SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934 for the quarter ended March 31, 2002
OR
- ----- TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 for the transition period from _______________
to ___________________.
Commission File Number: 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.)
2000 Market Street, Philadelphia, Pennsylvania 19103
- ----------------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number: (215) 557-4630
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 May 8, 2002
- ------------------------------- ----------------------------
Common Stock (no par value) 260,433,805 shares
FORWARD LOOKING STATEMENTS
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward-looking statements made by or on behalf of Sovereign
Bancorp, Inc. ("Sovereign"). Sovereign may from time to time make
forward-looking statements in Sovereign's filings with the Securities and
Exchange Commission (including this Quarterly Report on Form 10-Q and the
Exhibits hereto), in its reports to shareholders (including its 2001 Annual
Report) and in other communications by Sovereign, which are made in good faith
by Sovereign, pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Some of the disclosure communications by
Sovereign, including any statements preceded by, followed by or which include
the words "may," "could," "should," "pro forma," "looking forward," "will,"
"would," "believe," "expect," "anticipate," "estimate," "intend," "plan,"
"strive," "hopefully," "try," "assume" or similar expressions constitute
forward-looking statements.
These forward-looking statements include statements with respect to
Sovereign's vision, mission, strategies, goals, beliefs, plans, objectives,
expectations, anticipations, estimates, intentions, financial condition, results
of operations, future performance and business of Sovereign, including
statements relating to:
o growth in cash earnings, operating earnings, net income, shareholder
value and internal tangible equity generation;
o growth in earnings per share;
o return on equity;
o return on assets;
o efficiency ratio;
o Tier 1 leverage ratio;
o annualized net charge-offs and other asset quality measures;
o fee income as a percentage of total revenue;
o ratio of tangible equity to assets;
o book value and tangible book value per share; and
o loan and deposit portfolio compositions, employee retention, deposit
retention, asset quality and reserve adequacy.
These forward-looking statements, implicitly and explicitly, include the
assumptions underlying the statements. Although Sovereign believes that the
expectations reflected in these forward-looking statements are reasonable, these
statements involve risks and uncertainties which are subject to change based on
various important factors (some of which are beyond Sovereign's control). The
following factors, among others, could cause Sovereign's financial performance
FORWARD LOOKING STATEMENTS
(continued)
to differ materially from its goals, plans, objectives, intentions,
expectations, forecasts and projections (and the underlying assumptions)
expressed in the forward-looking statements:
o the strength of the United States economy in general and the strength
of the regional and local economies in which Sovereign conducts
operations;
o the effects of, and changes in, trade, monetary and fiscal policies
and laws, including interest rate policies of the Board of Governors
of the Federal Reserve System;
o inflation, interest rate, market and monetary fluctuations;
o Sovereign's ability to successfully integrate any assets, liabilities,
customers, systems and management personnel Sovereign acquires into
its operations and its ability to realize related revenue synergies
and cost savings within expected time frames;
o Sovereign's timely development of competitive new products and
services in a changing environment and the acceptance of such products
and services by customers;
o the willingness of customers to substitute competitors' products and
services and vice versa;
o the impact of changes in financial services policies, laws and
regulations, including laws, regulations and policies concerning
taxes, banking, capital, liquidity, proper accounting treatment,
securities and insurance, and the application thereof by regulatory
bodies and the impact of changes in and interpretation of generally
accepted accounting principles;
o technological changes;
o changes in consumer spending and savings habits;
o terrorist attacks in the United States or upon United States interests
abroad, or armed conflicts relating to these attacks;
o regulatory or judicial proceedings;
o changes in asset quality; and
o Sovereign's success in managing the risks involved in the foregoing.
If one or more of the factors affecting Sovereign's forward-looking
information and statements proves incorrect, then its actual results,
performance or achievements could differ materially from those expressed in, or
implied by, forward-looking information and statements. Therefore, Sovereign
cautions you not to place undue reliance on any forward-looking information and
statements.
FORWARD LOOKING STATEMENTS
(continued)
Sovereign does not intend to update any forward-looking information and
statements, whether written or oral, to reflect any change. All forward-looking
statements attributable to Sovereign are expressly qualified by these cautionary
statements.
Operating earnings and cash earnings which are included and defined herein,
and the related ratios using these measures are not a substitute for other
financial measures determined in accordance with generally accepted accounting
principles. Because all companies do not calculate these measures in the same
fashion, these measures as presented may not be comparable to other similarly
titled measures of other companies.
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at March 31, 2002
and December 31, 2001 6
Consolidated Statements of Operations for the three-
month periods ended March 31, 2002 and 2001 7
Consolidated Statement of Stockholders' Equity for
the three-month period ended March 31, 2002 9
Consolidated Statements of Cash Flows for the three-month
periods ended March 31, 2002 and 2001 10
Notes to Consolidated Financial Statements 11 - 20
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 21 - 41
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 41
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 42
SIGNATURES
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2002 2001
------------- -------------
(Unaudited)
(in thousands, except
per share data)
ASSETS
Cash and amounts due from
depository institutions $ 720,391 $ 887,964
Interest-earning deposits 254,402 19,315
Investment securities:
Available-for-sale 9,597,001 9,581,679
Held-to-maturity
(fair value of $815,942 and $883,208
at March 31, 2002 and December 31, 2001,
respectively) 820,642 883,437
Loans (including loans held for sale
at approximate fair value of
$176,981 and $308,950 at March 31, 2002
and December 31, 2001, respectively) 21,790,733 20,399,584
Allowance for loan losses (287,015) (264,667)
Premises and equipment 278,178 251,587
Other real estate owned
and other repossessed assets 16,583 18,928
Accrued interest receivable 123,753 183,913
Goodwill 1,024,292 954,688
Core deposit intangible 403,346 389,216
Bank owned life insurance 714,258 706,175
Other assets 1,376,800 1,463,019
----------- -----------
TOTAL ASSETS $36,833,364 $35,474,838
=========== ===========
LIABILITIES
Deposits and other customer accounts $24,815,550 $23,297,574
Short-term borrowings 2,204,609 2,678,764
Long-term borrowings:
FHLB advances and repurchase agreements 4,297,830 4,260,929
Senior secured credit facility 245,000 225,000
Senior notes and subordinated debentures 1,752,850 1,775,077
Advance payments by borrowers
for taxes and insurance 22,930 20,943
Other liabilities 469,712 406,270
----------- -----------
TOTAL LIABILITIES 33,808,481 32,664,557
----------- ----------
Company-obligated mandatorily redeemable
preferred securities of subsidiary trust
holding junior subordinated debentures of
Sovereign ("Trust Preferred Securities") 413,136 404,136
Minority interest-preferred securities of subsidiaries 208,852 203,664
STOCKHOLDERS' EQUITY
Common stock; no par value; 400,000,000 shares
authorized; 264,517,048 shares issued at
March 31, 2002 and 252,386,163 shares
issued at December 31, 2001 1,569,274 1,416,267
Warrants 91,500 91,500
Unallocated common stock held by the Employee
Stock Ownership Plan at cost;
3,626,414 shares at March 31, 2002
and 4,247,873 shares at December 31, 2001 (23,177) (30,945)
Treasury stock at cost; 358,472 shares at
March 31, 2002 and 108,792 shares at
December 31, 2001 (3,562) (515)
Restricted stock at cost; 559,791 shares
at March 31, 2002 and December 31, 2001 (6,272) (6,272)
Accumulated other comprehensive loss (51,196) (33,135)
Retained earnings 826,328 765,581
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 2,402,895 2,202,481
----------- -----------
TOTAL LIABILITIES, MINORITY INTERESTS
AND STOCKHOLDERS' EQUITY $36,833,364 $35,474,838
=========== ===========
See accompanying notes to consolidated financial statements.
-6-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three-Month Period
Ended March 31,
------------------
2002 2001
-------- ---------
(in thousands, except
per share data)
INTEREST INCOME:
Interest-earning deposits $ 1,940 $ 514
Investment securities:
Available-for-sale 140,698 106,767
Held-to-maturity 13,533 19,397
Interest and fees on loans 338,656 453,168
-------- ---------
TOTAL INTEREST INCOME 494,827 579,846
-------- ----------
INTEREST EXPENSE:
Interest on deposits
and other customer accounts 111,010 221,114
Interest on short-term and
long-term borrowings 111,888 111,252
-------- ---------
TOTAL INTEREST EXPENSE 222,898 332,366
-------- ---------
NET INTEREST INCOME 271,929 247,480
Provision for loan losses 44,500 20,000
-------- ---------
NET INTEREST INCOME AFTER PROVISION FOR
LOAN LOSSES 227,429 227,480
-------- ---------
NON-INTEREST INCOME:
Consumer banking fees 38,563 39,432
Commercial banking fees 22,751 18,265
Mortgage banking revenues 9,466 21,314
Capital markets revenue 3,337 3,469
Bank owned life insurance 10,289 9,745
Miscellaneous income 2,564 5,725
-------- ---------
TOTAL FEES AND OTHER INCOME 86,970 97,950
-------- ---------
Gain on investment securities and
related derivatives transactions 20,566 7,344
-------- ---------
TOTAL NON-INTEREST INCOME 107,536 105,294
-------- ---------
GENERAL AND ADMINISTRATIVE EXPENSES:
Compensation and benefits 83,932 77,630
Occupancy and equipment expenses 50,287 53,965
Technology expense 16,640 16,019
Outside services 11,452 13,699
Other administrative expenses 29,649 28,173
-------- ---------
TOTAL GENERAL AND ADMINISTRATIVE EXPENSES 191,960 189,486
-------- ---------
-7-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(continued)
Three-Month Period
Ended March 31,
------------------
2002 2001
-------- --------
(in thousands, except
per share data)
OTHER EXPENSES:
Amortization of intangibles,
including goodwill in 2001 $ 20,234 $ 36,076
Trust Preferred Securities and
other minority interest expense 15,558 14,484
Merger-related and integration charges 15,871 --
Non-solicitation expense -- 72,216
Restructuring expense -- 8,500
-------- --------
TOTAL OTHER EXPENSES 51,663 131,276
-------- --------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEM 91,342 12,012
Income tax provision 24,400 900
-------- --------
Income before extraordinary item 66,942 11,112
Extraordinary item (net of tax of $3,526 - 2001) -- (6,549)
-------- ---------
NET INCOME $ 66,942 $ 4,563
======== ========
EARNINGS PER SHARE:
Basic
Income before extraordinary item $ .27 $ .05
Extraordinary item -- (.03)
-------- ---------
NET INCOME $ .27 $ .02
======== ========
Diluted
Income before extraordinary item $ .25 $ .05
Extraordinary item -- (.03)
-------- ---------
NET INCOME $ .25 $ .02
======== ========
DIVIDENDS DECLARED PER COMMON SHARE $ .025 $ .025
See accompanying notes to consolidated financial statements.
