outstanding
at end of period(3) 158,907 152,050 157,765 150,404
Dilutive effect of average stock
options, net of shares assumed to
be repurchased under the treasury
stock method(3) 2,442 3,918 3,086 3,849
-------- -------- -------- --------
Total average diluted shares
Outstanding at end of period(3) 161,349 155,968 160,851 154,253
======== ======== ======== ========
Diluted earnings per share(2)(3) $ .22 $ .06 $ .58 $ .43
- ----------
(1) Results for the three-month and nine-month periods ended September 30, 1998
include a one-time, merger charge of $7.8 million (after-tax) related to
Sovereign's acquisitions of Carnegie and First Home during the third
quarter of 1998. Results for the nine-month period ended September 30, 1998
also 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 three-month and nine-month periods ended September 30, 1997
include a one-time, merger charge of $25.9 million (after-tax) related to
Sovereign's acquisition of Bankers during the third quarter of 1997.
Results for the nine-month period ended September 30, 1997 also 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 three-month and nine-month periods ended September 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 three-month and nine-month periods ended September 30, 1998
and 1997 were $.27 and $.83 and $.25 and $.72, respectively and diluted
earnings per share for the same periods were $.27 and $.79 and $.23 and
$.67, respectively.
(3) All share data has been adjusted to reflect all stock dividends and stock
splits.(3)
-10-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(3) INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The following table presents the composition and fair value of investment
securities available-for-sale at the dates indicated: (dollars in thousands)
September 30, 1998
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ ----------
Investment Securities:
U.S. Treasury and
government agency
securities $ 38,171 $ 51 $ -- $ 38,222
Equity securities 861,775 12,255 9,845 864,185
Other securities 12,628 111 -- 12,739
Mortgage-backed Securities:
FHLMC 163,291 2,870 189 165,972
FNMA 50,779 522 48 51,253
GNMA 303,575 5,909 7 309,477
Collateralized mortgage
Obligations 3,392,726 27,810 588 3,419,948
Other securities 848,623 6,301 -- 854,924
---------- ------- ------- ----------
Total investment securities
available-for-sale $5,671,568 $55,829 $10,677 $5,716,720
========== ======= ======= ==========
December 31, 1997
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ -----------
Investment Securities:
U.S. Treasury and
government agency
securities $ 46,515 $ 115 $ -- $ 46,630
Equity securities 643,288 18,898 79 662,107
Other securities 46,935 4,447 298 51,084
Mortgage-backed Securities:
FHLMC 420,590 3,493 397 423,686
FNMA 202,740 1,631 401 203,970
GNMA 256,532 1,908 600 257,840
Collateralized mortgage
obligations 296,633 1,581 1,515 296,699
Other securities 14,295 9 58 14,246
---------- ------- ------ ----------
Total investment securities
available-for-sale $1,927,528 $32,082 $3,348 $1,956,262
========== ======= ====== ==========
-11-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(4) INVESTMENT SECURITIES HELD-TO-MATURITY
The following table presents the composition and fair value of investment
securities held-to-maturity at the dates indicated: (dollars in thousands)
September 30, 1998
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ -----------
Investment Securities:
U.S. Treasury and
government agency
securities $ 21,461 $ 248 $ -- $ 21,709
Corporate securities 1,000 15 -- 1,015
Other securities 62,239 7,429 106 69,562
Mortgage-backed Securities:
FHLMC 293,632 24,207 2,699 315,140
FNMA 180,064 3,530 177 183,417
GNMA 332,025 14,901 -- 346,926
RTC -- -- -- --
Private issues 83,004 1,379 157 84,226
Collateralized mortgage
obligations 1,196,828 7,512 1,302 1,203,038
---------- ------- ------ ----------
Total investment securities
held-to-maturity $2,170,253 $59,221 $4,441 $2,225,033
========== ======= ====== ==========
December 31, 1997
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ -----------
Investment Securities:
U.S. Treasury and
government agency
securities $ 47,520 $ 335 $ 430 $ 47,425
Corporate securities 1,050 24 -- 1,074
Other securities 61,406 3,832 150 65,088
Mortgage-backed Securities:
FHLMC 383,790 7,569 520 390,839
FNMA 243,116 3,752 412 246,456
GNMA 415,840 8,336 157 424,019
RTC 411 -- 1 410
