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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 June 30, 2002
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934 for the transition period from _______________
to_________________.
Commission File Number: 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 August 9, 2002
- ------------------------------- ------------------------------
Common Stock (no par value) 260,942,008 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, operating earnings and cash 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, customer
retention, asset quality and reserve adequacy.
These forward-looking statements, implicitly and explicitly, include the
assumptions underlying the statements. Although Sovereign believes that the
expectations reflected in these forward-looking statements are reasonable, these
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 June 30, 2002
and December 31, 2001 6
Consolidated Statements of Operations for the three-month and
six-month periods ended June 30, 2002 and 2001 7
Consolidated Statement of Stockholders' Equity for
the six-month period ended June 30, 2002 9
Consolidated Statements of Cash Flows for the six-month
periods ended June 30, 2002 and 2001 10
Notes to Consolidated Financial Statements 11 - 21
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 22 - 42
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 42
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 43
Item 6. Exhibits and Reports on Form 8-K 43
SIGNATURES 44
EXHIBITS INDEX 45
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
2002 2001
-------------- --------------
(Unaudited)
(in thousands, except
per share data)
ASSETS
Cash and amounts due from
depository institutions $ 953,258 $ 887,964
Interest-earning deposits 108,317 19,315
Investment securities:
Available-for-sale 10,735,785 9,581,679
Held-to-maturity
(fair value approximates $773,456 and $883,208
at June 30, 2002 and December 31, 2001,
respectively) 761,480 883,437
Loans (including loans held for sale
at approximate fair value of
$140,156 and $308,950 at June 30, 2002
and December 31, 2001, respectively) 21,937,613 20,399,584
Allowance for loan losses (287,741) (264,667)
Premises and equipment 276,660 251,587
Accrued interest receivable 195,982 183,913
Goodwill 1,025,292 954,688
Core deposit intangible 382,889 389,216
Bank owned life insurance 722,806 706,175
Other assets 1,425,442 1,481,947
------------ ------------
TOTAL ASSETS $ 38,237,783 $ 35,474,838
============ ============
LIABILITIES
Deposits and other customer accounts $ 25,602,935 $ 23,297,574
Borrowings 2,732,032 2,678,764
Long-term debt 6,275,186 6,261,006
Advance payments by borrowers
for taxes and insurance 26,166 20,943
Other liabilities 454,853 409,542
------------ ------------
TOTAL LIABILITIES 35,091,172 32,667,829
------------ ------------
Company-obligated mandatorily redeemable
preferred securities of subsidiary trust
holding junior subordinated debentures of
Sovereign ("Trust Preferred Securities") 405,679 404,136
Minority interests-preferred securities of subsidiaries 200,340 200,392
STOCKHOLDERS' EQUITY
Common stock; no par value; 400,000,000 shares
authorized; 265,116,473 shares issued at
June 30, 2002 and 252,386,163 shares
issued at December 31, 2001 1,573,942 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 June 30, 2002
and 4,247,873 shares at December 31, 2001 (23,177) (30,945)
Treasury stock at cost; 232,262 shares at
June 30, 2002 and 108,792 shares at
December 31, 2001 (2,215) (515)
Restricted stock at cost; 379,834 shares at June 30,
2002 and 559,791 shares at December 31, 2001 (4,256) (6,272)
Accumulated other comprehensive loss (7,299) (33,135)
Retained earnings 912,097 765,581
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 2,540,592 2,202,481
------------ ------------
TOTAL LIABILITIES, MINORITY INTERESTS
AND STOCKHOLDERS' EQUITY $ 38,237,783 $ 35,474,838
============ ============
See accompanying notes to consolidated financial statements.
- 6 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
----------------------- -----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
(in thousands, except
per share data)
INTEREST INCOME:
Interest-earning deposits $ 978 $ 340 $ 2,918 $ 854
Investment securities:
Available-for-sale 158,638 120,432 299,336 227,199
Held-to-maturity 12,351 18,052 25,884 37,449
Interest and fees on loans 353,809 418,783 692,465 871,951
---------- ---------- ---------- ----------
TOTAL INTEREST INCOME 525,776 557,607 1,020,603 $1,137,453
---------- ---------- ---------- ----------
INTEREST EXPENSE:
Interest on deposits
and other customer accounts 116,295 192,981 227,305 414,095
Interest on borrowings and
other debt 112,476 106,303 224,364 217,555
---------- ---------- ---------- ----------
TOTAL INTEREST EXPENSE 228,771 299,284 451,669 631,650
---------- ---------- ---------- ----------
NET INTEREST INCOME 297,005 258,323 568,934 505,803
Provision for loan losses 28,000 23,100 72,500 43,100
---------- ---------- ---------- ----------
NET INTEREST INCOME AFTER PROVISION FOR
LOAN LOSSES 269,005 235,223 496,434 462,703
---------- ---------- ---------- ----------
NON-INTEREST INCOME:
Consumer banking fees 44,243 39,480 82,806 78,912
Commercial banking fees 23,554 17,762 46,305 36,027
Mortgage banking revenues 6,609 14,757 16,075 36,071
Capital markets revenue 1,808 2,427 5,145 5,896
Bank owned life insurance 10,644 9,922 20,933 19,667
Miscellaneous income 5,588 31,433 8,152 37,158
---------- ---------- ---------- ----------
TOTAL FEES AND OTHER INCOME 92,446 115,781 179,416 213,731
---------- ---------- ---------- ----------
Gain on investment securities and
related derivatives transactions 3,841 5,752 24,407 13,096
---------- ---------- ---------- ----------
TOTAL NON-INTEREST INCOME 96,287 121,533 203,823 226,827
---------- ---------- ---------- ----------
GENERAL AND ADMINISTRATIVE EXPENSES:
Compensation and benefits 89,476 81,087 173,408 158,717
Occupancy and equipment expenses 49,984 51,656 100,271 105,621
Technology expense 17,715 18,769 34,355 34,788
Outside services 12,631 14,854 24,083 28,553
Other administrative expenses 33,105 33,614 62,754 61,787
---------- ---------- ---------- ----------
TOTAL GENERAL AND ADMINISTRATIVE EXPENSES 202,911 199,980 394,871 389,466
---------- ---------- ---------- ----------
- 7 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(continued)
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
----------------------- -----------------------
2002 2001 2002 2001
-------- --------- -------- --------
(in thousands, except
per share data)
OTHER EXPENSES:
Amortization of intangibles,
including goodwill in 2001 $ 20,457 $ 32,788 $ 40,691 $ 68,864
Trust Preferred Securities and
other minority interest expense 15,906 14,590 31,464 29,074
Merger-related and integration charges - - 15,871 -
Non-solicitation expense - 72,216 - 144,432
Restructuring expense - - - 8,500
-------- --------- -------- --------
TOTAL OTHER EXPENSES 36,363 119,594 88,026 250,870
-------- --------- -------- --------
INCOME BEFORE INCOME TAXES
AND EXTRAORDINARY ITEM 126,018 37,182 217,360 49,194
Income tax provision 33,635 7,000 58,035 7,900
-------- --------- -------- --------
Income before extraordinary item 92,383 30,182 159,325 41,294
Extraordinary item - Early debt extinguishment
(net of tax of $3,526 - 2001) - - - (6,549)
-------- --------- -------- --------
NET INCOME $ 92,383 $ 30,182 $159,325 $ 34,745
======== ======== ======== ========
EARNINGS PER SHARE:
Basic
Income before extraordinary item $ .35 $ .12 $ .62 $ .17
Extraordinary item - - - (.03)
-------- --------- -------- --------
NET INCOME $ .35 $ .12 $ .62 $ .14
======== ======== ======== ========
Diluted
Income before extraordinary item $ .33 $ .12 $ .58 $ .17
Extraordinary item - - - (.03)
-------- --------- -------- --------
NET INCOME $ .33 $ .12 $ .58 $ .14
======== ======== ======== ========
DIVIDENDS DECLARED PER COMMON SHARE $ .025 $ .025 $ .050 $ .050
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 - - - 159,325 - -
Change in unrecognized gain/
(loss) net of tax:
Investments available-for-sale - - - - - -
Derivative financial instruments - - - - - -
Total comprehensive income - - - - - -
Acquisition of Main Street Bancorp 11,367 148,578 - - (3,116) -
Contingent purchase payout --
Network Leasing 166 8 - - 1,993 -
Exercise of stock options 944 6,368 - - - -
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan 160 2,027 - - - -
Dividends paid on common stock - - - (12,809) - -
Treasury stock purchases (64) - - - (815) -
Treasury stock sold 34 130 - - 309 -
Vesting and allocation of shares
for restricted stock plan 180 - - - (71) 2,016
Termination of Employee Stock
Ownership Plan 621 564 - - - -
------- ----------- --------- --------- -------- --------
Balance, June 30, 2002 260,878 $ 1,573,942 $ 91,500 $ 912,097 $ (2,215) $ (4,256)
======= =========== ========= ========= ======== ========
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 - - 159,325
Change in unrecognized gain/
(loss) net of tax:
Investments available-for-sale - 70,707 70,707
Derivative financial instruments - (44,871) (44,871)
Total comprehensive income - - 185,161
Acquisition of Main Street Bancorp - - 145,462
Contingent purchase payout --
Network Leasing - - 2,001
Exercise of stock options - - 6,368
Sale of stock under Dividend
Reinvestment Plan and Employee
Stock Purchase Plan - - 2,027
Dividends paid on common stock - - (12,809)
Treasury stock purchases - - (815)
Treasury stock sold - - 439
Vesting and allocation of shares
for restricted stock plan - - 1,945
Termination of Employee Stock
Ownership Plan 7,768 - 8,332
--------- --------- -----------
Balance, June 30, 2002 $ (23,177) $ (7,299) $ 2,540,592
========= ========= ===========
See accompanying notes to consolidated financial statements.
