-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, D0vnNepwd0ECeTLLaKr7v9fzYJ2nZhq7I61CaiyqFsojnX6y1AcFMu8cIvxSxuT1 UgMqDUBtaKB7Ufhm7xEEfA== 0000950115-99-000860.txt : 19990625 0000950115-99-000860.hdr.sgml : 19990625 ACCESSION NUMBER: 0000950115-99-000860 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990601 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOVEREIGN BANCORP INC CENTRAL INDEX KEY: 0000811830 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 232453088 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 333-32109 FILM NUMBER: 99638368 BUSINESS ADDRESS: STREET 1: 1130 BERKSHIRE BLVD CITY: WYOMISSING STATE: PA ZIP: 19610 BUSINESS PHONE: 6103208400 MAIL ADDRESS: STREET 1: PO BOX 12646 CITY: READING STATE: PA ZIP: 19612 10-K405/A 1 ANNUAL REPORT ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A {X} ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998, OR { } TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, FOR THE TRANSITION PERIOD FROM _N/A_ TO ____________ . COMMISSION FILE NUMBER 0-16533 SOVEREIGN BANCORP, INC. ------------------------------------------------------ (Exact name of Registrant as specified in its charter) PENNSYLVANIA 23-2453088 - ----------------------------------------------------------- ------------------- (State or other jurisdiction of incorporation or (I.R.S. Employer organization) Identification No.) 1130 BERKSHIRE BOULEVARD, WYOMISSING, PENNSYLVANIA 19610 - ------------------------------------------------------------ ---------- (Address of principal executive offices) (Zip Code) REGISTRANT'S TELEPHONE NUMBER: (610) 320-8400 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common Stock (without par value) (Title of class) 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 _________ . Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. {X} The aggregate market value of the shares of Common Stock of the Registrant held by nonaffiliates of the Registrant was $2,010,010,980 at March 30, 1999. As of March 29, 1999, the Registrant had 160,000,874 shares of Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE The Registrant's definitive Proxy Statement to be used in connection with its 1999 Annual Meeting of Shareholders is incorporated herein by reference in response to Part III hereof. ================================================================================ FORWARD LOOKING STATEMENTS Sovereign Bancorp, Inc. ("Sovereign") may from time to time make "forward-looking statements," including statements contained in Sovereign's filings with the Securities and Exchange Commission (including its Annual Report on Form 10-K and the Exhibits thereto), in its reports to shareholders (including this 1998 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. 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: (i) statements relating to Sovereign's expectations and goals with respect to (a) growth in earnings per share; (b) return on equity; (c) return on assets; (d) efficiency ratio; (e) tier 1 leverage ratio; (f) annualized net charge-offs and other asset quality measures; (g) fee income as a percentage of total revenue; (h) tangible equity to assets; (i) book value and tangible book value per share; (j) loan and deposit portfolio compositions, and (ii) statements preceded by, followed by or that include the words "may," "could," "should," "pro forma," "looking forward," "would," "believe," "expect," "anticipate," "estimate," "intend," "plan," or similar expressions. These forward-looking statements involve risks and uncertainties which are subject to change based on various important factors (some of which, in whole or in part, are beyond Sovereign's control). The following factors, among others, could cause Sovereign's financial performance to differ materially from the goals, plans, objectives, intentions and expectations expressed in such forward-looking statements: (1) the strength of the United States economy in general and the strength of the regional and local economies in which Sovereign conducts operations; (2) 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; (3) inflation, interest rate, market and monetary fluctuations; (4) the timely development of competitive new products and services by Sovereign and the acceptance of such products and services by customers; (5) the willingness of customers to substitute competitors' products and services and vice versa; (6) the success of Sovereign in gaining regulatory approval of its products and services, when required; (7) the impact of changes in financial services' laws and regulations (including laws concerning taxes, banking, proper accounting treatment, securities and insurance); (8) technological changes; (9) changes in consumer spending and savings habits; (10) the impact of pending and completed acquisitions of Sovereign, including the success of Sovereign in fully realizing, within the expected time frame, expected cost savings and/or revenue enhancements from such pending or completed acquisitions, including, without limitation, the expected cost savings and revenue enhancements expected from the acquisition of Peoples Bancorp, Inc.; (11) unanticipated regulatory or judicial proceedings; (12) unanticipated results of its efforts to be Year 2000 complaint; (13) the success of Sovereign at managing the risks involved in the foregoing. Sovereign cautions that the foregoing list of important factors is not exclusive, and neither such list nor any such forward-looking statement takes into account the impact that any future acquisition may have on Sovereign and any such forward-looking statement. Sovereign does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Sovereign. 1 PART I ITEM 1. BUSINESS. GENERAL Sovereign is a Pennsylvania business corporation and is the holding company for Sovereign Bank. Sovereign is headquartered in Philadelphia, Pennsylvania and Sovereign Bank is headquartered in Wyomissing, Pennsylvania, a suburb of Reading, Pennsylvania. Sovereign Bank was created in 1984 under the name Penn Savings Bank, F.S.B. through the merger of two financial institutions with market areas primarily in Berks and Lancaster counties, Pennsylvania. Sovereign Bank assumed its current name on December 31, 1991. Sovereign was incorporated by Sovereign Bank in 1987. From 1989 through 1997, Sovereign completed 18 acquisitions with assets totaling approximately $9.7 billion and expanded its markets throughout eastern Pennsylvania, central New Jersey and northern Delaware. Sovereign also serves customers throughout New York and several New England states. At December 31, 1997, Sovereign had 150 offices and $17.7 billion in assets. On September 4, 1998, Sovereign acquired 93 former CoreStates Financial Corp. ("CoreStates") branch offices from First Union Corporation ("First Union"). The former CoreStates offices are located throughout Pennsylvania and New Jersey and added approximately $2.2 billion of commercial bank deposits and $725 million of commercial and consumer loans to Sovereign's balance sheet. This transaction was accounted for as a purchase. On July 31, 1998, Sovereign acquired First Home Bancorp Inc. ("First Home"), a $510 million savings bank holding company headquartered in Pennsville, New Jersey. First Home had one principal operating subsidiary which operated ten branch offices in Salem, Gloucester and Camden counties, New Jersey and New Castle County, Delaware. This transaction was accounted for as a pooling-of-interests. On July 31, 1998, Sovereign acquired Carnegie Bancorp ("Carnegie"), a $414 million commercial bank holding company headquartered in Princeton, New Jersey, which operated seven branch offices located throughout central New Jersey and one in Pennsylvania. This transaction was accounted for as a pooling-of-interests. On February 28, 1998, Sovereign acquired ML Bancorp, Inc. ("ML Bancorp"), a $2.4 billion bank holding company headquartered in Villanova, Pennsylvania. ML Bancorp's principal operating subsidiary, Main Line Bank, operated 29 branch offices located in the suburbs of Philadelphia, Pennsylvania. This transaction was accounted for as a pooling-of-interests. At December 31, 1998, Sovereign's consolidated assets, deposits and stockholders' equity were approximately $21.9 billion, $12.3 billion and $1.2 billion, respectively. Based on assets at December 31, 1998, Sovereign is the largest thrift holding company and the third largest bank headquartered in Pennsylvania. Sovereign's primary business consists of attracting deposits from its network of community banking offices, located throughout eastern and northcentral Pennsylvania, New Jersey and northern Delaware, and originating commercial, consumer and residential mortgage loans in those communities. Sovereign also serves customers throughout New York and several New England States. Sovereign operates in a heavily regulated environment. Changes in laws and regulations affecting it and its subsidiaries may have an impact on its operations. See "Business -- Supervision and Regulation." For additional information with respect to Sovereign's business activities, see Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" hereof. 2 SUBSIDIARIES Sovereign has four wholly-owned subsidiaries: Sovereign Bank, Sovereign Delaware Investment Corporation, Sovereign Capital Trust I and ML Capital Trust I. Sovereign Bank has the following wholly-owned subsidiaries: Main Line Abstract Corporation, 201 Associates, Inc., First Lancaster Financial Corp., and Sovereign Real Estate Investment Trust ("REIT") Holdings, Inc. Main Line Abstract Corporation is a Pennsylvania corporation whose primary function is a title insurance agency and abstract company. 201 Associates, Inc. is a Delaware corporation whose primary purpose is to purchase and hold certain investment securities. First Lancaster Financial Corp. is a Pennsylvania business corporation whose primary function is to act as a holding company for The Sovereign Annuity Corp. and The Sovereign Agency, Inc. The Sovereign Annuity Corp. is a New Jersey corporation whose primary purpose is to market investment securities, mutual funds and insurance annuities. The Sovereign Agency, Inc. is a New Jersey corporation whose primary purpose is to market insurance products. Sovereign REIT Holdings, Inc. is a Delaware corporation whose primary purpose is to act as a holding company for Sovereign REIT. Sovereign REIT is a Delaware business trust whose primary purpose is to invest in and manage certain real estate assets. Sovereign Capital Trust I has no subsidiaries. Sovereign Capital Trust I is a special-purpose statutory trust, created in 1997 expressly for the issuance of preferred capital securities, which solely holds subordinated debentures of Sovereign. ML Capital Trust I is a special-purpose statutory trust created expressly for the issuance of preferred capital securities. Federal regulations generally permit federally-chartered savings institutions to invest up to 2% of assets in the capital stock of, and make secured and unsecured loans to, certain types of subsidiary service corporations. At December 31, 1998, Sovereign Bank was authorized to have a maximum investment of approximately $436.2 million in such subsidiaries, pursuant to applicable federal regulations. As of such date, Sovereign Bank had a total investment of $43.7 million in subsidiary service corporations, which excludes 201 Associates, Inc. and Sovereign REIT Holdings, Inc., as they are considered to be operating subsidiaries for purposes of this test. EMPLOYEES At December 31, 1998, Sovereign had 3,843 full-time and 519 part-time employees. None of these employees are represented by a collective bargaining agent, and Sovereign believes it enjoys good relations with its personnel. COMPETITION Sovereign experiences substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits are the ability to offer attractive rates and the convenience of office locations. Direct competition for deposits comes primarily from other thrift institutions and commercial banks. Competition for deposits also comes from money market mutual funds, corporate and government securities, and credit unions. The primary factors in the competition for loans are interest rates, loan origination fees and the range of products and services offered. Competition for origination of real estate loans normally comes from other thrift institutions, commercial banks, mortgage bankers, mortgage brokers and insurance companies. THE YEAR 2000 COMPUTER ISSUE The Year 2000 ("Y2K") computer issue refers to the inability of many computers, computer-based systems, related software, and other electronics to process dates accurately during the year 2000 and beyond. Many of these computers, systems, software programs and devices use only two digits to indicate the year. For example, the year 1998 is input, stored and calculated as "98." The year 2000 will in many systems and software programs be represented as "00," but "00" can also be read as 1900. The ambiguity may cause errors which may cause the computer, system, or device to fail completely, cause programs to operate incorrectly, or slowly corrupt or contaminate data over time. 3 These problems may arise both in information systems used for data storage and processing, and in connection with mechanical systems such as bank vaults, elevators, escalators, heating, ventilating and air conditioning systems, and other systems which use embedded microprocessors as timers or for other purposes. For additional information with respect to Sovereign's state of readiness, the steps which Sovereign has taken and the risks which Sovereign believes the Year 2000 issues are likely to present, see Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- The Year 2000 Computer Issue" hereof. ENVIRONMENTAL LAWS Environmentally related hazards have become a source of high risk and potentially unlimited liability for financial institutions relative to their loans. Environmentally contaminated properties owned by an institution's borrowers may result in a drastic reduction in the value of the collateral securing the institution's loans to such borrowers, high environmental clean up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean up costs, and liability to the institution for clean up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower. To minimize this risk, Sovereign Bank may require an environmental examination of and report with respect to the property of any borrower or prospective borrower if circumstances affecting the property indicate a potential for contamination, taking into consideration the potential loss to the institution in relation to the burdens to the borrower. Such examination must be performed by an engineering firm experienced in environmental risk studies and acceptable to the institution, and the costs of such examinations and reports are the responsibility of the borrower. These costs may be substantial and may deter a prospective borrower from entering into a loan transaction with Sovereign Bank. Sovereign is not aware of any borrower who is currently subject to any environmental investigation or clean up proceeding which is likely to have a material adverse effect on the financial condition or results of operations of Sovereign Bank. 4 SUPERVISION AND REGULATION General. Sovereign is a "savings and loan holding company" registered with the Office of Thrift Supervision ("OTS") under the Home Owners' Loan Act ("HOLA") and as such, Sovereign is subject to OTS regulation, examination, supervision and reporting. The deposits of Sovereign Bank are insured by the Federal Deposit Insurance Corporation ("FDIC"). The FDIC manages two funds: the Savings Association Insurance Fund ("SAIF") and the Bank Insurance Fund ("BIF"). These funds are required to be separately maintained and not combined. The majority of Sovereign Bank's deposits are subject to the FDIC's SAIF deposit insurance assessment rate; however, certain deposits which Sovereign acquired from other institutions are subject to the FDIC's BIF deposit insurance assessment rate. See "Insurance of Deposit Accounts" below. Sovereign Bank is required to file reports with the OTS describing its activities and financial condition and is periodically examined to test compliance with various regulatory requirements. Sovereign Bank is also subject to examination by the FDIC. Such examinations are conducted for the purpose of protecting depositors and the insurance fund and not for the purpose of protecting holders of equity or debt securities of Sovereign or Sovereign Bank. Sovereign Bank is a member of the Federal Home Loan Bank ("FHLB") of Pittsburgh, which is one of the twelve regional banks comprising the FHLB system. Sovereign Bank is also subject to regulation by the Board of Governors of the Federal Reserve System with respect to reserves maintained against deposits and certain other matters. Except as described herein, Sovereign's management is not aware of any current recommendations by regulatory authorities that would have a material effect on Sovereign's operations, capital resources or liquidity. Holding Company Regulation. The HOLA prohibits a registered savings and loan holding company from directly or indirectly acquiring control, including through an acquisition by merger, consolidation or purchase of assets, of any savings association (as defined in HOLA to include a federal savings bank) or any other savings and loan holding company, without prior OTS approval. Generally, a savings and loan holding company may not acquire more than 5% of the voting shares of any savings association unless by merger, consolidation or purchase of assets. Certain regulations of the OTS describe standards for control under the HOLA. See "Control of Sovereign" below. Federal law empowers the Director of the OTS to take substantive action when the Director determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of any particular activity constitutes a serious risk to the financial safety, soundness or stability of a savings and loan holding company's subsidiary savings institution. The Director of the OTS has oversight authority for all holding company affiliates, not just the insured institution. Specifically, the Director of the OTS may, as necessary, (i) limit the payment of dividends by the savings institution; (ii) limit transactions between the savings institution, the holding company and the subsidiaries or affiliates of either; (iii) limit any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution. Any such limits would be issued in the form of a directive having the legal efficacy of a cease and desist order. Control of Sovereign. Under the Savings and Loan Holding Company Act and the related Change in Bank Control Act (the "Control Act"), individuals, corporations or other entities acquiring Sovereign common stock may, alone or "in concert" with other investors, be deemed to control Sovereign and thereby Sovereign Bank. If deemed to control Sovereign, such person or group will be required to obtain OTS approval to acquire Sovereign's common stock and will be subject to certain ongoing reporting procedures and restrictions under federal law and regulations. Under the regulations, ownership of 25% of the capital stock of Sovereign will be deemed to constitute "control," and ownership of more than 10% of the capital stock may also be deemed to constitute "control" if certain other control factors are present. It is possible that even lower levels of ownership of such securities could constitute "control" under the regulations. As of December 31, 1998, no individual corporation or other entity owned more than 10% of Sovereign's capital stock. Regulatory Capital Requirements. OTS regulations require savings associations to maintain a minimum tangible capital ratio of not less than 1.5%, a minimum core capital, or "leverage" ratio of 5 not less than 3% and a minimum risk-based capital ratio (based upon credit risk) of not less than 8%. These standards are the same as the capital standards that are applicable to other insured depository institutions, such as banks. Federal banking agencies are required to ensure that their risk-based capital guidelines take adequate account of interest rate risk, concentration of credit risk and risks of non-traditional activities. In August 1995, the federal banking agencies, including the OTS, issued a rule modifying their then-existing risk-based capital standards to provide for consideration of interest rate risk when assessing the capital adequacy of an institution. This new rule implements the first step of a two-step process by explicitly including a depository institution's exposure to declines in the value of its capital due to changes in interest rates as one factor that the banking agencies will consider in evaluating an institution's capital adequacy. The new rule does not establish a measurement framework for assessing an institution's interest rate risk exposure level. Examiners will use data collected by the banking agencies to determine the adequacy of an individual institution's capital in light of interest rate risk. Examiners will also consider historical financial performance, earnings exposure to interest rate movements and the adequacy of internal interest rate risk management, among other things. This case-by-case approach for assessing an institution's capital adequacy for interest rate risk is transitional. The second step of the federal banking agencies' interest rate risk regulation will be to establish an explicit minimum capital charge for interest rate risk, based on measured levels of interest rate risk exposure. The banking agencies may implement this second step at some future date. The federal banking agencies, including the OTS, also adopted final rules relating to concentration of credit risk and risks of non-traditional activities effective on January 17, 1995. The agencies declined to adopt a quantitative test for concentrations of credit risk and, instead, provided that such risk would be considered in addition to other risks in assessing an institution's overall capital adequacy. Institutions with higher concentration of credit risk will be required to maintain greater levels of capital. Similarly, the federal agencies incorporated the evaluation of the risks of non-traditional activities into the overall assessment of capital adequacy. The agencies also indicated that proposed rules regarding specific types of non-traditional activities will be promulgated from time to time. Under the Federal Deposit Insurance Act ("FDIA"), insured depository institutions must be classified in one of five defined categories (well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized). Under OTS regulations, an institution will be considered "well-capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level. An "adequately-capitalized" institution is one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater, (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with the highest composite regulatory examination rating) and (iv) does not meet the definition of a well-capitalized institution. An institution will be considered (A) "undercapitalized" if it has (i) a total risk-based capital ratio of less than 8% (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest regulatory examination rating); (B) "significantly undercapitalized" if the institution has (i) a total risk-based capital ratio of less than 6% (ii) a Tier 1 risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3%; and (C) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets of equal to or less than 2%. The OTS may, under certain circumstances, reclassify a "well-capitalized" institution as "adequately-capitalized" or require an "adequately-capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification could be made if the OTS determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings). A savings institution's capital category is determined with respect to its most recent thrift financial report filed with the OTS. In the event an institution's capital deteriorates to the undercapitalized category or below, the FDIA and OTS regulations prescribe an increasing amount of regulatory intervention, including the adoption by the institution of a capital restoration plan, a guarantee of the plan by its parent holding company and the placement of a hold on increases in assets, number of branches and lines of business. 6 If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver or conservator. Critically undercapitalized institutions generally may not, beginning 60 days after becoming critically undercapitalized, make any payment of principal or interest on their subordinated debt. All but well-capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval. Pursuant to the FDIA and OTS regulations, savings associations which are not categorized as well-capitalized or adequately-capitalized are restricted from making capital distributions which include cash dividends, stock redemptions or repurchases, cash-out mergers, interest payments on certain convertible debt and other transactions charged to the capital account of a savings association. At December 31, 1998, Sovereign Bank met the criteria to be classified as "well-capitalized." Standards for Safety and Soundness. The federal banking agencies adopted, effective in August 1995, certain operational and managerial standards for depository institutions, including internal audit system components, loan documentation requirements, asset growth parameters, and compensation standards for officers, directors and employees. The implementation or enforcement of these guidelines has not had a material adverse effect on Sovereign's results of operations. Insurance of Deposit Accounts. The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and supervisory measures. Under the risk-related premium schedule, the FDIC assigns, on a semi-annual basis, each institution to one of three capital groups (well-capitalized, adequately- capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution's subgroup assignment is based upon the FDIC's judgment of the institution's strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to measuring the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. At December 31, 1998, Sovereign Bank was classified as well-capitalized for purposes of calculating insurance assessments. Institutions are prohibited from disclosing the risk classification of the subgroup to which they have been assigned. For the year ended December 31, 1998, the FDIC calculated deposit insurance assessments at the rate of $.00 for every $100 of insured deposits for the members of the SAIF in the lowest risk-based premium category and $.27 for every $100 of insured deposits for members of the SAIF in the highest risk-based premium category. This compares to 1996 FDIC SAIF deposit insurance assessment rates of $.23 and $.31, respectively, for every $100 of insured deposits. In August 1995, the FDIC adopted an amendment to the BIF risk-based assessment schedule that lowers the deposit insurance assessment rate for most (90% or more) commercial banks and other depository institutions with deposits insured by the BIF to $.04 per $100 of insured deposits. On November 14, 1995, the FDIC further reduced the BIF assessment rates to a range of $.00 per $100 of insured deposits (subject to a minimum annual premium of $2,000 prior to 1997) for those institutions with the least risk to $.27 for every $100 of insured deposits for institutions deemed to have the highest risk, beginning January 1, 1996. At the same time, the FDIC voted to retain the existing assessment rates for SAIF-insured institutions. The reduced BIF assessment rates resulted in a substantial disparity in the deposit insurance premiums paid by BIF and SAIF members and placed SAIF-insured savings associations at a significant competitive disadvantage to BIF-insured institutions. On January 1, 1997, in accordance with the Deposit Insurance Funds Act of 1996 ("DIFA"), the Financing Corporation ("FICO") debt service assessment became applicable to all insured institutions. The FICO assessment is paid in addition to the FDIC deposit insurance assessment; however, it is not tied to the FDIC risk classification. On September 30, 1996, legislation was signed into law which effectively ends the BIF/SAIF rate disparity by the year 2000, and significantly reduces the disparity for years 1997 through 1999. As part of the new law, SAIF-insured institutions were required to make a one-time payment of 65.7 basis 7 points for all SAIF-insured deposits held as of March 31, 1995. At Sovereign, this amounted to an after-tax charge of $24.9 million during 1996. Federal savings banks like Sovereign Bank are required by OTS regulations to pay assessments to the OTS to fund the operations of the OTS. The general assessment is paid on a quarterly basis and is computed based on total assets of the institution, including subsidiaries. 8 ITEM 2. PROPERTIES. Sovereign Bank is the owner of a five-story office building in Wyomissing, Berks County, Pennsylvania. The building is used as Sovereign Bank's executive offices and operations center. Sovereign Bank has 295 branch and loan production offices. Sovereign owns 140 of these offices and leases 155. Sovereign Bank also leases several other facilities throughout its market area to support its various administrative functions. 9 ITEM 3. LEGAL PROCEEDINGS. Sovereign is not involved in any pending legal proceedings other than non-material legal proceedings occurring in the ordinary course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT. Certain information, including principal occupation during the past five years, relating to the principal executive officers of Sovereign, as of March 29, 1999, is set forth below: Richard E. Mohn -- Age 67. Mr. Mohn was elected the Chairman of the Board of Sovereign on April 24, 1995. Mr. Mohn became Chairman of the Board of Sovereign Bank in November 1989. He is Chairman of Cloister Spring Water Company, Lancaster, Pennsylvania, a bottler and distributor of spring water. Jay S. Sidhu -- Age 47. Mr. Sidhu has served as President and Chief Executive Officer of Sovereign since November 21, 1989. Prior thereto, Mr. Sidhu served as Treasurer and Chief Financial Officer of Sovereign. Mr. Sidhu is also President and Chief Executive Officer of Sovereign Bank. Prior to becoming President and Chief Executive Officer of Sovereign Bank on March 28, 1989, Mr. Sidhu served as Vice Chairman and Chief Operating Officer of Sovereign Bank. Lawrence M. Thompson, Jr. -- Age 46. Mr. Thompson serves as Chief Administrative Officer and Secretary of Sovereign and Chief Operating Officer and Secretary of Sovereign Bank. Mr. Thompson was hired as Sovereign Bank's General Counsel and Secretary in 1984. He was promoted to Vice President in 1985. In April 1986, he became Sovereign Bank's Senior Vice President for legal affairs and administration. In January 1990, he became Group Executive Officer - -- Lending and in June 1995, he became Chief Administrative Officer of Sovereign and Sovereign Bank. Mr. Thompson became Chief Operating Officer of Sovereign Bank in November 1996. Dennis S. Marlo -- Age 56. Mr. Marlo was appointed Chief Financial Officer and Treasurer of Sovereign on May 19, 1998. Mr. Marlo joined Sovereign in February 1998 as the President of the Pennsylvania Division of Sovereign Bank. Prior thereto, Mr. Marlo served as President and Chief Executive Officer of ML Bancorp, a predecessor company of Sovereign. 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Sovereign's common stock is traded in the over-the-counter market and is quoted on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") National Market System under the symbol "SVRN." At March 30, 1999, the total number of holders of record of Sovereign's common stock was 15,074. The high and low bid prices reported on the NASDAQ National Market System for Sovereign's common stock for 1998, adjusted to reflect all stock dividends and splits, were $22.188 and $9.000 and for 1997 were $18.000 and $9.125, respectively. During 1998, as restated for ML Bancorp, Carnegie and First Home, Sovereign paid a cash dividend of $.020 per share in the first quarter, $.023 per share in the second quarter, $.020 per share in the third quarter and $.021 per share in the fourth quarter. During 1997, Sovereign paid a cash dividend of $.037 per share in the first quarter, $.038 per share in the second quarter, $.036 per share in the third quarter and $.017 per share in the fourth quarter. During 1996, Sovereign paid a cash dividend of $.035 per share in the first quarter, $.033 in the second quarter, $.036 in the third quarter and $.035 in the fourth quarter. These per share amounts have been adjusted to reflect all stock dividends and stock splits. For certain limitations on the ability of Sovereign Bank to pay dividends to Sovereign, see Part I, Item 1 "Business -- Supervision and Regulation -- Regulatory Capital Requirements" and Note 11 at Item 8 "Financial Statements and Supplementary Data" hereof. 11 ITEM 6. SELECTED FINANCIAL DATA.