Private issues 124,794 999 82 125,711
Collateralized mortgage
obligations 2,138,524 9,964 2,647 2,145,841
---------- ------- ------ ----------
Total investment securities
held-to-maturity $3,416,451 $34,811 $4,399 $3,446,863
========== ======= ====== ==========
-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)
September 30, 1998 December 31, 1997
--------------------------- ----------------------------
Amount Percent Amount Percent
----------- ------- ----------- -------
Residential real estate loans $ 5,538,306 48.9% $ 6,634,271 58.6%
Residential construction loans
(net of loans in process of
$92,416 and $49,568, respectively) 149,410 1.3 137,367 1.2
----------- ----- ----------- -----
Total Residential Loans 5,687,716 50.2 6,771,638 59.8
----------- ----- ----------- -----
Multi-family loans 106,353 .9 115,570 1.0
Commercial real estate loans 857,370 7.6 664,943 5.9
Commercial loans 719,709 6.4 356,517 3.1
Automotive floor plan loans 243,449 2.1 279,757 2.5
----------- ----- ----------- -----
Total Commercial Loans 1,926,881 17.0 1,416,787 12.5
----------- ----- ----------- -----
Automobile loans 1,601,620 14.1 1,553,318 13.7
Home equity loans 1,562,310 13.8 1,050,304 9.3
Loans to automotive lessors 249,743 2.2 267,033 2.3
Student loans 264,272 2.3 190,440 1.7
Credit cards -- -- 54,887 .5
Other 42,278 .4 19,715 .2
----------- ----- ----------- -----
Total Consumer Loans 3,720,223 32.8% 3,135,697 27.7%
----------- ----- ----------- -----
Total Loans $11,334,820 100.0% $11,324,122 100.0%
=========== ===== =========== =====
Total Loans with: (1)
Fixed rates $ 5,611,314 49.5% $ 4,548,951 40.2%
Variable rates 5,723,506 50.5 6,775,171 59.8
----------- ----- ----------- -----
Total Loans $11,334,820 100.0% $11,324,122 100.0%
=========== ===== =========== =====
- ----------
(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)
September 30, 1998 December 31, 1997
----------------------------------------- --------------------------------------
Weighted Weighted
Average Average
Account Type Amount Percent Rate Amount Percent Rate
------------ ----------- ------- -------- ---------- ------- --------
Demand deposit accounts $ 986,050 8.0% --% $ 611,670 6.4% --%
NOW accounts 1,196,124 9.7 1.40 723,182 7.6 1.29
Savings accounts 2,264,562 18.3 3.02 1,900,334 20.0 3.02
Money market accounts 1,455,354 11.7 4.13 916,788 9.6 4.06
Retail certificates 5,343,176 43.2 5.39 4,673,467 49.1 5.54
Jumbo certificates 1,124,057 9.1 5.48 689,853 7.3 5.76
----------- ----- ----- ---------- ----- ----
Total Deposits $12,369,323 100.0% 3.78% $9,515,294 100.0% 4.23%
=========== ===== ===== ========== ===== ====
(7) BORROWINGS
The following table presents information regarding borrowings at the dates
indicated: (dollars in thousands)
September 30, 1998 December 31, 1997
------------------------ -------------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
---------- -------- ---------- --------
Securities sold under
repurchase agreements $ 627,577 5.62% $1,150,093 5.70%
FHLB advances 6,548,340 5.57 5,525,399 5.93
Other borrowings 375,752 6.70 188,151 5.88
---------- ----- ---------- ----
Total Borrowings $7,551,669 5.63% $6,863,643 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)
September 30, 1998
--------------------------------------------------------------
Weighted
Average
Notional Book Estimated Maturity
Amount Value Fair Value In Years
---------- -------- ---------- ---------
Amortizing interest rate swaps:
Pay variable-receive fixed (1) $ 162,809 $ -- $ 1,565 3.6
Pay fixed-receive variable (2) 183,036 -- (838) .1
Non-amortizing interest rate swaps:
Pay fixed-receive variable (4) 3,370,000 -- (73,641) 4.1
Interest rate caps/floors(5) 1,200,000 7,906 (196) 3.3
---------- -------- --------
$4,915,845 $ 7,906 $(73,110)
========== ======== ========
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) 2,770,000 -- (9,293) 2.3
Interest rate caps/floors (5) 1,200,000 9,963 (4,434) 4.0
---------- ------ --------
$4,809,376 $9,963 $(12,861)
========== ====== ========
-15-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(1) The weighted average pay rate was 5.67% and 5.58% and the weighted average
receive rate was 6.84% and 5.97% at September 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 6.83% and 6.80% at September 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 5.62% and 4.48% at September 30, 1998 and December 31,
1997, respectively.