- 9 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Six-month Period
Ended June 30,
--------------------------
2002 2001
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES: (in thousands)
Net income $ 159,325 $ 34,745
Adjustments to reconcile net income to
net cash provided by operating activities:
Provision for loan losses 72,500 43,100
Deferred taxes 26,652 (38,327)
Depreciation and amortization 63,624 64,587
Net amortization/(accretion) of investment
securities and loan premiums 10,660 9,456
(Gain)/loss on sale of investment
securities and related derivatives (24,407) (13,342)
(Gain)/loss on real estate owned 124 123
(Gain)/loss on sale of fixed assets (190) (688)
Loss on the retirement of Bancorp debt - 10,075
Restricted stock compensation expense 2,016 -
Net change in:
Loans held for sale 168,794 199,831
Accrued interest receivable (7,014) 28,857
Other assets and bank owned life insurance (180,521) (107,194)
Other liabilities 16,358 (77,999)
----------- -----------
Net cash provided(used) by operating activities 307,921 153,224
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities:
Available-for-sale 3,423,601 2,704,924
Proceeds from repayments and maturities of
investment securities:
Available-for-sale 1,150,066 673,523
Held-to-maturity 133,447 139,315
Purchases of investment securities:
Available-for-sale (5,326,116) (4,793,933)
Held-to-maturity - (1,224)
Proceeds from sales of loans 1,249,438 1,953,368
Purchase of loans (938,872) (1,480,113)
Net change in loans other than purchases and sales (1,085,964) (340,778)
Proceeds from sales of premises and equipment 1,476 20,793
Purchases of premises and equipment (16,531) (7,497)
Proceeds from sale of real estate owned 12,164 3,069
Net cash (paid)received due to acquisitions 207,704 -
----------- -----------
Net cash provided(used) by investing activities (1,189,587) (1,128,553)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease)/increase in deposits
and other customer accounts 1,045,783 (1,157,955)
Net increase/(decrease) in borrowings 53,268 1,562,621
Net increase/(decrease) in long-term debt (72,784) 513,674
Proceeds from senior secured credit facility
and senior and subordinated notes 20,000 525,000
Repayments of senior secured credit facility
and senior and subordinated notes (20,000) (590,000)
Net increase in advance payments by
borrowers for taxes and insurance 5,223 195
Cash dividends paid to stockholders (12,809) (12,200)
Proceeds from issuance of common stock 8,533 152,460
Termination of ESOP 8,332 -
Net change in treasury and restricted stock 416 (3,112)
----------- -----------
Net cash provided(used) by financing activities 1,035,962 990,683
----------- -----------
Net change in cash and cash equivalents 154,296 15,354
Cash and cash equivalents at beginning of period 907,279 959,643
----------- -----------
Cash and cash equivalents at end of period $ 1,061,575 $ 974,997
=========== ===========
Supplemental Disclosures:
Income tax payments totaled $87 million for the six-month period ended June 30,
2002 and $10 million for the same period in 2001. Interest payments totaled $438
million for the six-month period ended June 30, 2002 and $632 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
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 six-month period ended June 30, 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.
On July 19, 2002, Sovereign announced its intention to adopt the expense
recognition provisions of Statement of Financial Accounting Standards No. 123
"Accounting for Stock Based Compensation" beginning in the third quarter 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 for purposes of calculating weighted
average dilutive shares used to determine diluted earnings per share.
The following table presents the computation of earnings per share for the
periods indicated (in thousands, except per share data).
Three-Month Period Six-Month Period
Ended June 30, Ended June 30,
---------------------- ----------------------
2002 2001 2002 2001
-------- -------- -------- ---------
CALCULATION OF INCOME FOR EPS:
- -----------------------------
Income before extraordinary
item for basic EPS $ 92,383 $ 30,182 $159,325 $ 41,294
Extraordinary item, after tax - - - (6,549)
-------- -------- -------- --------
Net income for basic and diluted EPS $ 92,383 $ 30,182 $159,325 $ 34,745
======== ======== ======== ========
WEIGHTED AVERAGE SHARES FOR EPS:
- -------------------------------
Weighted average basic shares 260,513 246,684 255,694 242,314
Dilutive effect of average stock
options and warrants 21,710 15,513 20,576 8,477
-------- -------- -------- --------
Weighted average diluted shares 282,223 262,197 276,270 250,791
======== ======== ======== ========
EARNINGS PER SHARE:
- ------------------
Basic
Income before extraordinary item $ .35 $ .12 $ .62 $ .17
Extraordinary item - - - (.03)
-------- -------- -------- --------
Net income $ .35 $ .12 $ .62 $ .14
======== ======== ======== ========
Diluted
Income before extraordinary item $ .33 $ .12 $ .58 $ .17
Extraordinary item - - - (.03)
-------- -------- -------- --------
Net income $ .33 $ .12 $ .58 $ .14
======== ======== ======== ========
- 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)
June 30, 2002
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
----------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 32,304 $ 400 $ 56 $ 32,648
Corporate debt and
asset-backed securities 912,289 9,389 4,057 917,621
Equities (1) 1,051,790 2,519 123 1,054,186
State and municipal
securities 27,876 2,485 - 30,361
Mortgage-backed securities:
U.S. government agencies 5,887,147 78,279 4,061 5,961,365
Non-agencies 2,701,668 39,608 1,672 2,739,604
----------- -------- ------- -----------
Total investment securities
available-for-sale $10,613,074 $132,680 $ 9,969 $10,735,785
=========== ======== ======= ===========
December 31, 2001
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
----------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 23,109 $ 93 $ 23 $ 23,179
Corporate debt and
asset-backed securities 322,813 5,357 14,310 313,860
Equities (1) 790,391 2,631 160 792,862
State and municipal
securities 22,452 1,942 2 24,392
Mortgage-backed securities:
U.S. government agencies 6,625,498 34,371 33,828 6,626,041
Non-agencies 1,783,485 23,062 5,202 1,801,345
---------- ------- ------- ----------
Total investment securities
available-for-sale $9,567,748 $67,456 $53,525 $9,581,679
========== ======= ======= ==========
(1) Equity investments consist principally of FHLB, FHLMC, and FNMA common
and preferred stock.
- 13 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(4) INVESTMENT SECURITIES HELD-TO-MATURITY
The following table presents the composition and fair value of investment
securities held-to-maturity at the dates indicated: (dollars in thousands)
June 30, 2002
-----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
----------- ------------ ------------ -----
Investment Securities:
U.S. Treasury and
government agency
securities $ 1,705 $ 60 $ - $ 1,765
State and municipal
securities 1,723 36 4 1,755
Mortgage-backed securities:
U.S. government agencies 753,457 16,132 4,225 765,364
Non-agencies 4,595 39 62 4,572
-------- -------- ------- --------
Total investment securities
held-to-maturity $761,480 $ 16,267 $ 4,291 $773,456
======== ======== ======= ========
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)
June 30, 2002 December 31, 2001
----------------------- ------------------------
Amount Percent Amount Percent
Commercial real estate loans $ 3,784,692 17.3% $ 3,082,330 15.1%
Commercial and industrial loans 4,758,043 21.7 4,506,198 22.1
Other 1,084,302 4.9 975,075 4.8
----------- ------ ----------- ------
Total Commercial Loans 9,627,037 43.9 8,563,603 42.0
----------- ------ ----------- ------
Home equity loans 4,589,785 20.9 3,756,621 18.4
Auto loans 3,076,608 14.0 2,880,449 14.1
Other 196,951 .9 193,692 .9
----------- ------ ----------- ------
Total Consumer Loans 7,863,344 35.8 6,830,762 33.4
----------- ------ ----------- ------
Residential Real Estate Loans 4,447,232 20.3 5,005,219 24.6
----------- ------ ----------- ------
Total Loans (1) (2) $21,937,613 100.0% $20,399,584 100.0%
=========== ====== =========== ======
Total Loans with:
Fixed rate $12,713,081 58.0% $12,875,742 63.1%
Variable rate 9,224,532 42.0 7,523,842 36.9
----------- ------ ----------- ------
Total Loans (1) $21,937,613 100.0% $20,399,584 100.0%
=========== ====== =========== ======
(1) Loan totals are net of deferred loan fees of $39 million for June 30, 2002
and $41 million for December 31, 2001.
(2) Loan totals are net of unamortized premium/(discount) of $6 million and
$(9) million for June 30, 2002 and December 31, 2001, respectively.