-8-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(unaudited)
(in thousands)
Common
Shares Common Retained Treasury Restricted
Outstanding Stock Warrants Earnings Stock Stock
----------- ----- -------- -------- ----- -----
Balance, December 31, 2001 247,470 $1,416,267 $ 91,500 $765,581 $ (515) $ (6,272)
Comprehensive income:
Net income -- -- -- 66,942 -- --
Change in unrecognized gain/(loss)
net of tax on:
Investments available-for-sale -- -- -- -- -- --
Derivative financial instruments -- -- -- -- -- --
Total comprehensive income -- -- -- -- -- --
Acquisition of Main Street Bancorp 11,367 148,578 -- -- (3,116) --
Exercise of stock options 419 2,817 -- -- -- --
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan 85 1,010 -- -- -- --
Dividends paid on common stock -- -- -- (6,195) -- --
Treasury stock purchases (9) -- -- -- (109) --
Treasury stock sold 19 38 -- -- 178 --
Termination of Employee
Stock Ownership Plan 621 564 -- -- -- --
------- ---------- ---------- -------- -------- ---------
Balance, March 31, 2002 259,972 $1,569,274 $ 91,500 $826,328 $ (3,562) $ (6,272)
======= ========== ========== ======== ======== =========
Accumulated Total
Unallocated Other Stock-
Common Stock Comprehensive Holders'
Held by ESOP Income/(Loss) Equity
------------ ------------- ------
Balance, December 31, 2001 $ (30,945) $ (33,135) $2,202,481
Comprehensive income:
Net income -- -- 66,942
Change in unrecognized gain/(loss)
net of tax on:
Investments available-for-sale -- (31,792) (31,792)
Derivative financial instruments -- 13,731 13,731
----------
Total comprehensive income -- -- 48,881
Acquisition of Main Street Bancorp -- -- 145,462
Exercise of stock options -- -- 2,817
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan -- -- 1,010
Dividends paid on common stock -- -- (6,195)
Treasury stock purchases -- -- (109)
Treasury stock sold -- -- 216
Termination of Employee
Stock Ownership Plan 7,768 -- 8,332
---------- ----------- ----------
Balance, March 31, 2002 $ (23,177) $ (51,196) $2,402,895
========== =========== ==========
See accompanying notes to consolidated financial statements.
-9-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three-month Period
Ended March 31,
---------------------------------
2002 2001
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES: (in thousands)
Net income $ 66,942 $ 4,563
Adjustments to reconcile net income to
net cash provided by operating activities:
Provision for loan losses 44,500 20,000
Deferred taxes 10,920 (43,607)
Depreciation and amortization 35,482 48,440
Net amortization/(accretion) of investment
securities and loan premiums 12,413 5,233
(Gain)/loss on sale of loans, investment
securities and real estate owned (20,423) (7,356)
(Gain)on sale of fixed assets -- (344)
Allocation of ESOP shares 7,768 --
Loss on the retirement of Bancorp debt -- 10,075
Net change in:
Unrealized gain/(loss) on derivatives 13,732 (9,905)
Loans held for sale 131,969 --
Accrued interest receivable 65,215 14,123
Prepaid expenses and other assets (6,088) (689,217)
Other liabilities 39,744 125,652
---------- -----------
Net cash provided (used) by operating activities 402,174 (522,343)
---------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities:
Available-for-sale 2,001,589 1,619,275
Proceeds from repayments and maturities of
investment securities:
Available-for-sale 689,919 260,181
Held-to-maturity 72,906 66,624
Purchases of investment securities:
Available-for-sale (2,452,392) (2,156,144)
Held-to-maturity 1,396 (1,024)
Proceeds from sales of loans 741,282 1,116,152
Purchase of loans (655,805) (765,516)
Net change in loans other than purchases and sales (662,279) (251,698)
Proceeds from sales of premises and equipment 7 379
Purchases of premises and equipment (20,298) (4,628)
Proceeds from sale of real estate owned 7,993 630
Net cash (paid) received due to acquisitions net
of cash acquired 207,704 --
---------- -----------
Net cash provided (used) by investing activities (67,978) (115,769)
---------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease)/increase in deposits
and other customer accounts 257,633 (533,575)
Net increase/(decrease) in short-term borrowings (474,155) 378,212
Net increase in long-term borrowings (50,450) 517,532
Proceeds from long-term borrowings 20,000 525,000
Repayments of long-term borrowings (20,000) (590,000)
Net increase in advance payments by
borrowers for taxes and insurance 1,987 (357)
Cash dividends paid to stockholders (6,195) (5,872)
Proceeds from issuance of common stock 4,429 150,328
Net change in treasury and restricted stock 69 261
Proceeds from the issuance of preferred stock
by subsidiary --
---------- -----------
Net cash provided(used) by financing activities (266,682) 441,529
---------- -----------
Net change in cash and cash equivalents 67,514 (196,583)
Cash and cash equivalents at beginning of period 907,279 959,643
---------- -----------
Cash and cash equivalents at end of period $ 974,793 $ 763,060
========== ===========
Supplemental Disclosures:
Income tax payments totaled $4.1 million for the three-month period ended March
31, 2002 and $1.3 million for the same period in 2001. Interest payments totaled
$216 million for the three-month period ended March 31, 2002 and $342 million
for the same period in 2001. See Note 12 - Purchase of Main Street Bancorp,
Inc., in a later section of these financial statements for the fair value of
non-cash assets and liabilities acquired in 2002.
See accompanying notes to consolidated financial statements.
-10-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) BASIS OF PRESENTATION AND ACCOUNTING POLICIES
Basis of Presentation
- ---------------------
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
Delaware Investment Corporation, Sovereign Capital Trust I, Sovereign Capital
Trust II, Sovereign Capital Trust III, Main Street 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 accounting
principles generally accepted in the United States. 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 accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates. Certain amounts in the financial statements of prior periods have
been reclassified to conform with the presentation used in current period
financial statements. These reclassifications have no effect on net income.
The results of operations for the three-month period ended March 31, 2002
are not necessarily indicative of the results which may be expected for the
entire year. These consolidated financial statements should be read in
conjunction with the Form 10-K for the year ended December 31, 2001.
Statement of Financial Accounting Standards No. 142 "Goodwill and Other
Intangible Assets" ("SFAS No. 142") was adopted effective January 1, 2002.
Amortization of goodwill was discontinued upon adoption in accordance with SFAS
No. 142 as discussed in a later section of these footnotes.
The Company completed its purchase of Main Street Bancorp, Inc. ("Main
Street") on March 8, 2002. Sovereign's results include the operations of Main
Street from the date of its acquisition as discussed in a later section of these
footnotes.
-11-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(2) EARNINGS PER SHARE
Basic earnings per share is calculated by dividing income before and after
extraordinary item by the weighted average common shares outstanding, excluding
options and warrants. The dilutive effect of options and warrants is calculated
using the treasury stock method.
The following table presents the computation of earnings per share for the
periods indicated (in thousands, except per share data).
Three-Month Period
Ended March 31,
-------------------------------
2002 2001
-------- --------
CALCULATION OF INCOME FOR EPS:
- ------------------------------
Income before extraordinary
item for basic EPS $ 66,942 $ 11,112
Extraordinary item, after tax -- (6,549)
-------- --------
Net income for basic and diluted EPS $ 66,942 $ 4,563
======== ========
WEIGHTED AVERAGE SHARES FOR EPS:
- --------------------------------
Weighted average basic shares 250,619 237,874
Dilutive effect of average stock
options and warrants 19,243 1,392
-------- --------
Weighted average diluted shares 269,862 239,266
======== ========
EARNINGS PER SHARE:
- -------------------
Basic
Income before extraordinary item $ .27 $ .05
Extraordinary item -- (.03)
-------- --------
Net income $ .27 $ .02
======== ========
Diluted
Income before extraordinary item $ .25 $ .05
Extraordinary item -- (.03)
-------- --------
Net income $ .25 $ .02
======== ========
-12-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(3) INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The following table presents the composition and fair value of investment
securities available-for-sale at the dates indicated: (dollars in thousands)
March 31, 2002
----------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 32,567 $ 105 $ 257 $ 32,415
Corporate debt and
asset-backed securities 349,188 8,569 15,692 342,065
Equities 994,437 3,582 111 997,908
State and municipal
securities 23,194 3,571 -- 26,765
Mortgage-backed securities:
U.S. government agencies 5,643,207 14,170 69,179 5,588,198
Non-agencies 2,592,292 21,354 3,996 2,609,650
---------- ------- ------- ----------
Total investment securities
available-for-sale $9,634,885 $51,351 $89,235 $9,597,001
========== ======= ======= ==========
December 31, 2001
----------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 23,109 $ 93 $ 23 $ 23,179
Corporate debt and
asset-backed securities 322,813 5,357 14,310 313,860
Equities 790,391 2,631 160 792,862
State and municipal
securities 22,452 1,942 2 24,392
Mortgage-backed securities:
U.S. government agencies 6,625,498 34,371 33,828 6,626,041
Non-agencies 1,783,485 23,062 5,202 1,801,345
---------- ------- ------- ----------
Total investment securities
available-for-sale $9,567,748 $67,456 $53,525 $9,581,679
========== ======= ======= ==========
-13-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(4) INVESTMENT SECURITIES HELD-TO-MATURITY
The following table presents the composition and fair value of investment
securities held-to-maturity at the dates indicated: (dollars in thousands)
March 31, 2002
--------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
-------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 1,705 $ 60 $ -- $ 1,765
State and municipal
securities 3,925 36 4 3,957
Mortgage-backed securities:
U.S. government agencies 810,235 8,061 12,895 805,401
Non-agencies 4,777 49 7 4,819
-------- -------- -------- ---------
Total investment securities
held-to-maturity $820,642 $ 8,206 $ 12,906 $815,942
======== ======== ======== ========
December 31, 2001
--------------------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
-------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 1,905 $ 55 $ -- $ 1,960
State and municipal
securities 4,128 35 2 4,161
Mortgage-backed securities:
U.S. government agencies 872,154 9,851 10,144 871,861
Non-agencies 5,250 47 71 5,226
-------- -------- -------- --------
Total investment securities
held-to-maturity $883,437 $ 9,988 $ 10,217 $883,208
======== ======== ======== ========
-14-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(5) COMPOSITION OF LOAN PORTFOLIO
The following table presents the composition of the loan portfolio by type
of loan and by fixed and adjustable rates at the dates indicated: (dollars in
thousands)
March 31, 2002 December 31, 2001
--------------------------- ---------------------------
Amount Percent Amount Percent
------ ------- ------ -------
Commercial real estate loans $ 3,714,156 17.1% $ 3,082,330 15.1%
Commercial and industrial loans 4,629,240 21.2 4,506,198 22.1
Other 1,041,110 4.8 975,075 4.8
----------- ------ ----------- ------
Total Commercial Loans 9,384,506 43.1 8,563,603 42.0
----------- ------ ----------- ------
Home equity loans 4,419,534 20.3 3,756,621 18.4
Auto loans 3,026,170 13.9 2,880,449 14.1
Other 201,609 0.9 193,692 .9
----------- ------ ----------- ------
Total Consumer Loans 7,647,313 35.1 6,830,762 33.4
----------- ------ ----------- ------
Residential Real Estate Loans 4,758,914 21.8 5,005,219 24.6
----------- ------ ----------- ------
Total Loans (1) $21,790,733 100.0% $20,399,584 100.0%
=========== ====== =========== ======
Total Loans with:
Fixed rate $13,147,995 60.3% $12,875,742 63.1%
Variable rate 8,642,738 39.7 7,523,842 36.9
----------- ------ ----------- ------
Total Loans (1) $21,790,733 100.0% $20,399,584 100.0%
=========== ====== =========== ======
(1) Loan totals include deferred loan fees and unamortized premiums and
discounts. These fees, premiums and discounts resulted in a net increase in
loans of $35 million at March 31, 2002 and a net increase of $22 million at
December 31, 2001.