Selected Financial Data(1) At or for the Year Ended December 31, ----------------------------------------------------------------------- 1998 1997 1996 1995 1994 ----------- ----------- ----------- ----------- ----------- (Dollars in thousands, except per share data) Balance Sheet Data Total assets ........................................... $21,913,873 $17,655,455 $15,298,690 $13,082,579 $11,021,718 Loans .................................................. 11,285,840 11,324,122 9,595,495 7,591,107 6,972,184 Allowance for loan losses .............................. (133,802) (116,823) (73,847) (67,515) (64,611) Investment securities .................................. 8,502,082 5,372,713 5,012,118 4,695,805 3,546,687 Deposits ............................................... 12,322,716 9,515,294 8,660,684 8,548,888 7,064,223 Borrowings ............................................. 7,900,592 6,863,643 5,599,109 3,566,857 3,144,265 Stockholders' equity ................................... 1,204,068 1,047,795 889,751 843,733 696,018 Summary Statement of Operations Total interest income .................................. $ 1,355,371 $ 1,178,777 $ 1,016,826 $ 838,261 $ 626,241 Total interest expense ................................. 861,759 746,695 629,860 518,483 335,846 ----------- ----------- ----------- ----------- ----------- Net interest income .................................... 493,612 432,082 386,966 319,778 290,395 Provision for loan losses (3) .......................... 27,961 41,125 22,685 13,119 14,562 ----------- ----------- ----------- ----------- ----------- Net interest income after provision for loan losses..... 465,651 390,957 364,281 306,659 275,833 Other income ........................................... 105,181 48,688 63,379 42,908 24,674 Other expenses ......................................... 359,626 269,783 289,773 199,647 166,155 ----------- ----------- ----------- ----------- ----------- Income before income taxes ............................. 211,206 169,862 137,887 149,920 134,352 Income tax provision ................................... 74,751 67,324 47,509 51,051 49,013 ----------- ----------- ----------- ----------- ----------- Net income ............................................. $ 136,455 $ 102,538 $ 90,378 $ 98,869 $ 85,339 =========== =========== =========== =========== =========== Share Data(2) Common shares outstanding at end of period (in thousands) ....................................... 159,727 141,218 134,000 130,762 133,140 Preferred shares outstanding at end of period (in thousands) ....................................... -- 1,996 2,000 2,000 -- Basic earnings per share(3) ............................ $ .88 $ .70 $ .63 $ .68 $ .65 Diluted earnings per share(3) .......................... $ .85 $ .66 $ .59 $ .66 $ .63 Book value per share at end of period(4) ............... $ 7.54 $ 7.42 $ 6.64 $ 6.45 $ 5.23 Common share price at end of period $ 14 1/4 $ 17 5/16 $ 9 1/8 $ 6 11/16 $ 4 7/8 Dividends paid per common share(5) ..................... $ .084 $ .114 $ .140 $ .119 $ .095 Selected Financial Ratios Dividend payout ratio(6) ............................... 9.88% 17.27% 23.73% 18.03% 15.08% Return on average assets(7) ............................ .70% .63% .63% .83% .89% Return on average equity(7) ............................ 12.42% 10.92% 10.34% 12.60% 13.58% Equity to assets ....................................... 5.49% 5.93% 5.82% 6.45% 6.31%
- --------------- (1) All selected financial data has been restated to reflect all acquisitions which have been accounted for under the pooling-of-interests method of accounting. (2) All per share data have been adjusted to reflect all stock dividends and stock splits. (3) The 1998 and 1997 results include special charges comprised of merger-related charges of $33.5 million (after-tax) in 1998 and $29.8 million (after-tax), including $16.2 million classified as a special provision for loan loss in 1997, resulting from Sovereign's acquisitions during 1998 and 1997, and losses from non-recurring sales of held-to-maturity securities of $0.3 million (after-tax) and $6.9 million (after-tax) in 1998 and 1997, respectively. Excluding the special charges, basic earnings per share and diluted earnings per share were $1.10 and $1.06, respectively, for 1998 and $.97 and $.89, respectively, for 1997. The 1996 results include the non-recurring SAIF assessment of $24.9 million (after-tax). Excluding the non-recurring SAIF assessment, basic earnings per share and diluted earnings per share for 1996 were $.81 and $.76, respectively. (4) Book value is calculated using equity divided by common shares outstanding at end of period. (5) The higher dividend rate in prior periods is the result of acquisitions which were accounted for as a pooling-of-interests. (6) The dividend payout ratio is calculated using dividends per common share divided by diluted earnings per share. (7) Results for 1998 and 1997 include the special charges described in Note 3 above. Results for 1996 include the non-recurring SAIF assessment described in Note 3 above. 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General. Sovereign reported net operating income of $170 million for the year ended December 31, 1998. This represents an increase of 22% over net operating income of $139 million reported for 1997. Operating earnings per share was $1.06 for 1998, which represents an increase of 19% over 1997 operating earnings per share of $.89. Return on average equity and return on average assets were 15.50% and .87%, respectively, for 1998 compared to 14.83% and .85%, respectively, for 1997. The term "operating" income and "operating" earnings per share represent income and earnings per share excluding the following: 1998 merger charges of $33.5 million (after-tax) related to Sovereign's 1998 acquisitions of ML Bancorp, Inc. ("ML Bancorp"), Carnegie Bancorp ("Carnegie") and First Home Bancorp Inc. ("First Home") and 1997 merger charges of $29.8 million (after-tax) related to Sovereign's 1997 acquisitions of First State Financial Services, Inc. ("First State") and Bankers Corp. ("Bankers"), and losses from non-recurring sales of held-to-maturity securities of $0.3 million (after-tax) and $6.9 million (after-tax) in 1998 and 1997, respectively. For additional information with respect to Sovereign's merger-related charges, see Note 2 at "Notes to Consolidated Financial Statements" hereof. All per share amounts presented in Management's Discussion and Analysis of Financial Condition and Results of Operations have been calculated based on average diluted shares outstanding and have been adjusted to reflect all stock dividends and stock splits. Net income for the year ended December 31, 1998 was $136 million or $.85 per share. Net income for the year ended December 31, 1997 was $103 million or $.66 per share. Sovereign's financial results for 1998 include the following significant events: (For additional information with respect to Sovereign's 1998 acquisition activity, see Note 2 at "Notes to Consolidated Financial Statements" hereof). ML Bancorp. On February 28, 1998, Sovereign acquired ML Bancorp, a $2.4 billion bank holding company headquartered in Villanova, Pennsylvania. ML Bancorp's principal operating subsidiary, Main Line Bank, operated 29 branch offices located in the suburbs of Philadelphia, Pennsylvania. This transaction was accounted for as a pooling-of-interests. Carnegie. On July 31, 1998, Sovereign acquired Carnegie, a $414 million commercial bank holding company headquartered in Princeton, New Jersey, which operated seven branch offices located throughout central New Jersey and one in Pennsylvania. This transaction was accounted for as a pooling-of-interests. First Home. On July 31, 1998, Sovereign acquired First Home, a $510 million savings bank holding company headquartered in Pennsville, New Jersey. First Home had one principal operating subsidiary which operated ten branch offices in Salem, Gloucester and Camden counties, New Jersey and New Castle County, Delaware. This transaction was accounted for as a pooling-of-interests. CoreStates. On September 4, 1998, Sovereign acquired 93 former CoreStates Financial Corp. ("CoreStates") branch offices from First Union Corporation ("First Union"). The former CoreStates offices are located throughout Pennsylvania and New Jersey and added approximately $2.2 billion of commercial bank deposits and $725 million of commercial and consumer loans to Sovereign's balance sheet. This transaction was accounted for as a purchase. Stock Dividends/Splits. Sovereign declared a 6-for-5 stock split on January 22, 1998 and a 6-for-5 stock split on January 16, 1997. All per share information such as earnings, book value, share price and dividends have been restated to reflect all stock dividends and stock splits. For a detailed discussion of Sovereign's stock dividends and stock splits, see Note 1(c) at Item 8 "Financial Statements and Supplementary Data" hereof. 13 Management's Discussion and Analysis RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997 Net Interest Income. Net interest income for 1998 was $494 million compared to $432 million for 1997. This represents an increase of 14% and was primarily due to an increase in average balances resulting from internal growth and recent acquisitions. Interest on interest-earning deposits was $7.4 million for 1998 compared to $5.4 million for 1997. The average balance of interest-earning deposits was $56.4 million with an average yield of 13.12% for 1998 compared to an average balance of $32.3 million with an average yield of 16.71% for 1997. The high yields on interest-earning deposits were the result of a contractual arrangement whereby a third-party vendor performed check processing and reconcilement functions for Sovereign's disbursement accounts. Under the agreement, the vendor is required to pay Sovereign interest on disbursed funds during the two to three day float period, effectively producing interest income with no corresponding asset balance. This agreement will continue to favorably impact the yield on Sovereign's interest-earning deposits in future years. Interest on investment securities available-for-sale was $284 million for 1998 compared to $102 million for 1997. The average balance of investment securities available-for-sale was $4.3 billion with an average yield of 6.75% for 1998 compared to an average balance of $1.6 billion with an average yield of 6.77% for 1997. The increase in the average balance of investment securities available-for-sale was due to favorable market conditions which have created opportunities for Sovereign to realign its investment portfolio and an active decision by management to increase balance sheet flexibility by placing more investments into available-for-sale. Interest on investment securities held-to-maturity was $182 million for 1998 compared to $280 million for 1997. The average balance of investment securities held-to-maturity was $2.5 billion with an average yield of 7.22% for 1998 compared to an average balance of $3.9 billion with an average yield of 7.18% for 1997. Interest and fees on loans were $881 million for 1998 compared to $791 million for 1997. The average balance of net loans was $11.1 billion with an average yield of 7.94% for 1998 compared to an average balance of $10.1 billion with an average yield of 7.82% for 1997. The increases in average balance and average yield were primarily the result of continued growth in Sovereign's commercial lending and auto finance divisions, Sovereign's acquisition of 93 CoreStates branch offices, which added approximately $725 million of higher yielding commercial and consumer loans to Sovereign's loan portfolio, as well as planned run-off of lower yielding residential loans. Interest on total deposits was $440 million for 1998 compared to $379 million for 1997. The average balance of total deposits was $10.7 billion with an average cost of 4.11% for 1998 compared to an average balance of $9.0 billion with an average cost of 4.21% for 1997. The increase in the average balance and the decrease in the average cost of deposits was primarily the result of Sovereign's acquisition of approximately $2.2 billion of low cost deposits from the CoreStates branch acquisition and strong internal core deposit growth during 1998. Interest on total borrowings was $421 million for 1998 compared to $368 million for 1997. The average balance of total borrowings was $7.4 billion with an average cost of 5.69% for 1998 compared to an average balance of $6.2 billion with an average cost of 5.97% for 1997. The increase in the average balance and the decrease in the average cost of borrowings was the result of balance sheet growth being partially funded by borrowings and generally lower borrowing rates in 1998 compared to 1997. 14 Table 1 presents a summary of Sovereign's average balances, the yields earned on average assets and the cost of average liabilities and stockholders' equity for the years indicated (in thousands): Table 1: Spread Analysis
Year Ended December 31, ------------------------------------------------------------------------------------------------- 1998 1997 1996 ------------------------------ ----------------------------- ------------------------------ Average Yield/ Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Balance Interest Rate ------------------------------ ------------------------------ ------------------------------ Interest-earning assets: Interest-earning deposits $ 56,389 $ 7,397 13.12% $ 32,261 $ 5,392 16.71% $ 26,092 $ 4,103 15.73% Investment securities available-for-sale(1) 4,336,872 284,392 6.75 1,566,975 102,123 6.77 1,290,649 84,656 6.70 Investment securities held-to-maturity 2,530,143 182,499 7.22 3,902,940 279,900 7.18 3,500,212 250,938 7.17 Net loans(2)(3) 11,105,400 881,083 7.94 10,138,964 791,362 7.82 8,789,397 677,129 7.72 ----------- ---------- ----- ----------- ---------- ----- --------- --------- ----- Total interest-earning assets 18,028,804 1,355,371 7.57 15,641,140 1,178,777 7.57 13,606,350 1,016,826 7.49 Non-interest-earning assets 1,589,937 -- -- 689,618 -- -- 634,416 -- -- ----------- ---------- ----- ----------- ---------- ----- --------- --------- ----- Total assets $19,618,741 1,355,371 6.96 $16,330,758 1,178,777 7.25 $14,240,766 1,016,826 7.16 =========== ---------- ----- =========== ---------- ----- =========== --------- ----- Interest-bearing liabilities: Deposits: Demand deposit and NOW accounts $ 1,712,730 16,387 .96 $ 1,157,372 7,967 .69 $ 996,815 9,422 .95 Savings accounts 2,126,149 62,694 2.95 1,946,404 58,974 3.03 1,884,076 51,824 2.75 Money market accounts 1,173,889 45,055 3.84 834,933 33,719 4.04 853,862 34,388 4.03 Certificates of deposit 5,688,568 316,164 5.56 5,069,113 278,153 5.49 4,722,999 255,450 5.41 ----------- ---------- ----- ----------- ---------- ----- --------- --------- ----- Total deposits 10,701,336 440,300 4.12 9,007,822 378,813 4.21 8,457,752 351,084 4.15 Total borrowings 7,404,186 421,459 5.69 6,164,004 367,882 5.97 4,736,718 278,776 5.89 ----------- ---------- ----- ---------- ---------- ----- --------- --------- ----- Total interest-bearing liabilities 18,105,522 861,759 4.76 15,171,826 746,695 4.92 13,194,470 629,860 4.77 Non-interest-bearing liabilities 414,719 -- -- 220,047 -- -- 171,920 -- -- ----------- ---------- ----- ----------- ---------- ----- --------- --------- ---- Total liabilities 18,520,241 861,759 4.65 15,391,873 746,695 4.85 13,366,390 629,860 4.71 Stockholders' equity 1,098,500 -- -- 938,885 -- -- 874,376 -- -- =========== ---------- ----- ----------- ---------- ----- ---------- --------- ----- Total liabilities and stockholders' equity $19,618,741 861,759 4.39 $16,330,758 746,695 4.57 $14,240,766 629,860 4.42 =========== ---------- ----- =========== ---------- ----- =========== --------- ----- Interest rate spread(4) 2.56% 2.68% 2.74% ===== ===== ==== Net interest income/net interest margin(5) $ 493,612 2.79% $ 432,082 2.79% $ 386,966 2.86% ========== ===== ========= ===== ========= ==== Ratio of interest-earning assets to interest-bearing liabilities 1.00x 1.03x 1.03x ===== ===== ====
- -------------------------------------------------------------------------------- (1) The tax equivalent adjustments for the years ended December 31, 1998, 1997 and 1996 were $8.1 million, $3.9 million and $1.8 million, respectively, and are based on an effective tax rate of 35%. (2) Amortization of net fees of $2.6 million, $4.8 million and $4.7 million for the years ended December 31, 1998, 1997 and 1996, respectively, are included in interest income. Average loan balances include non-accrual loans and loans held for sale. (3) The tax equivalent adjustments for the years ended December 31, 1998, 1997 and 1996, were $1.1 million, $1.0 million and $991,000, respectively, and are based on an effective tax rate of 35%. (4) Represents the difference between the yield on total assets and the cost of total liabilities and stockholders' equity. (5) Represents tax equivalent net interest income divided by average interest-earning assets. 15 Management's Discussion and Analysis Table 2 presents, prior to any tax equivalent adjustments, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income and interest expense attributable to the combined impact of both volume and rate has been allocated proportionately to the change due to volume and the change due to rate (in thousands): Table 2: Volume/Rate Analysis
Year Ended December 31, ------------------------------------------------------------------------ 1998 vs. 1997 1997 vs. 1996 Increase/(Decrease) Increase/(Decrease) ----------------------------------- --------------------------------- Volume Rate Total Volume Rate Total --------- --------- --------- --------- --------- -------- Interest-earning assets: Interest-earning deposits $ 2,815 $ (810) $ 2,005 $ 1,018 $ 271 $ 1,289 Investment securities available-for-sale 181,633 636 182,269 18,005 (538) 17,467 Investment securities held-to-maturity (99,029) 1,628 (97,401) 28,882 80 28,962 Net loans(1) 76,492 13,229 89,721 105,228 9,005 114,233 --------- -------- Total interest-earning assets 176,594 161,951 --------- -------- Interest-bearing liabilities: Deposits 69,478 (7,991) 61,487 23,082 4,647 27,729 Borrowings 69,571 (15,994) 53,577 85,131 3,975 89,106 --------- -------- Total interest-bearing liabilities 115,064 116,835 --------- -------- Net change in net interest income $ 40,833 $ 20,697 $ 61,530 $ 56,465 $ (11,349) $ 45,116 ========= ========= ========= ========= ========= ========
- -------------------------------------------------------------------------------- (1) Includes non-accrual loans and loans held for sale. - -------------------------------------------------------------------------------- Provision for Loan Losses. The provision for loan losses was $28.0 million for 1998 compared to $41.1 million for 1997. The higher loan loss provision for 1997 included $24.9 million of reserves recorded as part of the merger charges related to Sovereign's acquisitions of First State and Bankers during 1997. These additional reserves were added as a result of Sovereign's conservative approach with respect to an aggressive workout plan for certain non-performing assets acquired from First State and Bankers. Excluding these merger-related charges, Sovereign's loan loss provision for 1998 increased 73% from 1997 levels. In addition, during 1998, Sovereign established an initial loan loss reserve of $20.5 million related to $725 million of loans acquired in connection with its CoreStates branch acquisition, and during 1997, Sovereign established an initial loan loss reserve of $22.0 million in connection with its acquisition of Fleet Financial Group Inc.'s ("Fleet") Automobile Finance Division ("Fleet Auto"). Over the last two 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 asset-based lending and automobile loans. As a result of the increased risk inherent in these loan products and as Sovereign continues to place emphasis on small business and consumer lending in future years, management will regularly evaluate its loan portfolio and record additional loan loss reserves as is necessary. Historically, Sovereign's additions to its loan loss reserve (through income statement charges and acquisition accounting) have been sufficient to absorb the incremental credit risk in its loan portfolio. As shown in Table 3 on the next page, provisioning plus acquired reserves are sufficiently in excess of net losses for all years presented. Management believes that these extra reserves are warranted due to the changing composition and increased risk in the loan portfolio, as discussed above. For additional information with respect to Sovereign's asset quality, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Credit Quality." Sovereign's net charge-offs for 1998 were $33.6 million and consisted of charge-offs of $46.3 million and recoveries of $12.7 million. This compares to 1997 net charge-offs of $18.8 million consisting of charge-offs of $24.2 million and recoveries of $5.4 million. The ratio of net loan charge-offs to average loans, including loans held for sale, was .30% for 1998, compared to .18% for 1997 and .19% for 1996. Commercial loan net charge-offs as a percentage of average commercial loans were .14% for 1998, compared to .14% for 1997 and .85% for 1996. The higher figure in 1996 was due to charge-offs related to a pool of non-performing loans charged-off by First State, a predecessor institution acquired by Sovereign, previous to its 1997 acquisition that was accounted for as a pooling-of-interests. Consumer loan net charge-offs as a percentage of average consumer loans were .80% for 1998, compared to .55% for 1997 and .18% for 1996. Residential real estate mortgage loan net charge-offs as a percentage of average residential mortgage loans, including loans held for sale, were .08% for 1998, .11% for 1997 and .13% for 1996. Sovereign's increased level of consumer and commercial loan charge-offs in 1998 was primarily related to Sovereign's acquisition activity over the past two years. Although commercial and consumer lending will typically result in higher net charge-off levels than residential lending, historically, it has also resulted in higher income potential. In Sovereign's experience, a strategy that involves the accelerated resolution of problem assets is more appropriate than a long-term workout approach. In connection with this philosophy, additional reserves were established in conjunction with both Sovereign's recent acquisitions described above and internal growth. 16 Table 3 presents the activity in the allowance for loan losses for the years indicated (in thousands): Table 3: Reconciliation of the Allowance for Loan Losses
December 31, --------------------------------------------------------- 1998 1997 1996 1995 1994 -------- -------- -------- -------- --------- Allowance, beginning of year $116,823 $ 73,847 $ 67,515 $ 64,611 $ 61,087 Charge-offs: Residential 6,223 8,869 11,016 9,546 10,279 Commercial 3,220 3,687 5,846 2,563 5,749 Consumer(1) 36,887 11,628 2,079 962 1,109 -------- -------- -------- -------- -------- Total charge-offs 46,330 24,184 18,941 13,071 17,137 -------- -------- -------- -------- -------- Recoveries: Residential 1,134 1,040 1,376 923 534 Commercial 839 2,264 133 201 653 Consumer(1) 10,715 2,079 363 227 370 -------- -------- -------- -------- -------- Total recoveries 12,688 5,383 1,872 1,351 1,557 -------- -------- -------- -------- -------- Charge-offs, net of recoveries 33,642 18,801 17,069 11,720 15,580 Provision for loan losses 27,961 41,125 22,685 13,119 14,562 Acquired reserves and other additions(2) 22,660 20,652 716 1,505 4,542 -------- -------- -------- -------- -------- Allowance, end of year $133,802 $116,823 $ 73,847 $ 67,515 $ 64,611 ======== ======== ======== ======== ======== Charge-offs, net of recoveries to average total loans .300% .184% .193% .159% .261% ======== ======== ======== ======== ========