Loans to related parties include loans made to certain officers, directors
and their affiliated interests. At June 30, 2002 and December 31, 2001, loans to
related parties totaled $31.8 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)
June 30, 2002 December 31, 2001
------------------------------- ---------------------------------
Weighted Weighted
Average Average
Account Type Amount Percent Rate Amount Percent Rate
- ------------ ------ ------- -------- ------ ------- ---------
Demand deposit accounts $ 4,174,254 16% -% $ 3,910,171 17% - %
NOW accounts 4,972,711 19 1.24 4,162,169 18 0.87
Savings accounts 3,104,766 12 1.38 2,985,464 13 1.44
Money market accounts 5,774,899 23 1.99 4,992,163 21 1.73
Retail certificates 7,203,542 28 3.59 6,985,397 30 4.14
Jumbo certificates 372,763 2 2.98 262,210 1 3.04
----------- ---- ----------- ---
Total Deposits $25,602,935 100% 1.91% $23,297,574 100% 1.99%
=========== ==== ===== =========== === =====
(7) BORROWINGS
The following table presents information regarding borrowings with original
maturities of up to one year at the dates indicated: (dollars in thousands)
June 30, 2002 December 31, 2001
---------------------- ------------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- ---- ------- ----
Federal funds purchased $ - -% $ 452,002 1.75%
Securities sold under
repurchase agreements 273,032 1.84 297,741 1.45
FHLB advances 2,459,000 2.15 1,929,021 3.08
---------- ----------
Total Borrowings $2,732,032 2.12% $2,678,764 2.67%
========== ==== ========== ====
(8) LONG-TERM DEBT
Long-term debt with original maturities greater than one year consisted of
the following: (dollars in thousands)
June 30, 2002 December 31, 2001
-------------------- -----------------------
Weighted Weighted
Average Average
Balance Rate Balance Rate
------- ---- ------- ----
Securities sold under
repurchase agreements $ 155,000 4.71% $ 155,000 4.71%
FHLB advances 4,142,759 5.27 4,105,929 5.28
Senior secured credit facility 225,000 4.53 225,000 5.72
Asset-backed floating rate notes 821,000 2.22 821,000 2.51
Senior and subordinated notes 931,427 9.90 954,077 9.92
---------- ----------
$6,275,186 5.52% $6,261,006 5.63%
========== ===== ========== ====
- 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, for the periods indicated: (dollars in thousands)
Three-month Period Six-Month Period
Ended June 30, Ended June 30,
---------------------- ----------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Net income $ 92,383 $ 30,182 $ 159,325 $ 34,745
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 (58,602) 2,807 (44,871) 2,888
Investment securities available-for-sale 104,993 (29,370) 86,561 (1,649)
Less reclassification adjustment:
Derivative instruments - - - 35
Investments available-for-sale 2,494 3,584 15,854 8,545
--------- --------- --------- ---------
Net unrealized gain recognized
in other comprehensive income 43,897 (30,147) 25,836 (17,292)
--------- --------- --------- ---------
Comprehensive income $ 136,280 $ 35 $ 185,161 $ 17,453
========= ========= ========= =========
Accumulated other comprehensive loss, net of related tax, consisted of net
unrealized gains on securities of $79.8 million and net unrealized losses on
derivatives of $87.1 million at June 30, 2002 and net unrealized losses on
securities of $48.7 million and net unrealized losses on derivatives of $7.1
million at June 30, 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 mitigate the impact of interest rate movements on the
value of certain liabilities and on probable future cash outflows. These
instruments primarily include interest rate swaps 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 interest rate environment. On January 1, 2001,
the Company adopted SFAS No. 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 No. 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 changes in fair values of certain brokered CDs and senior notes. In May
2002, Sovereign implemented $400 million of pay-fixed interest rate swaps in
accordance with its interest rate risk management strategies. All of Sovereign's
interest rate swaps accounted for as fair value hedges outstanding as of June
30, 2002 satisfied the criteria in SFAS No. 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.
These hedges effectively converted fixed rate brokered CDs to 1 month LIBOR
floating rate CDs.
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. All of Sovereign's interest rate swaps accounted
for as cash flow hedges outstanding as of June 30, 2002, satisfied the criteria
in SFAS No. 133 to use the short-cut method of accounting for changes in fair
value. These hedges effectively converted 3 month borrowings to longer term
fixed rate borrowings.
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. During the six months ended
June 30, 2002, the Company terminated $1.4 billion of pay-fixed interest rate
swaps that were hedging the future cash flows on $1.4 billion of FHLB advances
resulting in a loss of $26.5 million (after-tax). Because the future cash flows
are still probable of occurring, the loss has been deferred in accumulated other
comprehensive income and will be reclassified into earnings as the future cash
flows occur.
Other Derivative Activities. Sovereign's derivative activities also include
derivative instruments not included in SFAS No. 133 hedge relationships such as
interest rate swaps, interest rate futures, forward sales, foreign exchange
futures, and fixed income options in accordance with Sovereign's investment
policy. This policy is periodically reviewed and updated by management and is
approved by Sovereign Bank's Board of Directors. Those derivatives are used by
Sovereign for risk management purposes and to facilitate the risk management
strategies of its customers.
Net gains generated from derivative instruments executed with customers are
included as capital markets revenue on the income statement and totaled $2.9
million for the six-months ended June 30, 2002.
(11) GOODWILL AND CORE DEPOSIT INTANGIBLE ASSETS
The Company adopted Statement of Financial Accounting Standards No. 142 -
Goodwill and Other Intangible Assets ("SFAS No. 142") and discontinued
amortizing goodwill effective January 1, 2002. Under SFAS No. 142 goodwill and
indefinite lived intangible assets are no longer amortized but are reviewed
annually for impairment. Separable intangible assets that are not deemed to have
an indefinite life continue to be amortized over their useful lives. No
impairment charges were required to be recorded through June 30, 2002 as a
result of adoption of this statement. If an impairment loss is determined in the
future, the loss will be reflected in expense in the statement of operations in
the period in which impairment is determined. The Company 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.
- 18 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
The estimated aggregate amortization expense related to core deposit
intangibles for each of the five succeeding calendar years ending December 31,
is:
Calendar Remaining
Year Recorded Amount
Year Amount To Date To Record
- ---- ------ ------- ---------
2002 $80,274 $40,691 $39,583
2003 73,835 - 73,835
2004 66,856 - 66,856
2005 57,945 - 57,945
2006 51,047 - 51,047
The following table reflects the components of intangible assets (in
thousands):
Gross Carrying Accumulated
Amount Amortization
------------------------------- ----------------------------
June 30, December 31, June 30, December 31,
2002 2001 2002 2001
---- ---- ---- ----
Non-amortized intangible
assets:
Goodwill $1,156,945 $1,086,341 $131,653 $131,653
Amortized intangible assets:
Core Deposit Intangibles 642,543 608,179 259,654 218,963
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 Six-months ended
June 30, June 30,
----------------------- ------------------------
2002 2001 2002 2001
---------- ---------- ----------- ----------
Reported income before
extraordinary item $ 92,383 $ 30,182 $ 159,325 $ 41,294
Add back goodwill amortization,
net of tax - 7,381 - 14,251
---------- ---------- ----------- ----------
Proforma income before
extraordinary item $ 92,383 $ 37,563 $ 159,325 $ 55,545
========== ========== =========== ==========
Proforma net income $ 92,383 $ 37,563 $ 159,325 $ 48,996
========== ========== =========== ==========
Reported diluted EPS before
extraordinary item $ .33 $ .12 $ .58 $ .17
Add back goodwill amortization,
net of tax - .03 - .06
---------- ---------- ----------- ----------
Proforma diluted EPS before
extraordinary item $ .33 $ .15 $ .58 $ .23
========== ========== =========== ==========
Proforma diluted EPS $ .33 $ .15 $ .58 $ .20
========== ========== =========== ==========
- 19 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(12) PURCHASE OF MAIN STREET BANCORP, INC. ("MAIN STREET")
On March 8, 2002 Sovereign completed the purchase of Main Street, a
commercial bank holding company headquartered in Reading, Pennsylvania, and the
results of its operations are included subsequent to the purchase date.
Collectively, Main Street shareholders elected to receive approximately 85% of
the purchase price in Sovereign common stock and 15% in cash. Sovereign issued
11.4 million shares of common stock, net of 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 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 Total deposits 1,255.2
Residential 165.6 Borrowings and long-term debt 86.9
---------
Total loans 845.3 Other liabilities 23.7
Less allowance for loan losses (14.9) Trust preferred securities 10.0
--------- --------
Total loans, net 830.4
Federal funds and cash 239.3 Total liabilities $1,375.8
Premises and equipment, net 26.0 ========
Other real estate owned 0.8
Prepaid expenses and other assets 14.9
Core deposit intangible 34.4
Goodwill 69.6
--------
Total assets $1,521.3
========
In connection with the Main Street acquisition, Sovereign recorded charges
against its earnings for the three-month period ended March 31, 2002 and the
six-month period ended June 30, 2002 for an additional loan loss provision of
$6.0 million pre-tax ($3.9 million net of tax) to conform Main Street's
allowance for loan losses to Sovereign's reserve policies and for merger related
expenses of $15.9 million pre-tax ($10.3 million net of tax).
These merger-related expenses include the following:
Community grants $ 1,000
Branch and office consolidations 11,338
Account conversion and other 3,533
-------
$15,871
=======
- 20 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(continued)
(13) SUBSEQUENT EVENT
On July 19, 2002, Sovereign announced its intention to adopt the expense
recognition provisions of Statement of Financial Accounting Standards No. 123
(SFAS No. 123) "Accounting for Stock Based Compensation" for stock based
employee compensation awards during the third quarter ending September 30, 2002.