Loans to related parties include loans made to certain officers, directors
and their affiliated interests. At March 31, 2002 and December 31, 2001, loans
to related parties totaled $21.6 million and $20.1 million, respectively.
-15-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(6) DEPOSIT PORTFOLIO COMPOSITION
The following table presents the composition of deposits and other customer
accounts at the dates indicated: (dollars in thousands)
March 31, 2002 December 31, 2001
--------------------------------------- -------------------------------------
Weighted Weighted
Average Average
Account Type Amount Percent Rate Amount Percent Rate
------------ ------ ------- ---- ------ ------- ----
Demand deposit accounts $ 3,985,739 16% --% $ 3,910,171 17% --%
NOW accounts 4,207,635 17 0.84 4,162,169 18 0.87
Savings accounts 3,135,102 13 1.40 2,985,464 13 1.44
Money market accounts 5,767,822 23 1.96 4,992,163 21 1.73
Retail certificates 7,292,676 29 3.79 6,985,397 30 4.14
Jumbo certificates 426,576 2 3.02 262,210 1 3.04
----------- --- ---- ----------- --- ----
Total Deposits $24,815,550 100% 1.94% $23,297,574 100% 1.99%
=========== === ==== =========== === ====
(7) SHORT-TERM BORROWINGS
The following table presents information regarding short-term borrowings
(original maturities of up to one year) at the dates indicated: (dollars in
thousands)
March 31, 2002 December 31, 2001
--------------------------- ----------------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- ---- ------- ----
Federal funds purchased $ 335,000 1.77% $ 452,002 1.75%
Securities sold under
repurchase agreements -- -- 297,741 1.45
FHLB advances 1,869,609 2.66 1,929,021 3.08
---------- ---- ---------- ----
Total Borrowings $2,204,609 2.53% $2,678,764 2.67%
========== ==== ========== ====
(8) LONG-TERM BORROWINGS
Long-term borrowings (original maturities greater than one year) consisted
of the following: (dollars in thousands)
March 31, 2002 December 31, 2001
-------------- -----------------
Securities sold under
repurchase agreements $ 155,000 $ 155,000
FHLB advances 4,142,830 4,105,929
Senior secured credit facility 245,000 225,000
Senior and subordinated notes 1,752,850 1,775,077
---------- ----------
$6,295,680 $6,261,006
========== ==========
-16-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(9) COMPREHENSIVE INCOME
The following table presents the components of comprehensive income/(loss),
net of related tax, based on the provisions of SFAS No. 130 for the periods
indicated: (dollars in thousands)
Three-month Period
Ended March 31,
------------------------
2002 2001
------- --------
Net income $66,942 $ 4,563
Cumulative change in accounting principle:
Fair value of derivative instruments and
hedged items -- (6,736)
Reclassification of held-to-maturity
securities to available-for-sale -- (3,215)
Net unrealized gain/(loss):
Derivative instruments 13,731 81
Investment securities available-for-sale (18,432) 27,721
Less reclassification adjustment:
Derivative instruments -- 35
Investments available-for-sale 13,360 4,961
------- -------
Net unrealized gain recognized
in other comprehensive income (18,061) 12,855
------- -------
Comprehensive income $48,881 $17,418
======= =======
Accumulated other comprehensive loss, net of related tax, consisted of net
unrealized losses on securities of $24.3 million and net unrealized losses on
derivatives of $26.9 million at March 31, 2002 and net unrealized losses on
securities of $15.8 million and net unrealized losses on derivatives of $9.9
million at March 31, 2001.
(10) DERIVATIVES
Sovereign uses derivative instruments as part of its interest rate risk
management process, to manage risk associated with its mortgage banking
activities, and to assist its commercial banking customers with their risk
management strategies.
Sovereign's primary market risk is interest rate risk. Management uses
derivative instruments to protect against the risk of interest rate movements on
the value of certain liabilities and on probable future cash outflows. These
instruments primarily include interest rate swaps and interest rate caps and
floors that have underlying interest rates based on key benchmark indexes. The
nature and volume of the derivative instruments used to manage interest rate
risk depend on the level and type of assets and liabilities on the balance sheet
and the risk management strategies for the current and anticipated rate
environment. On January 1, 2001, the Company adopted SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities", which requires all derivative
instruments to be carried at fair value on the balance sheet. The Company
designates derivative instruments used to manage interest rate risk into SFAS
133 hedge relationships with the specific assets, liabilities, or cash flows
being hedged.
-17-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
Fair Value Hedges. Sovereign used receive-fixed interest rate swaps to
hedge the fair values of certain brokered CDs for changes in interest rates. All
of Sovereign's interest rate swaps accounted for as fair value hedges
outstanding as of March 31, 2002 satisfied the criteria in SFAS 133 to use the
"short-cut" method of accounting for changes in fair value. The short-cut method
allows the Company to assume that there is no ineffectiveness in the hedging
relationship and that changes in the fair value of the derivative perfectly
offset changes in the fair value of the hedged asset or liability, resulting in
no volatility in earnings.
Cash Flow Hedges. Sovereign hedges cash flow variability related to
variable-rate liabilities, specifically FHLB advances, through the use of
pay-fixed interest rate swaps. Sovereign also held pay-fixed interest rate swaps
to hedge forecasted cash flows associated with periodic floating rate interest
payments payable subsequent to March 31. All of Sovereign's interest rate swaps
accounted for as cash flow hedges outstanding as of March 31, 2002, satisfied
the criteria in SFAS 133 to use the short-cut method of accounting for changes
in fair value.
Gains and losses on derivative instruments reclassified from accumulated
other comprehensive income to current-period earnings are included in the line
item in which the hedged cash flows are recorded. At March 31, 2002, accumulated
other comprehensive income included a deferred after-tax net loss of $26.9
million, consisting of a loss on pay-fixed interest rate swaps used to hedge
future cash flows on FHLB advances. The loss will be reclassified from other
comprehensive income into earnings during the same period the forecasted
transactions occur. During the first quarter of 2001, the Company terminated
$950 million of cash flow interest rate swaps. The resulting gain on termination
of $4.7 million is being deferred and amortized as a yield adjustment against
the remaining expected future cash flows originally being hedged. This deferred
gain will be amortized over the period April, 2002 through June, 2012.
Other Derivative Activities. Sovereign's derivative portfolio also includes
derivative instruments not included in SFAS 133 hedge relationships. Those
derivatives include mortgage banking loan commitments and forward sales defined
as derivatives under SFAS 133 used for risk management purposes, and derivatives
executed with customers, primarily interest rate swaps and foreign exchange
futures, to facilitate their risk management strategies.
Net gains generated from other than hedging derivative instruments for the
three-months ended March 31, 2002 totaled $2.2 million and are included as
capital markets revenue on the income statement.
(11) GOODWILL AND OTHER INTANGIBLE ASSETS
The Company adopted Statement of Financial Accounting Standards No. 142 -
Goodwill and Other Intangible Assets ("SFAS No. 142") and discontinued
amortizing goodwill effective January 1, 2002. Under SFAS No. 142 goodwill and
indefinite lived intangible assets are no longer amortized but are reviewed
annually for impairment. Separable intangible assets that are not deemed to have
an indefinite life continue to be amortized over their useful lives. The Company
is required to complete the transitional impairment test within six months of
adoption of SFAS No. 142. Any impairment loss resulting from the transitional
impairment test will be recorded as a cumulative effect of a change in
accounting principle. Subsequent impairment losses will be reflected in expense
in the statement of
-18-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
operations. The Company has costs in excess of net assets acquired (goodwill),
which are deemed to be an indefinite life intangible asset, and core deposit
intangibles, which are deemed to have a definite life and continue to be
amortized.