- -------------------------------------------------------------------------------- (1) Includes indirect auto loans and home equity lines of credit. (2) For 1998, acquired reserves and other additions include $20.5 million of loan loss reserves established in connection with the CoreStates branch acquisition. For 1997,acquired reserves and other additions represent $22.0 million of loan loss reserves established as part of the Fleet Auto acquisition, partially off-set by net charge-offs of $2.7 million related to First State for the three-month period ended December 31, 1996 resulting from the differing fiscal year end of First State. - -------------------------------------------------------------------------------- Sovereign's policy for charging off loans varies with respect to the category of loans and specific circumstances surrounding each loan under consideration. Consumer loans are generally charged off when deemed to be uncollectible or 120 days past due, whichever comes first. Charge-offs of commercial loans and residential real estate mortgage loans are made on the basis of management's ongoing evaluation of non-performing loans. 17 Other Income. Total other income was $105 million for 1998 compared to $48.7 million for 1997. Several factors contributed to the increase in other income as discussed below. Loan fees and service charges were $10.5 million for 1998 compared to $5.8 million for 1997. This increase was directly attributable to the full year effect of fees earned on Sovereign's auto loan portfolio which was acquired in September 1997. Loan fees and service charges result primarily from Sovereign's loan servicing portfolio. At December 31, 1998, Sovereign serviced $9.2 billion of its own loans and $6.7 billion of loans for others. This compares to $9.3 billion of its own loans and $6.4 billion of loans for others at December 31, 1997. Deposit fees were $26.1 million for 1998 compared to $20.9 million for 1997. This increase was primarily the result of an increase in the number of Sovereign's transaction accounts and a larger retail customer base over the last year. Mortgage banking gains were $24.7 million for 1998 compared to $21.7 million for 1997. This increase was primarily due to internal restructuring and management enhancements made to this business unit during 1998 and a favorable external environment. Gains on sales of loans and investment securities were $19.8 million for 1998 compared to losses of $7.2 million for 1997, which included investment security net gains (losses) of $15.8 million and $(9.2) million and net gains on sales of loans of $4.0 million and $2.0 million in 1998 and 1997, respectively. This increase was in part due to a net gain of $2.8 million resulting from the sale of Sovereign's credit card portfolio during the second quarter of 1998. The remaining increase was the result of gains on sales of investment securities available-for sale during 1998 and a $10.3 million (pre-tax) loss on the liquidation of $750 million of investments including some held-to-maturity securities in conjunction with the Bankers acquisition during the third quarter of 1997. This sale was completed in accordance with the provisions of Statement of Financial Accounting Standard ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" to maintain Sovereign's pre-merger interest rate risk position. Recent favorable market trends have created opportunities for Sovereign to realign its investment portfolio with no adverse impact on future earnings or its interest rate risk profile. Sovereign will continue to evaluate these opportunities in the context of its overall asset/liability management process. Miscellaneous income was $24.0 million for 1998 compared to $7.5 million for 1997. This increase was primarily due to Sovereign's investment in Bank Owned Life Insurance ("BOLI") which was made during the first quarter of 1998 and increased inter-change income resulting from growth in the number and transaction volume of Sovereign's debit cards over the last year. General and Administrative Expenses. Total general and administrative expenses were $277 million for 1998 compared to $225 million for 1997. The ratio of general and administrative expenses to average assets was 1.41% for 1998 compared to 1.38% for 1997. Sovereign's efficiency ratio (all general and administrative expenses as a percentage of net interest income and recurring non-interest income) for 1998 was 46.6% compared to 46.1% for 1997. The increase in general and administrative expenses during 1998 was primarily due to Sovereign's overall franchise growth, as well as special systems-related charges. These special systems-related charges include Sovereign's conversion to a new commercial bank data processing system and its Year 2000 initiatives. Other Operating Expenses. Total other operating expenses were $82.3 million for 1998 compared to $44.8 million for 1997. Other operating expenses included merger-related charges of $49.9 million for 1998 compared to $19.2 million for 1997. These expenses are related to Sovereign's acquisitions over the last two years and include human resources related costs, losses on the sale of certain assets and other expenses, including investment banker fees and legal expenses. Also included in other operating expenses was amortization of goodwill and other intangible assets of $20.6 million for 1998 compared to $13.2 million for 1997, Trust Preferred Securities expense of $12.5 million for 1998 compared to $11.7 million for 1997, and other net real estate owned ("OREO") gains of $804,000 for 1998 compared to net OREO losses of $767,000 for 1997. 18 Income Tax Provision. The income tax provision was $74.8 million for 1998 compared to $67.3 million for 1997. The effective tax rate for 1998 was 35.4% compared to 39.6% for 1997. The effective tax rates for 1998 and 1997 include the effect of certain non-deductible expenses incurred in conjunction with Sovereign's acquisitions during each of these years. For additional information with respect to Sovereign's income taxes, see Note 14 at "Notes to Consolidated Financial Statements" hereof. FINANCIAL CONDITION Loan Portfolio. Sovereign's loan portfolio at December 31, 1998 was $11.3 billion, unchanged from December 31, 1997. Sovereign's consumer and commercial loan portfolios have increased as a result of strong originations and the 1998 CoreStates branch acquisition, which added approximately $725 million of commercial and consumer loans to Sovereign's loan portfolio. This increase has been off-set by a planned decline in Sovereign's residential mortgage loan portfolio resulting from the refinance environment and Sovereign's increased mortgage banking capabilities, which results in residential mortgage loan originations being sold in the secondary market rather than held in Sovereign's loan portfolio. At December 31, 1998, Sovereign's total loan portfolio included $5.1 billion of first mortgage loans secured primarily by liens on owner-occupied one-to-four family residential properties compared to $6.6 billion at December 31, 1997. With its increased focus on non-residential lending and Sovereign's acquisition activity over the past two years, at December 31, 1998, Sovereign's total loan portfolio also included $2.3 billion of commercial loans and $3.8 billion of consumer loans, including $1.8 billion of outstanding home equity loans (excluding $600 million of additional unused commitments for home equity lines of credit) secured primarily by second mortgages on owner-occupied one-to-four family residential properties and $1.5 billion of auto loans. This compares to $1.4 billion of commercial loans and $3.1 billion of consumer loans, including $1.1 billion of outstanding home equity loans and $1.6 billion of auto loans, at December 31, 1997. Over the past two years, Sovereign has increased its emphasis on commercial and consumer loan originations. As a result, during 1998, Sovereign closed $1.3 billion of commercial loans compared to $310 million of commercial loans for 1997. This increase was due to strong business loan demand in Sovereign's market area resulting from a strong regional economy, recent bank mergers affecting the region, and significant staffing increases in Sovereign's commercial banking unit. Sovereign closed $2.0 billion of consumer loans during 1998 compared to $924 million of consumer loans for 1997. This increase was primarily the result of home equity loan originations of approximately $331 million and indirect auto loan originations of approximately $587 million during 1998. During 1998, Sovereign closed $2.1 billion of first mortgage loans of which $1.9 billion were fixed rate and sold in the secondary market. This compares to first mortgage loan closings of $2.0 billion and $897 million of fixed rate loans for 1997. 19 Management's Discussion and Analysis Table 4 presents the composition of Sovereign's loan portfolio by type of loan and by fixed and variable rates at the dates indicated (in thousands): Table 4: Composition of Loan Portfolio
At December 31, ---------------------------------------------------------------------------- 1998 1997 1996 ----------------------- ------------------------ ---------------------- Balance Percent Balance Percent Balance Percent ----------------------- ------------------------ ---------------------- Residential real estate loans $ 5,113,537 45.3% $ 6,634,271 58.6% $7,381,820 76.9% Residential construction loans 62,536 .6 137,367 1.2 136,436 1.4 ----------- ----- ------------ ----- ---------- ----- Total Residential Loans 5,176,073 45.9 6,771,638 59.8 7,518,256 78.3 ----------- ----- ------------ ----- ---------- ----- Commercial real estate loans 887,938 7.9 664,943 5.9 511,071 5.3 Commercial loans 717,440 6.4 356,517 3.1 262,840 2.7 Automotive floor plan loans 578,147 5.1 279,757 2.5 -- -- Multi-family loans 115,195 1.0 115,570 1.0 109,774 1.2 ----------- ----- ------------ ----- ---------- ----- Total Commercial Loans 2,298,720 20.4 1,416,787 12.5 883,685 9.2 ----------- ----- ------------ ----- ---------- ----- Home equity loans 1,750,883 15.5 1,050,304 9.3 800,559 8.3 Auto loans 1,510,676 13.4 1,553,318 13.7 73,393 .8 Loans to automotive lessors 252,856 2.2 267,033 2.3 -- -- Student loans 256,744 2.3 190,440 1.7 211,358 2.2 Credit cards -- -- 54,887 .5 82,798 .9 Other 39,888 .3 19,715 .2 25,446 .3 ------------ ----- ------------ ----- ---------- ----- Total Consumer Loans 3,811,047 33.7 3,135,697 27.7 1,193,554 12.5 ------------ ----- ------------ ----- ---------- ----- Total Loans $11,285,840 100.0% $11,324,122 100.0% $9,595,495 100.0% ============ ===== ============ ===== ========== ===== Total Loans with:(1) Fixed rates $5,798,158 51.4% $ 4,548,951 40.2% $2,180,356 22.7% Variable rates 5,487,682 48.6 6,775,171 59.8 7,415,139 77.3 ------------ ----- ------------ --- ---------- --- Total Loans $11,285,840 100.0% $11,324,122 100.0% $9,595,495 100.0% ============ ===== ============ ===== ========== =====
At December 31, ----------------------------------------------------- 1995 1994 ------------------------ ---------------------- Balance Percent Balance Percent ------------------------ ----------------------- Residential real estate loans $6,059,064 79.8% $ 5,660,704 81.2% Residential construction loans 116,110 1.6 83,630 1.2 ------------ ----- ---------- ----- Total Residential Loans 6,175,174 81.4 5,744,334 82.4 ------------ ----- ---------- ----- Commercial real estate loans 358,334 4.7 288,739 4.2 Commercial loans 166,712 2.2 113,686 1.6 Automotive floor plan loans -- -- -- -- Multi-family loans 130,819 1.7 148,878 2.1 ------------ ----- ----------- ----- Total Commercial Loans 655,865 8.6 551,303 7.9 ------------ ----- ----------- ----- Home equity loans 648,033 8.5 583,837 8.4 Auto loans 14,267 .2 14,954 .2 Loans to automotive lessors -- -- -- -- Student loans 14,232 .2 13,107 .2 Credit cards 32,274 .4 10,338 .1 Other 51,262 .7 54,311 .8 ----------- ----- ---------- ----- Total Consumer Loans 760,068 10.0 676,547 9.7 ----------- ----- ---------- ----- Total Loans $7,591,107 100.0% $6,972,184 100.0% ============ ===== =========== ===== Total Loans with:(1) Fixed rates $1,896,384 25.0% $1,768,859 25.4% Variable rates 5,694,723 75.0 5,203,325 74.6 ------------ ----- ----------- ----- Total Loans $7,591,107 100.0% $6,972,184 100.0% ============ ===== =========== =====
- -------------------------------------------------------------------------------- (1) Loan totals do not reflect the impact of off-balance sheet interest rate swaps used for interest rate risk management as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management." - -------------------------------------------------------------------------------- Table 5 sets forth the maturity of Sovereign's residential construction, commercial real estate and commercial loans as scheduled to mature contractually at December 31, 1998 (in thousands): Table 5: Loan Maturity Schedule
At December 31, 1998, Maturing --------------------------------------------------------- In One Year After One Year After Or Less --Five Years Five Years Total ----------- -------------- ---------- --------- Residential construction loans (net of loans in process of $89,509)(1) $ 3,367 $ -- $ 59,169 $ 62,536 Commercial real estate loans 108,259 285,961 493,718 887,938 Commercial loans 244,834 210,491 262,115 717,440 -------- -------- --------- ---------- Total $356,460 $496,452 $ 815,002 $1,667,914 ======== ======== ========= ========== Loans with: Fixed rates $ 90,151 $375,734 $ 507,280 $ 973,165 Variable rates 266,309 120,718 307,722 694,749 -------- -------- --------- ---------- Total $356,460 $496,452 $ 815,002 $1,667,914 ======== ======== ========= ==========
- -------------------------------------------------------------------------------- (1) Loans classified as residential construction loans convert to residential mortgage loans after a one-year period. The residential construction loans are closed as either fifteen-year or thirty-year terms added to the one-year construction loan period. Accordingly, the majority of these loan balances are anticipated to mature beyond five years. Sovereign's recent strategic acquisitions, coupled with expanded origination capacity, accelerated Sovereign's transition in becoming a Super Community Bank by increasing consumer loans to 34% and commercial loans to 20% of total loans in 1998, up from 28% and 12%, respectively for 1997. Commercial loan credit quality remains strong and the commercial loan division's growing portfolio is regularly examined for quality by an experienced internal credit review team. Commercial loans are allocated reserves based upon individual asset risk assessments. 20 Credit Risk Management Extending credit to businesses and consumers exposes Sovereign to credit risk. Credit risk is the risk that the principal balance of a loan and any related interest will not be collected due to the inability of the borrower to repay the loan. Sovereign manages credit risk in the loan portfolio through adherence to consistent standards, guidelines and limitations established by senior management. Written loan policies establish underwriting standards, lending limits and other standards or limits as deemed necessary and prudent. Various approval levels, based on the amount of the loan and whether the loan is secured or unsecured, have also been established. Loan approval authority ranges from the individual loan officer to the Board of Directors' Loan Committee. The Loan Review group within Sovereign's Risk Management Department conducts ongoing, independent reviews of the lending process to ensure adherence to established policies and procedures, monitors compliance with applicable laws and regulations, provides objective measurement of the risk inherent in the loan portfolio, and ensures that proper documentation exists. The results of these periodic reviews are reported to the Asset Review Committee, to Sovereign's Board of Directors and to the Board of Directors of Sovereign Bank. In response to Sovereign's increased emphasis on commercial and consumer lending since 1997, Sovereign has added to its loan review group by hiring loan review officers with significant commercial and consumer experience. The following discussion summarizes the underwriting policies and procedures for the major categories within the loan portfolio and addresses Sovereign's strategies for managing the related credit risk. Commercial Loans - Credit risk associated with commercial loans is primarily influenced by prevailing and expected economic conditions and the level of underwriting risk Sovereign is willing to assume. To manage credit risk when extending commercial credit, Sovereign focuses on adequately assessing the borrower's ability to repay and on obtaining sufficient collateral. Commercial and industrial loans are generally secured by the borrower's assets and by personal guarantees. Commercial Real Estate loans are originated primarily within the Pennsylvania and New Jersey market areas and are secured by developed real estate at conservative loan-to-values and often by a guarantee of the borrower. Management closely monitors the composition and quality of the total commercial loan portfolio to ensure that significant credit concentrations by borrower or industry do not exist. Consumer Loans - The consumer loan portion of Sovereign's loan portfolio has increased from 27.7% at December 31, 1997 to 33.7% of the loan portfolio at December 31, 1998. The portion of the consumer portfolio which is secured by real estate, vehicles, deposit accounts or government guarantees comprises 98.9% of the entire portfolio. Credit risk in the direct consumer loan portfolio is controlled by strict adherence to conservative underwriting standards that consider debt to income levels and the creditworthiness of the borrower. In the home equity loan portfolio, combined loan-to-value ratios are generally limited to 80%. Other credit considerations may warrant higher combined loan-to-value ratios for approved loans. Residential Loans - Sovereign originates fixed rate and adjustable rate residential mortgage loans which are secured by the underlying 1-4 family residential property. At December 31, 1998 and 1997, these loans accounted for 45.9% and 59.8% respectively, of the total loan portfolio. This decrease was the outcome of a planned decline resulting from the refinance environment and Sovereign's increased mortgage banking capabilities, which facilitates residential mortgage loan originations being sold in the secondary market rather than held in Sovereign's loan portfolio. Credit risk exposure in this area of lending is minimized by the evaluation of the creditworthiness of the borrower, including debt-to-equity ratios and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance, unless otherwise guaranteed or insured by the Federal, state or local government. Sovereign also utilizes underwriting standards which comply with those of the Federal Home Loan Mortgage Corporation ("FHLMC") or the Federal National Mortgage Association ("FNMA"). Credit risk is further reduced since the majority of Sovereign's fixed rate mortgage loan production and all of its sub-prime mortgage loan production is sold to investors in the secondary market without recourse. Collections Sovereign closely monitors delinquencies as another means of maintaining high asset quality. Collection efforts begin within 15 days after a loan payment is missed. A predictive dialer is used to assist collection efforts in the early stages of delinquency on the entire retail portfolio. An attempt is made to contact all borrowers and to offer a variety of loss mitigation alternatives. If these attempts fail, Sovereign will proceed to gain control of any and all collateral in a timely manner in order to minimize losses. While liquidation and recovery efforts continue, officers continue to work with the borrowers, if appropriate, to recover all monies owed to Sovereign. Legal counsel is retained when necessary. Sovereign monitors delinquency trends at 30, 60, and 90 days past due. These trends are discussed at the monthly Asset Review meetings. Minutes from these meetings are submitted to the Board of Directors of Sovereign Bank. Approximately $231 million, or 2.05%, of the loans in the loan portfolio at December 31, 1998, were 30 to 89 days delinquent, compared to $190 million, or 1.68% of portfolio loans, at December 31, 1997. Sovereign also maintains a watch list for loans identified as requiring a higher level of monitoring by management because of one or more characteristics, such as economic conditions, industry trends, nature of collateral, collateral margin, payment history or other factors. Non-Performing Assets At December 31, 1998, Sovereign's non-performing assets were $116 million compared to $108 million at December 31, 1997. Non-performing assets as a percentage of total assets was .53% at December 31, 1998 compared to .61% at December 31, 1997. At December 31, 1998, 66% of non-performing assets consisted of loans related to real estate or OREO . Another 5% of non-performing assets consist of indirect auto loans and other repossessed assets. Indirect auto loans delinquent in excess of 120 days carry a reserve allocation of 100%. Repossessed autos carry a reserve allocation of 50%. The remainder of Sovereign's non-performing assets consist principally of consumer loans, many of which are secured by collateral. Sovereign places all loans 90 days or more delinquent (except auto loans and loans guaranteed by the government or secured by deposit accounts) on non-performing status. Sovereign's auto loans continue to accrue interest until they are 120 days delinquent, at which time they are placed on non-accrual status and a 100% reserve allocation is assigned. 21 Management's Discussion and Analysis Table 6 presents the composition of non-performing assets at the dates indicated (in thousands): Table 6: Non-Performing Assets
At December 31, ------------------------------------------------------------ 1998 1997 1996 1995 1994 -------- -------- -------- -------- -------- Non-accrual loans: Past due 90 days or more as to interest or principal: Real estate related $ 63,258 $ 65,930 $ 78,715 $ 81,571 $ 76,545 Other 33,297 22,368 19,671 11,721 6,968 Past due less than 90 days as to interest or principal: Real estate related -- 555 639 3,884 2,980 Other -- -- 160 739 -- -------- -------- -------- -------- -------- Total non-accrual loans 96,555 88,853 99,185 97,915 86,493 Other 3,404 6,524 -- -- -- Restructured loans 141 327 1,561 3,772 4,264 -------- -------- -------- -------- -------- Total non-performing loans 100,100 95,704 100,746 101,687 90,757 Other real estate owned and other repossessed assets: Residential real estate owned 12,147 11,299 13,669 9,988 11,943 Commercial real estate owned 665 710 4,380 11,676 14,435 Other repossessed assets 2,772 -- -- -- -- -------- -------- -------- -------- -------- Total other real estate owned and other repossessed assets 15,584 12,009 18,049 21,664 26,378 -------- -------- -------- -------- -------- Total non-performing assets $115,684 $107,713 $118,795 $123,351 $117,135 ======== ======== ======== ======== ======== Past due 90 days or more as to interest or principal and accruing interest(1) $ 6,571 $ 7,053 $ 16,722 $ 2,299 $ 2,138 Non-performing assets as a percentage of total assets .53% .61% .78% .94% 1.06% Non-performing loans as a percentage of total loans .86 .82 1.04 1.30 1.29 Non-performing assets as a percentage of total loans and other real estate owned 1.05 .99 1.39 1.60 1.70 Allowance for loan losses as a percentage of total non-performing assets 111.5 103.7 58.5 53.5 53.0 Allowance for loan losses as a percentage of total non-performing loans 128.9 116.7 69.0 65.0 68.4
- -------------------------------------------------------------------------------- (1) Non-performing assets past due 90 days or more as to interest or principal and accruing interest at December 31, 1998, 1997 and 1996 included $6.6 million, $6.7 million and $10.5 million, respectively, of student loans which are government-guaranteed and Sovereign retains minimal risk of credit losses related to these loans. - -------------------------------------------------------------------------------- Impaired Loans At December 31, 1998 and 1997, the gross recorded investment in impaired loans totaled $63.3 million and $24.9 million, respectively. The increase in the investment in impaired loans at December 31, 1998 compared to December 31, 1997 was primarily the result of Sovereign's recent balance sheet transformation strategy which places more emphasis on building the commercial and consumer loan portfolios. Along with higher yields, these loan types also bring greater risk of impairment, especially as the portfolio becomes more seasoned. Sovereign classifies all commercial loans that are greater than 90 days delinquent on non-accrual status, and certain criticized loans as impaired. Gross interest income for the years ended December 31, 1998, 1997 and 1996 would have increased by approximately $9.5 million, $7.5 million and $8.5 million, respectively, had Sovereign's non-accruing and restructured loans been current in accordance with their original terms and outstanding throughout the period. Interest income recorded on these loans for the years ended December 31, 1998, 1997 and 1996 was $3.3 million, $2.4 million and $2.4 million, respectively. Potential problem loans (consisting of loans which management has serious doubts as to the ability of such borrowers to comply with present repayment terms, although not currently classified as non-performing loans) amounted to approximately $41.0 million at December 31, 1998 and consisted principally of commercial real estate loans. 22 At December 31, 1998, Sovereign serviced, with recourse, a total of $35.4 million of single-family residential loans. Substantially all of this recourse servicing was acquired in a 1992 acquisition. These are seasoned loans with decreasing balances and historical loss experience has been minimal. Allowance for Loan Loss The adequacy of Sovereign's allowance for loan losses is regularly evaluated. Management's evaluation of the adequacy of the allowance to absorb potential 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 unallocated allowance. At December 31, 1998, Sovereign's loan delinquencies (all loans greater than 30 days delinquent) as a percentage of total loans was 2.95% compared to 2.71% at December 31, 1997. This increase was primarily attributable to Sovereign's business decision to transform its balance sheet to look much more like a community-oriented commercial bank. At December 31, 1997, Sovereign's loan portfolio was 60% residential, 28% consumer and 12% commercial. At December 31, 1998, Sovereign's loan portfolio was 46% residential, 34% consumer and 20% commercial. This transition achieved management's goal of more than 50% of the loan portfolio in higher yielding consumer and commercial loans by year-end 1998. Along with higher yields, this transformation brings higher risk and higher delinquencies. The following table summarizes Sovereign's allocation of the allowance for loan losses for class, specific and unallocated allowances by loan type and the percentage of each loan type of total portfolio loans. Due to the inavailibility of certain historical data, only 1998 is separated into class versus specific allowances. For all years prior to 1998, amounts are allocated entirely to the class allowance. The entire allowance, however, is available for use against any type of loan loss deemed necessary. Table 7 Allocation of the Allowance for Loan Losses