(5) The strike price range was 5.25% - 9.00% at September 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/ September 30,
1997 Additions Amortization Terminations 1998
----------- ---------- ------------ ------------ -------------
Amortizing interest
rate swaps $ 810,877 $ -- $ 76,021 $ 389,011 $ 345,845
Non-amortizing interest
rate swaps 2,798,499 1,300,000 100,000 628,499 3,370,000
Interest rate
caps/floors 1,200,000 -- -- -- 1,200,000
---------- ---------- -------- ---------- ----------
$4,809,376 $1,300,000 $176,021 $1,017,510 $4,915,845
========== ========== ======== ========== ==========
At September 30, 1998, Sovereign's balance sheet included a net deferred
loss of $498,000 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, $109,000 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 $5.7 million of income and $3.4 million of expense for the nine-month
period ended September 30, 1998.
-16-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(9) ACQUISITIONS
On September 4, 1998, Sovereign acquired 93 former CoreStates Financial
Corp. ("CoreStates") branch offices from First Union Corporation ("First Union")
for approximately $320 million (pre-tax). The former CoreStates offices are
located throughout Pennsylvania and New Jersey and added approximately $2.2
billion of commercial bank deposits and $725 million of commercial and consumer
loans to Sovereign's balance sheet. The transaction was accounted for as a
purchase.
On July 31, 1998, Sovereign acquired Carnegie and First Home. Carnegie, a
$414 million commercial bank holding company headquartered in Princeton, New
Jersey, operated seven branches throughout central New Jersey and one in
Pennsylvania. Carnegie added loans, deposits and stockholders' equity to
Sovereign of $285.5 million, $329.4 million and $37.1 million, respectively.
First Home, a $510 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. First Home added loans, deposits and stockholders' equity to
Sovereign of $273.1 million, $319.9 million and $37.7 million, respectively.
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 and accordingly, the consolidated financial
statements have been restated to include the accounts of Carnegie and First Home
for all periods presented. During the third quarter of 1998, Sovereign recorded
a one-time, merger-related charge of $7.8 million (after-tax) as a result of
these transactions. Expenses included as part of the one-time charge consisted
of human resources related costs and other expenses, including investment banker
fees and legal expenses.
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
First Home 15,288 15,086
Carnegie 16,377 13,580
-------- --------
Combined $432,082 $386,966
======== ========
Net income:
Sovereign $ 77,640 $ 70,139
ML Bancorp (1) 16,548 13,810
First Home 4,728 4,285
Carnegie 3,625 2,144
-------- --------
Combined $102,541 $ 90,378
======== ========
- ----------
(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 nine-month periods
ended September 30, 1997 include ML Bancorp's results of operations for the
three-month and nine-month periods ended December 31, 1997.
On September 8, 1998, Sovereign executed a Definitive Agreement to acquire
Peoples Bancorp, Inc. ("Peoples"), a $875 million bank holding company
headquartered in Lawrenceville, New Jersey whose principal operating subsidiary
operates 14 community banking offices in Mercer, Burlington and Ocean counties,
New Jersey. The terms of the agreement call for a fixed exchange, without
collars, of .80 shares of Sovereign common stock for each outstanding share of
Peoples common stock. Peoples may elect to terminate the transaction at the
closing if Sovereign's common stock price decreases below $11.00 per share and
such a decrease exceeds, by 10% or more, the decrease of price derived from a
-18-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
peer group index. The transaction, which will be accounted for as a
pooling-of-interests, is subject to approval by various regulatory agencies and
Peoples' shareholders. The transaction will add loans, deposits and
stockholders' equity to Sovereign of approximately $430 million, $500 million
and $340 million, respectively. Sovereign anticipates recording a one-time,
after-tax, merger-related charge of approximately $13 million at the closing of
the transaction which is anticipated to be early in the second quarter of 1999.
(10) ACCOUNTING CHANGES
In September 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 September 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 September 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 September 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 Nine-month Period
Ended September 30, Ended September 30,
-------------------- --------------------
1998 1997 1998 1997
------- ------- ------- -------
Net income $34,790 $ 9,218 $92,784 $66,068
Unrealized (losses) gains on
securities arising during the year (6,095) 3,379 (3,367) 13,993
Less reclassification adjustment (1) (2,411) -- (241) --
------- ------- ------- -------
Net unrealized (losses) gains recognized
in other comprehensive income (3,684) 3,379 (3,126) 13,993
------- ------- ------- -------
Comprehensive income (2) $31,106 $12,597 $89,658 $80,061
======= ======= ======= =======
- ----------
(1) Sovereign has not calculated the reclassification adjustment for the
nine-month period ended September 30, 1997.