Management made this election since it now believes, in light of recent events,
it is the preferable method of accounting in this area. Sovereign will estimate
the fair value of our option grants and expense this value over the vesting
periods as required in SFAS No. 123. The recognition transition provisions of
SFAS No. 123 require that it be applied to all awards granted after the
beginning of the fiscal year in which the recognition provisions are first
applied. As a result, reported quarterly results in the year of adoption must be
restated. The Company is in the process of finalizing its calculations of the
effect of this change in accounting principle. Based on the analysis to date,
the Company expects that the effect will be to lower reported net income for the
six-month period ended June 30, 2002 between $4 and $5 million. Additionally,
third and fourth quarter net income are each expected to be reduced by
approximately $2.5 million. Based on our recent stock option grant history, we
do not expect the issuance of grants in the third and fourth quarter to have a
material impact to results reported in the last two quarters of 2002.
- 21 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
RESULTS OF OPERATIONS
- ---------------------
General
- -------
Net income, including special charges discussed below, was $159.3 million,
or $.58 per share, for the six-month period ended June 30, 2002, as compared to
$34.7 million, or $.14 per share, for the same period in 2001. Cash earnings, as
defined below, for the six-month period ended June 30, 2002 increased 8% to
$202.0 million, or $.73 per share, up from $187.6 million, or $.75 per share,
for the same period in 2001. Operating earnings for 2002 increased 23% to $173.5
million, or $.63 per share, as compared to $140.7 million, or $.56 per share,
for 2001.
Operating earnings exclude certain special charges for 2002 and 2001.
Special charges for the six months ended June 30, 2002 and 2001 were $14.2
million and $106.0 million, respectively, after tax, and are outlined in the
Reconciliation of Net Income to Operating and Cash Earnings table on the
following page. Cash Earnings are operating earnings excluding amortization
(after-tax) of intangible assets and ESOP-related expense.
Cash return on average equity and cash return on average total assets,
excluding special charges discussed above, were 17.11% and 1.12% for the
six-month period ended June 30, 2002 compared to 18.25% and 1.13% for the same
period in 2001.
Effective January 1, 2002, the Company ceased to amortize goodwill in
accordance with SFAS No. 142 (see Note 11 in Notes to Consolidated Financial
Statements). Had SFAS No. 142 been applied as of January 1, 2001, net income and
operating earnings would have increased by $7.4 million and $14.3 million for
the three-months ended and the six-months ended June 30, 2001, respectively.
Critical Accounting Policies
- ----------------------------
Our significant accounting policies are described in Note 1 to the December
31, 2001 consolidated financial statements filed on Form 10-K. The preparation
of financial statements in accordance with accounting principles generally
accepted in the United States requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses, and disclosure of contingent assets and liabilities. Actual
results could differ from those estimates. We have identified accounting for the
allowance for credit losses, securitizations, and goodwill as our most critical
accounting policies and estimates in that they are important to the portrayal of
our financial condition and results, and they require management's most
difficult, subjective or complex judgments as a result of the need to make
estimates about the effect of matters that are inherently uncertain. These
accounting policies, including the nature of the estimates and types of
assumptions used, are described throughout this Management's Discussion and
Analysis and the December 31, 2001 Management's Discussion and Analysis filed on
Form 10-K.
- 22 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Reconciliation of Net Income to Operating and Cash Earnings
-----------------------------------------------------------
(In thousands, except per share data - all amounts are after tax)
Three-month Period Six-Month Period
Ended June 30, Ended June 30,
--------------------------------------- -------------------------------------
Total Per Share Total Per Share
--------------------------------------- -------------------------------------
2002 2001 2002 2001 2002 2001 2002 2001
---- ---- ---- ---- ---- ---- ---- ----
Net income as reported $ 92,383 $30,182 $.33 $.12 $159,325 $ 34,745 $.58 $.14
Loss on the early extinguish-
ment of debt - - - - - 6,549 - .03
Main Street Bancorp acquisition:
Merger-related and
integration costs - - - - 10,316 - .04 -
Provision for loan losses - - - - 3,900 - .01 -
Restructuring expense - - - - - 5,525 - .02
Non-solicitation expense - 46,940 - .17 - 93,881 - .37
-------- ------- ---- ---- -------- -------- ---- ----
Operating earnings $ 92,383 $77,122 $.33 $.29 $173,541 $140,700 $.63 $.56
======== ======= ==== ==== ======== ======== ==== ====
Amortization of intangibles $ 13,839 $21,962 $.05 $.09 $ 27,307 $ 46,061 $.10 $.19
ESOP expense 575 484 - - 1,176 882 - -
-------- ------- ---- ---- -------- -------- ---- ----
Cash earnings $106,797 $99,568 $.38 $.38 $202,024 $187,643 $.73 $.75
======== ======= ==== ==== ======== ======== ==== ====
Weighted average
diluted shares 282,223 262,197 276,270 250,791
- 23 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
CONSOLIDATED AVERAGE BALANCE SHEET /
TAX EQUIVALENT NET INTEREST MARGIN ANALYSIS
SIX-MONTH PERIOD ENDED JUNE 30, 2002 and 2001
(in thousands)
2002 2001
--------------------------------------- -------------------------------------------
Tax Tax
Average Equivalent Yield/ Average Equivalent Yield/
Balance Interest Rate Balance Interest Rate
--------------------------------------- -------------------------------------------
EARNING ASSETS
- --------------
INVESTMENTS $10,582,311 $ 335,770 6.36% $ 7,584,628 $ 270,296 7.14%
LOANS:
Commercial loans 9,107,620 276,040 6.07% 8,189,022 323,484 7.92%
Consumer loans 7,375,186 252,852 6.91% 6,446,535 270,118 8.45%
Residential loans 4,803,865 166,040 6.91% 7,231,291 280,872 7.77%
----------- ---------- ----- ----------- ---------- -----
Total loans 21,286,671 694,932 6.55% 21,866,848 874,474 8.03%
Allowance for loan losses (282,849) - - (253,662) - -
----------- ---------- ----- ----------- ---------- -----
NET LOANS 21,003,822 694,932 6.64% 21,613,186 874,474 8.12%
----------- ---------- ----- ----------- ---------- -----
TOTAL EARNING ASSETS 31,586,133 1,030,702 6.55% 29,197,814 1,144,770 7.87%
Other assets 4,780,244 - - 4,419,740 - -
----------- ---------- ----- ----------- ---------- -----
TOTAL ASSETS $36,366,377 $1,030,702 5.68% $33,617,554 $1,144,770 6.83%
=========== ========== ===== =========== ========== =====
FUNDING LIABILITIES
- -------------------
DEPOSITS:
Core deposits $16,876,174 $ 91,632 1.09% $15,093,504 $ 163,386 2.18%
Time deposits 7,477,328 135,673 3.66% 8,784,649 250,709 5.75%
----------- ---------- ----- ----------- ---------- -----
TOTAL DEPOSITS 24,353,502 227,305 1.88% 23,878,153 414,095 3.50%
----------- ---------- ----- ----------- ---------- -----
BORROWED FUNDS:
FHLB advances 6,070,281 153,663 5.05% 5,218,772 144,167 5.50%
Repurchase agreements 448,085 5,752 2.55% 323,250 7,500 4.61%
Other borrowings 1,981,427 64,950 6.56% 1,344,231 65,888 9.82%
----------- ---------- ----- ----------- ---------- -----
TOTAL BORROWED FUNDS 8,499,793 224,365 5.27% 6,886,253 217,555 6.30%
----------- ---------- ----- ----------- ---------- -----
TOTAL FUNDING LIABILITIES 32,853,295 451,670 2.76% 30,764,406 631,650 4.12%
Other liabilities 1,132,397 - - 779,710 - -
----------- ---------- ----- ----------- ---------- -----
TOTAL LIABILITIES 33,985,692 451,670 3.67% 31,544,116 631,650 4.02%
STOCKHOLDERS' EQUITY 2,380,685 - - 2,073,438 - -
- -------------------- ----------- ---------- ----- ----------- ---------- -----
TOTAL LIABILITIES
AND STOCKHOLDERS' EQUITY $36,366,377 $ 451,670 2.49% $33,617,554 $ 631,650 3.77%
=========== ========== ===== =========== ========== =====
NET INTEREST INCOME $ 579,032 $ 513,120
========== ==========
NET INTEREST SPREAD (1) 3.19% 3.06%
===== =====
NET INTEREST MARGIN (2) 3.68% 3.52%
===== =====
(1) Represents the difference between the yield on total assets and the cost of
total liabilities and stockholders' equity.
(2) Represents taxable equivalent net interest income divided by average
interest-earning assets.
- 24 -
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 and six-month periods ended June
30, 2002 was $297 million and $569 million compared to $258 million and $506
million for the same periods in 2001. This increase was attributable to an
increase in average balances, and improvements of 12 and 16 basis points in net
interest margin for the three-month and six-month periods ended June 30, 2002,
respectively, over the same periods in 2001. Net interest margin was 3.72% and
3.68% for the three-month and six-month periods ended June 30, 2002 compared to
3.60% and 3.52% for the same periods in 2001. Net interest margin has been
stable over the past four quarters despite volatility of market rates. The
increase in average balances is a result of core deposit growth and greater uses
of the Company's increased capital position.