- ---------------------------------------------------------------------------------------------------------------- December 31 (Dollars in thousands) 1998 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------------- % of % of % of % of total total total total Amount loans Amount loans Amount loans Amount loans - ---------------------------------------------------------------------------------------------------------------- Class allowances: Commercial loans $14,549 18% $30,793 11% $21,091 9% $13,753 9% Residential real estate mortgage loans 13,690 49 36,351 62 25,835 78 23,968 81 Consumer loans 40,866 33 24,300 27 10,274 13 6,748 10 ------- ------- ------- ------- Total class allowances 69,105 91,444 57,200 44,469 Specific allowances: Commercial loans 16,191 -- -- -- -- -- -- -- Residential real estate mortgage loans 16,351 -- -- -- -- -- -- -- Consumer loans 7,217 -- -- -- -- -- -- -- ------- --- ------- --- ------- --- ------ ---- Total specific allowances 39,759 -- -- -- -- -- -- -- Unallocated allowances 24,938 -- 25,379 -- 16,647 -- 23,046 -- ------- --- ------- --- ------- --- ------- --- Total allowance for loan losses 133,802 100% $116,823 100% $73,847 100% $ 67,515 100% ======= ===== ======= ==== ======= ==== ======== ==== - ---------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------- December 31 (Dollars in thousands) 1994 - -------------------------------------------------------- % of total Amount loans - -------------------------------------------------------- Class allowances: Commercial loans $11,415 8% Residential real estate mortgage loans 23,620 82 Consumer loans 6,308 10 ------- Total class allowances 41,343 Specific allowances: Commercial loans -- -- Residential real estate mortgage loans -- -- Consumer loans -- -- ------- ---- Total specific allowances -- -- Unallocated allowances 23,268 -- ------- ---- Total allowance for loan losses $64,611 100% ======= ==== - ------------------------------------------------------- Sovereign periodically reviews its loan portfolio and assigns a risk-rating based on loan type, collateral value, financial condition of the borrower and payment history. Delinquent mortgage and consumer loans are reviewed monthly and assigned a rating based on their payment history, financial condition of the borrower and collateral values. Specific mortgage and consumer loans are also reviewed in conjunction with the previously described review of any related commercial loan. Class Allowance - The class allowance for December 31, 1998 and 1997 is a general allowance for "Pass" rated loans and was determined by applying specific risk percentages to each "Pass" rated loan. The risk percentages are determined by Sovereign in consultation with regulatory authorities, actual loss experience, peer group loss experience and are adjusted for current economic conditions. The risk percentages are considered a prudent measurement of the risk of Sovereign's loan portfolio. Such risk percentages are applied to individual loans based on loan type. Residential Portfolio - Class reserves for the residential portfolio were reduced from .20% of the portfolio in 1997 to .15% of the portfolio in 1998. This reduction was based on a combination of reduced losses and increased recoveries during 1998. Net charge-offs in 1998 were $5.1 million, compared to $7.8 million in 1997. Consumer Portfolio - Consumer Portfolio class reserves are between the range of 50 basis points of that portion of the consumer portfolio fully secured by real estate, and 140 basis points for the higher risk portions of its portfolio. The class reserve for Sovereign's indirect auto loan portfolio increased during 1998 due to higher than expected net charge-offs. In response to the higher charge-offs, in the latter half of 1998, Sovereign revised its indirect auto underwriting guidelines to reflect a more conservative lending philosophy. Commercial Portfolio - In addition to the specific reserves established for the commercial loan portfolio, Sovereign reserves in the range of 75 to 150 basis points of its commercial loan portfolio, based on product type and collateral value. Specific Allowance - Sovereign determines the specific portion of its allowance for loan losses for all criticized loans, or those classified as special mention, sub-standard, doubtful, or loss. Risk percentages are applied to each class of criticized commercial, consumer and residential loans to determine the specific allowance. Additionally, additional specific reserves are established for certain impaired commercial loans based on expected shortfalls in future cash flows and inadequate collateral value. Management believes this periodic review provides a mechanism that results in loans being rated in the proper category and accordingly, assigned the proper risk loss percentage in computing the class or specific reserve. Unallocated Allowance - The unallocated allowance for loan losses decreased $441,000 to $24.9 million at December 31, 1998 from $25.4 million at December 31, 1997. This slight decrease can be attributed to the increased class reserves of $3.9 million to $69.1 million at December 31, 1998. The change in the mix of Sovereign's loan portfolio through both internal growth and portfolio acquisitions indicated to management that a higher provision for loan losses was necessary to maintain the allowance for loan losses at a level which management conservatively estimates is necessary to absorb potential losses inherent in the December 31, 1998 portfolio. As a result, excluding the additional provision of $24.9 million recorded as part of the merger charges related to Sovereign's 1997 acquisition activity, Sovereign's 1998 loan loss provision increased 73% to $28.0 million in 1998 from $16.2 million in 1997. For additional information with respect to Sovereign's provision for loan losses, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Provision for Loan Losses." Investment Securities. Sovereign's investment portfolio is concentrated in mortgage-backed securities and collateralized mortgage obligations issued by federal agencies or private label issues. The private label issues have ratings of "AAA" by Standard and Poor's and Fitch at the date of issuance. The classes are backed by single-family residential loans which are primary residences geographically dispersed throughout the United States. Sovereign purchases classes which are senior positions backed by subordinate classes. The subordinate classes absorb the losses and must be completely eliminated before any losses flow through the senior positions. Sovereign's strategy is to purchase classes which have an average life of three years or less. The effective duration of the total investment portfolio at December 31, 1998 was 1.7 years. Investment Securities Available-for-Sale. Securities expected to be held for an indefinite period of time are classified as available-for-sale and are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity, net of estimated income taxes. Decisions to purchase or sell these securities are based on economic conditions including changes in interest rates, liquidity, and asset/liability management strategies. For additional information with respect to the amortized cost and estimated fair value of Sovereign's investment securities available-for-sale, see Note 4 at Item 8 "Financial Statements and Supplementary Data" hereof. The maturities of mortgage-backed securities available-for-sale are based upon contractually scheduled repayments. Expected maturities will differ from contractual maturities because borrowers may have the right to put or repay obligations with or without put or prepayment penalties. Yields on tax-exempt securities were computed on a tax equivalent basis using Sovereign's effective tax rate of 35%. 23 Management's Discussion and Analysis Table 8 sets forth the amortized cost, expected maturities and yields of Sovereign's investment securities available-for-sale at December 31, 1998 (in thousands): Table 8: Investment Securities Available for Sale Maturity Schedule
At December 31, 1998, Due -------------------------------------------------------------------- After Ten Years/ In One Year One Year/ Five Years/ No Stated or Less Five Years Ten Years Maturity Total ---------- ---------- ----------- ---------- --------- Investment Securities: U.S. Treasury and government agency securities $ 23,486 $ 11,994 $ -- $ -- $ 35,480 4.65% 6.12% -- -- 5.15% Corporate securities -- 636 30,247 7,901 38,784 -- 3.67% 7.42% 8.08% 7.49% Equity securities -- -- -- 881,817 881,817 -- -- -- 6.51% 6.51% Other securities -- 88 1,620 6,652 8,360 -- 6.70% 4.92% 6.02% 5.81% Mortgage-backed Securities: FHLMC 22,926 48,240 11,392 3,203 85,761 7.39% 7.48% 7.47% 7.38% 7.45% FNMA 10,571 23,252 5,308 1,514 40,645 7.30% 7.35% 7.36% 7.29% 7.34% GNMA 9,575 24,343 6,062 2,454 42,434 7.60% 7.34% 7.24% 7.28% 7.38% Private issues 241,378 1,608,863 114,150 4,931 1,969,322 6.89% 6.84% 6.84% 6.83% 6.85% Collateralized mortgage obligations 1,163,945 2,166,359 139,230 62,414 3,531,948 6.68% 6.69% 6.69% 6.59% 6.68% ---------- ---------- -------- -------- ---------- Total investment securities available-for-sale $1,471,881 $3,883,775 $308,009 $970,886 $6,634,551 ========== ========== ======== ======== ========== 6.70% 6.77% 6.86% 6.53% 6.72% ========== ========== ======== ======== ==========
- -------------------------------------------------------------------------------- Investment Securities Held-to-Maturity. Securities that Sovereign has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. This portfolio is primarily comprised of U.S. Treasury and government agency securities; corporate debt securities; mortgage-backed securities issued by FHLMC, FNMA, the Government National Mortgage Association ("GNMA"), the RTC and private issuers; and collateralized mortgage obligations. For additional information with respect to the amortized cost and estimated fair value of Sovereign's investment securities held-to-maturity, see Note 4 at Item 8 "Financial Statements and Supplementary Data" hereof. The maturities of mortgage-backed securities held-to-maturity are based upon contractually scheduled repayments. Expected maturities will differ from contractual maturities because borrowers may have the right to put or repay obligations with or without put or prepayment penalties. Yields on tax-exempt securities were computed on a tax equivalent basis using Sovereign's effective tax rate of 35%. 24 Table 9 sets forth the expected maturity and yields of Sovereign's investment securities held-to-maturity at December 31, 1998 (in thousands): Table 9: Investment Securities Held-to-Maturity Maturity Schedule
At December 31, 1998, Due ----------------------------------------------------------------- In One Year One Year/ Five Years/ After or Less Five Years Ten Years Ten Years Total ---------- ----------- ----------- --------- ---------- Investment Securities: U.S. Treasury and government agency securities $ 31,180 $ -- $ -- $ -- $ 31,180 5.44% -- -- -- 5.44% Other securities 1,710 265 40,912 11,594 54,481 8.05% 8.27% 9.98% 10.29% 9.98% Mortgage-backed Securities: FHLMC 71,718 143,419 22,678 4,743 242,558 7.44% 7.45% 7.50% 7.60% 7.45% FNMA 58,292 99,435 15,584 2,856 176,167 7.12% 7.38% 7.42% 7.56% 7.30% GNMA 53,901 158,478 53,606 26,679 292,664 6.91% 6.96% 7.02% 7.15% 6.98% Private issues 22,106 42,840 7,729 1,848 74,523 6.74% 6.84% 6.95% 7.01% 6.83% Collateralized mortgage obligations 516,286 436,716 10,994 4,086 968,082 6.61% 6.74% 6.66% 6.78% 6.67% -------- -------- -------- ------- ---------- Total investment securities held-to-maturity $755,193 $881,153 $151,503 $51,806 $1,839,655 ======== ======== ======== ======= ========== 6.71% 6.97% 7.90% 7.88% 6.97% ======== ======== ======== ======= ==========
25 Management's Discussion and Analysis Table 10 presents the securities of single issuers (other than obligations of the United States and its political subdivisions, agencies and corporations) having an aggregate book value in excess of 10% of Sovereign's stockholders' equity which were held by Sovereign at December 31, 1998 (in thousands): Table 10: Investment Securities of Single Issuers At December 31, 1998 -------------------------------- Carrying Value Fair Value -------------- -------------- Cendant Mortgage $ 509,304 $ 508,449 Countrywide Home Loans, Inc. 772,857 775,268 Delta Funding 133,163 132,266 First Union Mortgage Corporation 159,852 160,976 G.E. Capital Mortgage Servicing, Inc. 609,118 610,391 Norwest Asset Securities Corporation 655,486 654,144 PNC Mortgage Securities Corporation 754,551 754,069 Residential Asset Securitization Trust 438,875 441,134 Residential Funding Corporation 801,935 809,456 Structured Asset Mortgage Investments, Inc. 209,315 209,938 Structured Asset Securities Corporation 309,690 315,184 ---------- ---------- Total $5,354,146 $5,371,275 ========== ========== Other Assets. At December 31, 1998, premises and equipment, net of accumulated depreciation, was $98.5 million compared to $92.3 million at December 31, 1997. This increase was primarily attributable to the CoreStates branch acquisition and hardware upgrades related to Sovereign's Year 2000 initiatives. Total goodwill and other intangible assets at December 31, 1998 were $426 million compared to $126 million at December 31, 1997. This increase was primarily attributable to the CoreStates branch acquisition during the third quarter of 1998, which added approximately $325 million of goodwill and other intangibles to Sovereign's balance sheet. Sovereign's increase in other assets during 1998 was partially attributable to the purchase of $250 million of BOLI during the year. Deposits. Deposits are attracted from within Sovereign's primary market area through the offering of various deposit instruments including NOW accounts, money market accounts, savings accounts, certificates of deposit and retirement savings plans. Total deposits at December 31, 1998 were $12.3 billion compared to $9.5 billion at December 31, 1997. Table 11 presents the composition of Sovereign's deposits at the dates indicated (in thousands): Table 11: Deposit Portfolio Composition
At December 31, --------------------------------------------------------------------------- 1998 1997 1996 ----------------------- ---------------------- --------------------- % of % of % of Balance Deposits Balance Deposits Balance Deposits ---------- -------- ---------- --------- ---------- -------- Demand deposit and NOW accounts $ 2,385,686 19.4% $1,334,852 14.0% $1,156,840 13.4% Savings accounts 2,295,448 18.6 1,900,334 20.0 1,869,633 21.6 Money market accounts 1,545,634 12.5 916,788 9.6 853,505 9.8 Retail certificates of deposit 5,172,196 42.0 4,673,467 49.1 4,386,401 50.6 ---------- ----- --------- ----- --------- ----- Total retail deposits 11,398,964 92.5 8,825,441 92.7 8,266,379 95.4 Jumbo certificates of deposit 923,752 7.5 689,853 7.3 394,305 4.6 ---------- ----- --------- ----- --------- ----- Total deposits $12,322,716 100.0% $9,515,294 100.0% $8,660,684 100.0% =========== ===== ========== ===== ========== =====
26 Borrowings. Sovereign utilizes borrowings as a source of funds for its asset growth and its asset/liability management. Collateralized advances are available from the Federal Home Loan Bank of Pittsburgh ("FHLB") provided certain standards related to creditworthiness have been met. Another source of funds for Sovereign is reverse repurchase agreements. Reverse repurchase agreements are short-term obligations collateralized by securities fully guaranteed as to principal and interest by the U.S. Government or an agency thereof. Total borrowings at December 31, 1998 were $7.9 billion of which $3.9 billion were short-term compared to total borrowings of $6.9 billion of which $5.5 billion were short-term at December 31, 1997. Table 12 presents information regarding Sovereign's borrowings at the dates indicated (in thousands): Table 12: Borrowings
At December 31, -------------------------------------------------------------------------------- 1998 1997 1996 ------------------------- ----------------------- ------------------------ Weighted Weighted Weighted Balance Average Rate Balance Average Rate Balance Average Rate ---------- ------------ --------- ------------ ---------- ------------ Securities sold under repurchase agreements $ 655,540 5.46% $1,150,093 5.70% $1,168,172 5.60% FHLB advances 6,901,505 5.14 5,525,399 5.93 4,251,189 5.88 Other borrowings 343,547 8.19 188,151 5.88 179,748 7.45 ---------- ---- --------- ---- ---------- ---- Total borrowings $7,900,592 5.30% $6,863,643 5.89% $5,599,109 5.87% ========== ==== ========== ==== ========== ====
- -------------------------------------------------------------------------------- Through the use of interest rate swaps, $2.8 billion of the FHLB advances at December 31, 1998 have been effectively converted from variable rate obligations to fixed rate obligations. In addition, $1.2 billion of borrowings have been protected from upward repricing through the use of interest rate caps, floors and/or corridors. 27 Management's Discussion and Analysis LIQUIDITY AND CAPITAL RESOURCES Sovereign Bank is required under applicable federal regulations to maintain specified levels of "liquid" investments in cash and U.S. Treasury securities and other qualifying investments. Regulations currently in effect require Sovereign Bank to maintain liquid assets of not less than 4% of its net withdrawable accounts plus short-term borrowings. These levels are changed from time to time by the OTS to reflect economic conditions. Sovereign Bank's liquidity ratio for December 1998 was 44.9%. Sovereign's primary financing sources are deposits obtained in its own market area and borrowings in the form of securities sold under repurchase agreements and advances from the FHLB. While the majority of Sovereign's certificate of deposit accounts are expected to mature within a one year period, historically, the retention rate has been approximately 70%. If a significant portion of maturing certificates would not renew at maturity, the impact on Sovereign's operations and liquidity would be minimal due to cash flows produced by Sovereign's investment portfolio which approximate $265 million per month. At December 31, 1998, Sovereign had $6.2 billion in unpledged investment securities which could be used to collateralize additional borrowings. Sovereign Bank can also borrow from the FHLB, subject to required collateralization. Other sources of funds include operating activities, repayments of principal on investment securities, repayment of principal on loans and other investing activities. Sovereign also maintains strong relationships with numerous investment banking firms, and has the ability to access the capital markets through a variety of products and structures, should liquidity or capital needs arise. On May 17, 1995, Sovereign completed the sale of 2.0 million shares of Convertible Preferred Stock, raising $96.4 million in capital. The 6 1/4% non-voting, Cumulative Convertible Preferred Stock was convertible at the option of the holder at any time, unless previously redeemed, at a conversion rate (adjusted to reflect all stock dividends and stock splits) of 7.184 shares of common stock for each share of preferred stock; equivalent to a conversion price of $6.960 per share of common stock. On May 15, 1998, Sovereign redeemed all outstanding shares of its 6 1/4% Cumulative Convertible Preferred Stock, Series B. Cash and cash equivalents increased $298 million for 1998. Net cash used by operating activities was $15.0 million for 1998. Net cash used by investing activities for 1998 was $3.5 billion consisting primarily of purchases of mortgage-backed securities and loans purchased from CoreStates, partially off-set by proceeds from sales, repayments and maturities of investment securities and sales of loans. Net cash provided by financing activities for 1998 was $3.8 billion which was primarily attributable to the assumption of deposits from CoreStates and an increase in proceeds from long-term borrowings, partially off-set by a net decrease in short-term borrowings. At December 31, 1998, Sovereign Bank was classified as well-capitalized and was in compliance with all capital requirements. For a detailed discussion on regulatory capital requirements, see Note 11 at "Notes to Consolidated Financial Statements" hereof. The following table sets forth the capital ratios of Sovereign Bancorp and Sovereign Bank and the current regulatory requirements at December 31, 1998:
Well Sovereign Sovereign Minimum Capitalized Bancorp(1) Bank Requirement Requirement --------- --------- ----------- ----------- Tangible capital to tangible assets 3.51% 5.11% 1.50% None Leverage (core) capital to tangible assets 4.20 5.21 3.00 5.00% Leverage (core) capital to risk-adjusted assets 7.33 9.29 4.00 6.00 Risk-based capital to risk-adjusted assets 11.25 10.32 8.00 10.00
- -------------------------------------------------------------------------------- (1) OTS capital regulations do not apply to holding companies. These ratios are computed as if those regulations did apply to Sovereign Bancorp. 28 ASSET AND LIABILITY MANAGEMENT The objective of Sovereign's asset and liability management is to identify, measure and control its interest rate risk in order to produce consistent earnings that are not contingent upon favorable trends in interest rates. Sovereign manages its assets and liabilities to attain a stable net interest margin across a wide spectrum of interest rate environments. This is attained by monitoring the levels of interest rates, the relationships between the rates earned on assets and the rates paid on liabilities, the absolute amount of assets and liabilities which reprice or mature over similar periods, off-balance sheet positions and the effect of all these factors on the estimated level of net interest income. There are a number of industry standards used to measure an institution's interest rate risk position. Most common among these is the one year gap which is the ratio representing the difference between assets, liabilities and off-balance sheet positions which will mature or reprice within one year expressed as a percentage of total assets. Using management's estimates of asset prepayments, core deposit decay and core deposit repricing in its computation, Sovereign estimates that its cumulative one year gap position was a positive 5.65% at December 31, 1998. Sovereign manages the one year interest rate gap within a range of +/-10%. A positive gap position implies that the bank is asset sensitive which could cause net interest income to decrease if interest rates fall. Conversely, a negative gap position implies that the bank is liability sensitive which could cause net interest income to decrease if interest rates rise. Sovereign manages the impact to net interest income in a +/-200 basis point instantaneous parallel rate shock environment to be within a 10% loss. At December 31, 1998, Sovereign estimates that if interest rates decline by 200 basis points, net interest income would decrease by $52.4 million or 8.52%; conversely, if interest rates increase by 200 basis points, net interest income would increase by $22.1 million or 3.59%. Sovereign also utilizes income simulation modeling in measuring its interest rate risk and managing its interest rate sensitivity. Income simulation considers not only the impact of changing market interest rates on forecasted net interest income, but also other factors such as yield curve relationships, the volume and mix of assets and liabilities, customer preferences and general market conditions. Pursuant to its interest rate risk management strategy, Sovereign enters into off-balance sheet transactions which involve interest rate exchange agreements (swaps, caps and floors) for interest rate risk management purposes. Sovereign's objective in managing its interest rate risk is to provide sustainable levels of net interest income while limiting the impact that changes in interest rates have on net interest income. Amortizing and non-amortizing interest rate swaps are generally used to convert fixed rate assets and liabilities to variable rate assets and liabilities and vice versa. Sovereign utilizes amortizing interest rate swaps to convert discounted adjustable rate loans to fixed rates for a period of time. The amortization of the notional amount of the interest rate swaps are tied to the level of an index such as the One Year Constant Maturity Treasury, LIBOR, or a prepayment rate of a pool of mortgage-backed securities. In order for interest rate swaps to achieve the desired objective, Sovereign selects interest rate swaps that will have a high degree of correlation to the related financial instrument. Sovereign utilizes non-amortizing interest rate swaps to convert fixed rate liabilities to floating, and floating rate liabilities to fixed, to reduce Sovereign's overall cost of funds. At December 31, 1998, Sovereign's principal off-balance sheet transactions were pay fixed-receive variable non-amortizing interest rate swaps with a total notional amount of $2.8 billion, which are being used to hedge Sovereign's short-term borrowing portfolio. Interest rate caps are generally used to limit the exposure from the repricing and maturity of liabilities and interest rate floors are generally used to limit the exposure from the repricing and maturity of assets. Interest rate caps and floors are also used to limit the exposure created by other interest rate swaps. In certain cases, interest rate caps and floors are simultaneously bought and sold to create a range of protection against changing interest rates while limiting the cost of that protection. 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 which are originated for sale. 29 Management's Discussion and Analysis Sovereign's primary funding source is deposits obtained in its own marketplace. Deposit programs at Sovereign are priced to meet management's asset/liability objectives, while taking into account the rates available on investment opportunities and also considering the cost of alternative funding sources. Borrowings are a significant funding source for Sovereign and have primarily been in the form of securities sold under repurchase agreements and advances from the FHLB. Since borrowings are not subject to the market constraints to which deposits are, Sovereign uses borrowings to add flexibility to its interest rate risk position. Table 13 presents the amounts of interest-earning assets and interest-bearing liabilities that are assumed to mature or reprice during the periods indicated at December 31, 1998, and their related average yields and costs. Adjustable and floating rate loans and securities are included in the period in which interest rates are next scheduled to adjust rather than the period in which they mature (in thousands): Table 13: Gap Analysis
At December 31, 1998, Repricing --------------------------------------------------------------- 0-3 4 Months Year 2 Months -1 Year & over Total ------------ ------------ ----------- ----------- Interest-earning assets: Investment securities(1)(2) $ 1,742,625 $ 2,401,844 $ 4,440,263 $ 8,584,732 6.09% 6.51% 6.68% 6.51% Loans(3) 3,302,338 3,126,632 5,019,998 11,448,968 8.03% 7.89% 8.10% 8.02% ------------ ------------ ------------ ------------ Total interest-earning assets 5,044,963 5,528,476 9,460,261 20,033,700 7.36% 7.29% 7.43% 7.37% Non-interest-earning assets -- -- 1,880,173 1 ,880,173 ------------ ------------ ------------ ------------ Total assets $ 5,044,963 $ 5,528,476 $ 11,340,434 $21,913,873 7.36% 7.29% 6.20% 6.74% ------------ ------------ ------------ ------------ Interest-bearing liabilities: Deposits(4) $ 3,946,410 $ 3,558,976 $ 4,817,330 $12,322,716 4.50% 4.92% 2.22% 3.73% Borrowings 4,092,167 547,834 3,260,591 7,900,592 5.42% 5.22% 5.17% 5.30% ------------ ------------ ------------ ------------ Total interest-bearing liabilities 8,038,577 4,106,810 8,077,921 20,223,308 4.97% 4.96% 3.41% 4.35% Non-interest-bearing liabilities -- -- 486,497 486,497 Stockholders' equity -- -- 1,204,068 1,204,068 ------------ ------------ ------------ ------------ Total liabilities and stockholders' equity $ 8,038,577 $ 4,106,810 $ 9,768,486 $21,913,873 4.97% 4.96% 2.82% 4.01% ------------ ------------ ------------ ------------ Excess assets (liabilities) before effect of off-balance sheet positions $ (2,993,614) $ 1,421,666 $ 1,571,948 ------------ ------------ ------------ To total assets (13.66)% 6.49% 7.17% 2.73% ============ ============ ============ ============ Cumulative excess assets (liabilities) before effect of off-balance sheet positions $ (2,993,614) $ (1,571,948) $ -- ============ ============ ============ To total assets (13.66)% (7.17)% Effect of off-balance sheet positions on assets and liabilities $ 3,140,000 $ (330,000) $ (2,810,000) ------------ ------------ ------------ Excess assets (liabilities) after effect of off-balance sheet positions $ 146,386 $ 1,091,666 $ (1,238,052) ============ ============ ============ To total assets .67% 4.98% (5.65)% Cumulative excess assets (liabilities) after off-balance sheet positions $ 146,386 $ 1,238,052 $ -- ============ ============ ============ To total assets .67% 5.65%