(2) Excluding one-time, merger-related charges, comprehensive income for the
three-month and nine-month periods ended September 30, 1998 and 1997 was
$39.1 million and $123.5 million and $38.6 million and $116.8 million,
respectively.
Accumulated other comprehensive income, net of related tax, at September
30, 1998 and December 31, 1997 consisted of net unrealized gains on securities
of $15.0 million and $18.9 million, respectively.
-20-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
(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. Per the
terms of the stock purchase agreement, Sovereign invested $10 million in Mego
Series A Convertible Preferred stock on July 1, 1998. 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 another 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)
Sovereign's State of Readiness for Year 2000 Computer Issues.
Sovereign's Year 2000 readiness project has six phases: (i) identifying the
computers, computer programs and computer-based systems used by Sovereign and
the business applications to which they are devoted; (ii) determining whether
such items store or process information in a manner which will avoid year 2000
date errors, (iii) assessing the risks resulting from any such errors and
prioritizing remediation or replacement based on how critical they are to
Sovereign's business operations; (iv) replacing, modifying or otherwise
remediating deficient computers programs and systems which pose material risk;
(v) testing to determine if the remediated or new items so operate as to reduce
risk to an acceptable level; and (vi) bringing the remediated or new items on
line.
Sovereign is currently in the testing phase, and estimates that by December
31, 1998 it will substantially complete testing of systems and software which
are essential to Sovereign's operations and can be modified, if necessary, by
Sovereign without the assistance of software licensors or outside data
processing service providers. Sovereign also estimates that, by March 31, 1999
it, together with its outside data processing service providers will
substantially complete testing of systems, software and services which are
provided by them and which are essential to Sovereign's operations. Sovereign is
endeavoring to complete testing of other important systems and software provided
by outside vendors and licensors by no later than June 30, 1999. Sovereign
estimates that it will substantially complete implementation of all essential
modifications and new installations of computers, software and systems by June
30, 1999.
As part of its Year 2000 project, Sovereign is also endeavoring to analyze
the risks posed to it by its material borrowers and providers of funds. Vendors
whom Sovereign considers to be critical to Sovereign's operations have also been
asked to provide Sovereign with assurances and other evidence as to their Year
2000 readiness.
Sovereign's budget for its Year 2000 project is approximately $13.5
million, up from the $10 million previously reported. Sovereign estimates that
the majority of this total will be expensed by the end of the first quarter of
1999.
Sovereign believes the most reasonably likely worst case Year 2000 scenario
relates to its principal outside service providers, substantially all of which
are large, seasoned, national companies experienced in serving financial
institutions. Sovereign depends on these service providers for substantially all
of its data processing needs relating to its account processing, item processing
and other important functions. Certain of these service providers are also
subject to the jurisdiction of the regulatory bodies which have jurisdiction
over Sovereign with respect to Year 2000 readiness. Based on all of the
foregoing, Sovereign has no reason to believe that its providers will not be
substantially Year 2000 compliant.
-22-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Continued)
Sovereign has contracted with a leading information technology service
provider to prepare a Year 2000 contingency plan, which Sovereign expects to be
substantially complete with respect to mission-critical items by June 30, 1999.
Because of the uncertainties discussed above, there can be no assurance
that Sovereign's assessment of Year 2000 compliance and the risks and costs
associates therewith will prove to be correct, or that Year 2000 issues will not
ultimately have a material adverse effect on Sovereign and its operations.
-23-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS
General
Net operating income for the three-month and nine-month periods ended
September 30, 1998 was $42.8 million and $126.6 million compared to net
operating income of $35.3 million and $102.8 million for the same periods in
1997. Operating diluted earnings per share for the three-month and nine-month
periods ended September 30, 1998 was $.27 and $.79 compared to $.23 and $.67 for
the same periods in 1997. Operating results exclude all one-time, merger-related
charges discussed below.
Net income for the three-month and nine-month periods ended September 30,
1998 was $34.8 million and $92.8 million and diluted earnings per share for the
same periods was $.22 and $.58, respectively. Net income for the three-month and
nine-month periods ended September 30, 1998 includes a one-time, merger charge
of $10.9 million ($7.8 million after-tax) related to Sovereign's acquisitions of
Carnegie Bancorp ("Carnegie") and First Home Bancorp, Inc. ("First Home") during
the third quarter of 1998. Net income for the nine-month period ended September
30, 1998 also includes a one-time, merger charge of $39.5 million ($25.8 million
after-tax) related to Sovereign's acquisition of ML Bancorp, Inc. ("ML Bancorp")
during the first quarter of 1998. Expenses included as part of the one-time
charge consisted of human resources related costs and other expenses, including
investment banker fees and legal expenses.