The estimated aggregate amortization expense related to core deposit intangibles
for each of the five succeeding fiscal years ending December 31, is:
Year Amount
---- ------
2002 $80,274
2003 73,835
2004 66,856
2005 57,945
2006 51,047
The following table reflects the components of intangible assets (in
thousands):
Gross Carrying Accumulated
Amount Amortization
----------------------- ----------------------
March 31 December 31, March 31, December 31,
2002 2001 2002 2001
---- ---- ---- ----
Non-amortized intangible
assets:
Goodwill $1,155,945 $1,086,341 $131,653 $131,653
Amortized intangible assets:
Core Deposit
Intangibles 642,543 608,179 239,197 218,963
The following table reflects the pro forma results of operations as if SFAS
No. 142 had been adopted as of January 1, 2001 (in thousands, except per share
data):
Three-months ended
March 31,
-------------------
2002 2001
------- -------
Reported income before extraordinary item $66,942 $11,112
Add back goodwill amortization, net of tax -- 6,871
------- -------
Proforma income before extraordinary item $66,942 $17,983
======= =======
Proforma net income $66,942 $11,434
======= =======
Reported diluted EPS before extraordinary item $ .25 $ .05
Add back goodwill amortization, net of tax $ -- .03
------- -------
Proforma diluted EPS before extraordinary item $ .25 $ .08
======= =======
Proforma diluted EPS $ .25 $ .05
======= =======
-19-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(12) PURCHASE OF MAIN STREET BANCORP, INC. ("MAIN STREET")
On March 8, 2002 Sovereign completed the purchase of Main Street and the
results of its operations are included from purchase date through March 31,
2002. Sovereign issued 11.4 million shares of common stock, net of treasury
shares, valued at $145.5 million and made cash payments of $31.5 million to
acquire and convert all outstanding Main Street shares and associated fees. The
value of the common stock was determined based on the average price of
Sovereign's shares over the ten day period preceding closing as provided in the
purchase agreement. The acquisition enhanced Sovereign's market share throughout
its existing service area in eastern Pennsylvania. Sovereign's preliminary
purchase price allocation is as follows:
Assets and Liabilities Acquired at fair value from Main Street as of March
8, 2002 (dollars in millions):
Assets Liabilities
- ------ -----------
Investments $ 305.9 Deposits:
Loans: Core $ 700.6
Commercial 527.0 Time 554.6
Consumer 152.7 --------
Residential 165.6 Total deposits 1,255.2
-------- Borrowings and
Total loans 845.3 long-term debt 86.9
Less allowance for loan losses (14.9) Other liabilities 23.7
-------- Trust preferred
Total loans, net 830.4 securities 10.0
Federal funds and cash 239.3 --------
Premises and equipment, net 26.0
Other real estate owned 0.8 Total liabilities $1,375.8
Prepaid expenses and other assets 14.9 ========
Core deposit intangible 34.4
Goodwill 69.6
--------
Total assets $1,521.3
========
In connection with the Main Street acquisition, Sovereign recorded charges
against its earnings for the three-month period ended March 31, 2002 for an
additional loan loss provision of $6.0 million pre-tax ($3.9 million net of tax)
to conform Main Street's allowance for loan losses to Sovereign's reserve
policies and for merger related expenses of $15.9 million pre-tax ($10.3 million
net of tax).
These merger-related expenses include the following:
Community grants $ 1,000
Branch and office consolidations 11,338
Account conversion and other 3,533
-------
$15,871
=======
-20-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS
- ---------------------
General
- -------
Cash earnings, as defined below, for the three-month period ended March 31,
2002 increased 8% to $95.2 million, or $.35 per share, up from $88.1 million, or
$.37 per share, for the same period in 2001. Operating earnings for 2002
increased 27% to $81.2 million, or $.30 per share, as compared to $63.6 million,
or $.27 per share, for 2001.
Operating earnings exclude certain special charges for 2002 and 2001.
Special charges for the quarters ended March 31, 2002 and 2001 were $14.2
million and $59.0 million, respectively, after tax, and are outlined in the
Reconciliation of Net Income to Operating Earnings table on the following page.
Cash earnings are operating earnings excluding amortization (after-tax) of
intangible assets and ESOP-related expense.
Net income, including the special charges noted above, was $66.9 million,
or $.25 per share, for the three-month period ended March 31, 2002, as compared
to $4.6 million, or $.02 per share, for the same period in 2001. Effective
January 1, 2002, the Company ceased to amortize goodwill in accordance with SFAS
No. 142 (see Note 11 in Notes to Consolidated Financial Statements). Proforma
2001 net income and operating earnings were $11.4 million and $70.4 million,
excluding the effects of goodwill amortization.
Cash return on average equity and cash return on average total assets,
excluding special charges discussed above, were 16.96% and 1.10% for the
three-month period ended March 31, 2002 compared to 17.42% and 1.06% for the
same period in 2001.
Main Street Bancorp, Inc. Acquisition ("Main Street")
- -----------------------------------------------------
On March 8, 2002 Sovereign closed the acquisition of Main Street, a
commercial bank holding company headquartered in Reading, Pennsylvania.
Collectively, Main Street shareholders elected to receive approximately 85% of
the purchase price in Sovereign common stock valued at 145.5 million and 15% in
cash, or $31.5 million, including associated fees. The value of the common stock
was determined based on the average price of Sovereign's shares over the ten day
period preceding closing as provided in the purchase agreement. Under the terms
of the deal, up to 30% of total consideration was available in the form of cash.
In connection with the Main Street acquisition, Sovereign recorded charges
against its earnings for the three-month period ended March 31, 2002 for an
additional loan loss provision of $6.0 million pretax ($3.9 million net of tax)
to conform Main Street's allowance for loan losses to Sovereign's reserve
policies and for merger related expenses of $15.9 million pretax ($10.3 million
net of tax).
See Note 12 in the Consolidated Financial Statements for Sovereign's
preliminary purchase allocation, including fair values of acquired assets and
liabilities, and a description of merger-related expenses.
-21-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Reconciliation of Net Income to Operating Earnings
--------------------------------------------------
(In thousands, except per share data - all amounts are after tax)
Three-month Period
Ended March 31,
----------------------------------
Total Per Share
----------------------------------
2002 2001 2002 2001
---- ---- ---- ----
Net income as reported $ 66,942 $ 4,563 $.25 $.02
Loss on the early
extinguishment of debt -- 6,549 -- .03
Merger-related and integration
costs recorded during the
period 10,316 -- .04 --
Restructuring expense -- 5,525 -- .02
Non-solicitation expense -- 46,940 -- .20
Provision for loan losses -
Main Street Bancorp
acquisition 3,900 -- .01 --
-------- -------- ---- ----
Operating earnings $ 81,158 $ 63,577 $.30 $.27
======== ======== ==== ====
Amortization of intangibles 13,468 24,099 .05 .10
ESOP expense 601 399 -- --
-------- -------- ---- ----
Cash earnings $ 95,227 $ 88,075 $.35 $.37
======== ======== ==== ====
Average shares 269,862 239,315
-22-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
CONSOLIDATED AVERAGE BALANCE SHEET / NET INTEREST MARGIN ANALYSIS
THREE-MONTH PERIOD ENDED MARCH 31, 2002 AND 2001
(in thousands)
2002 2001
---------------------------------------- ----------------------------------------
Average Yield/ Average Yield/
Balance Interest(1) Rate Balance Interest(1) Rate
---------------------------------------- ----------------------------------------
EARNING ASSETS
- --------------
INVESTMENTS $10,088,524 $159,700 6.34% $ 7,167,511 $129,026 7.20%
LOANS:
Residential loans 4,978,654 86,050 6.91% 7,860,387 153,738 7.82%
Commercial loans 8,772,839 133,764 6.14% 8,138,466 172,886 8.57%
Consumer loans 6,996,999 120,084 6.96% 6,273,139 128,059 8.27%
----------- -------- ---- ----------- -------- -----
Total loans 20,748,492 339,897 6.60% 22,271,992 454,683 8.22%
Allowance for loan losses (287,100) -- -- (255,288) -- --
----------- -------- ---- ----------- -------- -----
NET LOANS 20,461,392 339,897 6.70% 22,016,704 454,683 8.32%
----------- -------- ---- ----------- -------- -----
TOTAL EARNING ASSETS 30,549,916 499,597 6.58% 29,184,215 583,709 8.05%
Other assets 4,700,621 -- -- 4,381,587 -- --
----------- ------- ---- ----------- -------- -----
TOTAL ASSETS $35,250,537 499,597 5.70% $33,565,802 $583,709 7.00%
=========== ======= ==== =========== ======== =====
FUNDING LIABILITIES
- -------------------
DEPOSITS:
Core deposits $16,238,079 42,317 1.06% $14,867,116 88,426 2.41%
Time deposits 7,329,853 68,693 3.80% 9,070,640 132,688 5.93%
----------- -------- ---- ----------- --------- -----
TOTAL DEPOSITS 23,567,932 111,010 1.91% 23,937,756 221,114 3.74%
----------- -------- ---- ----------- -------- -----
BORROWED FUNDS:
FHLB advances 5,939,169 76,007 5.13% 5,231,007 73,561 5.63%
Repurchase agreements 341,002 2,654 3.11% 217,472 2,698 4.96%
Other borrowings 1,990,840 33,227 6.69% 1,394,238 34,993 10.08%
----------- -------- ---- ----------- -------- -----
TOTAL BORROWED FUNDS 8,271,011 111,888 5.42% 6,842,717 111,252 6.51%
----------- -------- ---- ----------- -------- -----
TOTAL FUNDING LIABILITIES 31,838,943 222,898 2.82% 30,780,473 332,366 4.36%
Other liabilities 1,134,377 -- -- 735,213 -- --
----------- -------- ---- ----------- -------- -----
TOTAL LIABILITIES 32,973,320 222,898 2.73% 31,515,686 332,366 4.26%
STOCKHOLDERS' EQUITY 2,277,217 -- -- 2,050,116 -- --
- -------------------- ----------- ------- ---- ----------- -------- -----
TOTAL LIABILITIES
AND STOCKHOLDERS' EQUITY $35,250,537 222,898 2.55% $33,565,802 332,366 4.00%
=========== ------- ---- =========== -------- -----
NET INTEREST INCOME $276,699 $251,343
======== ========
NET INTEREST SPREAD (2) 3.15% 3.00%
---- -----
NET INTEREST MARGIN (3) 3.64% 3.45%
==== ====
(1) Tax-equivalent basis
(2) Represents the difference between the yield on total assets and the cost of
total liabilities and stockholders' equity.
(3) Represents taxable equivalent net interest income divided by average
interest-earning assets
-23-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Net interest income for the three-month period ended March 31, 2002 was
$272 million compared to $247 million for the same period in 2001. This increase
was attributable to an increase in average balances, and an improvement of 19
basis points in net interest margin which was 3.64% for the three-month period
ended March 31, 2002 compared to 3.45% for the same period in 2001. Net interest
margin has been very stable over the past four quarters, fluctuating within a
tight, 10 basis point range despite volatility of market rates. The increase in
average balances is a result of leveraging the Company's increased capital
position.