Interest on investment securities and interest earning deposits was $172
million and $328 million for the three-month and six-month periods ended June
30, 2002 compared to $139 million and $266 million for the same periods in 2001.
The average balance of investment securities was $10.6 billion with an average
tax equivalent yield of 6.36% for the six-month period ended June 30, 2002
compared to an average balance of $7.6 billion with an average yield of 7.14%
for the same period in 2001.
Interest and fees on loans were $354 million and $692 million for the
three-month and six-month periods ended June 30, 2002 compared to $419 million
and $872 million for the same periods in 2001. The average balance of loans was
$21.3 billion with an average yield of 6.55% for the six-month period ended June
30, 2002 compared to an average balance of $21.9 billion with an average yield
of 8.03% for the same period in 2001. Average balances of commercial and
consumer loans in 2002 each increased $0.9 billion as compared to 2001 primarily
due to the Main Street acquisition, while average residential loans declined
$2.4 billion. These changes are consistent with Sovereign's strategy to
emphasize commercial and consumer lending and include the impact of the Main
Street acquisition. The decrease in loan rates is due to declining market
interest rates and the aforementioned shift in the components of the loan
portfolio, which now includes more variable rate and shorter maturity assets.
Interest on deposits was $116 million and $227 million for the three-month
and six-month periods ended June 30, 2002 compared to $193 million and $414
million for the same periods in 2001. The average balance of deposits was $24.4
billion with an average cost of 1.88% for the six-month period ended June 30,
2002 compared to an average balance of $23.9 billion with an average cost of
3.50% for the same period in 2001. The decrease in average cost year to year is
due to a combination of declining market interest rates and the Company's
emphasis on attracting and retaining core deposits.
Interest on borrowed funds was $112 million and $224 million for the
three-month and six-month periods ended June 30, 2002 compared to $106 million
and $218 million for the same periods in 2001. The average balance of borrowings
was $8.5 billion with an average cost of 5.27% for the six-month period ended
June 30, 2002 compared to an average balance of $6.9 billion with an average
cost of 6.30% for the same period in 2001. Wholesale borrowings are currently an
attractive source of funding to support the growth of Sovereign's earning
assets.
- 25 -
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 and six-month periods ended June 30, 2002
was $28.0 million and $72.5 million compared to $23.1 and $43.1 million for the
same periods in 2001.
The increase over 2001 was based on several factors:
o One large commercial loan totaling $17.1 million impacted the
provision in both the first and second quarters through downgrade and
subsequent charge-offs aggregating $15.5 million. This loan should not
require further charge-offs.
o In the first quarter, a $2.3 million charge-off was taken associated
with the sale of $20.5 million in non-performing residential
mortgages, and a $6 million provision was taken relative to Main
Street acquisition.
o An increase in adversely classified loans during the first and second
quarters. This increase was driven by the commercial portfolios, where
overall business conditions remained less than favorable.
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 six-month period ended June 30, 2002
were $64.3 million and consisted of charge-offs of $83.6 million and recoveries
of $19.3 million. This compared to net charge-offs of $43.4 million consisting
of charge-offs of $62.6 million and recoveries of $19.2 million for the
six-month period ended June 30, 2001. The increased level of charge-offs was
driven by the events discussed above.
- 26 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The following table presents the activity in the allowance for possible
loan losses for the periods indicated: (dollars in thousands)
Six-month Period Ended June 30,
2002 2001
---------------------------------
Allowance, beginning of period $ 264,667 $ 256,356
Charge-offs:
Residential 4,433 5,841
Commercial 43,135 20,968
Consumer 36,023 35,770
--------- ---------
Total Charge-offs 83,591 62,579
--------- ---------
Recoveries:
Residential 304 1,859
Commercial 2,281 985
Consumer 16,703 16,327
--------- ---------
Total Recoveries 19,288 19,171
--------- ---------
Charge-offs, net of recoveries 64,303 43,408
Provision for possible loan losses 72,500 43,100
Main Street's allowance for loan losses 14,877 -
--------- ---------
Allowance, end of period $ 287,741 $ 256,048
========= =========
Non-Interest Income
- -------------------
Total non-interest income was $96.3 million and $203.8 million for the
three-month and six-month periods ended June 30, 2002 compared to $121.5 million
and $226.8 million for the same periods in 2001. Excluding securities and
related derivatives transactions, total fees and other income for the
three-month and six-month periods ended June 30, 2002 were $92.4 million and
$179.4 million as compared to $115.8 million and $213.7 million for the same
periods in 2001.
Consumer banking fees were $44.2 million and $82.8 million for the
three-month and six-month periods ended June 30, 2002 as compared to $39.5
million and $78.9 million for the same periods in 2001. Average core deposit
balances have grown 12% over the past year due to the success of recent product
initiatives and the Main Street acquisition. This increase in consumer banking
fees of $4.7 million and $3.9 million is attributed to the increase in the
number of core deposit accounts and balances.
Commercial banking fees were $23.6 million and $46.3 million for the
three-month and six-month periods ended June 30, 2002 as compared to $17.8
million and $36.0 million for the same periods in 2001. This increase of $5.8
million and $10.3 million was primarily due to higher loan volumes, increased
market share and increased cash management fee income.
Mortgage banking revenue was $6.6 million and $16.1 million for the
three-month and six-month periods ended June 30, 2002 as compared to $14.8
million and $36.1 million for the same periods in 2001. The second quarter of
2002 includes a charge of $1.7 million to increase the valuation allowance
related to mortgage servicing rights. The first quarter of 2001 includes a gain
of $19.3 million
- 27 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
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
$2.9 million on lower refinancing activity.
Miscellaneous income was $5.6 million and $8.2 million for the three-month
and six-month periods ended June 30, 2002 compared to $31.4 million and $37.2
million for the same periods in 2001. The three and six months ended June 30,
2001 includes a $28.1 million gain related to the sale of branches located in
southern New Jersey, Delaware and eastern Pennsylvania.
Gain on investment securities and related derivatives transactions were
$3.8 million and $24.4 million for the three-month and six-month period ended
June 31, 2002 compared to $5.8 million and $13.1 million for the same periods in
2001. During the first quarter of 2002, the Company repositioned its investment
portfolio with the sale of $1.1 billion of investment securities resulting in a
gain of approximately $20 million. Additional investment securities were
purchased late in the first quarter and had a higher weighted average yield and
a shorter blended effective duration than the investments sold.
General and Administrative Expenses
- -----------------------------------
General and administrative expenses for the three-month and six-month
periods ended June 30, 2002 were $202.9 million and $394.9 million, compared to
$200.0 million and $389.5 million for the same periods in 2001 an increase of
$2.9 million and $5.4 million or 1.47% and 1.39%. Compensation costs increased
due to insourcing of certain technology services, normal annual increases, and
the Main Street acquisition. Expense reduction initiatives have favorably
impacted occupancy and outside services.
Other operating expenses were $36.4 million and $88.0 million for the
three-month and six-month periods ended June 30, 2002 compared to $119.6 million
and $250.9 million for the same periods in 2001. The six-month period ended June
30, 2001, includes $144.4 million of non-solicitation expense related to the
non-solicitation provisions of the New England purchase and assumption
agreement. In 2000, Sovereign acquired certain businesses from Fleet Boston
Financial as more fully described in the 2001 Annual Report on Form 10-K, the
"New England Acquisition". Also during the six-month period ended June 30, 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.
Results for the three-month and six-month periods ended June 30, 2002
included amortization of core deposit intangibles of $20.5 million and $40.7
million compared to $32.8 million and $68.9 million for amortization of goodwill
and core deposit intangibles for the same periods 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. No
- 28 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
impairment charges were required to be recorded through June 30, 2002 as a
result of adoption of this statement. 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.
Income Tax Provision
- --------------------
The income tax provision was $33.6 million and $58.0 million for the
three-month and six-month periods ended June 30, 2002 compared to $7.0 million
and $7.9 million for the same periods in 2001. The effective tax rate for the
three-month and six-month periods ended June 30, 2002 was 26.7%, compared to
18.8% and 16.1% for the same periods in 2001. The current year tax rate differs
from the statutory rate of 35% due to income from tax-exempt investments and
income related to bank-owned life insurance. The effective tax rate for the 2001
quarter is not meaningful due to the high proportion of permanent tax
differences, in relation to the low level of recorded pretax income.
Extraordinary Item
- ------------------
In last year's reported results, Sovereign completed a $400 million term
and revolving credit facility with Bank of Scotland of which $350 million was
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.
Pending Change in Stock Option Accounting
- -----------------------------------------
On July 19, 2002, Sovereign announced its intention to adopt the expense
recognition provisions of Statement of Financial Accounting Standards No. 123
(SFAS No. 123) "Accounting for Stock Based Compensation" for stock based
employee compensation awards in the third quarter ending September 30, 2002.