- -------------------------------------------------------------------------------- (1) Includes interest-earning deposits. (2) Investment securities include market rate prepayment and repayment assumptions. (3) Loan balances include annual prepayment and repayment assumptions between 6% and 45% initially with gradual slowing thereafter. Loan balances are presented net of deferred loan fees and include loans held for sale and the allowance for loan losses. (4) Savings, NOW, money market and demand deposit accounts have been assumed to decay at an annual rate of 8%. 30 Table 14 presents selected quarterly consolidated financial data (in thousands, except per share data): Table 14: Selected Quarterly Consolidated Financial Data
Three Months Ended ------------------------------------------------------------------------------------- Dec. 31, Sept. 30, June 30, Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 31, 1998 1998 1998 1998 1997 1997 1997 1997 -------- -------- -------- --------- -------- --------- -------- --------- Total interest income $357,631 $341,768 $331,860 $ 324,112 $312,868 $305,069 $288,509 $ 272,331 Total interest expense 224,915 220,521 212,828 203,495 197,572 195,750 182,821 170,552 -------- -------- -------- --------- -------- -------- --------- --------- Net interest income 132,716 121,247 119,032 120,617 115,296 109,319 105,688 101,779 Provision for loan losses(1) 7,000 7,001 7,200 6,760 6,200 20,329 3,450 11,146 -------- -------- -------- --------- -------- -------- -------- --------- Net interest income after provision 125,716 114,246 111,832 113,857 109,096 88,990 102,238 90,633 -------- -------- -------- --------- -------- -------- --------- --------- Gain/(loss) on sale of loans and investment securities(2) 7,455 6,262 3,075 3,052 (79) (8,704) 1,352 239 Other income 24,421 19,484 22,118 19,314 15,909 13,719 13,695 12,557 Other expenses 93,397 74,164 70,282 71,851 66,592 64,079 61,633 58,255 Merger-related charges(3) -- 10,860 -- 39,072 -- 11,269 -- 7,955 -------- -------- -------- --------- -------- -------- -------- --------- Income before income taxes 64,195 54,968 66,743 25,300 58,334 18,657 55,652 37,219 Income tax provision 20,524 20,178 23,849 10,200 21,864 9,439 20,941 15,080 -------- -------- -------- --------- -------- -------- -------- --------- Net income $ 43,671 $ 34,790 $ 42,894 $ 15,100 $ 36,470 $ 9,218 $ 34,711 $ 22,139 ======== ======== ======== ========= ======== ======== ======== ======== Net income before merger-related and other special charges (1)(2)(3) $ 43,671 $ 42,781 $ 42,894 $ 40,941 $ 36,470 $ 35,250 $ 34,711 $ 32,839 ======== ======== ======== ========= ======== ======== ======== ========= Net income applicable to common stock $ 43,671 $ 34,790 $ 42,894 $ 13,604 $ 34,910 $ 7,658 $ 33,149 $ 20,577 ======== ======== ======== ========= ======== ======== ======== ========= Basic earnings per share(4)(5) $ .27 $ .22 $ .29 $ .10 $ .25 $ .06 $ .24 $ .15 Diluted earnings per share(4)(6) .27 .22 .27 .09 .23 .06 .23 .14 Operating basic earnings per share(4)(6) .27 .27 .29 .27 .25 .25 .24 .23 Operating diluted earnings per share(4)(6) .27 .26 .27 .26 .23 .23 .22 .21 Market prices(4) High 14-7/16 18-1/4 22-3/16 18-15/16 18 14-9/16 12-11/16 11-11/16 Low 9 12 16-5/16 14-15/16 14-5/16 12-1/4 9-1/2 9 1/8 Dividends per common share(4)(7) .021 .020 .023 .020 .017 .022 .038 .037
- -------------------------------------------------------------------------------- (1) Reflects additional provision for loan losses of $17.0 million established in connection with the acquisition of Bankers during the three month period ended September 30, 1997 and $7.9 million established in connection with the acquisition of First State during the three month period ended March 31, 1997. (2) Reflects a $10.3 million loss on the liquidation of $750 million of available for sale and held-to-maturity securities in conjunction with the Bankers acquisition in September, 1997. (3) Reflects merger charges of: $10.9 million related to the acquisitions of Carnegie and First Home in July, 1998; $39.1 million related to the acquisition of ML Bancorp in February, 1998; $11.3 million related to the acquisition of Bankers during September, 1997; and $8.0 million related to the acquisition of First State in February, 1997. (4) All per share data have been adjusted to reflect all stock dividends and stock splits. (5) Results for the three-month periods ended September 30, 1998, March 31, 1998, September 30, 1997 and March 31, 1997 include the merger-related and other special charges described in Notes 1, 2, and 3 above. (6) Results for the three-month periods ended September 30, 1998, March 31, 1998, September 30, 1997 and March 31, 1997 exclude the merger-related and other special charges described in Notes 1, 2, and 3 above. (7) The higher dividend rate in prior periods is the result of acquisitions which were accounted for as a pooling-of-interests. 31 RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996 Net Income. Net operating income for the year ended December 31, 1997 was $139 million. This represents an increase of 21% over net operating income of $115 million reported for 1996. Operating earnings per share was $.89 for 1997, which represents an increase of 17% over 1996 operating earnings per share of $.76. Return on average equity and return on average assets were 14.83% and .85%, respectively, for 1997 compared to 13.18% and .81%, respectively, for 1996. The amounts presented for 1997 exclude merger charges and losses on non-recurring sales of held-to-maturity securities of $36.7 million (after-tax) related to Sovereign's acquisition of First State and Bankers during 1997. Results for 1996 exclude a non-recurring Savings Association Insurance Fund ("SAIF") assessment of $24.9 million (after-tax) paid to the Federal Deposit Insurance Corporation ("FDIC") during 1996 for the recapitalization of the SAIF. Net income for the year ended December 31, 1997 was $103 million or $.66 per share. Net income for the year ended December 31, 1996, including the impact of the non-recurring SAIF assessment, was $90.4 million or $.59 per share. Net Interest Income. Net interest income for 1997 was $432 million compared to $387 million for 1996. This represents an increase of 12% and was primarily due to an increase in average balances resulting from internal growth and acquisitions, partially off-set by a decline in Sovereign's net interest margin. Interest on interest-earning deposits was $5.4 million for 1997 compared to $4.1 million for 1996. The average balance of interest-earning deposits was $32.3 million with an average yield of 16.71% for 1997 compared to an average balance of $26.1 million with an average yield of 15.73% for 1996. The high yields on interest-earning deposits were the result of a contractual arrangement whereby a third-party vendor performed check processing and reconcilement functions for Sovereign's disbursement accounts. Under the agreement, the vendor is required to pay Sovereign interest on disbursed funds during the two to three day float period, effectively producing interest income with no corresponding asset balance. Interest on investment securities available-for-sale was $102 million for 1997 compared to $84.7 million for 1996. The average balance of investment securities available-for-sale was $1.6 billion with an average yield of 6.77% for 1997 compared to an average balance of $1.3 billion with an average yield of 6.70% for 1996. Interest on investment securities held-to-maturity was $280 million for 1997 compared to $251 million for 1996. The average balance of investment securities held-to-maturity was $3.9 billion with an average yield of 7.18% for 1997 compared to an average balance of $3.5 billion with an average yield of 7.17% for 1996. Interest and fees on loans were $791 million for 1997 compared to $677 million for 1996. The average balance of net loans was $10.1 billion with an average yield of 7.82% for 1997 compared to an average balance of $8.8 billion with an average yield of 7.72% for 1996. The increases in average balance and average yield were primarily due to Sovereign's acquisition of Fleet Auto in 1997, which added $2.0 billion of higher yielding commercial and consumer loans to Sovereign's loan portfolio, and the full year effect of Sovereign's record level of residential mortgage loan originations in 1996. Interest on total deposits was $379 million for 1997 compared to $351 million for 1996. The average balance of total deposits was $9.0 billion with an average cost of 4.21% for 1997 compared to an average balance of $8.5 billion with an average cost of 4.15% for 1996. The increase in the average balance of deposits was primarily the result of Sovereign's relationship selling campaign during 1997. Interest on total borrowings was $368 million for 1997 compared to $279 million for 1996. The average balance of total borrowings was $6.2 billion with an average cost of 5.97% for 1997 compared to an average balance of $4.7 billion with an average cost of 5.89% for 1996. The increase in the average balance of borrowings was the result of the Fleet Auto acquisition and other internal balance sheet growth being funded principally by borrowings. Provision for Loan Losses. The provision for loan losses was $41.1 million for 1997 compared to $22.7 million for 1996. The 81% increase in loan loss provision for 1997 included $24.9 million of additional reserves which Sovereign determined would be necessary as a result of its conservative approach with respect to an aggressive workout plan for certain assets acquired from Bankers and First State. In addition, Sovereign established an initial loan loss reserve of $22.0 million in connection with its acquisition of Fleet Auto during 1997. 32 During 1997, Sovereign charged-off $24.2 million compared to $18.9 million for 1996. This increased level of charge-offs for 1997 was partially off-set by recoveries of $5.4 million, resulting in net charge-offs for 1997 of $18.8 million. This compares to recoveries of $1.9 million and net charge-offs of $17.1 million for 1996. Sovereign's increased level of charge-offs for 1997 was primarily the result of increased consumer and commercial loan charge-offs, the majority of which are related to Sovereign's 1997 acquisition activity. Although non-residential lending will typically result in higher net charge-off levels than other types of lending, historically, it has also resulted in higher income potential. In Sovereign's experience, a strategy that involves the accelerated resolution of problem assets is more appropriate than a long-term workout approach. In connection with this philosophy, additional reserves were added during 1997 as described above. Other Income. Total other income was $48.7 million for 1997 compared to $63.4 million for 1996. The decrease in other income was the result of a decrease in loan fees and service charges which is directly attributable to First State's credit card portfolio as discussed below. Loan fees and service charges were $5.8 million for 1997 compared to $19.6 million for 1996. This decrease was the result of fees earned in 1996 by First State's credit card portfolio which was sold prior to Sovereign's acquisition of First State in February 1997. Excluding First State's credit card portfolio, other loan fees and service charges for 1996 were $6.9 million. Loan fees and service charges result primarily from Sovereign's loan servicing portfolio. At December 31, 1997, Sovereign serviced $9.3 billion of its own loans and $6.4 billion of loans for others. This compares to $7.6 billion of its own loans and $5.9 billion of loans for others at December 31, 1996. Deposit fees were $20.9 million for 1997 compared to $18.1 million for 1996. This increase was primarily the result of an increase in the number of transaction accounts in 1997 compared to 1996. Mortgage banking gains were $21.7 million for 1997 compared to $13.9 million for 1996. This increase was primarily due to gains of $5.3 million resulting from the sale of loans and mortgage servicing rights in 1997. Losses on sales of loans and investment securities were $7.2 million for 1997 compared to gains of $5.9 million for 1996. This decrease was primarily attributable to losses of $10.3 million (pre-tax) related to the liquidation of $750 million of investments including some held-to-maturity securities in conjunction with the Bankers acquisition during the third quarter of 1997. This sale was completed in accordance with the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" to maintain Sovereign's pre-merger interest rate risk position. The decrease is also the result of gains of $4.2 million related to the liquidation of $157 million of available-for-sale and equity securities in 1996. These gains were realized as part of Sovereign's ongoing management of risk in its available-for-sale portfolio and taking advantage of favorable market conditions. Miscellaneous income was $7.5 million for 1997 compared to $5.9 million for 1996. This increase was primarily due to increased inter-change income resulting from growth in the number of Sovereign's debit cards and credit cards issued and in use over the last year. General and Administrative Expenses. Total general and administrative expenses were $225 million for 1997 compared to $228 million for 1996. The ratio of general and administrative expenses to average assets was 1.38% for 1997 compared to 1.60% for 1996. Sovereign's efficiency ratio (all general and administrative expenses as a percentage of net interest income and recurring non-interest income) for 1997 was 46.1% compared to 51.3% for 1996. The decrease in total general and administrative expenses and the resulting favorable decrease in Sovereign's expense ratios was the result of efficiencies realized from recent acquisitions and an increase in average balances and net interest income without a corresponding increase in operating expenses. Other Operating Expenses. Total other operating expenses were $44.8 million for 1997 compared to $61.4 million for 1996. Results for 1997 include merger-related charges of $19.2 million related to Sovereign's 1997 acquisitions. Expenses included as part of the merger-related charges were human resources related costs, losses on the sale of certain assets and other expenses, including investment banker fees and legal expenses. Results for 1996 include a non-recurring SAIF assessment of $40.1 million paid to the FDIC for the recapitalization of the SAIF. Also included in other operating expenses was amortization of goodwill and other intangible assets of $13.2 million for 1997 compared to $17.4 million for 1996, Trust Preferred Securities expense of $11.7 million for 1997 compared to $274,000 for 1996, and net OREO losses of $767,000 for 1997 compared to net OREO losses of $3.6 million for 1996. Income Tax Provision. The income tax provision was $67.3 million for 1997 compared to $47.5 million for 1996. The effective tax rate for 1997 was 39.6% compared to 34.5% for 1996. The increased effective tax rate for 1997 was primarily attributable to certain non-deductible expenses incurred in conjunction with Sovereign's 1997 acquisitions. 33 Management's Discussion and Analysis The Year 2000 Computer Issue. The Year 2000 ("Y2K") computer issue refers to the inability of many computers, computer-based systems, related software, and other electronics to process dates accurately during the year 2000 and beyond. Many of these computers, systems, software programs and devices use only two digits to indicate the year. For example, the year 1998 is input, stored and calculated as "98." The year 2000 will in many systems and software programs be represented as "00," but "00" can also be read as 1900. This ambiguity may cause errors which may cause the computer, system or device to fail completely, cause programs to operate incorrectly, or slowly corrupt or contaminate data over time. These problems may arise both in information systems used for data storage and processing, and in connection with mechanical systems such as bank vaults, elevators, escalators, heating, ventilating and air conditioning systems, and other systems which use embedded microprocessors as timers or for other purposes. Sovereign's State of Readiness. Sovereign's Y2K readiness project has five phases: Inventory - identification of the computers, software, systems and devices used by Sovereign and the business applications to which such computers, programs, systems and devices are devoted. Assessment - analyzing those computers, software, systems, devices and related applications with a view to determining if they store or process date information in a manner which will avoid millennial errors of the type described above and the risks resulting from any such errors and prioritizing them based on how critical they are to Sovereign's business operations. Remediation - modification or replacement of deficient computers, programs, systems and devices to the extent such deficiency poses material risk to Sovereign. Testing - the modified or new computers, software or systems are tested to determine if they operate and interoperate in a manner which should reduce risk to an acceptable level. Items are addressed in accordance with the priorities given to them in the Assessment Phase. Implementation - bringing the new or changed computers, software, systems and electronics on line. Sovereign is currently in the testing phase. Sovereign has substantially completed testing of its internal mission-critical items as of December 31, 1998 and will substantially complete testing of its external mission critical items by March 31, 1999. "Internal" items would include software developed by Sovereign or the remediation of which is controlled by Sovereign, whereas external items would include software provided by others, and systems provided by Sovereign's service providers. Sovereign also estimates that it will complete the implementation phase for all mission-critical items by June 30, 1999. The description set forth above applies to both information technology ("IT") systems and non-IT systems, such as embedded microprocessors. As part of its Y2K project, Sovereign has also endeavored to analyze the risks posed to it by its material borrowers according to regulatory guidelines. Borrowers whose businesses have been determined by Sovereign to be subject to material levels of risk from Y2K computer problems have been questioned regarding their own state of readiness. Sovereign has similarly questioned providers of funds and substantial vendors and suppliers. Vendors whom Sovereign considers to be critical to Sovereign's operations have been asked, in addition, to provide Sovereign with assurances and other evidence as to their Y2K readiness. Costs. Sovereign has established a budget for its Y2K project costs, which cover the estimated costs of remediation, including modification or replacement of systems and software, utilization of outside consultants, and costs of internal personnel. Based on Sovereign's current assessment of its Y2K project status, the amount of this budget is $13.5 million for fiscal 1998 and 1999. Sovereign is using its internal funds for this project. Sovereign's expenditures with regard to its Y2K project are substantially in accordance with its current budget. Through February 28, 1999, Sovereign's cash outlay was approximately $6.5 million of its $13.5 million budget. Sovereign's estimates are, of necessity, judgmental and subject to revision based on the results of the testing referred to above and other changed facts or circumstances, including changes in Sovereign's assessment of the state of readiness and contingency plans of its principal outside service providers. 34 Risks. Sovereign believes, based on the advice of its consultants, that the most reasonably likely worst case Y2K scenario relates to its principal outside service providers, substantially all of which are large, seasoned, national companies experienced in serving financial institutions. Sovereign depends on these service providers for substantially all of its data processing needs relating to its account processing, item processing and other important functions. Sovereign is requiring material providers to provide evidence and other assurance of this compliance and/or their progress towards compliance, as well as their contingency plans. Certain of these service providers are also subject to the jurisdiction of the regulatory bodies which have jurisdiction over Sovereign. Those regulatory bodies are examining the service providers with respect to Y2K readiness using the same standards and deadlines as the regulators use to examine financial institutions and Sovereign has reviewed the results of certain of these examinations to assist in assessing the state of readiness and contingency plans of such providers. Based on all of the foregoing, Sovereign believes that (i) its providers will be substantially Y2K compliant and (ii) have adequate contingency plans to address compliance. Notwithstanding the foregoing, no assurances can be given that a service providers' system or software will not fail and, if not, that such failure will not have a material adverse effect on Sovereign or its business. Sovereign is presently in the process of developing contingency plans to deal with issues relating to the failure of system segments. In addition, utility services, which are generally beyond Sovereign's control, may present a significant Y2K risk. In particular, disruption of telecommunication and electric utility service because of a Y2K related problem (or otherwise) could interfere significantly with Sovereign's operations, even if Sovereign and its service providers and customers, and their computers, systems, and software, are fully Y2K compliant. The foregoing is a summary of the steps which Sovereign has taken as of December 31, 1998 and proposed to take as of that date with respect to the Y2K issue, and the risks which Sovereign, at this time, believes the Y2K issues are likely to present. Sovereign is using good faith efforts, which it believes are reasonable, to prepare for the Y2K issue and avoid disruption in its business. Nonetheless, the Y2K issue presents an unprecedented challenge to the financial services industry, an industry characterized by a high degree of interdependence among financial institutions and those who deal with and service them, such as outside data processing services, computer network system providers, local and long distance telecommunications companies, utilities, and ATM terminal service providers. Whether these outside parties are ready for the year 2000 is largely beyond Sovereign's control. Accordingly, there can be no assurance that (i) Sovereign's assessment of the Y2K risks will prove to be correct; (ii) the steps Sovereign is taking will be sufficient to avoid disruption to its business and other material risks; (iii) the foregoing will not ultimately have a material adverse effect on Sovereign and its business. Pending Accounting Pronouncements. In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which is required to be adopted in years beginning after June 15, 1999. SFAS No. 133 permits early adoption as of the beginning of any fiscal quarter after its issuance. Sovereign expects to adopt SFAS No. 133 effective January 1, 2000. SFAS No. 133 requires the recognition of all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value as a component of income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be off-set against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. Sovereign has not yet determined what the effect of SFAS No. 133 will be on the earnings and financial position of Sovereign. 35 To Our Stockholders: Financial Statements Sovereign Bancorp, Inc. ("Sovereign") is responsible for the preparation, integrity and fair presentation of its published financial statements. The consolidated financial statements of Sovereign have been prepared in accordance with generally accepted accounting principles and, as such, include some amounts that are based on judgments and estimates of management. Internal Controls Over Financial Reporting Management is responsible for establishing and maintaining effective internal control over financial reporting presented in conformity with generally accepted accounting principles. The system contains monitoring mechanisms, and actions are taken to correct deficiencies identified. There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. Management assessed Sovereign's internal control structure over financial reporting presented in conformity with generally accepted accounting principles as of December 31, 1998. This assessment was based on criteria for effective internal control over financial reporting described in "Internal Control -- Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that Sovereign maintained effective internal control over financial reporting presented in conformity with generally accepted accounting principles as of December 31, 1998. Compliance With Laws and Regulations Management is also responsible for compliance with the federal and state laws and regulations concerning dividend restrictions and federal laws and regulations concerning loans to insiders designated by the Office of Thrift Supervision as safety and soundness laws and regulations. Management assessed compliance by Sovereign Bank with the designated laws and regulations relating to safety and soundness. Based on this assessment, management believes that Sovereign Bank complied, in all significant respects, with the designated laws and regulations related to safety and soundness for the year ended December 31, 1998. Jay S. Sidhu Dennis S. Marlo Mark R. McCollom President and Treasurer and Chief Accounting Officer Chief Executive Officer Chief Financial Officer 36 Item 7a. Management's Discussion of Market Risk. Incorporated herein by reference from Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset and Liability Management" hereof. 37 Item 8. Financial Statements and Supplementary Data. Report of Independent Auditors The Board of Directors and Stockholders, Sovereign Bancorp, Inc. We have audited the accompanying consolidated balance sheets of Sovereign Bancorp, Inc. as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the management of Sovereign. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the 1997 and 1996 financial statements of ML Bancorp, Inc., Carnegie Bancorp, or First Home Bancorp Inc. or the 1996 financial statements of First State Financial Services, Inc. and Bankers Corp., which combined statements reflect total assets constituting 18.8% as of December 31, 1997 of the related consolidated financial statement totals, and combined net interest income constituting 21.1% and 44.0% in 1997 and 1996 respectively, of the related consolidated financial statement totals for each of the two years in the period ended December 31, 1997. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to data included for ML Bancorp, Inc., Carnegie Bancorp, First Home Bancorp Inc., First State Financial Services, Inc., and Bankers Corp. for the respective years noted, is based solely on the reports of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sovereign Bancorp, Inc. at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. In 1997, Sovereign changed its method of accounting for transfers of financial instruments and extinguishment of liabilities, as discussed in Note 1 to the consolidated financial statements. /s/ Ernst & Young LLP March 11, 1999 Philadelphia, Pennsylvania 38 Consolidated Balance Sheets (IN THOUSANDS EXCEPT FOR SHARE DATA)