Net income for the three-month and nine-month periods ended September 30,
1997 was $9.2 million and $66.1 million and diluted earnings per share for the
same periods was $.06 and $.43, respectively. Net income for the three-month and
nine-month periods ended September 30, 1997 includes a one-time, merger charge
of $38.3 million ($25.9 million after-tax) related to Sovereign's acquisition of
Bankers Corp. ("Bankers") during the third quarter of 1997. Net income for the
nine-month period ended September 30, 1997 also includes 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.
Return on average equity and return on average total assets, excluding the
one-time, merger-related charges discussed above were 15.87% and .90% for the
nine-month period ended September 30, 1998 compared to 14.62% and .85% for the
same period in 1997. Average equity to average total assets for the nine-month
period ended September 30, 1998 and 1997 was 5.66% and 5.79%, respectively.
Net Interest Income
Net interest income for the three-month and nine-month periods ended
September 30, 1998 was $121.2 million and $360.9 million compared to $109.3
million and $316.8 million for the same periods in 1997. This increase is
attributable to an increase in average balances resulting from internal growth
and recent acquisitions. Sovereign's net interest margin (net interest income
divided by average interest-earning assets) for the three-month and nine-month
periods ended September 30, 1998 was 2.73% and 2.80% compared to 2.77% and 2.75%
for the same periods in 1997.
-24-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Interest on interest-earning deposits for the three-month and nine-month
periods ended September 30, 1998 was $2.0 million and $5.4 million compared to
$1.4 million and $3.8 million for the same periods in 1997. The average balance
of interest-earning deposits was $52.7 million with an average yield of 13.57%
for the nine-month period ending September 30, 1998 compared to an average
balance of $39.1 million with an average yield of 13.34% for the same period in
1997.
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 securities available-for-sale was $85.4 million and
$187.8 million for the three-month and nine-month periods ended September 30,
1998 compared to $30.2 million and $78.4 million for the same periods in 1997.
The average balance of investment securities available-for-sale was $3.81
billion with an average yield of 6.78% for the nine-month period ended September
30, 1998 compared to an average balance of $1.55 billion with an average yield
of 6.95% for the same period in 1997.
Interest on investment securities held-to-maturity was $38.3 million and
$148.1 million for the three-month and nine-month periods ended September 30,
1998 compared to $74.2 million and $216.8 million for the same periods in 1997.
The average balance of investment securities held-to-maturity was $2.72 billion
with an average yield of 7.26% for the nine-month period ended September 30,
1998 compared to an average balance of $4.11 billion with an average yield of
7.03% for the same period in 1997.
Interest and fees on loans were $216.0 million and $656.5 million for the
three-month and nine-month periods ended September 30, 1998 compared to $199.3
million and $566.9 million for the same periods in 1997. The average balance of
loans was $11.13 billion with an average yield of 7.87% for the nine-month
period ended September 30, 1998 compared to an average balance of $9.84 billion
with an average yield of 7.68% for the same period in 1997. The increases in the
average balance and yield of loans and in the interest and fees on loans are due
to continued growth in Sovereign's commercial lending and auto finance
divisions, as well as planned run-off of lower-yielding residential loans..
Interest on deposits was $112.9 million and $319.2 million for the
three-month and nine-month periods ended September 30, 1998 compared to $99.8
million and $281.6 million for the same periods in 1997. The average balance of
deposits was $10.15 billion with an average cost of 4.20% for the nine-month
period ended September 30, 1998 compared to an average balance of $8.99 billion
with an average cost of 4.19% for the same period in 1997.
-25-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Interest on borrowings was $107.6 million and $317.6 million for the
three-month and nine-month periods ended September 30, 1998 compared to $95.9
million and $267.5 million for the same periods in 1997. The average balance of
borrowings was $7.39 billion with an average cost of 5.69% for the nine-month
period ended September 30, 1998 compared to an average balance of $5.99 billion
with an average cost of 5.93% for the same period in 1997.