Interest on investment securities and interest earning deposits was $156
million for the three-month period ended March 31, 2002 compared to $127 million
for the same period in 2001. The average balance of investment securities was
$10 billion with an average tax equivalent yield of 6.34% for the three-month
period ended March 31, 2002 compared to an average balance of $7.2 billion with
an average yield of 7.20% for the same period in 2001. On a linked-quarter
basis, the Company had slight margin compression of 5 basis points as it
repositioned its investment portfolio. The transaction involved the sale and
subsequent purchase of $1.1 billion of securities and generated a gain of
approximately $20 million. In addition to the gain, the newly purchased
securities had a higher weighted average yield with a shorter blended effective
duration. Approximately $4 million of the gain was mitigated by holding the sale
proceeds in short-term, liquid instruments pending reinvestment late in the
quarter.
Interest and fees on loans were $339 million for the three-month period
ended March 31, 2002 compared to $453 million for the same period in 2001. The
average balance of loans was $20.7 billion with an average yield of 6.60% for
the three-month period ended March 31, 2002 compared to an average balance of
$22.3 billion with an average yield of 8.22% for the same period in 2001.
Average balances of commercial and consumer loans in 2002 increased $0.6 billion
and $0.7 billion, respectively as compared to 2001 while average residential
loans declined $2.9 billion. These changes are consistent with Sovereign's
strategy to emphasize commercial and consumer lending. The decrease in loan
rates is due to declining market interest rates and the aforementioned shift in
the components of the loan portfolio, which now includes more variable rates and
shorter maturity assets.
Interest on deposits was $111 million for the three-month period ended
March 31, 2002 compared to $221 million for the same period in 2001. The average
balance of deposits was $23.6 billion with an average cost of 1.91% for the
three-month period ended March 31, 2002 compared to an average balance of $23.9
billion with an average cost of 3.74% for the same period in 2001. The decrease
in average cost year to year is due to a combination of declining market
interest rates generally, and the Company's emphasis on attracting and retaining
core deposits.
Interest on borrowings was $112 million for the three-month period ended
March 31, 2002 compared to $111 million for the same period in 2001. The average
balance of borrowings was $8.3 billion with an average cost of 5.42% for the
three-month period ended March 31, 2002 compared to an average balance of $6.8
billion with an average cost of 6.51% for the same period in 2001.
-24-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Provision for Loan Losses
- -------------------------
The provision for loan losses is based upon credit loss experience and on
the estimation of losses inherent in the current loan portfolio. The provision
for loan losses for the three-month period ended March 31, 2002 was $44.5
million compared to $20.0 million for the same period in 2001.
The increase over 2001 was based on several factors:
o One large commercial loan that was downgraded from pass to adversely
classified status, placed on non-accrual and charged down in a very
short time period. This accounted for a $10.7 million charge-off, and
the remaining balance was reserved at a high level. The impact on the
provision was slightly in excess of $14.2 million covered entirely in
this quarter.
o A modest increase in adversely classified assets, requiring more
allowance driven by our established reserving methodology.
o A $20.5 million portfolio of non-performing residential mortgages was
sold. This group of loans was concentrated in substandard assets and
as such required a charge-off of $2.3 million.
o An additional $6 million of provision related to conform Main Street's
allowance for loan losses to Sovereign's reserve policies.
Over the last few years, through several strategic acquisitions and
internal restructuring initiatives, Sovereign has diversified its lending
efforts and increased its emphasis on providing its customers with small
business loans and an expanded line of commercial and consumer products, such as
middle market asset-based lending and automobile loans. As a result of the
increased risk inherent in these loan products and as Sovereign continues to
place emphasis on commercial business and consumer lending in future periods,
management will regularly evaluate its loan portfolio, and its allowance for
loan losses, and will adjust the loan loss provision as is necessary.
Sovereign's net charge-offs for the three-month period ended March 31, 2002
were $37.0 million and consisted of charge-offs of $45.2 million and recoveries
of $8.1 million. This compared to net charge-offs of $20.3 million consisting of
charge-offs of $33.8 million and recoveries of $13.5 million for the three-month
period ended March 31, 2001. The increased level of charge-offs was driven by
the events discussed above.
-25-
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)
Three-month Period Ended March 31,
2002 2001
------------------------------------
Allowance, beginning of period $ 264,667 $ 256,356
Charge-offs:
Residential 3,784 3,063
Commercial 24,876 9,743
Consumer 16,499 20,961
--------- ---------
Total Charge-offs 45,159 33,767
--------- ---------
Recoveries:
Residential 131 1,760
Commercial 1,307 458
Consumer 6,692 11,256
--------- ---------
Total Recoveries 8,130 13,474
--------- ---------
Charge-offs, net of recoveries 37,029 20,293
Provision for possible loan losses 44,500 20,000
Main Street's allowance
for loan losses 14,877 --
--------- ---------
Allowance, end of period $ 287,015 $ 256,063
========= =========
Non-Interest Income
- -------------------
Total non-interest income was $107.5 million for the three-month period
ended March 31, 2002 compared to $105.3 million for the same period in 2001.
Excluding securities and related derivatives transactions, total fees and other
income for the three-month period ended March 31, 2002 was $87.0 million as
compared to $98.0 million for the same period in 2001.
Consumer banking fees were $38.6 million for the three-month period ended
March 31, 2002 as compared to $39.4 million for the same period in 2001. Core
deposits have grown 8% over the past year and include approximately 250,000 new
checking accounts. The slight decrease in consumer banking fees of $0.8 million
is attributed to recent economy-related consumer conservatism. Commercial
banking fees were $22.8 million for the three-month period ended March 31, 2002
as compared to $18.3 million for the same period in 2001. This increase of $4.5
million was primarily due to higher loan volumes and increased market share.
Mortgage banking revenue was $9.5 million for the three-month period ended
March 31, 2002 as compared to $21.3 million for the same period in 2001. The
first quarter of 2001 includes a gain of $19.3 million related to the sale of
$580 million of residential mortgages offset by a charge of $6.8 million to
increase the valuation allowance related to mortgage servicing rights. On a
linked-quarter basis mortgage banking revenue declined $3.6 million on lower
refinancing activity.
-26-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Gain on investment securities and related derivatives transactions were
$20.6 million for the three-month period ended March 31, 2002 compared to $7.3
million for the same period in 2001. During 2002, the Company repositioned its
investment portfolio. The transaction involved the sale and subsequent purchase
of $1.1 billion of investment securities. In addition to a gain of approximately
$20 million, the newly purchased securities had a higher weighted average yield
and a shorter blended effective duration.
General and Administrative Expenses
- -----------------------------------
General and administrative expenses for the three-month period ended March
31, 2002 were $191.9 million, compared to $189.5 million for the same period in
2001 an increase of $2.4 million or 1.3%. Compensation costs increased due to
insourcing of certain technology services and normal annual increases. Expense
reduction initiatives have also favorably impacted occupancy and outside
services.
Other operating expenses were $51.7 million for the three-month period
ended March 31, 2002 compared to $131 million for the same period in 2001.
Results for the three-month period ended March 31, 2002 included amortization of
core deposit intangibles of $20.2 million compared to $36.1 million for
amortization of goodwill and core deposit intangibles for the same period in
2001. The discontinuance of goodwill amortization is a result of the adoption of
Statement of Financial Accounting Standard No. 142. "Goodwill and Other
Intangible Assets" effective January 1, 2002 which eliminated goodwill
amortization as more fully discussed in the Notes to Consolidated Financial
Statements in Part I of this document. The impact of required impairment tests
has not yet been determined. Merger-related and integration charges of $15.9
million ($10.3 million or $0.04 per share, net of tax) related to the Main
Street acquisition were recorded in the three-month period ended March 31, 2002.
The three-month period ended March 31, 2001, includes $72.2 million of
non-solicitation expense related to the non-solicitation provisions of the SBNE
purchase and assumption agreement. Also during the three-month period ended
March 31, 2001, Sovereign recorded an $8.5 million charge ($5.5 million net of
tax) as the last portion of restructuring charges related to its company-wide
restructuring announced in November of 2000. The restructuring, completed over
the first quarter of 2001 and last quarter of 2000, resulted in elimination of
over 600 positions, closure of 14 in-store offices and redirection of e-commerce
efforts to consolidate efforts within our geographic footprint.
Income Tax Provision
- --------------------
The income tax provision was $24.4 million for the three-month period ended
March 31, 2002 compared to $.9 million for the same period in 2001. The
effective tax rate for the three-month period ended March 31, 2002 was 26.7%,
compared to 7.5% for the same period in 2001. The current year tax rate differs
from the statutory rate of 35% due to income from tax-exempt investments and
income related to bank-owned life insurance. The effective tax rate for the 2001
quarter is not meaningful due to the high proportion of permanent tax
differences, in relation to the low level of recorded pretax income.
-27-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Extraordinary Item
- ------------------
In last year's quarter ended March 31, 2001, Sovereign completed a $400
million term and revolving credit facility with Bank of Scotland of which $350
million was drawn to prepay an existing $350 million senior secured credit
facility. In connection with this transaction, Sovereign wrote-off $6.5 million
net of tax ($10.1 million pretax) of deferred issuance costs remaining from the
existing line of credit. These costs were reflected net of tax as an
extraordinary item in accordance with generally accepted accounting principles.
-28-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
FINANCIAL CONDITION
- -------------------
Loan Portfolio
- --------------
At March 31, 2002, commercial loans totaled $9.4 billion representing 43%
of Sovereign's loan portfolio, compared to $8.6 billion and 42% of the loan
portfolio at December 31, 2001 and $8.2 billion and 38% of the loan portfolio at
March 31, 2001.
The consumer loan portfolio (including home equity loans and lines of
credit, automobile loans, and other consumer loans) totaled $7.6 billion at
March 31, 2002, representing 35% of Sovereign's loan portfolio, compared to $6.8
billion and 33% of the loan portfolio at December 31, 2001 and $6.5 billion and
30% of the loan portfolio at March 31, 2001.
Residential mortgage loans decreased $246 million during the quarter to
$4.8 billion and now represent 22% of Sovereign's loan portfolio as compared to
$5.0 billion and 25% at December 31, 2001. The decrease is primarily due to
scheduled payments and prepayments. At March 31, 2001 residential mortgage loans
totaled $6.9 billion representing 32% of the loan portfolio.