Year Ended December 31, 1998 1997 ------------- ------------ Assets Cash and amounts due from depository institutions $ 471,074 $ 238,623 Interest-earning deposits 82,650 17,314 Loans held for sale (approximate fair value of $297,414 and $310,750 at December 31, 1998 and 1997, respectively) 296,930 310,678 Investment securities available-for-sale 6,662,427 1,956,262 Investment securities held-to-maturity (approximate fair value of $1,860,583 and $3,446,863 at December 31, 1998 and 1997, respectively) 1,839,655 3,416,451 Loans 11,285,840 11,324,122 Allowance for loan losses (133,802) (116,823) Premises and equipment 98,491 92,273 Other real estate owned and other repossessed assets 15,584 12,009 Accrued interest receivable 147,441 108,029 Goodwill and other intangible assets 425,925 126,332 Other assets 721,658 170,185 ------------ ----------- Total Assets $ 21,913,873 $17,655,455 ============ =========== Liabilities Deposits $ 12,322,716 $ 9,515,294 Borrowings Short-term 3,921,684 5,455,894 Long-term 3,978,908 1,407,749 Advance payments by borrowers for taxes and insurance 27,655 41,847 Other liabilities 329,792 57,904 ------------ ------------ Total Liabilities 20,580,755 16,478,688 ------------ ------------ Corporation-obligated mandatorily redeemable capital securities of subsidiary trust holding solely subordinated debentures of Sovereign Bancorp, Inc. ("Trust Preferred Securities") 129,050 128,972 ------------ ------------ Stockholders' Equity Preferred stock; no par value; $50 liquidation preference; 7,500,000 shares authorized; 1,996,467 shares issued and outstanding at December 31, 1997 -- 96,276 Common stock; no par value; 200,000,000 shares authorized; 164,146,353 shares issued at December 31, 1998 and 147,216,301 shares issued at December 31, 1997 649,341 523,327 Unallocated common stock held by the Employee Stock Ownership Plan at cost; 4,340,572 shares at December 31, 1998 and 5,984,934 shares at December 31, 1997 (26,892) (37,211) Treasury stock; at cost; 78,626 shares at December 31, 1998 and 13,210 shares at December 31, 1997 (1,086) (185) Accumulated other comprehensive income 18,120 18,944 Retained earnings 564,585 446,644 ------------ ------------ Total Stockholders' Equity 1,204,068 1,047,795 ------------ ----------- Total Liabilities, Minority Interests and Stockholders' Equity $ 21,913,873 $17,655,455 ============ ===========
See accompanying notes to consolidated financial statements. 39 Consolidated Statements of Operations (IN THOUSANDS EXCEPT FOR SHARE DATA)
Year Ended December 31, --------------------------------------------- 1998 1997 1996 ----------- ----------- ----------- Interest Income: Interest on interest-earning deposits $ 7,397 $ 5,392 $ 4,103 Interest and dividends on investment securities available-for-sale 284,392 102,123 84,656 Interest and dividends on investment securities held-to-maturity 182,499 279,900 250,938 Interest and fees on loans 881,083 791,362 677,129 ----------- ----------- ----------- Total interest income 1,355,371 1,178,777 1,016,826 ----------- ----------- ----------- Interest Expense: Interest on deposits 440,300 378,813 351,084 Interest on borrowings 421,459 367,882 278,776 ----------- ----------- ----------- Total interest expense 861,759 746,695 629,860 ----------- ----------- ----------- Net Interest Income 493,612 432,082 386,966 Provision for loan losses 27,961 41,125 22,685 ----------- ----------- ----------- Net interest income after provision for loan losses 465,651 390,957 364,281 ----------- ----------- ----------- Other Income: Loan fees and service charges 10,546 5,780 19,607 Deposit fees 26,088 20,892 18,110 Mortgage banking gains 24,738 21,693 13,858 Gain/(loss) on sale of loans and investment securities 19,844 (7,192) 5,893 Miscellaneous income 23,965 7,515 5,911 ----------- ---------- ----------- Total other income 105,181 48,688 63,379 ----------- ----------- ----------- General and Administrative Expenses: Salaries and employee benefits 124,357 105,487 99,368 Occupancy and equipment expenses 53,837 41,067 37,205 Outside services 47,523 28,708 36,459 Deposit insurance premiums 4,652 4,471 13,253 Other administrative expenses 46,992 45,222 42,078 ----------- ----------- ----------- Total general and administrative expenses 277,361 224,955 228,363 ----------- ----------- ----------- Other Operating Expenses: Merger-related charges 49,932 19,224 -- Non-recurring SAIF assessment -- -- 40,148 Amortization of goodwill and other intangibles 20,609 13,160 17,372 Trust Preferred Securities expense 12,528 11,677 274 Other real estate owned (gains)/losses, net (804) 767 3,616 ----------- ----------- ----------- Total other operating expenses 82,265 44,828 61,410 ----------- ----------- ----------- Income before income taxes 211,206 169,862 137,887 Income tax provision 74,751 67,324 47,509 ----------- ----------- ----------- NET INCOME $ 136,455 $ 102,538 $ 90,378 =========== =========== =========== NET INCOME APPLICABLE TO COMMON STOCK $ 134,959 $ 96,294 $ 84,128 =========== =========== =========== Basic Earnings Per Share(1) $ .88 $ .70 $ .63 =========== =========== =========== Diluted Earnings Per Share(1) $ .85 $ .66 $ .59 =========== =========== =========== Dividends Per Common Share(1) $ .084 $ .114 $ .140 =========== =========== ===========
- -------------------- (1) All per share data have been adjusted to reflect all stock dividends and stock splits. See accompanying notes to consolidated financial statements. 40 Consolidated Statements of Stockholders' Equity (IN THOUSANDS)
Common Preferred Shares Shares Common Preferred Retained Treasury Outstanding Outstanding Stock Stock Earnings Stock ----------- ----------- ----------- --------- -------- -------- Balance, December 31, 1995 130,762 2,000 $491,581 $ 96,446 $325,795 $(36,136) Comprehensive income: Net income -- -- -- -- 90,378 -- Change in unrecognized income on investment securities available- for-sale, net of tax -- -- -- -- -- -- Total comprehensive income Exercise of stock options 1,027 -- 2,257 -- -- 918 Cash in lieu of fractional shares -- -- (2) -- (16) -- Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan 241 -- 1,699 -- -- -- Stock dividends 3,663 -- 25,931 -- (25,931) -- Stock dividends on unallocated Employee Stock Ownership Plan shares (215) -- -- -- 1,506 -- Dividends paid on common stock -- -- -- -- (18,763) -- Dividends paid on preferred stock -- -- -- -- (6,250) -- Treasury stock repurchase (4,046) -- -- -- -- (29,580) Purchase of shares under Employee Stock Ownership Plan (653) -- -- -- -- -- Allocation of shares under Employee Stock Ownership Plan 795 -- 1,903 -- -- -- Issuance of stock for West Jersey 2,396 -- 1,030 -- 7,255 -- Other 30 -- 65 -- -- -- ----------- ----------- -------- ---------- -------- -------- Balance, December 31, 1996 134,000 2,000 524,464 96,446 373,974 (64,798) ----------- ----------- -------- ---------- -------- -------- Comprehensive income: Net income -- -- -- -- 102,538 -- Change in unrecognized income on investment securities available- for-sale, net of tax -- -- -- -- -- -- Total comprehensive income Exercise of stock options 3,207 -- 12,527 -- -- 5,423 Cash in lieu of fractional shares (3) -- (28) -- (2) -- Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan 216 -- 2,544 -- -- -- Stock dividends 200 -- 1,855 -- (1,855) -- Dividends paid on common stock -- -- -- -- (15,550) -- Dividends paid on preferred stock -- -- -- -- (6,244) -- Treasury stock repurchase (40) -- -- -- -- (473) Treasury stock sold 2,608 -- 17,423 -- -- 17,682 Retirement of treasury shares -- -- (41,981) -- -- 41,981 Conversion of preferred stock 25 (4) 170 (170) -- -- Allocation of shares under Employee Stock Ownership Plan 796 -- 5,132 -- -- -- Adjustment for First State's different fiscal year end 209 -- 1,010 -- (6,217) -- Other -- -- 211 -- -- -- ----------- ----------- -------- ---------- -------- -------- Balance, December 31, 1997 141,218 1,996 523,327 96,276 446,644 (185) ----------- ----------- -------- ---------- -------- -------- Comprehensive income: Net income -- -- -- -- 136,455 -- Change in unrecognized income on investment securities available- for-sale, net of tax -- -- -- -- -- -- Total comprehensive income Exercise of stock options 2,296 -- 15,910 -- -- -- Cash in lieu of fractional shares -- -- (68) -- -- -- Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan 296 -- 4,609 -- -- -- Dividends paid on common stock -- -- -- -- (12,790) -- Dividends paid on preferred stock -- -- -- -- (1,496) -- Treasury stock repurchase (86) -- -- -- -- (1,258) Treasury stock sold 18 -- -- -- -- 357 Conversion of preferred stock 14,342 (1,996) 96,270 (96,270) -- -- Redemption of preferred stock -- -- -- (6) -- -- Allocation of shares under Employee Stock Ownership Plan 1,643 -- 9,293 -- -- -- Adjustment for ML Bancorp's different fiscal year end -- -- -- -- (4,228) -- ----------- ----------- -------- ---------- -------- -------- Balance, December 31, 1998 159,727 -- $649,341 -- $564,585 $(1,086)
Unallocated Accumulated Stock Other Total Held By Comprehensive Stockholders' ESOP Income Equity ----------- ------------- ------------- Balance, December 31, 1995 $(38,281) $ 4,328 $ 843,733 Comprehensive income: Net income -- -- 90,378 Change in unrecognized income on investment securities available- for-sale, net of tax -- (4,011) (4,011) Total comprehensive income 86,367 Exercise of stock options -- -- 3,175 Cash in lieu of fractional shares -- -- (18) Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan -- -- 1,699 Stock dividends -- -- -- Stock dividends on unallocated Employee Stock Ownership Plan shares (1,506) -- -- Dividends paid on common stock -- -- (18,763) Dividends paid on preferred stock -- -- (6,250) Treasury stock repurchase -- -- (29,580) Purchase of shares under Employee Stock Ownership Plan (4,559) -- (4,559) Allocation of shares under Employee Stock Ownership Plan 3,694 -- 5,597 Issuance of stock for West Jersey -- -- 8,285 Other -- -- 65 -------- ------- ---------- Balance, December 31, 1996 (40,652) 317 889,751 -------- ------- ---------- Comprehensive income: Net income -- -- 102,538 Change in unrecognized income on investment securities available- for-sale, net of tax -- 18,399 18,399 Total comprehensive income 120,937 Exercise of stock options -- -- 17,950 Cash in lieu of fractional shares -- -- (30) Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan -- -- 2,544 Stock dividends -- -- -- Dividends paid on common stock -- -- (15,550) Dividends paid on preferred stock -- -- (6,244) Treasury stock repurchase -- -- (473) Treasury stock sold -- -- 35,105 Retirement of treasury shares -- -- -- Conversion of preferred stock -- -- -- Allocation of shares under Employee Stock Ownership Plan 3,441 -- 8,573 Adjustment for First State's different fiscal year end -- 228 (4,979) Other -- -- 211 -------- ------- ---------- Balance, December 31, 1997 (37,211) 18,944 1,047,795 -------- ------- ---------- Comprehensive income: Net income -- -- 136,455 Change in unrecognized income on investment securities available- for-sale, net of tax -- (32) (32) Total comprehensive income 136,423 Exercise of stock options -- -- 15,910 Cash in lieu of fractional shares -- -- (68) Sale of stock under Dividend Reinvestment and Employee Stock Purchase Plan -- -- 4,609 Dividends paid on common stock -- -- (12,790) Dividends paid on preferred stock -- -- (1,496) Treasury stock repurchase -- -- (1,258) Treasury stock sold -- -- 357 Conversion of preferred stock -- -- -- Redemption of preferred stock -- -- (6) Allocation of shares under Employee Stock Ownership Plan 10,319 -- 19,612 Adjustment for ML Bancorp's different fiscal year end -- (792) (5,020) -------- ------- ---------- Balance, December 31, 1998 $(26,892) $18,120 $1,204,068
See accompanying notes to consolidated financial statements. 41 Consolidated Statements of Cash Flows (IN THOUSANDS)
Year Ended December 31, --------------------------------------- 1998 1997 1996 ---------- -------- ---------- Cash Flows From Operating Activities: Net income $ 136,455 $102,538 $ 90,378 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses and deferred taxes 37,508 30,812 23,411 Depreciation 13,434 12,070 12,661 Amortization 18,204 34,725 23,991 (Gain)/loss on sale of loans, investment securities and other real estate owned (20,076) 7,959 (13,457) Allocation of Employee Stock Ownership Plan 19,612 8,573 5,597 Net change in: Loans held for sale 13,748 (172,305) 102,049 Accrued interest receivable (39,560) (18,108) (11,962) Prepaid expenses and other assets (467,329) (66,276) (31,352) Other liabilities 272,989 6,128 (24,793) ---------- -------- ---------- Net cash (used)/provided by operating activities (15,015) (53,884) 176,523 ---------- -------- ---------- Cash Flows From Investing Activities: Proceeds from sales of investment securities available-for-sale and held-to-maturity 2,157,904 847,215 901,987 Proceeds from repayments and maturities of investment securities: Available-for-sale 1,109,075 314,998 248,215 Held-to-maturity 2,062,628 965,549 710,988 Purchases of investment securities: Available-for-sale (7,996,541) (1,072,205) (833,243) Held-to-maturity (471,326) (1,418,741) (1,309,363) Proceeds from sales of loans 1,422,279 23,570 69,324 Purchase of loans and mortgage servicing rights (1,966,864) (2,794,487) (1,444,452) Net change in loans other than purchases and sales 464,382 1,027,549 (616,657) Proceeds from sales of premises and equipment 18,437 10,112 2,970 Purchases of premises and equipment (32,872) (15,790) (14,739) Proceeds from sales of other real estate owned 19,069 19,593 23,054 Net cash (paid)/received from business combinations (302,808) (8,552) 1,112 Other, net (4,228) (4,996) -- ---------- -------- ---------- Net cash used by investing activities (3,520,865) (2,106,185) (2,260,804) ---------- --------- ---------- Cash Flows From Financing Activities: Assumption of deposits 2,231,149 -- -- Net increase in deposits 576,982 855,750 25,435 Net (decrease)/increase in short-term borrowings (2,135,369) 638,573 973,066 Proceeds from long-term borrowings 3,169,839 621,630 1,061,051 Repayments of long-term borrowings -- -- (2) Net (decrease)/increase in advance payments by borrowers for taxes and insurance (14,192) (420) 2,778 Proceeds from issuance of Trust Preferred Securities -- 97,574 30,000 Cash dividends paid to stockholders (14,286) (23,777) (24,850) Proceeds from issuance of common stock 20,451 17,919 5,952 Redemption of preferred stock (6) -- -- Advance to the Employee Stock Ownership Plan -- (325) (10,206) (Purchase)/issuance of treasury stock (901) 34,632 (29,580) ---------- --------- ---------- Net cash provided by financing activities 3,833,667 2,241,556 2,033,644 ---------- --------- ---------- Net change in cash and cash equivalents 297,787 81,487 (50,637) Cash and cash equivalents at beginning of period 255,937 174,450 225,087 ---------- --------- ---------- Cash and cash equivalents at end of period $ 553,724 $ 255,937 $ 174,450 ========== ========= ========== Reconciliation of Cash And Cash Equivalents to Consolidated Balance Sheets: Cash and amounts due from depository institutions $ 471,074 $238,623 $ 159,383 Interest-earning deposits 82,650 17,314 15,067 ---------- --------- ---------- Cash and cash equivalents at end of period $ 553,724 $ 255,937 $ 174,450 ========== ========= ==========
42 Supplemental Disclosures: Income tax payments totaled $77.4 million in 1998, $63.2 million in 1997 and $60.5 million in 1996. Interest payments totaled $263 million in 1998, $717 million in 1997 and $679 million in 1996. Noncash activity consisted of mortgage loan securitization of $1.2 billion in 1998, $283 million in 1997 and $372 million in 1996; reclassification of long-term borrowings to short-term borrowings of $613 million in 1998, $862 million in 1997 and $958 million in 1996; and reclassification of mortgage loans to other real estate owned of $18.8 million in 1998, $22.1 million in 1997 and $21.9 million in 1996. See accompanying notes to consolidated financial statements. 43 Notes to Consolidated Financial Statements SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Sovereign Bancorp, Inc. and subsidiaries ("Sovereign") is a Pennsylvania business corporation and is the holding company for Sovereign Bank. Sovereign is headquartered in Philadelphia, Pennsylvania and Sovereign Bank is headquartered in Wyomissing, Pennsylvania, a suburb of Reading, Pennsylvania. Sovereign's primary business consists of attracting deposits from its network of community banking offices, located throughout eastern and northcentral Pennsylvania, New Jersey and northern Delaware, and originating commercial, consumer and residential mortgage loans in those communities. Sovereign also serves customers throughout New York and several New England States. The following is a description of the significant accounting policies of Sovereign. Such accounting policies are in accordance with generally accepted accounting principles and have been followed on a consistent basis. a. Principles of Consolidation -- The accompanying financial statements 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 and ML Capital Trust I. All material intercompany balances and transactions have been eliminated in consolidation. b. Use of Estimates -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. c. Per Share Information -- All per share data has been restated to reflect the effect of the 6-for-5 stock split which was authorized on January 22, 1998, with a record date of March 31, 1998 and the 6-for-5 stock split which was authorized on January 16, 1997, with a record date of March 3, 1997. Basic earnings per share is calculated by dividing income available to common stockholders by the weighted average common shares outstanding, excluding options, warrants, and convertible securities from the calculation. In calculating diluted earnings per share, the dilutive effect of options and warrants is calculated using the treasury stock method, which uses the average market price for the period. The dilutive effect of convertible debt or preferred stock continues to be calculated using the if-converted method. The following table presents the computation of earnings per share for the years indicated (in thousands, except per share data):
1998 1997 1996 -------- -------- -------- Basic Earnings Per Share: Net income applicable to common stock(1) $134,959 $ 96,294 $ 84,128 -------- -------- -------- Average basic shares outstanding at end of period 152,910 136,997 134,081 ======== ======== ======== Basic earnings per share(2) $ .88 $ .70 $ .63 ======== ======== ======== 1998 1997 1996 -------- -------- -------- Diluted Earnings Per Share: Net income(1) $136,455 $102,538 $ 90,378 -------- -------- -------- Average diluted shares outstanding at end of period 158,172 151,356 148,449 Dilutive effect of average stock options, net of shares assumed to be repurchased under the treasury stock method 3,039 4,550 3,874 -------- -------- -------- Total average diluted shares outstanding at end of period 161,211 155,906 152,323 ======== ======== ======== Diluted earnings per share(2) $ .85 $ .66 $ .59 ======== ======== ========
- -------------------------------------------------------------------------------- 1) The 1998 results include $33.5 million (after-tax) of merger-related charges and losses from non-recurring sales of held-to-maturity securities resulting from Sovereign's acquisitions during 1998. The 1997 results include $36.7 million (after-tax) of merger-related charges and losses from non-recurring sales of held-to-maturity securities resulting from Sovereign's acquisitions during 1997. The 1996 results include a non-recurring SAIF assessment of $24.9 million (after-tax) paid to the FDIC for the recapitalization of the SAIF. 44 2) Excluding the merger-related charges and losses from non-recurring sales of held-to-maturity securities described in Note 1 above, basic earnings per share and diluted earnings per share for 1998 were $1.10 and $1.06, respectively and for 1997 were $.97 and $.89, respectively. Excluding the non-recurring SAIF assessment described in Note 1 above, basic earnings per share and diluted earnings per share for 1996 were $.81 and $.76, respectively. 45 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED d. Interest-earning Deposits -- Interest-earning deposits consist of deposit accounts with the Federal Home Loan Bank of Pittsburgh ("FHLB") and deposits with other financial institutions generally having maturities of three months or less. e. Investment Securities -- Debt securities that the company has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Securities expected to be held for an indefinite period of time are classified as available-for-sale and are carried at fair value with unrealized gains and losses reported as a separate component of stockholders' equity, net of estimated income taxes. Securities that are bought and held principally for the purpose of selling are classified as trading and reported at fair value, with unrealized gains and losses included in earnings. Sovereign has no securities held for trading. Gains or losses on the sales of securities are recognized at trade date utilizing the specific identification method. f. Forward Commitments and Options -- Sovereign utilizes forward commitments and/or options to hedge interest rate risk associated with loans held for sale and/or commitments to fund loans. Gains and losses on these transactions are included in the net gain or loss when the asset is sold. g. Mortgage Banking Activity -- Loans held for sale consist of residential mortgage loans originated or purchased by Sovereign and mortgage-backed securities originated by Sovereign. They are recorded at the lower of cost or estimated fair value on an aggregate basis. Gains and losses are included in the consolidated statements of operations. The fair value calculation includes consideration of all open positions, outstanding commitments and related fees paid. Excess servicing fees are computed as the present value of the difference between the estimated future net revenues and normal servicing net revenues as established by the federally sponsored secondary market makers. Resultant premiums are deferred and amortized over the estimated life of the related mortgages using the constant yield method. During 1997, Sovereign adopted the requirements of Statement of Financial Accounting Standard ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," for various transfers of receivables and other financial assets that occurred during the year. In December 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125," which defers the effective date for the provisions of SFAS No. 125 relating to accounting for repurchase agreements, dollar rolls, securities lending and similar transactions until January 1, 1998. As a result of the adoption of SFAS No. 125 in 1997, as amended by SFAS No. 127, Sovereign continues to record servicing assets as well as retained rights to future interest income from the serviced assets that exceed the contractual servicing fee (interest-only strips) as assets on the balance sheet at the time the receivables are sold. As a result, the impact of adoption on net income was immaterial. The following table presents the activity of Sovereign's mortgage servicing rights for the years indicated. This activity does not reflect the reduction from the activity in Sovereign's valuation allowance for mortgage servicing rights presented in the table on the next page (in thousands): 1998 1997 -------- ------- Balance, beginning of year $ 68,063 $ 58,759 Net servicing assets recognized during the year 19,439 19,979 Amortization (11,875) (10,675) -------- ------- Balance, end of year $ 75,627 $ 68,063 ======== ======= The mortgage servicing rights are amortized against loan servicing fee income on an accelerated basis in proportion to, and over the period of, estimated net future loan servicing fee income, which periods initially do not exceed eight years. For purposes of measuring impairment of capitalized mortgage servicing rights and minimizing the impact of risk, Sovereign conservatively evaluates the loans underlying these rights by stratifying them into certain homogeneous categories which include, but are not limited to, residential real estate 30-year and 15-year fixed rate mortgage loans, adjustable rate mortgage loans and balloon loans. For valuation purposes, at December 31, 1998, a weighted average discount rate of 9.19% was assumed and assumed prepayment speeds were consistent with published secondary market rates for Sovereign's market area. Sovereign also takes into consideration any inherent risks, as well as other relevant factors associated with each portfolio. Prices are obtained in the secondary market and are based upon current market prices of similarly traded loans and/or comparable secondary market instruments. 