Provision for Possible Loan Losses
The provision for loan losses for the three-month and nine-month periods
ended September 30, 1998 was $7.0 million and $21.0 million, respectively. In
addition, during the third quarter of 1998, Sovereign established an initial
loan loss reserve of $20.0 million in connection with its CoreStates branch
acquisition. The provision for loan losses for the three-month and nine-month
periods ended September 30, 1997 was $20.5 million and $34.9 million,
respectively. Results for the three-month and nine-month periods ended September
30, 1997 includes $17.0 million and $24.9 million, respectively, of reserves
taken as part of the one-time, merger charges related to Sovereign's acquisition
of First State during the first quarter of 1997 and Bankers during the third
quarter of 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 and Bankers. Excluding these
one-time, merger-related charges, Sovereign's year-to-date loan loss provision
increased by 110% from $10.0 million for the nine-month period ended September
30, 1997 to $21.0 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 deemed 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 nine-month period ended September 30, 1998, Sovereign
charged-off $33.4 million of loans compared to $11.8 million for the same period
in 1997. This increased level of charge-offs during 1998 was partially off-set
by recoveries of $8.8 million, resulting in year-to-date net charge-offs of
$24.6 million. This compares to recoveries of $2.4 million and net charge-offs
of $9.4 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 Auto Finance
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.
-26-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
The following table presents the activity in the allowance for possible
loan losses for the periods indicated: (dollars in thousands)
Nine-month Period Ended
September 30,
--------------------------
1998 1997
-------- --------
Allowance, beginning of period $116,823 $ 73,847
Charge-offs:
Residential 5,139 7,103
Commercial Real Estate 625 542
Commercial 1,485 1,525
Consumer 26,137 2,666
-------- --------
Total Charge-offs 33,386 11,836
-------- --------
Recoveries:
Residential 693 633
Commercial Real Estate 51 1,104
Commercial 144 362
Consumer 7,935 335
-------- --------
Total Recoveries 8,823 2,434
-------- --------
Charge-offs, net of recoveries 24,563 9,402
Provision for possible loan losses 20,961 34,925
Other 22,661 20,651
-------- --------
Allowance, end of period $135,882 $120,021
======== ========
Other Income
Other income was $25.7 million and $73.8 million for the three-month and
nine-month periods ended September 30, 1998 compared to $15.0 million and $42.9
million for the same periods in 1997.
Loan fees and service charges were $2.9 million and $7.7 million for the
three-month and nine-month periods ended September 30, 1998 compared to $1.3
million and $2.1 million for the same periods in 1997. The increase in loan fees
and service charges is directly attributable to fees earned on Sovereign's AFD
portfolio which was acquired in September 1997. Loan fees and service charges
result primarily from Sovereign's loan servicing portfolio. Sovereign serviced
$9.33 billion of its own loans and $6.20 billion of loans for others at
September 30, 1998 compared to $9.58 billion of its own loans and $6.29 billion
of loans for others at September 30, 1997.
-27-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Deposit fees were $6.5 million and $18.2 million for the three-month and
nine-month periods ended September 30, 1998 compared to $5.4 million and $15.1
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 $5.2 million and $18.2 million for the
three-month and nine-month periods ended September 30, 1998 compared to $5.2
million and $17.2 million for the same periods in 1997.
Gains on sales of loans and investment securities available-for-sale were
$6.3 million and $12.8 million for the three-month and nine-month periods ended
September 30, 1998 compared to $1.3 million and $2.9 million for the same
periods in 1997. This increase is in part due to a net gain of $2.8 million
resulting from the sale of Sovereign's credit card portfolio during the second
quarter of 1998. Additionally, recent favorable market trends have created
opportunities for Sovereign to realign its investment portfolio with no adverse
impact on future earnings or its interest rate risk profile. Sovereign will
continue to evaluate these opportunities in the context of its overall
asset/liability management process.
Miscellaneous income was $4.8 million and $16.8 million for the three-month
and nine-month periods ended September 30, 1998 compared to $1.8 million and
$5.5 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 and transaction volume of Sovereign's debit cards over
the last year.
General and Administrative Expenses
Total general and administrative expenses were $66.4 million and $195.7
million for the three-month and nine-month periods ended September 30, 1998
compared to $57.0 million and $164.9 million for the same periods in 1997.
Results for the third quarter of 1998 were net of a change in estimate related
to certain employee benefir expenses. The ratio of general and administrative
expenses to average assets for the three-month and nine-month periods ended
September 30, 1998 was 1.33% and 1.37% compared to 1.35% and 1.36% 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 nine-month periods ended September 30, 1998 was
46.6% and 46.3% compared to 46.3% and 46.2% for the same periods in 1997.