Non-Performing Assets
- ---------------------
At March 31, 2002 Sovereign's non-performing assets increased by $5 million
to $233 million compared to $228 million at December 31, 2001. This increase is
due to increases in non-performing commercial loans, and to a lessor extent,
consumer non-performing loans all related to the Main Street acquisition. These
increases are partially offset by a decline in residential non-performing loans
as a result of the sale of certain residential assets. Non-performing assets as
a percentage of total assets was .63% at March 31, 2002, down from .64% at
December 31, 2001. At March 31, 2002 57% of non-performing assets consisted of
consumer and residential loans and OREO which are primarily secured by real
estate and other collateral. Sovereign places all commercial loans on
non-performing status at 90 days (unless return to current status is expected
imminently). All other loans continue to accrue until they are 120 days
delinquent, at which point they are either charged-off or fully reserved, unless
they are evaluated to be well secured based on current appraisals and are in the
process of collection.
-29-
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)
March 31, December 31,
2002 2001
------------ ------------
Non-accrual loans:
Residential $ 57,473 $ 74,500
Commercial real estate 30,958 16,957
Commercial 98,185 89,399
Consumer 28,487 26,941
-------- --------
Total non-accrual loans 215,103 207,797
-------- --------
Restructured loans 1,498 1,280
-------- --------
Total non-performing loans 216,601 209,077
Other real estate owned 10,594 9,261
Other repossessed assets 5,989 9,667
-------- --------
Total non-performing assets $233,184 $228,005
======== ========
Past due 90 days or more as to interest
or principal and accruing interest (1) $ 45,733 $ 54,599
Non-performing assets as a percentage
of total assets .63% .64%
Non-performing loans as a percentage
of total loans .99% 1.02%
Non-performing assets as a percentage of
total loans and real estate owned 1.07% 1.12%
Allowance for loan losses as a percentage
of total non-performing assets 123.1% 116.1%
Allowance for loan losses as a percentage
of total non-performing loans 132.5% 126.6%
(1) Includes consumer and residential loans of $42.6 million and $50.9 million
at March 31, 2002 and December 31, 2001, respectively.
Loans ninety (90) days or more past due and still accruing interest fell by
$8.8 million from December 31, 2001 to March 31, 2002. The decrease is due to a
reduction in residential 90 day loans ($4.8 million) that are well secured and
in the process of collection, and a reduction in consumer 90 day past due loans
($3.7 million).
Potential problem loans (consisting principally of commercial loans
delinquent more than 30 days but less than 90 days, although not currently
classified as non-performing loans) amounted to approximately $110 million and
$120 million at March 31, 2002 and December 31, 2001, respectively.
-30-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Allowance for Loan Losses
- -------------------------
The following table presents the allocation of the allowance for loan
losses and the percentage of each loan type of total loans at the dates
indicated:
(dollars in thousands)
March 31, 2002 December 31, 2001
------------------------- --------------------------
% of Loans % of Loans
to to
Amount Total Loans Amount Total Loans
------ ----------- ------ -----------
Allocated allowance:
Commercial loans $179,675 43% $161,075 40%
Residential real estate
mortgage loans 21,346 22 20,724 25
Consumer loans 68,054 35 61,200 35
--
Unallocated allowance 17,940 n/a 21,668 n/a
-------- --- -------- ---
Total allowance for loan losses $287,015 100% $264,667 100%
======== === ======== ===
The adequacy of Sovereign's allowance for loan losses is regularly
evaluated. Management's evaluation of the adequacy of the allowance to absorb
loan losses takes into consideration the risks inherent in the loan portfolio,
past loan loss experience, specific loans which have loss potential, geographic
and industry concentrations, delinquency trends, economic conditions, the level
of originations and other relevant factors. Management also considers loan
quality, changes in the size and character of the loan portfolio, consultation
with regulatory authorities, amount of non-performing loans, delinquency trends,
economic conditions and industry trends when determining the allowance. Along
with higher yields, management believes the shift in loan composition from
residential into commercial and consumer brings higher inherent risk.
Sovereign maintains an allowance for loan losses sufficient to absorb
inherent losses in the loan portfolio and believes the current allowance to be
at a level adequate to cover such inherent losses. The Company gives
consideration to other risk indicators when determining the appropriate
allowance level.
The allowance for loan losses consists of two elements: (i) an allocated
allowance, which is comprised of allowances established on specific loans, and
class allowances based on risk ratings, historical loan loss experience and
current trends, and (ii) unallocated allowances based on both general economic
conditions and other risk factors in the Company's individual markets and
portfolios, and to account for a level of imprecision in management's estimation
process.
The specific allowance element of the allocated allowance is based on a
regular analysis of criticized loans where internal credit ratings are below a
predetermined classification. This analysis is performed at the relationship
manager level, and periodically reviewed by the loan review department. The
specific allowance established for these criticized loans is based on a careful
-31-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
analysis of related collateral value, cash flow considerations and, if
applicable, guarantor capacity.
The class allowance element of the allocated allowance is determined by an
internal loan grading process in conjunction with associated allowance factors.
These class allowance factors are updated as required and are based primarily on
actual historical loss experience, peer group loss experience, and projected
future loss experience. While this analysis is conducted quarterly, the Company
has the ability to revise the class allowance factors whenever necessary in
order to address improving or deteriorating credit quality trends or specific
risks associated with a given loan pool classification.
Regardless of the extent of the Company analysis of customer performance,
portfolio evaluations, trends or risk management processes established, certain
inherent, but undetected losses are probable within the loan portfolio. This is
due to several factors including inherent delays in obtaining information
regarding a customer's financial condition or changes in their unique business
conditions; the judgmental nature of individual loan evaluations, collateral
assessments and the interpretation of economic trends; volatility of economic or
customer-specific conditions affecting the identification and estimation of
losses for larger non-homogeneous credits; and the sensitivity of assumptions
utilized to establish allocated allowances for homogeneous groups of loans among
other factors. The Company maintains an unallocated allowance to recognize the
existence of these exposures. These other risk factors are continuously reviewed
and revised by management where conditions indicate that the estimates initially
applied are different from actual results.
A comprehensive analysis of the allowance for loan losses is performed by
the Company on a quarterly basis. In addition, a review of allowance levels
based on nationally published statistics is conducted on an annual basis. The
Company has an Asset Review Committee, which has the responsibility of affirming
allowance methodology and assessing the general and specific allowance factors
in relation to estimated and actual net charge-off trends. This Committee is
also responsible for assessing the appropriateness of the allowance for loan
losses for each loan pool classification at Sovereign.
Residential Portfolio. The allowance for the residential mortgage portfolio
increased from $20.7 million at December 31, 2001 to $21.3 million at March 31,
2002. This change was due primarily to the addition of the Main Street
residential portfolio and the associated reserves.
Consumer Portfolio. The allowance for the consumer loan portfolio increased
from $61.2 million at December 31, 2001, to $68.1 million at March 31, 2002.
This change was due to increases in loan balances and the addition of the Main
Street consumer loan portfolio and the associated reserves.
Commercial Portfolio. The portion of the allowance for loan losses related
to the commercial portfolio has increased from $161.1 million at December 31,
2001 to $179.7 million at March 31, 2002. This increase is attributable to the
softening economy and increase in non-performing loans in this sector and the
higher level of loans as part of the Main Street acquisition.
-32-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Unallocated Allowance. The unallocated allowance for loan losses decreased
to $17.9 million at March 31, 2002 from $21.7 million at December 31, 2001.
Management continuously evaluates current economic conditions and loan portfolio
trends. A portion of the unallocated reserves were allocated to the commercial
portfolio in keeping with their purpose of availability for uncertainty.
Investment Securities
- ---------------------
Investment securities consist primarily of mortgage-backed securities, U.S.
Treasury and government agency securities, corporate debt securities and stock
in the Federal Home Loan Bank of Pittsburgh ("FHLB") Freddie Mac and Fannie Mae.
Mortgage-backed securities consist of passthroughs and collateralized mortgage
obligations issued by federal agencies or private label issuer. 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/IBCA at the date of issuance. Sovereign purchases classes which are senior
positions backed by subordinate classes. The subordinate classes absorb the
losses and must be completely eliminated before any losses flow through the
senior positions. The effective duration of the total investment portfolio at
March 31, 2002 was 3.66 years.
Total investment securities available-for-sale were $9.6 billion at March
31, 2002 and December 31, 2001. Investment securities held-to-maturity were $821
million at March 31, 2002 compared to $883 million at December 31, 2001. For
additional information with respect to Sovereign's investment securities, see
Notes 3 and 4 in the Notes to Consolidated Financial Statements.
Goodwill and Other Intangible Assets
- ------------------------------------
Goodwill and core deposit intangibles increased by $70 million and $34
million, respectively, due to the Main Street acquisition offset by core deposit
intangible amortization of $20.2 million in 2002.
Deposits
- --------
Sovereign attracts deposits within its primary market area with an offering
of deposit instruments including NOW accounts, money market accounts, savings
accounts, certificates of deposit and retirement savings plans.
Total deposits at March 31, 2002 were $24.8 billion compared to $23.3
billion at December 31, 2001. Average core deposits increased $541 million while
average time deposits declined $117 million as compared to the three-month
period ended December 31, 2001. Sovereign continues to emphasize strategies to
grow core deposits and limit higher priced time deposits.
-33-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Short-term Borrowings
- ---------------------
Sovereign utilizes short-term borrowings (original maturities of up to one
year) as a source of funds for its asset growth and its asset/liability
management. Collateralized advances are available from the FHLB provided certain
standards related to creditworthiness have been met. Sovereign also utilizes
reverse repurchase agreements, which are short-term obligations collateralized
by securities fully guaranteed as to principal and interest by the U.S.
Government or an agency thereof, and federal funds lines with other financial
institutions.
Total short-term borrowings at March 31, 2002 were $2.2 billion compared to
$2.7 billion at December 31, 2001. See Note 7 in the Notes to Consolidated
Financial Statements for additional information.
Long-term Borrowings
- --------------------
Long-term borrowings (original maturities greater than one year) remained
essentially flat at $6.3 billion at March 31, 2002 as compared to December 31,
2001. See Note 8 in the Notes to Consolidated Financial Statements for
additional information.
Trust Preferred Securities
- --------------------------
Sovereign has outstanding $514 million ($548 million par value) of
mandatorily redeemable trust preferred obligations that have stated maturities
ranging from 2027 through 2031 and have stated dividends of 7.50% to 9.875% of
par value. This represents an increase of $10 million from December 31, 2001 and
is due to trust preferred securities acquired with Main Street.