46 Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) Activity in the valuation allowance for mortgage servicing rights for the years indicated consisted of the following (in thousands): Year Ended December 31, -------------------------- 1998 1997 1996 ------ ------ ------ Balance, beginning of year $ 3,295 $2,200 $1,200 Provision for mortgage servicing rights in excess of fair value 10,000 1,095 1,000 ------ ----- ------ Balance, end of year $13,295 $3,295 $2,200 ====== ===== ====== h. Allowance for Loan Losses -- An allowance for loan losses is maintained at a level that management considers adequate to provide for potential losses based upon an evaluation of known and inherent risks in the loan portfolio. Management's evaluation 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. While management uses the best information available to make such evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. i. Loans -- Interest on loans is credited to income as it is earned. Interest income is not recognized on loans when the loan payment is 90 days or more delinquent (except auto loans, government-guaranteed loans or loans secured by deposit accounts) or sooner if management believes the loan has become impaired. Sovereign defines impairment as the existence of one or a combination of any of the following loan weaknesses: o The primary source of repayment is gone or severely impaired and Sovereign may have to rely on the secondary source o Loss does not seem likely, but sufficient problems have arisen to cause Sovereign to go to abnormal lengths to protect its position in order to maintain a high probability of repayment o Obligors are unable to generate enough cash flow to reduce their debts o Deterioration in collateral value or inadequate inspection or verification of value (if the collateral is expected to be a source of repayment) o Flaws in documentation leave Sovereign in a subordinated or unsecured position when the collateral is needed for repayment of the loan When a loan is placed on non-accrual status, all accrued yet uncollected interest is reversed from income. Payments received on non-accrual loans are generally applied to the outstanding principal balance. A non-accrual loan is a loan in which it is probable that scheduled payments of principal and interest will not be paid when due according to the contractual terms of the loan agreement. In order for a non-accrual loan to revert to accruing status, all delinquent interest must be paid and Sovereign must approve a repayment plan. Loans delinquent 180 days or more (120 days for auto loans) are considered for charge-off unless it can be clearly demonstrated that repayment will occur regardless of the delinquency status. Examples of this would include: a loan which is secured by collateral and is in the process of collection; a loan supported by a valid guarantee or insurance; or a loan supported by a valid claim against a solvent estate. A decision to charge-off a loan does not necessarily mean that the asset has no recovery or salvage value, but rather it is not practical to defer writing off the balance, even though partial or full recovery may be realized in the future. SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," requires that certain impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent, as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures." For purposes of measuring impairment as set forth by the provisions of SFAS No. 114 and SFAS No. 118, Sovereign defines impairment as all non-accrual loans, except for large groups of smaller-balance, homogeneous loans such as residential mortgage and consumer loans which are collectively evaluated for impairment. 47 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) j. Loan Fees, Discounts and Premiums -- Loan origination fees and certain direct loan origination costs are deferred and recognized as interest income in the consolidated statement of operations over the contractual life of the loan utilizing the level yield method, except in the case of certain discounted loans in which a portion of the net deferred fee may be amortized over the discount period. Discounts and premiums on loans purchased are amortized into income utilizing methods which approximate the level yield method. k. Premises and Equipment -- Premises and equipment are carried at cost, less accumulated depreciation. Depreciation is calculated utilizing both accelerated and straight-line methods. Estimated useful lives are as follows: Office buildings 15 to 50 years Leasehold improvements 5 to 10 years Furniture, fixtures and equipment 3 to 10 years Automobiles 3 years Expenditures for maintenance and repairs are charged to expense as incurred. l. Other Real Estate Owned -- Other real estate owned ("OREO") consists of properties acquired by or in lieu of foreclosure. OREO is stated at the lower of cost or estimated fair value minus estimated costs to sell. Write-downs of OREO which occur after the initial transfer from the loan portfolio are recorded as other operating expenses. Costs of holding foreclosed property are charged to expense in the current period, except for significant property improvements which are capitalized to the extent that carrying value does not exceed estimated fair value. m. Income Taxes -- Deferred income taxes are provided on temporary differences between amounts reported for financial statement and tax purposes in accordance with SFAS No. 109, "Accounting for Income Taxes." n. Interest Rate Exchange Agreements (Including Swaps, Caps, and Floors) -- Sovereign has entered into certain interest rate exchange agreements in connection with its asset/liability management program which are designated as hedges. Related fees are deferred and amortized on a straight line basis over the life of the interest rate exchange agreement, which corresponds to the estimated life of the asset or liability item being hedged. Net interest payments/receipts are accrued as an adjustment of interest expense/income on the hedged assets or liabilities. Gains or losses resulting from early termination of interest rate exchange agreements are deferred and amortized over the remaining term of the original exchange agreements. In the event the related asset/liability is disposed of, such deferred gains or losses are recognized as an adjustment to the respective gain or loss on disposition. Changes in the value of interest rate exchange agreements are not recorded in the financial statements because the interest rate exchange agreements are designated as hedges. o. General and Administrative Expenses -- General and administrative expenses are classified on a functional basis, except for salaries and employee benefits. Certain direct loan origination costs are deferred and are being amortized as a yield adjustment through net interest income (see note 1-j). p. Consolidated Statement of Cash Flows -- For purposes of reporting cash flows, cash and cash equivalents include cash and amounts due from depository institutions, interest-earning deposits and securities purchased under resale agreements with an original maturity of three months or less. q. Reclassifications -- 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. 48 Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) r. Intangibles -- Core deposit intangibles are a measure of the value of consumer demand and savings deposits acquired in business combinations accounted for as purchases. Core deposit intangibles are amortized on an accelerated basis pursuant to core deposit studies and in accordance with SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions," over the estimated lives of the existing deposit relationships acquired, but not exceeding 15 years. Goodwill is the excess of the purchase price over the fair value of net assets of companies acquired through business combinations accounted for as purchases. Goodwill is being amortized using the straight line method over various periods not exceeding 25 years. The carrying amount of the goodwill is reviewed if facts and circumstances suggest that it may be impaired. If this review indicates that goodwill will not be recoverable, as determined based on the loss of economic value, the carrying amount of the goodwill is reduced by the estimated loss of value. In addition, goodwill associated with impaired long-lived assets is included in the impairment evaluation which Sovereign assesses under the rules of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of." s. Comprehensive Income -- In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." The overall objective of SFAS No. 130 is to provide new rules for the reporting and display of comprehensive income and its components; however, the adoption of this statement had no impact on Sovereign's net income or stockholders' equity. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. The following table presents the components of comprehensive income, net of related tax, based on the provisions of SFAS No. 130 for the years indicated (in thousands):
Year Ended December 31, ----------------------------------- 1998 1997 1996 --------- --------- --------- Net income $ 136,455 $ 102,538 $ 90,378 --------- --------- --------- Unrealized (losses) gains on securities arising during the year (16,095) 18,399 (4,011) Less reclassification adjustment(1) 16,063 -- -- --------- --------- --------- Net unrealized (losses) gains recognized in other comprehensive income (32) 18,399 (4,011) -------- --------- --------- Comprehensive income(2) $ 136,423 $ 120,937 $ 86,367 ========= ========= =========
(1) Sovereign has not calculated the reclassification adjustment for 1997 and 1996. (2) Excluding merger-related charges and losses from non-recurring sales of held-to-maturity securities, comprehensive income for 1998 and 1997 was $170 million and $158 million, respectively. Excluding the non-recurring SAIF assessment, comprehensive income for 1996 was $111 million. - -------------------------------------------------------------------------------- Accumulated other comprehensive income, net of related tax, at December 31, 1998 and 1997 consisted of net unrealized gains on securities of $18.1 million and $18.9 million, respectively. t. Segment Reporting -- In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 requires that public companies report certain information about operating segments in complete sets of financial statements of the company and in condensed financial statements of interim periods issued to shareholders. It also requires that public companies report certain information about their products and services, the geographic areas in which they operate, and their major customers. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. Sovereign is a large regional bank which offers a wide array of products and services to its customers. Pursuant to its super-community banking strategy, emphasis is placed on building relationships with its customers, as opposed to building specific lines of business. As a result, as Sovereign is not organized around discernable lines of business and prefers to work as an integrated unit to customize solutions for its customers, with business line emphasis and product offerings changing over time as needs and demands change. Thus, all necessary requirements of SFAS No. 131 have been met by Sovereign as of December 31, 1998. 49 (2) BUSINESS COMBINATIONS On September 4, 1998, Sovereign acquired 93 former CoreStates Financial Corp. ("CoreStates") branch offices from First Union Corporation ("First Union"). The former CoreStates offices are located throughout Pennsylvania and New Jersey and added approximately $2.2 billion of commercial bank deposits and $725 million of commercial and consumer loans to Sovereign's balance sheet. This transaction was accounted for as a purchase. Sovereign paid a premium of $325 million for the CoreStates branches, of which $226 million was allocated to a core deposit intangible and of which $99 million was allocated to goodwill. Additionally, Sovereign established an initial loan loss reserve of $20.5 million in connection with the loans acquired from CoreStates. The goodwill and core deposit intangible are being amortized over approximately 25 years and 10 years, respectively. Sovereign's results of operations include the operations of the aforementioned branches from September 4, 1998 and thereafter. On July 31, 1998, Sovereign acquired Carnegie Bancorp ("Carnegie"), a $414 million commercial bank holding company headquartered in Princeton, New Jersey which operated seven branch offices throughout central New Jersey and one in Pennsylvania. Carnegie added loans, deposits and stockholders' equity to Sovereign of approximately $286 million, $329 million and $37 million, respectively. In accordance with the merger agreement, Carnegie common stock shareholders received 2.022 shares of Sovereign common stock in exchange for each share of Carnegie common stock. This transaction was accounted for as a pooling-of-interests. On July 31, 1998, Sovereign acquired First Home Bancorp Inc. ("First Home"), a $510 million savings bank holding company headquartered in Pennsville, New Jersey. First Home had one principal operating subsidiary which operated ten branch offices in Salem, Gloucester and Camden counties, New Jersey and New Castle County, Delaware. First Home added loans, deposits and stockholders' equity to Sovereign of approximately $273 million, $320 million and $38 million, respectively. In accordance with the merger agreement, First Home common stock shareholders received 1.779 of Sovereign common stock in exchange for each share of First Home common stock. This transaction was accounted for as a pooling-of-interests. As a result of the Carnegie and First Home transactions, Sovereign issued approximately 10.9 million new shares of common stock and recorded a merger-related charge of $7.8 million (after-tax) during the third quarter of 1998. On February 28, 1998, Sovereign acquired ML Bancorp, Inc. ("ML Bancorp"), a $2.4 billion bank holding company headquartered in Villanova, Pennsylvania. ML Bancorp's principal operating subsidiary, Main Line Bank, operated 29 branch offices located in the suburbs of Philadelphia, Pennsylvania. The transaction added loans, deposits and stockholders' equity to Sovereign of $1.1 billion, $1.0 billion and $201 million, respectively. In accordance with the merger agreement, ML Bancorp shareholders received 1.62 (1.944 shares as adjusted for all subsequent stock dividends and stock splits) shares of Sovereign common stock in exchange for each share of ML Bancorp common stock. Approximately 20.5 million new shares (24.6 million new shares as adjusted for all subsequent stock dividends and stock splits) of Sovereign common stock were issued in connection with the transaction. This transaction was accounted for as a pooling-of-interests. Prior to the combination, ML Bancorp's fiscal year end was March 31, and accordingly, Sovereign's consolidated results of operations for the twelve-month period ended December 31, 1998 include ML Bancorp's results of operations for the two-month period ended February 28, 1998, Sovereign's consolidated results of operations for the twelve-month period ended December 31, 1997 include ML Bancorp's results of operations for the eleven-month period ended February 28, 1998 and Sovereign's results of operations for the twelve-month period ended December 31, 1996 include MLBancorp's results of operations for the twelve-month period ended March 31, 1997. A net decrease to Sovereign's stockholders' equity of $5.0 million has been made to reflect ML Bancorp's activity for the two-month period ended February 28, 1998. That activity consisted of net income of $4.2 million and net unrealized gains on investment securities available-for-sale of $792,000. 50 Notes to Consolidated Financial Statements (2) BUSINESS COMBINATIONS - (CONTINUED) The pre-merger results of operations for Sovereign, ML Bancorp, Carnegie and First Home (which were acquired pursuant to transactions accounted for as a pooling-of-interests) are as follows (in thousands):
Sovereign MLBancorp(1) Carnegie(2) First Home(2) Combined ---------- ------------ ----------- ------------- ---------- Year Ended December 31, 1998 Interest income $1,284,933 $27,935 $ 19,517 $22,986 $1,355,371 Interest expense 821,529 16,295 9,848 14,087 861,759 Provision for loan losses 27,467 -- 260 234 27,961 Other income 100,962 3,441 427 808 105,638 Non-interest expense 332,710 8,534 10,180 8,659 360,083 Income tax provision 71,539 2,319 390 503 74,751 ---------- ------- -------- ------- ---------- Net Income $ 132,650 $ 4,228 $ (734) $ 311 $ 136,455 ========== ======= ======== ======= ==========
- ---------- (1) Reflects ML Bancorp's results of operations for the two-month period ended February 28, 1998. (2) Reflects Carnegie and First Home results of operations for the seven-month period ended July 31,1998. During 1998, Sovereign recorded pre-tax merger-related charges of $49.9 million ($33.5 million after-tax) or $.21 per share, primarily related to costs incurred in connection with its acquisitions of ML Bancorp, Carnegie and First Home. The components of the merger-related charges were as follows (in thousands): Requiring Cash Cash Outflow Provision Outflow To Date --------- --------- ------- Severance and employee-related costs $22,257 $22,257 $22,257 Merger transaction costs 5,307 5,307 5,307 Writedowns of assets 13,350 -- -- Office closing costs 3,085 1,274 1,274 Miscellaneous 5,933 5,933 5,933 ------- ------- ------- Total $49,932 $34,771 $34,771 ======= ======= ======= Severance and employee-related costs relate primarily to severance costs and related taxes for employees of the three companies who were displaced as a result of merger, as well as the termination and distribution of ML Bancorp's Employee Stock Ownership Plan ("ML ESOP") and restricted stock plans in connection with the merger. Writedowns of assets include obsolescence of data processing equipment at all three companies as well as writedowns of servicing-related assets at ML Bancorp. The following table summarizes the activity in the merger-related accrual for the year ended December 31, 1998 (in thousands): Balance at December 31, 1997 $ 268 Provision charged against income 49,932 Cash outflow (34,771) Writedowns of assets (15,429) -------- Balance at December 31, 1998 $ -- ======== 51 (2) BUSINESS COMBINATIONS - (CONTINUED) On September 19, 1997, Sovereign purchased Fleet Financial Group Inc.'s ("Fleet") Automobile Finance Division ("Fleet Auto"). Fleet Auto consisted of approximately $2.0 billion of indirect auto loans, automotive floor plan loans and loans to automotive lessors. Fleet Auto had business relationships with over 2,000 automotive dealerships and served approximately 225,000 customers throughout New Jersey, New York and several New England states. Sovereign purchased Fleet Auto at a discount, which in part, reflected the need to establish initial reserves for possible loan losses of approximately $22.0 million or 1.50% of the indirect auto loans acquired. The transaction added $10.7 million of goodwill to Sovereign's balance sheet. Sovereign's consolidated results of operations include Fleet Auto's results of operations from September 19, 1997 and thereafter. On August 29, 1997, Sovereign acquired Bankers Corp. ("Bankers"), a $2.6 billion financial services holding company headquartered in Perth Amboy, New Jersey. Bankers' sole banking subsidiary, Bankers Savings, operated 15 branch offices located in Middlesex, Monmouth and Ocean counties, New Jersey. The transaction added loans, deposits, and shareholders' equity to Sovereign of $1.5 billion, $1.7 billion, and $204 million, respectively. In accordance with the merger agreement, Bankers shareholders received 1.854 (2.225 shares as adjusted for all subsequent stock dividends and stock splits) shares of Sovereign common stock in exchange for each share of Bankers common stock. Sovereign issued approximately 23.0 million new shares (27.6 million new shares as adjusted for all subsequent stock dividends and stock splits) of Sovereign common stock in connection with the transaction. This transaction was accounted for as a pooling-of-interests. On February 18, 1997, Sovereign acquired First State Financial Services, Inc. ("First State"), a $603 million savings institution headquartered in West Caldwell, New Jersey with 14 branch offices located throughout central and northern New Jersey. In accordance with the merger agreement, First State shareholders received 1.225 (1.76 shares as adjusted for all subsequent stock dividends and stock splits) shares of Sovereign common stock in exchange for each share of First State common stock. Sovereign issued approximately 4.9 million new shares (7.06 million new shares as adjusted for all subsequent stock dividends and stock splits) of Sovereign common stock in connection with the transaction. This transaction was accounted for as a pooling-of-interests. Prior to the combination, First State's fiscal year end was September 30, and accordingly, Sovereign's consolidated results of operations for the year ended December 31, 1996 include First State's results of operations for the twelve-month period ended September 30, 1996. Sovereign's consolidated results of operations for the year ended December 31, 1997 include First State's results of operations for the twelve-month period ended December 31, 1997. A net decrease to Sovereign's stockholders' equity of $5.0 million has been made to reflect First State's activity for the three-month period ended December 31, 1996. That activity consisted of proceeds from the exercise of stock options of $1.0 million, net income of $6.2 million and net unrealized losses on investment securities available-for-sale of $228,000. The pre-merger results of operations for Sovereign, First State and Bankers (which were acquired pursuant to transactions accounted for as a pooling-of-interests) were as follows (in thousands): Sovereign(1) Bankers Combined ------------ ------- -------- Year Ended December 31, 1997 (unaudited) Interest income $360,816 $89,398 $450,214 Interest expense 234,302 55,548 289,850 Provision for loan losses 9,700 2,300 12,000 Other income 16,905 1,222 18,127 Non-interest expense 82,776 10,278 93,054 Income tax provision 20,230 8,172 28,402 ------- ------- ------- Net income $ 30,713 $14,322 $45,035 ======= ======= ======= - ---------- (1) Sovereign's result of operations include First State's results of operations. 52 Notes to Consolidated Financial Statements (2) BUSINESS COMBINATIONS - (CONTINUED) During 1997, Sovereign recorded pre-tax merger-related charges of $44.1 million ($29.8 million after-tax) or $.19 per share, primarily related to costs incurred in connection with its acquisitions of Bankers and First State. The components of the merger- related charges were as follows (in thousands): Requiring Cash Cash Outflow Provision Outflow To Date --------- --------- ------- Severance and employee-related costs $ 8,613 $ 8,613 $ 8,613 Merger transaction costs 5,811 5,811 5,811 Credit related reserves 24,900 -- -- Loss on sales of assets 1,093 -- -- Office closing costs 2,330 -- -- Miscellaneous 1,377 1,377 1,377 ------- ------- ------- Total $44,124 $15,801 $15,801 ======= ======= ======= On May 31, 1996, Sovereign acquired West Jersey Bancshares, Inc. ("West Jersey") in a transaction accounted for as a pooling-of-interests; however, the consolidated financial statements have not been restated due to immateriality. Sovereign acquired approximately $100 million in assets consisting principally of investment securities and loans and assumed approximately $73.0 million of deposit liabilities. West Jersey shareholders received .8335 (1.2 shares as adjusted for all subsequent stock dividends and stock splits) shares of Sovereign common stock in exchange for each share of West Jersey common stock, or $8.91 per share. Sovereign issued 1.7 million new shares (2.4 million shares as adjusted for all subsequent stock dividends and stock splits) of Sovereign common stock in connection with the transaction. On September 8, 1998, Sovereign executed a Definitive Agreement to acquire Peoples Bancorp, Inc. ("Peoples"), a $1.3 billion bank holding company headquartered in Lawrenceville, New Jersey whose principal operating subsidiary operates 14 community banking offices in Mercer, Burlington and Ocean counties, New Jersey. The terms of the agreement call for a fixed exchange, without collars, of .80 shares of Sovereign common stock for each outstanding share of Peoples common stock. Peoples may elect to terminate the transaction at the closing if Sovereign's common stock price decreases below $11.00 per share and such a decrease exceeds, by 10% or more, the decrease of price derived from a peer group index. The transaction, which will be accounted for as a purchase, is subject to approval by various regulatory agencies and Peoples' shareholders. The transaction will add loans, deposits and stockholders' equity to Sovereign of approximately $430 million, $500 million and $340 million, respectively. (3) Restrictions on cash and amounts due from depository institutions Sovereign Bank is required to maintain certain average reserve balances as established by the Federal Reserve Board. The amounts of those reserve balances for the reserve computation periods which included December 31, 1998 and 1997 were $237 million and $96.4 million, respectively. 53 (4) INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities are as follows (in thousands):
At December 31, ---------------------------------------------------------- 1998 ---------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ------------ ------------ ---------- Investment Securities Available-for-Sale: Investment Securities: U.S. Treasury and government agency securities $ 35,480 $ 1 $ 64 $ 35,417 Corporate securities 38,784 1,413 121 40,076 Equity securities 881,817 15,545 10,381 886,981 Other securities 8,360 972 -- 9,332 Mortgage-backed Securities: FHLMC 85,761 867 264 86,364 FNMA 40,645 335 57 40,923 GNMA 42,434 749 14 43,169 Collateralized mortgage obligations 3,531,948 11,214 2,785 3,540,377 Other securities 1,969,322 15,976 5,510 1,979,788 ---------- ------- ------- ---------- Total investment securities available-for-sale $6,634,551 $47,072 $19,196 $6,662,427 ========== ======= ======= ==========
At December 31, ---------------------------------------------------------- 1997 ---------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ------------ ------------ ---------- Investment Securities Available-for-Sale: Investment Securities: U.S. Treasury and government agency securities $ 46,515 $ 115 $ -- $ 46,630 Corporate securities -- -- -- -- Equity securities 643,288 18,898 79 662,107 Other securities 46,935 4,447 298 51,084 Mortgage-backed Securities: FHLMC 420,590 3,493 397 423,686 FNMA 202,740 1,631 401 203,970 GNMA 256,532 1,908 600 257,840 Collateralized mortgage obligations 296,633 1,581 1,515 296,699 Other securities 14,295 9 58 14,246 ---------- ------- ------ ---------- Total investment securities available-for-sale $1,927,528 $32,082 $3,348 $1,956,262 ========== ======= ====== ==========