-28-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Other operating expenses were $18.6 million and $71.0 million for the
three-month and nine-month periods ended September 30, 1998 compared to $28.4
million and $48.3 million for the same periods in 1997. Results for the
three-month and nine-month periods ended September 30, 1998 include one-time,
merger charges of $10.9 million and $50.4 million related to Sovereign's
acquisition's of Carnegie and First Home during the third quarter of 1998 and ML
Bancorp during the first quarter of 1998. Results for the three-month and
nine-month periods ended September 30, 1997 include one-time, merger charges of
$21.3 million and $29.3 million related to Sovereign's acquisition of Bankers
during the third quarter of 1997 and First State during the first quarter of
1997.
Income Tax Provision
The income tax provision was $20.2 million and $54.2 million for the
three-month and nine-month periods ended September 30, 1998 compared to $9.4
million and $45.5 million for the same periods in 1997. The effective tax rate
for the three-month and nine-month periods ended September 30, 1998 was 36.7%
and 36.9% compared to 50.6% and 40.8% for the same periods in 1997. The higher
than usual effective tax rate for the three-month and nine-month periods ended
September 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 September 30, 1998 was $11.3 billion compared
to $11.3 billion at December 31, 1997. Sovereign's consumer and commercial loan
portfolios have increased as a result of originations and the CoreStates branch
acquisition. This increase has been off-set by a decline in Sovereign's
residential mortgage loan portfolio resulting from the refinance environment and
Sovereign's lessened emphasis on portfolio lending.
During the nine-month period ended September 30, 1998, Sovereign closed
$1.47 billion of residential real estate loans of which approximately 91% were
fixed rate and sold in the secondary market. This compares to first mortgage
loan closings of $1.52 billion and approximately 40% 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 nine-month period ended
September 30, 1998, Sovereign closed $799.8 million of commercial loans compared
to $187.7 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 regional economy, recent bank mergers affecting the
region, and significant staffing increases in Sovereign's commercial banking
unit.
-29-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign closed $1.46 billion of consumer loans during the nine-month
period ended September 30, 1998 compared to $522.4 million of consumer loans
during the same period in 1997. This increase is partially the result of
Sovereign's Auto Finance Division which originated approximately $450.0 million
of indirect auto loans during the nine-month period ended September 30, 1998.
At September 30, 1998, Sovereign's total loan portfolio included $5.54
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 September 30, 1998,
Sovereign's total loan portfolio also included $1.93 billion of commercial loans
and $3.72 billion of consumer loans, including $1.60 billion of auto loans and
$1.56 billion of outstanding home equity loans (excluding $399.0 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 September 30, 1998, Sovereign's non-performing assets were $117.9
million compared to $107.7 million at December 31, 1997. Non-performing assets
as a percentage of total assets were .55% at September 30, 1998 compared to .61%
at December 31, 1997. Non-performing assets at September 30, 1998 included $18.0
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 September 30, 1998, the allowance for loan losses as a
percentage of non-performing assets was 108% compared to 104% at December
31, 1997.
-30-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The following table presents the composition of non-performing assets at
the dates indicated: (dollars in thousands)
September 30, December 31,
1998 1997
------------- ------------
Non-Accrual Loans:
Past due 90 days or more
as to interest or principal:
Real estate related $ 62,480 $ 65,930
Other 25,879 22,368
Past due less than 90 days
as to interest and principal:
Real estate related 516 555
Other 5,230 --
-------- --------
Total Non-Accrual Loans 94,105 88,853
Other 5,551 6,524
Restructured Loans 305 327
-------- --------
Total Non-Performing Loans 99,961 95,704
-------- --------
Real Estate Owned:
Real estate related 11,881 11,299
Other 6,093 710
-------- --------
Total Real Estate Owned 17,974 12,009
-------- --------
TOTAL NON-PERFORMING ASSETS $117,935 $107,713
======== ========
Past due 90 days or more as to
interest or principal and
accruing interest (1) $ 5,967 $ 7,053
Non-Performing Assets as a
percentage of Total Assets .55% .61%
Non-Performing Loans as a
percentage of Total Loans .87% .82%
Non-Performing Assets as a
percentage of Total Loans
and Real Estate Owned 1.07% .99%
Allowance for Loan Losses
as a percentage of
Total Non-Performing Assets 108% 104%
Allowance for Loan Losses
as a percentage of
Total Non-Performing Loans 127% 117%
- ----------
(1) Represents student loans which are government-guaranteed and Sovereign
retains minimal risk of credit losses related to these loans.
-31-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Contin ued)
The adequacy of Sovereign's allowance for loan losses is evaluated on a
monthly basis by management. 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 September
30, 1998, the allowance for loan losses was $135.9 million or 1.18% of total
loans compared to $116.8 million or 1.00% of total loans at December 31, 1997.