Securitization Transactions
- ---------------------------
Securitization transactions contribute to Sovereign's overall funding and
regulatory capital management. The total face amount of the outstanding debt and
equity securities assumed by third parties at March 31, 2002 approximates $2.6
billion. These transactions involve periodic transfers of loans or other
financial assets to special purpose entities ("SPEs") and are either recorded on
Sovereign's Consolidated Balance Sheet or off-balance sheet depending on whether
the transaction qualifies as a sale of assets in accordance with SFAS 140,
"Transfers of Financial Assets and Liabilities" ("SFAS 140"). No securitizations
were enacted in the three-month period ended March 31, 2002.
Off-Balance Sheet Securitizations
- ---------------------------------
In certain transactions, Sovereign has transferred assets to SPEs
qualifying for non-consolidation ("QSPE") and has retained interests in the
QSPEs. Off-balance sheet QSPEs had $1.7 billion of debt related to assets that
Sovereign sold to the QSPEs which are not included in Sovereign's consolidated
Balance Sheet at March 31, 2002. Sovereign retained interests in such QSPEs were
$97 million at March 31, 2002.
-34-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign does not provide contractual legal recourse to third party
investors that purchase debt or equity securities issued by the QSPEs beyond the
credit enhancement inherent in Sovereign's subordinated interests in the QSPEs.
However, should the performance of the underlying loans held by those QSPEs
deteriorate to a level that retained subordinated interests are insufficient to
collateralize the QSPE securities held by third party investors, Sovereign may
decide to provide the QSPEs with additional credit enhancements to reduce the
third party investors' risk of loss, although it is not contractually required
to do so. If management decides not to provide additional credit enhancements in
such a situation, it could adversely impact the availability and pricing of
future transactions. The performance of the underlying collateral in all of
Sovereign's transactions at March 31, 2002 is sufficient such that management
believes it is unlikely Sovereign will need to provide additional credit
enhancements to these transactions in the future.
Securitizations Consolidated in Sovereign's Consolidated Balance Sheet
- ----------------------------------------------------------------------
In a transaction consummated in November 2001, Sovereign accessed the
liquidity of international markets and transferred $957 million of indirect
automobile loans to SPEs in a financing transaction that does not qualify as a
sale of assets under SFAS 140, and therefore has consolidated both the assets
transferred to the SPEs and the debt and minority interests issued by the SPEs
in its Consolidated Balance Sheet. At March 31, 2002, Sovereign had $821 million
of debt and $64 million of minority interest reflected on its Consolidated
Balance Sheet related to consolidated SPEs.
Additionally, Sovereign will periodically sell qualifying mortgage loans to
FHLMC, GNMA, and FNMA in return for mortgage-backed securities issued by those
agencies. Sovereign reclassifies the net book balance of the loans sold to such
agencies from loans to investment securities held to maturity and available for
sale. For those loans sold to the agencies in which Sovereign retains servicing
rights, Sovereign allocates the net book balance transferred between servicing
rights and investment securities based on their relative fair values.
Minority Interests
- ------------------
In a financing transaction consummated in November 2001, Sovereign received
$64 million from the sale of ownership interests in consolidated SPEs to outside
investors. The SPEs were formed to issue debt and equity interests as parts of a
securitization transaction which raised a total of $885 million for Sovereign.
The controlling interests in the SPEs are reflected as minority interests in
Sovereign's Consolidated Balance Sheet, and the indirect automobile loans and
asset-backed notes remain on Sovereign's Consolidated Balance Sheet as the
entire transaction is considered a financing in accordance with SFAS 140.
On August 21, 2000, Sovereign received approximately $140 million of net
proceeds from the issuance of $161.8 million of 12% Series A Noncumulative
Preferred Interests in Sovereign Real Estate Investment Trust ("SREIT"), a
subsidiary of Sovereign Bank which holds primarily residential real estate
loans. The preferred stock was issued at a discount, which is being amortized
over the life of the preferred shares using the effective yield method. The
preferred shares may be redeemed at any time on or after May 16, 2020, at the
option of
-35-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign subject to the approval of the OTS. Under certain circumstances, the
preferred shares are automatically exchangeable into preferred stock of
Sovereign Bank. The offering was made exclusively to institutional investors;
however, Sovereign expects to register the SREIT preferred shares so that they
may be offered to other investors.
Termination of Employee Stock Ownership Plan
- --------------------------------------------
Sovereign terminated in 2002, the employee stock ownership plan it assumed
upon acquisition of Peoples Bancorp Inc., in 1999. The Plan repaid debt owed to
Sovereign with the proceeds of unallocated Sovereign shares, which the Plan
sold.
Bank Regulatory Capital
- -----------------------
The Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA")
requires institutions regulated by the Office of Thrift Supervision (OTS) to
have a minimum leverage capital ratio equal to 3% of tangible assets, and 4% of
risk-adjusted assets, and a risk-based capital ratio equal to 8% as defined. The
Federal Deposit Insurance Corporation Improvement Act ("FDICIA") requires OTS
regulated institutions to have a minimum tangible capital equal to 2% of total
tangible assets. Management believes, as of March 31, 2002 and December 31,
2001, that Sovereign Bank met all capital adequacy requirements to which they
are subject in order to be well-capitalized.
The FDICIA established five capital tiers: well-capitalized,
adequately-capitalized, undercapitalized, significantly undercapitalized and
critically undercapitalized. A depository institution's capital tier depends
upon its capital levels in relation to various relevant capital measures, which
include leverage and risk-based capital measures and certain other factors.
Depository institutions that are not classified as well-capitalized or
adequately-capitalized are subject to various restrictions regarding capital
distributions, payment of management fees, acceptance of brokered deposits and
other operating activities.
The OTS Order, as amended, applicable to the approval of the New England
Acquisition (the "OTS Order") requires Sovereign Bank to be "Well Capitalized",
and also to meet certain additional capital ratio requirements above the
regulatory minimums, and other conditions. Various agreements with Sovereign's
lenders also require Sovereign Bank to be "Well Capitalized" at all times and in
compliance with all regulatory requirements. To be "well capitalized", a thrift
institution must maintain a Tier 1 Leverage ratio of at least 5%, a Tier 1
risk-based capital ratio of 6% and total risk-based capital of 10%. Although OTS
capital regulations do not apply to savings and loan holding companies, the OTS
Order requires Sovereign to maintain certain Tier 1 capital levels.
At March 31, 2002, Sovereign had met all quantitative thresholds necessary
to be classified as well-capitalized under regulatory guidelines and the OTS
Order.
-36-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Federal banking laws, regulations and policies also limit Sovereign Bank's
ability to pay dividends and make other distributions to Sovereign Bancorp.
Sovereign Bank must obtain prior OTS approval to declare a dividend or make any
other capital distribution if, after such dividend or distribution, Sovereign
Bank's total distributions to the Bancorp within that calendar year would exceed
100% of its net income during the year plus retained net income for the prior
two years, Sovereign Bank would not meet capital levels imposed by the OTS in
connection with any order, including the OTS Order applicable to the New England
Acquisition completed in 2000, as amended, or if Sovereign Bank is not
adequately capitalized at the time. In addition, OTS prior approval would be
required if Sovereign Bank's examination or CRA ratings fall below certain
levels or Sovereign Bank is notified by the OTS that it is a problem association
or an association in troubled condition. The following schedule summarizes the
actual capital balances of Sovereign Bank at March 31, 2002 and December 31,
2001 (in thousands):
TIER 1 TIER 1 TOTAL
REGULATORY CAPITAL TANGIBLE LEVERAGE RISK-BASED RISK-BASED
CAPITAL TO CAPITAL TO CAPITAL TO CAPITAL TO
TANGIBLE TANGIBLE RISK ADJUSTED RISK ADJUSTED
ASSETS ASSETS ASSETS ASSETS
------ ------ ------ ------
Sovereign Bank at March 31, 2002:
Regulatory capital $2,632,813 $2,639,076 $2,539,379 $2,810,806
Minimum capital requirement (1) 710,502 2,486,757 1,054,181 2,767,224
---------- ---------- ---------- ----------
Excess $1,922,311 $ 152,319 $1,485,198 $ 43,582
========== ========== ========== ==========
Capital ratio 7.41% 7.43% 9.64% 10.67%
Sovereign Bank at December 31, 2001:
Regulatory capital $2,464,222 $2,470,620 $2,368,893 $2,616,871
Minimum capital requirement (1) 685,584 2,399,545 979,792 2,571,955
---------- ---------- ---------- ----------
Excess $1,778,638 $ 71,075 $1,389,101 $ 44,916
========== ========== ========== ==========
Capital ratio 7.19% 7.21% 9.67% 10.68%
(1) As defined by OTS Regulations, or the OTS Order, as applicable.
Liquidity and Capital Resources
- -------------------------------
Liquidity represents the ability of Sovereign to obtain cost effective
funding to meet the needs of customers, as well as Sovereign's financial
obligations. Sovereign's primary sources of liquidity include retail deposit
gathering, Federal Home Loan Bank (FHLB) borrowings, federal funds purchases,
reverse repurchase agreements and wholesale deposit purchases. Other sources of
liquidity include asset securitizations, liquid investment portfolio securities
and debt and equity issuances.
Factors which impact the liquidity position of Sovereign include loan
origination volumes, loan prepayment rates, maturity structure of existing
loans, core deposit growth levels, CD maturity structure and retention,
Sovereign's credit ratings, investment portfolio cash flows, maturity structure
of wholesale funding, etc. These risks are monitored and centrally managed. This
process includes reviewing all available wholesale liquidity sources. As of
March 31, 2002, Sovereign had $6.5 billion in available overnight liquidity in
the form of unused federal funds purchased lines, unused FHLB borrowing capacity
and unencumbered investment portfolio securities. Sovereign also forecasts
future liquidity needs and develops strategies to ensure that adequate liquidity
is available at all times.
-37-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
Sovereign Bank has several sources of funding to meet its liquidity
requirements, including the securities portfolio, the core deposit base, the
ability to acquire large deposits and issue public securities in the local and
national markets, FHLB borrowings, federal funds purchased, reverse repurchase
agreements, wholesale deposit purchases and the capability to securitize or
package loans for sale. Sovereign's holding company has the following major
sources of funding to meet its liquidity requirements: dividends and returns of
investment from its subsidiaries, a revolving credit agreement and access to the
capital markets. Sovereign Bank may pay dividends to its parent subject to
approval of the OTS. Sovereign Bank declared and paid dividends to the parent
company of $25 million in 2002. Sovereign also has approximately $900 million of
availability under a shelf registration statement on file with the Securities
and Exchange commission permitting ready access to the public debt and equity
markets. The OTS approved payment of up to $275 million of additional dividends
throughout the remainder of 2002 as long as Sovereign and Sovereign Bank comply
with the covenants contained within their dividend approval request.