Management made this election since it now believes, in light of recent events
it is the preferable method of accounting in this area. Sovereign will estimate
the fair value of our option grants and expense this value over the vesting
period as required in SFAS No. 123. The recognition transition provisions of
SFAS No. 123 require that it be applied to all awards granted after the
beginning of the fiscal year in which the recognition provisions are first
applied. As a result, reported quarterly results in the year of adoption must be
restated. The Company is in the process of finalizing its calculations of the
effect of this change in accounting principle. Based on the analysis to date,
the Company expects that the effect will lower reported net income for the
six-month period ended June 30, 2002 by between $4 and $5 million. Additionally,
third and fourth quarter net income are each expected to be reduced by
approximately $2.5 million. Based on our recent stock option grant history, we
do not expect the issuance of grants in the third and fourth quarter to have a
material impact to results reported in the last two quarters of 2002.
- 29 -
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 June 30, 2002, commercial loans totaled $9.6 billion representing 44% of
Sovereign's loan portfolio, compared to $8.6 billion and 42% of the loan
portfolio at December 31, 2001 and $8.3 billion and 40% of the loan portfolio at
June 30, 2001.
The consumer loan portfolio (including home equity loans and lines of
credit, automobile loans, and other consumer loans) totaled $7.9 billion at June
30, 2002, representing 36% of Sovereign's loan portfolio, compared to $6.8
billion and 33% of the loan portfolio at December 31, 2001 and $6.7 billion and
32% of the loan portfolio at June 30, 2001. The increase in the commercial and
consumer portfolios is due to our increased emphasis on these loan types and
de-emphasizing residential mortgage loans.
Residential mortgage loans decreased $558 million to $4.4 billion at June
30, 2002 and now represent 20% of Sovereign's loan portfolio as compared to $5.0
billion and 25% at December 31, 2001. The decrease is primarily due to scheduled
payments and prepayments. At June 30, 2001 residential mortgage loans totaled
$5.8 billion representing 28% of the loan portfolio.
Non-Performing Assets
- ---------------------
At June 30, 2002 Sovereign's non-performing assets increased by $14.6
million to $242.6 million compared to $228.0 million at December 31, 2001. This
increase is due to increases in non-performing commercial loans, which follows
the increase in adversely classified commercial loans previously mentioned.
These increases are partially offset by a decline in residential non-performing
loans as a result of the sale of certain residential assets in the first quarter
of 2002 and second quarter declines in both consumer and residential
non-performing assets. Non-performing assets as a percentage of total assets was
..63% at June 30, 2002, down from .64% at December 31, 2001. At June 30, 2002,
53% of non-performing assets consisted of consumer, commercial real estate and
residential loans and OREO which are primarily secured by real estate and other
collateral as compared to 61% at December 31, 2001. 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 placed on
non-accrual status and anticipated losses are fully reserved, unless they are
real estate loans evaluated to be well secured based on appraisals and are in
the process of collection. At 180 days delinquent, anticipated losses on real
estate loans are fully reserved or charged off.
- 30 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
The following table presents the composition of non-performing assets at
the dates indicated: (dollars in thousands)
June 30, December 31,
2002 2001
-------- ------------
Non-accrual loans:
Residential $ 55,634 $ 74,552
Commercial real estate 29,564 16,957
Commercial 112,302 89,399
Consumer 27,376 26,941
-------- --------
Total non-accrual loans 224,876 207,849
-------- --------
Restructured loans 1,305 1,280
-------- --------
Total non-performing loans 226,181 209,129
Other real estate owned 10,728 9,261
Other repossessed assets 5,711 9,667
-------- --------
Total non-performing assets $242,620 $228,057
======== ========
Past due 90 days or more as to interest
or principal and accruing interest (1) $ 36,513 $ 54,599
Non-performing assets as a percentage
of total assets .63% .64%
Non-performing loans as a percentage
of total loans 1.03% 1.03%
Non-performing assets as a percentage of
total loans and real estate owned 1.11% 1.12%
Allowance for loan losses as a percentage
of total non-performing assets 118.6% 116.1%
Allowance for loan losses as a percentage
of total non-performing loans 127.2% 126.6%
(1) Includes consumer and residential loans of $33.7 million and $51.0 million
at June 30, 2002 and December 31, 2001, respectively.
Loans ninety (90) days or more past due and still accruing interest fell
by $18 million from December 31, 2001 to June 30, 2002. Ninety day delinquencies
fell in all three categories, but primarily the decrease is due to a reduction
in residential 90 day loans ($11.4 million) that are well secured and in the
process of collection, and a reduction in consumer 90 day past due loans ($5.9
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 $100 million and
$120 million at June 30, 2002 and December 31, 2001, respectively.
- 31 -
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)
June 30, 2002 December 31, 2001
----------------------- -----------------------
% of Loans % of Loans
to to
Amount Total Loans Amount Total Loans
------ ----------- ------ -----------
Allocated allowance:
Commercial loans $182,675 44% $162,720 42%
Consumer loans 68,480 36 59,555 33
Residential real estate mortgage loans 19,024 20 20,724 25
Unallocated allowance 17,562 n/a 21,668 n/a
-------- ----- -------- ------
Total allowance for loan losses $287,741 100% $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 workout department. The
specific allowance established for these criticized loans is based on a careful
- 32 -
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; customer fraud, the judgmental nature of individual loan
evaluations, collateral assessments and the interpretation of economic trends;
volatility of economic or customer-specific conditions affecting the
identification and estimation of losses for larger non-homogeneous credits; and
the sensitivity of assumptions utilized to establish allocated allowances for
homogeneous groups of loans among other factors. The Company maintains an
unallocated allowance to recognize the existence of these exposures. These other
risk factors are continuously reviewed and revised by management where
conditions indicate that the estimates initially applied are different from
actual results.
A comprehensive analysis of the allowance for loan losses is performed by
the Company on a quarterly basis. In addition, a review of allowance levels
based on nationally published statistics is conducted on an annual basis. The
Company has an Asset Review Committee, which has the responsibility of affirming
allowance methodology and assessing the general and specific allowance factors
in relation to estimated and actual net charge-off trends. This Committee is
also responsible for assessing the appropriateness of the allowance for loan
losses for each loan pool classification at Sovereign.
Commercial Portfolio. The portion of the allowance for loan losses related
--------------------
to the commercial portfolio has increased from $162.7 million at December 31,
2001 to $182.7 million at June 30, 2002. This increase is warranted by the
softening economy, the increase in non-performing and adversely classified loans
in this sector and the addition of loans in part due to the Main Street
acquisition.
Consumer Portfolio. The allowance for the consumer loan portfolio increased
------------------
from $59.6 million at December 31, 2001, to $68.5 million at June 30, 2002. This
change was due to increases in loan balances and the addition of the Main Street
consumer loan portfolio and the associated reserves.
Residential Portfolio. The allowance for the residential mortgage portfolio
---------------------
decreased from $20.7 million at December 31, 2001 to $19.0 million at June 30,
2002. This change was due primarily to the reduction in size of the overall
residential portfolio.
- 33 -
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 $17.6 million at June 30, 2002 from $21.7 million at December 31, 2001.
Management continuously evaluates current economic conditions and loan portfolio
trends. However, this balance is subject to significant changes each reporting
period due to certain inherent but undetected losses that are probable within
the loan portfolio. This is due to several factors including delays in obtaining
information regarding a customer's financial condition or changes in their
unique business conditions; the judgmental nature of individual loan
evaluations, collateral assessments and the interpretation of economic trends;
volatility of economic or customer conditions and the sensitivity of assumptions
utilized to establish allocated allowances for homogeneous groups of loans among
other factors. We maintain an unallocated allowance to recognize the existence
of these exposures.
Investment Securities
- ---------------------
Investment securities consist primarily of mortgage-backed securities, U.S.
Treasury and government agency securities, corporate debt securities and stock
in the Federal Home Loan Bank of Pittsburgh ("FHLB"), Freddie Mac and Fannie
Mae. Mortgage-backed securities consist of pass-throughs and collateralized
mortgage obligations issued by federal agencies or private label issuers.
Approximately 70% of Sovereign's portfolio is invested in fixed rate 15 year and
30 year mortgage pass-throughs. Sovereign's mortgage-backed securities are
generally either guaranteed as to principal and interest by the issuer or have
ratings of "AAA" by Standard and Poor's and Moody's at the date of issuance.
Sovereign purchases classes which are senior positions backed by subordinate
classes. The subordinate classes absorb the losses and must be completely
eliminated before any losses flow through the senior positions. The effective
duration of the total investment portfolio at June 30, 2002 was 3.13 years.
Total investment securities available-for-sale were $10.7 billion at June
30, 2002 and $9.6 billion at December 31, 2001. Investment securities
held-to-maturity were $761 million at June 30, 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 Core Deposit Intangible Assets
- -------------------------------------------
Goodwill increased by $70.6 million and core deposit intangibles increased
by $34.4 million due to the Main Street acquisition offset by year-to-date core
deposit intangible amortization of $40.7 million in 2002.
Deposits
- --------
Sovereign attracts deposits within its primary market area with an offering
of deposit instruments including demand accounts, NOW accounts, money market
accounts, savings accounts, certificates of deposit and retirement savings
plans.
Total deposits at June 30, 2002 were $25.6 billion compared to $23.3
billion at December 31, 2001. Sovereign continues to emphasize strategies to
grow core deposits and limit higher priced time deposits.
- 34 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Borrowings
- ----------
Sovereign utilizes borrowings (original maturities of up to one year) as a
source of funds for its asset growth and its asset/liability management.