The following table presents the allocation of the allowance for loan
losses and the percentage of such allocation to each loan type for the dates
indicated: (dollars in thousands)
September 30, December 31,
1998 1997
Balance at End of ------------------- --------------------
Period Attributable to Amount Percent Amount Percent
- ---------------------- -------- ------- -------- -------
Residential real estate $ 30,109 22.2% $ 36,351 31.1%
Commercial real estate 9,332 6.9 21,707 18.6
Commercial 30,455 22.4 9,086 7.8
Consumer 41,107 30.2 24,300 20.8
Unallocated 24,879 18.3 25,379 21.7
-------- ----- ------- -----
Total $135,882 100.0% $116,823 100.0%
======== ===== ======== =====
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 $45.9 million at September 30, 1998 and consisted
principally of commercial and 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.
-32-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Impaired loans are summarized as follows (in thousands):
September 30, December 31,
1998 1997
------------- ------------
Impaired loans without a related reserve $45,008 $ 7,572
Impaired loans with a related reserve 23,331 17,367
------- -------
Total impaired loans $68,339 $24,939
======= =======
Reserve for impaired loans $ 7,508 $ 5,798
======= =======
The average balance of impaired loans for the nine-month periods ended
September 30, 1998 and 1997 was $56.3 million and $30.6 million, respectively.
Investment 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"). Investment securities also include mortgage-backed
securities which 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 September 30, 1998 was
under one year.
At September 30, 1998, total investment securities available-for-sale were
$5.68 billion compared to $1.96 billion at December 31, 1997 and investment
securities held-to-maturity were $2.20 billion compared to $3.42 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.
-33-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
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 September 30, 1998 were
$443.9 million compared to $126.3 million at December 31, 1997. This increase is
primarily attributable to the CoreStates branch acquisition during the third
quarter of 1998, which added approximately $325 million of goodwill and other
intangibles to Sovereign's balance sheet. In addition, 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 September 30, 1998 were $12.37 billion compared to
$9.52 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.
-34-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Total borrowings at September 30, 1998 were $7.55 billion of which $5.29
billion were short-term compared to $6.86 billion of which $5.46 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
September 30, 1998 have been effectively converted from variable rate
obligations to fixed rate obligations. In addition, at September 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 September 30, 1998 was 42.6%.
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 $225.0 million
per month. At September 30, 1998, Sovereign had $6.34 billion in unpledged
investment 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 securities, repayment of principal on
loans and other investing activities.
For the nine-month period ended September 30, 1998, cash and cash
equivalents increased $548.2 million. Net cash used by operating activities was
$67.8 million for the nine-month period ended September 30, 1998. Net cash used
by investing activities for the nine-month period ended September 30, 1998 was
$2.59 billion consisting primarily of purchases of investment securities which
are classified available-for-sale and loans purchased from CoreStates, partially
offset by proceeds from repayments of investment securities and loans. Net cash
provided by financing activities for the nine-month period ended September 30,
1998 was $3.20 billion, which includes an increase in deposits of $2.47 billion
primarily related to the assumption of deposits from CoreStates and an increase
in proceeds from long-term borrowings of $1.40 billion.
-35-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
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 September 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 September 30, 1998:
Well
Sovereign Sovereign Minimum Capitalized
Bancorp(1) Bank Requirement Requirement(1)
---------- --------- ----------- --------------
Stockholders' equity to
total assets 5.34% 7.09% None None
Tangible capital to tangible
assets 3.23 4.88 1.50% None
Leverage (core) capital to
tangible assets 4.11 5.21 3.00 5.00%
Leverage (core) capital to
risk adjusted assets 7.05 9.12 4.00 6.00
Risk-based capital to risk
adjusted assets 11.17 10.21 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.
-36-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
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 positive
8.93% at September 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 September 30, 1998, Sovereign estimates
that if interest rates decline by 200 basis points, net interest income would
decrease by $59.4 million or 9.86%.
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.
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
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.
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
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 September 10, 1998 (date of earliest event -
September 7, 1998), contained a press release announcing the execution
of a Definitive Agreement for Sovereign to acquire Peoples Bancorp,
Inc.
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.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOVEREIGN BANCORP, INC.
(Registrant)
Date November 16, 1998 /s/ Dennis S. Marlo
-------------------------------
Dennis S. Marlo
Chief Financial Officer
Date November 16, 1998 /s/ Mark R. McCollom
-------------------------------
Mark R. McCollom
Chief Accounting Officer
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