Cash and cash equivalents increased $67.5 million for 2002. Net cash
provided by operating activities was $402 million for 2002. Net cash used by
investing activities for 2002 was $680 million and consisted primarily of the
purchase of investments available for sale of $2.5 billion offset by sales of
investments available for sale of $2.0 billion and proceeds from the sales of
loans of $741 million. Net cash used by financing activities for 2002 was $267
million which was primarily due to the repayment of short-term borrowings of
$474 million offset by an increase in deposits of $258 million.
Contractual Obligations and Commercial Commitments
- --------------------------------------------------
Sovereign enters into contractual obligations in the normal course of
business as a source of funds for its asset growth and its asset/liability
management, to fund acquisitions, and to meet required capital needs. These
obligations require Sovereign to make cash payments over time as detailed in the
table below.
Contractual Obligations Payments Due by Period
- ----------------------- ----------------------
Less than After
Total 1 year 1-3 yrs 4-5 yrs 5 yrs
----- ------ ------- ------- -----
Borrowings $ 2,204,609 $2,204,609 $ -- $ -- $ --
Long-term debt:
Securities sold under
repurchase agreements 155,000 -- -- 155,000 --
FHLB advances 4,142,830 350,000 300,700 12,750 3,479,380
Other long-term debt 1,997,850 51,902 379,948 745,000 821,000
Trust Preferred securities 547,500 -- -- -- 547,500
Certificates of deposit 7,719,252 5,510,591 1,986,653 185,354 36,654
Operating leases 648,536 93,325 194,975 220,141 140,095
----------- ---------- ---------- ---------- ----------
Total contractual cash
obligations $17,415,577 $4,956,606 $5,814,796 $1,472,682 $5,171,493
=========== ========== ========== ========== ==========
Certain of Sovereign's contractual obligations require Sovereign to
maintain certain financial ratios and to maintain a "well capitalized"
regulatory status. Sovereign has complied with these covenants as of March 31,
-38-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
2002 and expects to be in compliance with these covenants for the foreseeable
future. However, if in the future Sovereign is not in compliance with these
ratios or is deemed to be other than well capitalized by the OTS, and is unable
to obtain a waiver from its lenders, the debt would be in default and callable
by Sovereign's lenders. Due to cross-default provisions in certain of
Sovereign's debt agreements, if more than $25 million of Sovereign's debt is in
default, $875 million of senior notes and the full amount of the senior secured
credit facility then outstanding will become due in full.
Sovereign is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its customers
and to manage its own exposure to fluctuations in interest rates. These
financial instruments include commitments to extend credit, standby letters of
credit, loans sold with recourse, forward contracts and interest rate swaps,
caps and floors. These financial instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheet. The contract or notional amounts of these
financial instruments reflect the extent of involvement Sovereign has in
particular classes of financial instruments.
Sovereign's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit,
standby letters of credit and loans sold with recourse is represented by the
contractual amount of those instruments. Sovereign uses the same credit policies
in making commitments and conditional obligations as it does for on-balance
sheet instruments. For interest rate swaps, caps and floors and forward
contracts, the contract or notional amounts do not represent exposure to credit
loss. Sovereign controls the credit risk of its interest rate swaps, caps and
floors and forward contracts through credit approvals, limits and monitoring
procedures. Unless noted otherwise, Sovereign does not require and is not
required to pledge collateral or other security to support financial instruments
with credit risk.
Amount of Commitment Expiration Per Period
------------------------------------------
Total
Other Commercial Amounts Less than
Commitments Committed 1 year 1-3 yrs 4-5 yrs Over 5 yrs
----------- --------- ---------- ------- ------- ----------
Commitments to
extend credit $7,034,329 $4,293,059 $ 948,010 $383,361 $1,409,899
Standby letters of credit 727,482 243,758 307,364 131,221 45,139
Loans sold with recourse 53,522 -- -- -- 53,522
Forward contracts 577,533 577,533 -- -- --
---------- ---------- ---------- -------- ----------
Total commercial
commitments $8,392,866 $5,114,350 $1,255,374 $514,582 $1,508,560
========== ========== ========== ======== ==========
Asset and Liability Management
- ------------------------------
Interest rate risk arises primarily through Sovereign's traditional
business activities of extending loans and accepting deposits. Many factors,
including economic and financial conditions, movements in market interest rates
-39-
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
and consumer preferences, affect the spread between interest earned on assets
and interest paid on liabilities. In managing its interest rate risk, Sovereign
seeks to minimize the variability of net interest income across various likely
scenarios while at the same time maximizing its net interest income and net
interest margin. To achieve these objectives, Sovereign works closely with each
business line in the company and guides new business flows. Sovereign also uses
various other tools to manage interest rate risk including wholesale funding
maturity targeting, investment portfolio purchase strategies, asset
securitization/sale, and financial derivatives.
Interest rate risk is managed centrally by the Treasury Group with
oversight by the Asset and Liability Committee. Management reviews various forms
of analysis to monitor interest rate risk including net interest income
sensitivity, market value sensitivity, repricing frequency of assets versus
liabilities and scenario analysis. Numerous assumptions are made to produce
these analyses including, but not limited to, assumptions on new business
volumes, loan and investment prepayment rates, deposit flows, interest rate
curves, economic conditions, and competitor pricing.
Sovereign simulates the impact of changing interest rates on its expected
future interest income and interest expense (net interest income sensitivity).
This simulation is run monthly and it includes nine different stress scenarios.
These scenarios shift interest rates up and down. Certain other scenarios shift
short-term rates up while holding longer-term rates constant and vice versa.
This scenario analysis helps management to better understand its risk and is
used to develop proactive strategies to ensure that Sovereign is not overly
sensitive to the future direction of interest rates. At March 31, 2002 and
December 31, 2001, the general level of interest rates represented a unique
economic environment in which several of Sovereign's declining interest rate
simulation scenarios would not apply. At March 31, 2002, if interest rates
dropped in parallel 100 basis points or rose in parallel 200 basis points,
Sovereign estimates the loss to net interest income to remain under 2.4%.
Sovereign also monitors the relative repricing sensitivities of its assets
versus its liabilities. Management attempts to keep assets and liabilities in
balance so that when interest rates do change, the net interest income of
Sovereign will not experience any significant short-term volatility as a result
of assets repricing more quickly than liabilities or vice versa. As of March 31,
2002, the one year cumulative gap was 8.87%, compared to 9% at December 31, 2001
indicating Sovereign is within policy and could benefit from rising rates.
Finally, Sovereign will calculate the market value of its balance sheet
including all assets, liabilities and hedges. This market value analysis is very
useful because it measures the present value of all estimated future interest
income and interest expense cash flows of the company. Management will calculate
what it calls Net Portfolio Value (NPV) which is the market value of assets
minus
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Continued)
the market value of liabilities. As of March 31, 2002, the NPV as a percentage
of the present value of assets was 10.56% as compared to 11.68% at December 31,
2001. Management will also review the sensitivity of NPV to changes in interest
rates. Management attempts to keep the NPV Ratio relatively constant across
various interest rate scenarios. As of March 31, 2002, a 200 basis point rise in
interest rates would increase the NPV ratio by 1.65% as compared to 1.18% at
December 31, 2001 and a 100 basis point decline in interest rates would decrease
the NPV ratio by .82% as compared to .45% at December 31, 2001.
Because the assumptions used are inherently uncertain, the model cannot
precisely predict the effect of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to the timing,
magnitude and frequency of interest rate changes, the difference between actual
experience and the assumed volume and characteristics of new business and
behavior of existing positions, and changes in market conditions and management
strategies, among other factors.
Pursuant to its interest rate risk management strategy, Sovereign enters
into hedging transactions that involve interest rate exchange agreements (swaps,
caps, and floors) for interest rate risk management purposes. Sovereign's
objective in managing its interest rate risk is to provide sustainable levels of
net interest income while limiting the impact that changes in interest rates
have on net interest income.
Interest rate swaps are generally used to convert fixed rate assets and
liabilities to variable rate assets and liabilities and vice versa. Sovereign
utilizes interest rate swaps that have a high degree of correlation to the
related financial instrument. At March 31, 2002, Sovereign's principal hedging
transactions were to convert liabilities from floating rate to fixed rate for
interest rate risk management purposes.
As part of its mortgage banking strategy, Sovereign originates fixed rate
residential mortgages. It sells the majority of these loans to FHLMC, FNMA, and
private investors. The loans are exchanged for cash or marketable fixed rate
mortgage-backed securities which are generally sold. This helps insulate
Sovereign from the interest rate risk associated with these fixed rate assets.
Sovereign uses forward sales, cash sales and options on mortgage-backed
securities as a means of hedging loans in the mortgage pipeline that are
originated for sale.
To accommodate customer needs, Sovereign enters into customer-related
financial derivative transactions primarily consisting of interest rate swaps,
caps, and floors. Risk exposure from customer positions is managed through
transactions with other dealers.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Incorporated by reference from Part I, Item 2. "Management's Discussion and
Analysis of Results of Operations and Financial Condition - Asset and Liability
Management" hereof.
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Items 1 through 5 not applicable or the responses are negative.
Item 6 - Exhibits and Reports on Form 8-K.
(a) Exhibits
(3.1) Articles of Incorporation, as amended and restated, of Sovereign
Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to
Sovereign's Registration Statement No. 333-86961-01 on Form S-3)
(3.2) By-Laws of Sovereign Bancorp, Inc.
(b) Reports on Form 8-K
None.
-42-
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 May 10, 2002 /s/Jay S. Sidhu
------------------------ -----------------------------------------
Jay S. Sidhu, Chairman,
Chief Executive Officer and President
(Authorized Officer)
Date May 10, 2002 /s/George S. Rapp
------------------------ -----------------------------------------
George S. Rapp
Chief Accounting Officer
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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
EXHIBITS INDEX
(3.1) Articles of Incorporation, as amended and restated, of Sovereign
Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to
Sovereign's Registration Statement No. 333-86961-01 on Form S-3)
(3.2) By-Laws of Sovereign Bancorp, Inc.
-44-