Collateralized advances are available from the FHLB provided certain standards
related to creditworthiness have been met. Sovereign also utilizes reverse
repurchase agreements, which are short-term obligations collateralized by
securities fully guaranteed as to principal and interest by the U.S. Government
or an agency thereof, and federal funds lines with other financial institutions.
Total borrowings at both June 30, 2002 and December 31, 2001 were $2.7
billion. See Note 7 in the Notes to Consolidated Financial Statements for
additional information.
Long-Term Debt
- --------------
Long-term debt with original maturities greater than one year remained
essentially flat at $6.3 billion at June 30, 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 $406 million ($507 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 $1.5 million from December 31, 2001
and is due to discount amortization of $1.4 million, $10.0 million of trust
preferred securities acquired with Main Street offset by an open market
repurchase of $7.1 million of trust preferred securities of Sovereign Capital
Trust I and Main Line Capital Trust I.
As discussed in our 2001 annual report on Form 10-K in Note 12, Sovereign
has outstanding a preferred capital security (Trust Preferred II) and associated
warrants whose balance totaled $192.4 million and $91.5 million, respectively at
June 30, 2002. Sovereign may elect to redeem the Trust Preferred II securities
and the warrants, if the value of Sovereign's common stock on 20 trading days
out of the preceding 30 consecutive trading days and on the day the election is
made exceeds $14.99 after November 20, 2002.
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 June 30, 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 No. 140,
"Transfers of Financial Assets and Liabilities" ("SFAS No. 140"). No new
securitizations were enacted in the six-month period ended June 30, 2002.
- 35 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
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 $1.5 billion of
debt related to assets that Sovereign sold to the QSPEs which is not included in
Sovereign's consolidated Balance Sheet at June 30, 2002. Sovereign retained
interests in such QSPEs were $100 million at June 30, 2002. Sovereign does not
provide contractual legal recourse to third party investors that purchase debt
or equity securities issued by the QSPEs beyond the credit enhancement inherent
in Sovereign's subordinated interests in the QSPEs.
Securitizations Consolidated in Sovereign's Consolidated Balance Sheet - In
a transaction consummated in November 2001, the "November 2001 transaction",
Sovereign accessed the liquidity of international markets and transferred $957
million of indirect automobile loans to SPEs in a financing transaction that did
not qualify as a sale of assets under SFAS No. 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 June 30,
2002, Sovereign had $821 million of debt and $64 million of minority interest
reflected on its Consolidated Balance Sheet related to consolidated SPEs. See
"Minority Interests" below.
Additionally, Sovereign will periodically sell qualifying mortgage loans to
FHLMC, GNMA, and FNMA in return for mortgage-backed securities issued by those
agencies. Sovereign reclassifies the net book balance of the loans sold to such
agencies from loans to investment securities held to maturity and available for
sale. For those loans sold to the agencies in which Sovereign retains servicing
rights, Sovereign allocates the net book balance transferred between servicing
rights and investment securities based on their relative fair values.
Minority Interests
- ------------------
As part of the November 2001 transaction, 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 No. 140.
On August 21, 2000, Sovereign received approximately $140 million of net
proceeds from the issuance of $161.8 million of 12% Series A Non-cumulative
Preferred Interests in Sovereign Real Estate Investment Trust ("SREIT"), a
subsidiary of Sovereign Bank which holds primarily residential real estate
loans. The preferred stock was issued at a discount, which is being amortized
over the life of the preferred shares using the effective yield method. The
preferred shares may be redeemed at any time on or after May 16, 2020, at the
option of Sovereign subject to the approval of the OTS. Under certain
circumstances, the preferred shares are automatically exchangeable into
preferred stock of Sovereign Bank.
- 36 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Termination of Employee Stock Ownership Plan
- --------------------------------------------
Sovereign 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 June 30, 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 June 30, 2002, Sovereign and Sovereign Bank had met all quantitative
thresholds necessary to be classified as well-capitalized under regulatory
guidelines and the OTS Order.
Federal banking laws, regulations and policies also limit Sovereign Bank's
ability to pay dividends and make other distributions to Sovereign Bancorp.
Sovereign Bank is required to give prior notice to the OTS before paying any
dividend. In addition Sovereign Bank must obtain prior OTS approval to declare a
dividend or make any other capital distribution if, after such dividend or
distribution, Sovereign Bank's total distributions to the Bancorp within that
calendar year would exceed 100% of its net income during the year plus retained
net income for the prior two years, Sovereign Bank would not meet capital levels
imposed by the OTS in connection with any order, including the OTS Order
applicable to the New England Acquisition completed in
- 37 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
2000, as amended, or if Sovereign Bank is not adequately capitalized at the
time. In addition, OTS prior approval would be required if Sovereign Bank's
examination or CRA ratings fall below certain levels or Sovereign Bank is
notified by the OTS that it is a problem association or an association in
troubled condition. The following schedule summarizes the actual capital
balances of Sovereign Bank at June 30, 2002 and December 31, 2001 (in
thousands):
TIER 1 TIER 1 TOTAL
REGULATORY CAPITAL TANGIBLE LEVERAGE RISK-BASED RISK-BASED
CAPITAL TO CAPITAL TO CAPITAL TO CAPITAL TO
TANGIBLE TANGIBLE RISK ADJUSTED RISK ADJUSTED
ASSETS ASSETS ASSETS ASSETS
------ ------ ------ ------
Sovereign Bank at June 30, 2002:
Regulatory capital $2,712,399 $2,718,254 $2,622,597 $2,896,531
Minimum capital requirement (1) 736,038 2,576,134 1,087,698 2,855,206
---------- ---------- ---------- ----------
Excess $1,976,361 $ 142,120 $1,534,899 $ 41,325
========== ========== ========== ==========
Capital ratio 7.37% 7.39% 9.64% 10.65%
Sovereign Bank at December 31, 2001:
Regulatory capital $2,464,222 $2,470,620 $2,368,893 $2,616,871
Minimum capital requirement (1) 685,584 2,399,545 979,792 2,571,955
---------- ---------- ---------- ----------
Excess $1,778,638 $ 71,075 $1,389,101 $ 44,916
========== ========== ========== ==========
Capital ratio 7.19% 7.21% 9.67% 10.68%
(1) Minimum capital requirement to be well capitalized as defined by OTS
Regulations, or the OTS Order, whichever is higher.
Liquidity and Capital Resources
- -------------------------------
Liquidity represents the ability of Sovereign to obtain cost effective
funding to meet the needs of customers, as well as Sovereign's financial
obligations. Sovereign's primary sources of liquidity include retail deposit
gathering, Federal Home Loan Bank (FHLB) borrowings, federal funds purchases,
reverse repurchase agreements and wholesale deposit purchases. Other sources of
liquidity include asset securitizations, liquid investment portfolio securities
and debt and equity issuances.
Factors which impact the liquidity position of Sovereign include loan
origination volumes, loan prepayment rates, maturity structure of existing
loans, core deposit growth levels, CD maturity structure and retention,
Sovereign's credit ratings, investment portfolio cash flows, maturity structure
of wholesale funding, etc. These risks are monitored and centrally managed. This
process includes reviewing all available wholesale liquidity sources. As of June
30, 2002, Sovereign had $6.9 billion in available overnight liquidity in the
form of unused federal funds purchased lines, unused FHLB borrowing capacity and
unencumbered investment portfolio securities. Sovereign also forecasts future
liquidity needs and develops strategies to ensure that adequate liquidity is
available at all times.
Sovereign's holding company has the following major sources of funding to
meet its liquidity requirements: dividends and returns of investment from its
subsidiaries, a revolving credit agreement and access to the capital markets.
Sovereign Bank may pay dividends to its parent subject to approval of the OTS,
as discussed above. Year-to-date Sovereign Bank declared and paid dividends to
the parent company of $80 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
- 38 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
equity markets. The OTS has approved payment of up to $220 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 $154.3 million for 2002. Net cash
provided by operating activities was $307.9 million for 2002. Net cash used by
investing activities for 2002 was $1.2 billion and consisted primarily of the
purchase of investments available for sale of $5.3 billion offset by sales,
repayments and maturities of investments available for sale of $4.6 billion and
proceeds from the sales of loans of $1.2 billion. Net cash provided by financing
activities for 2002 was $1.0 billion which was primarily due to an increase in
deposits.
Contractual Obligations and Commercial Commitments
- --------------------------------------------------
Sovereign enters into contractual obligations in the normal course of
business as a source of funds for its asset growth and its asset/liability
management, to fund acquisitions, and to meet required capital needs. These
obligations require Sovereign to make cash payments over time as detailed in the
table below.
Contractual Obligations Payments Due by Period
- ----------------------- ----------------------
(in thousands of dollars) Less than Over 1 yr Over 3 yrs Over
Total 1 year to 3 yrs to 5 yrs 5 yrs
----- ------ -------- -------- -----
Borrowings $ 2,732,032 $2,732,032 $ - $ - $ -
Securities sold under
repurchase agreements 155,000 - - 155,000 -
FHLB advances 4,142,759 350,000 300,700 13,058 3,479,001
Other debt 1,977,427 50,359 425,285 680,783 821,000
Trust Preferred securities 506,869 - - - 506,869
Certificates of deposit 7,576,305 4,414,852 2,849,889 200,466 111,098
Operating leases 797,779 105,440 294,256 97,032 301,051
----------- ---------- ---------- --------- ----------
Total contractual cash
obligations $17,888,171 $7,652,683 $3,870,130 $1,146,339 $5,219,019
=========== ========== ========== ========== ==========
Certain of Sovereign's contractual obligations require Sovereign to
maintain certain financial ratios and to maintain a "well capitalized"
regulatory status. Sovereign has complied with these covenants as of June 30,
2002 and expects to be in compliance with these covenants for the foreseeable
future. However, if in the future Sovereign is not in compliance with these
ratios or is deemed to be other than well capitalized by the OTS, and is unable
to obtain a waiver from its lenders, the debt would be in default and callable
by Sovereign's lenders. Due to cross-default provisions in certain of
Sovereign's debt agreements, if more than $25 million of Sovereign's debt is in
default, $875 million of senior notes and the full amount of the senior secured
credit facility then outstanding will become due in full.
- 39 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Sovereign is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its customers
and to manage its own exposure to fluctuations in interest rates. These
financial instruments include commitments to extend credit, standby letters of
credit, loans sold with recourse, forward contracts and interest rate swaps,
caps and floors. These financial instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheet. The contract or notional amounts of these
financial instruments reflect the extent of involvement Sovereign has in
particular classes of financial instruments.
Sovereign's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit,
standby letters of credit and loans sold with recourse is represented by the
contractual amount of those instruments. Sovereign uses the same credit policies
in making commitments and conditional obligations as it does for on-balance
sheet instruments. For interest rate swaps, caps and floors and forward
contracts, the contract or notional amounts do not represent exposure to credit
loss. Sovereign controls the credit risk of its interest rate swaps, caps and
floors and forward contracts through credit approvals, limits and monitoring
procedures. Unless noted otherwise, Sovereign does not require and is not
required to pledge collateral or other security to support financial instruments
with credit risk.
Amount of Commitment Expiration Per Period
------------------------------------------
Total
Other Commercial Amounts Less than Over 1 yr Over 3 yrs Over
Commitments Committed 1 year to 3 yrs to 5 yrs 5 yrs
----------- --------- ---------- --------- ---------- ----------
Commitments to
extend credit $7,562,803 $4,537,948 $1,048,314 $348,226 $1,628,315
Standby letters of credit 844,921 258,261 144,188 392,513 49,959
Loans sold with recourse 24,964 - - - 24,964
Forward contracts 864,544 739,544 100,000 25,000 -
---------- ---------- ---------- -------- ----------
Total commercial
commitments $9,297,232 $5,535,753 $1,292,502 $765,739 $1,703,238
========== ========== ========== ======== ==========
Asset and Liability Management
- -----------------------------
Interest rate risk arises primarily through Sovereign's traditional
business activities of extending loans and accepting deposits. Many factors,
including economic and financial conditions, movements in market interest rates
and consumer preferences, affect the spread between interest earned on assets
and interest paid on liabilities. In managing its interest rate risk, Sovereign
seeks to minimize the variability of net interest income across various likely
scenarios while at the same time maximizing its net interest income and net
interest margin. To achieve these objectives, Sovereign works closely with each
business line in the company and guides new business flows. Sovereign also uses
various other tools to manage interest rate risk including wholesale funding
maturity targeting, investment portfolio purchase strategies, asset
securitization/sale, and financial derivatives.
- 40 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Interest rate risk is managed centrally by the Treasury Group with
oversight by the Asset and Liability Committee. Management reviews various forms
of analysis to monitor interest rate risk including net interest income
sensitivity, market value sensitivity, repricing frequency of assets versus
liabilities and scenario analysis. Numerous assumptions are made to produce
these analyses including, but not limited to, assumptions on new business
volumes, loan and investment prepayment rates, deposit flows, interest rate
curves, economic conditions, and competitor pricing.
Sovereign simulates the impact of changing interest rates on its expected
future interest income and interest expense (net interest income sensitivity).
This simulation is run monthly and it includes nine different stress scenarios.
These scenarios shift interest rates up and down. Certain other scenarios shift
short-term rates up while holding longer-term rates constant and vice versa.
This scenario analysis helps management to better understand its short-term
interest rate risk and is used to develop proactive strategies to ensure that
Sovereign is not overly sensitive to the future direction of interest rates. At
June 30, 2002 and December 31, 2001, the general level of interest rates
represented a unique economic environment in which several of Sovereign's
declining interest rate simulation scenarios would not apply. At June 30, 2002,
if interest rates dropped in parallel 100 basis points Sovereign estimates that
net interest income would fall 3.4%. Alternatively, if interest rates rose in
parallel 200 basis points, estimated net interest income would increase 7.1%.
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 June 30,
2002, the one year cumulative gap was 8%, compared to 9% at December 31, 2001
indicating Sovereign could benefit from rising rates.
Finally, Sovereign calculates the market value of its balance sheet
including all assets, liabilities and hedges. This market value analysis is very
useful because it measures the present value of all estimated future interest
income and interest expense cash flows of the company. Net Portfolio Value (NPV)
is used to assess long-term interest rate risk. A higher NPV ratio indicates
lower long-term interest rate risk and a more valuable franchise. As of June 30,
2002, the NPV as a percentage of the present value of assets was 12.28% as
compared to 11.68% at December 31, 2001. Management reviews the sensitivity of
NPV to changes in interest rates. As of June 30, 2002, a 200 basis point rise in
interest rates would increase the NPV ratio by .88% as compared to 1.18% at
December 31, 2001 and a 100 basis point decline in interest rates would decrease
the NPV ratio by .68% as compared to .45% at December 31, 2001.
Because the assumptions used are inherently uncertain, Sovereign cannot
precisely predict the effect of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to the timing,
magnitude and frequency of interest rate changes, the difference between actual
experience and the assumed volume and characteristics of new business and
behavior of existing positions, and changes in market conditions and management
strategies, among other factors.
- 41 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations (Continued)
Pursuant to its interest rate risk management strategy, Sovereign enters
into hedging transactions that involve interest rate exchange agreements (swaps,
caps, and floors) for interest rate risk management purposes. Sovereign's
objective in managing its interest rate risk is to provide sustainable levels of
net interest income while limiting the impact that changes in interest rates
have on net interest income.
Interest rate swaps are generally used to convert fixed rate assets and
liabilities to variable rate assets and liabilities and vice versa. Sovereign
utilizes interest rate swaps that have a high degree of correlation to the
related financial instrument. At June 30, 2002, Sovereign's principal hedging
transactions were to convert liabilities from floating rate to fixed rate for
interest rate risk management purposes.
As part of its mortgage banking strategy, Sovereign originates fixed rate
residential mortgages. It sells the majority of these loans to FHLMC, FNMA, and
private investors. The loans are exchanged for cash or marketable fixed rate
mortgage-backed securities which are generally sold. This helps insulate
Sovereign from the interest rate risk associated with these fixed rate assets.
Sovereign uses forward sales, cash sales and options on mortgage-backed
securities as a means of hedging loans in the mortgage pipeline that are
originated for sale.
To accommodate customer needs, Sovereign enters into customer-related
financial derivative transactions primarily consisting of interest rate swaps,
caps, and floors. Risk exposure from customer positions is managed through
transactions with other dealers.
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.
- 42 -
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Items 1 through 3 not applicable or the responses are negative.
Item 4 - Submission of Matters to a Vote of Security Holders
The 2002 annual meeting of the shareholders of Sovereign Bancorp, Inc. was
held April 24, 2002. The following is a brief description of each matter voted
on at the meeting.
Proposal 1 - Election of Directors The following directors were nominated for
election to the Board of Directors as Class III Directors for a term of three
(3) years: John A. Fry and Andrew C. Hove, Jr.
Proposal 2 - Independent Auditors Shareholders were presented with a proposal to
ratify the appointment of Ernst & Young LLP, independent certified public
accountants, to audit the consolidated financial statements of Sovereign
Bancorp, Inc. and its subsidiaries for the year ending December 31, 2002.
SHARES
---------------------------------------------------------------------------------
BROKER
-----------------------------
PROPOSAL FOR AGAINST WITHHELD ABSTENTIONS NON-VOTES
- -------- --- ------- -------- ----------- ---------
1. Election of Directors
John A. Fry 185,315,693 N/A 38,841,276 N/A -
Andrew C. Hove, Jr. 221,005,492 N/A 3,151,477 N/A -
2. Independent Auditors 216,299,303 7,518,946 N/A 338,716 -
Item 5 - Not applicable
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. (Incorporated by
reference to Exhibit 3.2 to Sovereign's Quarterly
Report on Form 10Q for the quarter ended March 31, 2002.)
(99.1) Chief Executive Officer certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(99.2) Chief Financial Officer certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
None.
- 43 -
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SOVEREIGN BANCORP, INC.
-----------------------------------
(Registrant)
Date August 14, 2002 /s/Jay S. Sidhu
------------------------- ------------------------------------
Jay S. Sidhu, Chairman,
Chief Executive Officer and President
(Authorized Officer)
Date August 14, 2002 /s/James D. Hogan
------------------------- ------------------------------------
James D. Hogan
Chief Financial Officer
- 44 -
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. (Incorporated by
reference to Exhibit 3.2 to Sovereign's Quarterly Report
on Form 10Q for the quarter ended March 31, 2002.)
(99.1) Chief Executive Officer certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
(99.2) Chief Financial Officer certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
- 45 -