At December 31, ---------------------------------------------------------- 1998 ---------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ------------ ------------ ---------- Investment Securities Held-to-Maturity: Investment securities: U.S. Treasury and government agency securities $ 31,180 $ 151 $ 78 $ 31,253 Corporate securities -- -- -- -- Other securities 54,481 3,691 122 58,050 Mortgage-backed securities: FHLMC 242,558 4,733 104 247,187 FNMA 176,167 3,371 85 179,453 GNMA 292,664 6,009 -- 298,673 RTC -- -- -- -- Private issues 74,523 1,165 136 75,552 Collateralized mortgage obligations 968,082 4,541 2,208 970,415 ---------- ------- ------ ---------- Total investment securities held-to-maturity $1,839,655 $23,661 $2,733 $1,860,583 ---------- ------- ------ ----------
At December 31, ---------------------------------------------------------- 1997 ---------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ------------ ------------ ---------- Investment Securities Held-to-Maturity: Investment securities: U.S. Treasury and government agency securities $ 47,520 $ 335 $ 430 $ 47,425 Corporate securities 1,050 24 -- 1,074 Other securities 61,406 3,832 150 65,088 Mortgage-backed securities: FHLMC 383,790 7,569 520 390,839 FNMA 243,116 3,752 412 246,456 GNMA 415,840 8,336 157 424,019 RTC 411 -- 1 410 Private issues 124,794 999 82 125,711 Collateralized mortgage obligations 2,138,524 9,964 2,647 2,145,841 ---------- ------- ------ ---------- Total investment securities held-to-maturity $3,416,451 $34,811 $4,399 $3,446,863 ========== ======= ====== ==========
54 Notes to Consolidated Financial Statements (4) INVESTMENT SECURITIES - (CONTINUED) The amortized cost and estimated fair value of investment securities at December 31, 1998 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands): Amortized Cost Fair Value ---------- ---------- Investment Securities Available-for-Sale: Due in one year or less $ 192,684 $ 192,816 Due after one year through five years 14,060 14,040 Due after five years through ten years 16,449 16,585 Due after ten years 5,530,170 5,552,850 No stated maturity 881,188 886,136 ---------- ---------- Total investment securities available-for-sale $6,634,551 $6,662,427 ========== ========== Amortized Cost Fair Value ---------- ----------- Investment Securities Held-to-Maturity: Due in one year or less $ 36,478 $ 36,500 Due after one year through five years 4,074 4,156 Due after five years through ten years 158,928 160,310 Due after ten years 1,640,175 1,659,617 ---------- ----------- Total investment securities held-to-maturity $1,839,655 $ 1,860,583 ========== =========== Proceeds from sales of investment securities and the realized gross gains and losses from those sales are as follows (in thousands):
Available-for-Sale Held-to-Maturity Year Ended December 31, Year Ended December 31, ------------------------------------ -------------------------------------- 1998 1997 1996 1998 1997 1996 ---------- -------- -------- -------- --------- --------- Proceeds from sales $2,145,929 $295,933 $901,987 $ 12,432 $ 561,316 $ -- ========== ======== ======== ======== ========= ========= Gross realized gains(1) 27,729 3,751 9,844 -- 183 -- Gross realized losses(1) 11,449 2,893 4,858 457 10,217 -- ---------- -------- -------- -------- --------- --------- Net realized gains/(losses) $ 16,280 $ 858 $ 4,986 $ (457) $ (10,034) $ -- ========== ======== ======== ======== ========= =========
- ---------- (1) Included in gross realized gains and losses from sales of investment securities are $1.7 million of gains and $10.1 million of losses resulting from the termination of interest rate swaps which were hedging the specific securities sold. Proceeds from sales of investment securities held-to-maturity for the years ended December 31, 1998 and 1997 were the result of the liquidation of certain held-to-maturity securities acquired from ML Bancorp in 1998 and Bankers in 1997. These sales were completed in accordance with the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" to maintain Sovereign's pre-merger interest rate risk position. Tax-exempt income included in interest and dividends on investment securities for the years ended December 31, 1998, 1997 and 1996 were $17.9 million, $10.5 million and $5.4 million, respectively. Tax expense/(benefit) related to net realized gains and losses from sales of investment securities for the years ended December 31, 1998, 1997 and 1996 were $5.7 million, $(3.2) million and $1.7 million, respectively. Investment securities with an estimated fair value of $1.8 billion and $1.6 billion were pledged as collateral for borrowings, interest rate agreements and public deposits at December 31, 1998 and 1997, respectively. 55 (5) LOANS A summary of loans included in the consolidated balance sheets follows (in thousands): At December 31, ----------------------------- 1998 1997 ----------- ----------- Residential real estate loans $ 5,113,537 $ 6,634,271 Residential construction loans (net of loans in process of $89,509 and $49,568, respectively) 62,536 137,367 Total Residential Loans 5,176,073 6,771,638 Commercial real estate loans 887,938 664,943 Commercial loans 717,440 356,517 Automotive floor plan loans 578,147 279,757 Multi-family loans 115,195 115,570 ----------- ----------- Total Commercial Loans 2,298,720 1,416,787 ----------- ----------- Home equity loans 1,750,883 1,050,304 Auto loans 1,510,676 1,553,318 Loans to automotive lessors 252,856 267,033 Student loans 256,744 190,440 Credit cards -- 54,887 Other 39,888 19,715 ----------- ----------- Total Consumer Loans 3,811,047 3,135,697 ----------- ----------- Total Loans(1) $11,285,840 $11,324,122 Total Loans with:(2) Fixed rate $ 5,798,158 $ 4,548,951 Variable rate 5,487,682 6,775,171 ----------- ----------- Total Loans(1) $11,285,840 $11,324,122 =========== =========== - ---------- (1) Loan totals are net of deferred loan fees and unamortized premiums and discounts of $16.9 million for 1998 and $20.3 million for 1997. (2) Loan totals do not reflect the impact of off-balance sheet interest rate swaps used for interest rate risk management as discussed below. As a result of Sovereign's use of interest rate swaps for interest rate risk management, at December 31, 1998, $175 million of intermediate variable rate mortgage loans (loans with a five-year fixed rate period) have effectively been converted to variable rate over the fixed rate period. The total amount of loans being serviced for the benefit of others was $6.7 billion, $6.4 billion and $5.9 billion at December 31, 1998, 1997 and 1996, respectively. At December 31, 1998 and 1997, Sovereign had mortgage servicing rights of $62.3 million and $64.8 million, respectively. Loans to related parties include loans made to certain officers, directors and their affiliated interests. At December 31, 1998, loans to related parties totaled $2.7 million. For additional information with respect to the scheduled maturity of Sovereign's loan portfolio, see Table 5 in "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Loan Portfolio" on page 26. The activity in the allowance for loan losses is as follows (in thousands): Year Ended December 31, --------------------------------- 1998 1997 1996 -------- -------- ------- Balance, beginning of period $116,823 $ 73,847 $67,515 Acquired reserves and other additions 22,660 20,652 716 Provision for loan losses. 27,961 41,125 22,685 Charge-offs 46,330 24,184 18,941 Recoveries. 12,688 5,383 1,872 -------- -------- ------- Balance, end of period $133,802 $116,823 $73,847 ======== ======== ======= 56 Notes to Consolidated Financial Statements (5) LOANS - (CONTINUED) Sovereign encourages loan officers to follow specific procedures in the early identification and collection of problem loans. If a loan becomes seriously delinquent or the loan officer is not successful in the resolution of the problem loan, the account is transferred to Sovereign's Asset Recovery Team. At this time the account is analyzed for collateral values and the cash flows available to repay the loan. If it is determined that there is a collateral shortfall and insufficient cash flow to repay the debt, a reserve will be established. At any time during this process and at the loan officer's discretion, the account may be placed on non-accrual status. By following these procedures, losses are minimized on impaired loans. Impaired loans are summarized as follows (in thousands): At December 31, ---------------------- 1998 1997 ------- ------- Impaired loans without a related reserve $ -- $ 137 Impaired loans with a related reserve 63,296 24,802 ------- ------- Total impaired loans $63,296 $24,939 ======= ======= Reserve for impaired loans $18,582 $ 8,249 ======= ======= The average balance of impaired loans for 1998, 1997 and 1996 was $58.1 million, $29.2 million and $30.5 million, respectively. (6) Premises and equipment A summary of premises and equipment, less accumulated depreciation and amortization, follows (in thousands): At December 31, --------------------------- 1998 1997 --------- --------- Land $ 14,923 $ 15,636 Office buildings 69,542 64,532 Furniture, fixtures, and equipment 94,055 85,479 Leasehold improvements 21,351 16,578 Automobiles 849 1,129 --------- --------- 200,720 183,354 Less accumulated depreciation (102,229) (91,081) --------- --------- Total premises and equipment $ 98,491 $ 92,273 ========= ========= Sovereign is committed under various non-cancelable operating leases relating to branch facilities having initial or remaining terms in excess of one year. The minimum annual rental commitments under these leases at December 31, 1998, are summarized as follows (in thousands): At December 31, 1998 --------------- 1999 $14,538 2000 13,243 2001 12,332 2002 10,273 2003 7,568 Thereafter 27,665 -------- Total $85,619 ======== Total rental expense for all leases for the years ended December 31, 1998, 1997 and 1996 was $10.6 million, $7.9 million and $6.3 million, respectively. 57 (7) ACCRUED INTEREST RECEIVABLE Accrued interest receivable is summarized as follows (in thousands): At December 31, ------------------------- 1998 1997 -------- -------- Accrued interest receivable on: Investment securities $ 57,809 $ 36,800 Loans 89,632 71,229 -------- -------- Total interest receivable $147,441 $108,029 ======== ======== Accrued interest receivable is stated net of an allowance for potentially uncollected interest (for loans on non-accrual and for loans that have been restructured). If these non-accruing and restructured loans had been current in accordance with their original terms and had been outstanding throughout the period, gross interest income for the years ended December 31, 1998, 1997 and 1996 would have increased by approximately $9.5 million, $7.5 million and $8.5 million, respectively. Interest income recorded on these loans for the years ended December 31, 1998, 1997 and 1996 was $3.3 million, $2.4 million and $2.4 million respectively. (8) DEPOSITS Deposits are summarized as follows (in thousands):
At December 31, ---------------------------------------------------------------------- 1998 1997 -------------------------------- -------------------------------- Balance Percent Rate Balance Percent Rate ----------- ------- ---- ---------- ------- ---- Demand deposit accounts $ 1,104,170 9% --% $ 611,670 6% --% NOW accounts 1,281,516 10 1.24 723,182 8 1.29 Savings accounts 2,295,448 19 2.83 1,900,334 20 3.02 Money market accounts 1,545,634 13 3.78 916,788 10 4.06 Retail certificates of deposit 5,172,196 42 5.24 4,673,467 49 5.54 Jumbo certificates of deposit 923,752 7 5.40 689,853 7 5.76 ----------- --- ---- ---------- --- ---- Total deposits $12,322,716 100% 3.73% $9,515,294 100% 4.23% =========== === ==== ========== === ====
Certificate accounts are frequently renewed at maturity rather than paid out. The following table sets forth the maturity of Sovereign's certificates of deposit as scheduled to mature contractually at December 31, 1998 (in thousands):
Within Six Six Mos./ One/ Three/ Five/ Over Mos. One Yr. Three Yrs. Five Yrs. Ten Yrs. Ten Yrs. Total ---------- ---------- ---------- --------- -------- -------- ---------- Certificate accounts by rate: Less than 4.001% $ 163,830 $ 9,982 $ 12,147 $ 87 $24,249 $2,799 $ 213,094 4.001%-- 6.000% 3,511,179 1,433,186 502,519 73,956 14,250 301 5,535,391 6.001%-- 8.000% 76,754 86,156 114,658 29,478 27,301 8 334,355 8.001%-- 10.000% 5,043 1,412 1,507 387 1,083 354 9,786 Above 10.000% 167 105 957 213 1,791 89 3,322 ---------- ---------- -------- -------- ------- ------ ---------- Total certificate accounts $3,756,973 $1,530,841 $631,788 $104,121 $68,674 $3,551 $6,095,948 ========== ========== ======== ======== ======= ====== ==========
58 Notes to Consolidated Financial Statements (8) DEPOSITS - (CONTINUED) The following table sets forth the maturity of Sovereign's certificates of deposit as scheduled to mature contractually at December 31, 1998 (in thousands): At December 31, 1998 --------------- 1999 $5,287,816 2000 523,672 2001 108,114 2002 52,259 2003 51,862 Thereafter 72,225 ---------- Total $6,095,948 ========== The following table sets forth the maturity of Sovereign's certificates of deposit of $100,000 or more as scheduled to mature contractually at December 31, 1998 (in thousands): At December 31, 1998 --------------- Three months or less $ 496,443 Over three through six months 548,181 Over six through twelve month 181,048 Over twelve months 78,610 ---------- Total $1,304,282 ========== Interest expense on deposits is summarized as follows (in thousands): At December 31, ---------------------------------- 1998 1997 1996 -------- -------- -------- Demand deposit and NOW accounts $ 16,387 $ 7,967 $ 9,423 Savings accounts 62,694 58,974 51,824 Money market accounts 45,055 33,719 34,387 Certificates of deposit 316,164 278,153 255,450 -------- -------- -------- Total interest expense on deposits $440,300 $378,813 $351,084 ======== ======== ======== Deposits of related parties include deposits made by certain officers, directors and their affiliated interests. At December 31, 1998, deposits of related parties totaled $1.7 million. (9) SHORT-TERM AND LONG-TERM BORROWINGS Short-term Borrowings. Short-term borrowings included in the consolidated balance sheets are as follows (in thousands): At December 31, ------------------------------ 1998 1997 ---------- ---------- Securities sold under repurchase agreements $ 315,540 $ 787,700 Federal Home Loan Bank advances 3,409,243 4,626,401 Other borrowings 196,901 41,793 ---------- ---------- Total borrowings $3,921,684 $5,455,894 59 (9) SHORT-TERM AND LONG-TERM BORROWINGS - (CONTINUED) Included in short-term borrowings are sales of securities under repurchase agreements. Securities underlying these repurchase agreements consisted of investment securities which had a book value of $180 million and $723 million and a market value of $182 million and $729 million at December 31, 1998 and 1997, respectively. Effective January 1, 1998, Sovereign adopted the provisions of SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of SFAS No. 125." The provisions of SFAS No. 127 defer the effective date for the provisions of SFAS No. 125 relating to accounting for repurchase agreements, dollar rolls, securities lending and similar transactions. Accordingly, qualifying repurchase agreements are treated as financings and the obligations to repurchase securities sold are reflected as a liability in the balance sheet. The dollar amount of securities underlying the agreements remains in the asset accounts, although the securities underlying the agreements are delivered to the brokers who arranged the transactions. In certain instances, the broker may have sold, loaned, or disposed of the securities to other parties in the normal course of their operations, and have agreed to resell to Sovereign substantially similar securities at the maturity of the agreements. The broker/dealers who participate with Sovereign in these agreements are primarily broker/dealers reporting to the Federal Reserve Bank of New York. The following table summarizes information regarding short-term securities sold under repurchase agreements (in thousands):
December 31, ---------------------------------------- 1998 1997 1996 -------- ---------- ---------- Balance $315,540 $ 787,700 $ 939,659 Weighted average interest rate 5.32% 5.61% 5.58% Maximum amount outstanding at any month-end during the year $956,394 $1,515,156 $1,310,406 Average amount outstanding during the year $525,986 $1,222,183 $ 804,012 Weighted average interest rate during the year 5.39% 5.67% 5.77%
The following table summarizes information regarding short-term FHLB advances (in thousands):
December 31, ------------------------------------------ 1998 1997 1996 ---------- ---------- ---------- Balance $3,409,243 $4,626,401 $3,079,801 Weighted average interest rate 5.32% 5.91% 5.82% Maximum amount outstanding at any month-end during the year $5,361,401 $4,709,176 $3,842,670 Average amount outstanding during the year $4,420,827 $3,718,562 $2,356,162 Weighted average interest rate during the year 5.98% 6.03% 5.88%
The following table summarizes information regarding short-term federal funds purchased (in thousands):
December 31, ------------------------------------ 1998 1997 1996 ---- ------- --------- Balance $ -- $ -- $12,000 Weighted average interest rate --% --% 7.26% Maximum amount outstanding at any month-end during the year $ -- $22,400 $43,400 Average amount outstanding during the year $ -- $ 3,860 $15,840 Weighted average interest rate during the year --% 5.68% 5.44%
60 Notes to Consolidated Financial Statements (9) SHORT-TERM AND LONG-TERM BORROWINGS - (CONTINUED) Long-term Borrowings. Long-term securities sold under repurchase agreements had weighted average interest rates of 5.58% and 5.88% at December 31, 1998 and 1997, respectively. Long-term FHLB advances had weighted average interest rates of 4.96% and 6.07% at December 31, 1998 and 1997, respectively. Long-term borrowings are as follows (in thousands): At December 31, ------------------------- 1998 1997 ---------- ---------- Securities sold under repurchase agreements, maturing January 2000 to May 2008 $ 340,000 $ 362,393 FHLB advances, maturing February 2000 to April 2012 3,492,262 898,998 6.75% senior notes, due July 1, 2000 49,653 49,655 6.75% subordinated debentures, due 2000 27,894 27,831 8.50% subordinated debentures, due 2002 19,708 19,629 8.00% subordinated debentures, due 2003 49,391 49,243 ---------- ---------- Total long-term borrowings $3,978,908 $1,407,749 ========== ========== Included in long-term borrowings are sales of securities under repurchase agreements. Securities underlying these repurchase agreements consisted of mortgage-backed securities which had a book value of $340 million and a market value of $344 million at December 31, 1998. Single issuers of these repurchase agreements having an aggregate book value in excess of 10% of Sovereign's stockholders' equity at December 31, 1998 included Salomon Smith Barney Holdings, Inc. with $197 million and a weighted average maturity of 2.2 years and Lehman Brothers, Inc. with $123 million and a weighted average maturity of 7.7 years. The majority of FHLB advances are collateralized by qualifying mortgage-related assets as defined by the FHLB. The remaining FHLB advances are collateralized by mortgage-backed securities. The 6.75% notes are non-amortizing and are not redeemable prior to maturity. The 6.75% debentures are non-amortizing and are not redeemable prior to maturity. The 6.75% debentures and a portion of the FHLB advances have, through the use of interest rate swaps, been effectively converted from fixed rate obligations to variable rate obligations. The 8.50% debentures are non-amortizing and are redeemable at the option of Sovereign in whole or in part at any time on or after September 15, 1999. The 8.00% debentures are non-amortizing and are not redeemable prior to maturity. The following table sets forth the maturity of Sovereign's long-term borrowings as scheduled to mature contractually at December 31, 1998 (in thousands): At December 31, 1998 --------------- 1999 $ -- 2000 269,547 2001 363,000 2002 486,708 2003 814,391 Thereafter 2,045,262 --------- Total $3,978,908 ========= 61 (10) TRUST PREFERRED SECURITIES During March 1997, Sovereign issued $100 million of preferred capital securities ("Trust Preferred") through Sovereign Capital Trust I ("Trust"), a special-purpose statutory trust created expressly for the issuance of these securities. Distributions on the Trust Preferred will be payable at an annual rate of 9% of the stated liquidation amount of $1,000 per capital security, payable semi-annually. After issuance costs, proceeds of $97.6 million were invested in Junior Subordinated Debentures of Sovereign, at terms identical to the Trust Preferred offering. Cash distributions on the Trust Preferred are made to the extent interest on the debentures is received by the Trust. In the event of certain changes or amendments to regulatory requirements or federal tax rules, the Trust Preferred securities are redeemable in whole. Otherwise, the Trust Preferred securities are generally redeemable in whole or in part on or after April 1, 2007, at a declining redemption price ranging from 103.875% to 100% of the liquidation amount. On or after April 1, 2017, the Trust Preferred securities may be redeemed at 100% of the liquidation amount. During March 1997, ML Bancorp, a predecessor company of Sovereign, also issued $50.0 million of Trust Preferred securities at an interest rate of 9.875%, with a scheduled maturity of March 1, 2027. The securities were issued by ML Capital Trust I and proceeds from the issuance were invested in Junior Subordinated Debentures issued by ML Bancorp. Sovereign assumed ML Bancorp's obligations under this offering and has the option, subject to required regulatory approval, to prepay the securities beginning March 1, 2007. The Trust Preferred offerings are classified as and are similar to a minority interest and are presented as "Corporation-obligated mandatorily redeemable capital securities of subsidiary trust holding solely subordinated debentures of Sovereign Bancorp, Inc." The Trust Preferred offerings qualify for Tier I capital treatment for Sovereign and the loan payments from Sovereign to the Trust are fully tax deductible. (11) STOCKHOLDERS' EQUITY The Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA") requires institutions regulated by the OTS to have minimum regulatory tangible capital equal to 1.5% of total tangible assets, 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%. Sovereign Bank was in compliance with all of these capital requirements as of December 31, 1998. The following schedule summarizes the actual capital balances of Sovereign Bank at December 31, 1998 (in thousands):
Tangible Leverage Leverage Risk-Based Capital to Capital to Capital to Capital to Tangible Tangible Risk-Adjusted Risk-Adjusted Assets Assets Assets Assets ---------- ---------- ------------- ------------- Sovereign Bank: Regulatory capital $1,107,748 $1,107,748 $1,107,748 $1,230,442 Minimum capital requirement 325,259 637,364 476,865 953,731 ---------- ---------- ---------- ---------- Excess $ 782,489 $ 470,384 $ 630,883 $ 276,711 ========== ========== ========== ========== Capital ratio 5.11% 5.21% 9.29% 10.32%
62 Notes to Consolidated Financial Statements (11) STOCKHOLDERS' EQUITY - (CONTINUED) OTS capital regulations do not apply to holding companies. The following schedule summarizes actual capital balances of Sovereign Bancorp at December 31, 1998 as if those regulations did apply to Sovereign Bancorp (in thousands):
Tangible Leverage Leverage Risk-Based Capital to Capital to Capital to Capital to Tangible Tangible Risk-Adjusted Risk-Adjusted Assets Assets Assets Assets ---------- ---------- ------------- ------------- Sovereign Bancorp: Regulatory capital $753,790 $882,840 $882,840 $1,354,036 Minimum capital requirement 321,870 630,717 481,486 962,971 -------- -------- -------- ---------- Excess $431,920 $252,123 $401,354 $ 391,065 ======== ======== ======== ========= Capital ratio 3.51% 4.20% 7.33% 11.25%
The Federal Deposit Insurance Corporation Improvement Act ("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. At December 31, 1998, Sovereign Bank was classified as well-capitalized and in compliance with all capital requirements. Management anticipates that Sovereign Bank will continue to be classified as well-capitalized and will be in compliance with all regulatory capital requirements. As a result of provisions of the Small Business Jobs Protection Act of 1996 (the "Jobs Protection Act"), which repealed the tax reserve method for bad debts for thrift institutions and the circumstances requiring bad debt recapture for large institutions, Sovereign must determine the tax deduction for bad debt based on actual charge-offs. The Jobs Protection Act retained the existing base year bad debt reserve and requires recapture into taxable income in certain circumstances such as in the case of certain excess distributions or complete redemptions. None of the limited circumstances requiring recapture are anticipated by Sovereign. Retained earnings at December 31, 1998 included $62.4 million in bad debt reserves, for which no deferred taxes have been provided due to the indefinite nature of the recapture provisions. Sovereign maintains a Dividend Reinvestment and Stock Purchase Plan which permits holders of record of Sovereign common stock to purchase additional shares of common stock directly from Sovereign via reinvestment of cash dividends and optional cash purchases. At December 31, 1998, purchases of common stock with reinvested dividends are made at a 5% discount from the current market price as defined and optional cash purchases are limited to a maximum of $5,000 per quarter. Sovereign maintains a Stockholder Rights Plan (the "Rights Plan"). The Rights Plan is designed to protect stockholders from attempts to acquire control of Sovereign at an inadequate price. Under the Rights Plan, Sovereign distributed a dividend of one right to purchase a unit of preferred stock on each outstanding share of Sovereign's common stock. The rights are not currently exercisable or transferable and no separate certificates evidencing such rights will be distributed, unless certain events occur. The rights attach to shares of common stock outstanding on October 2, 1989 and will expire on September 27, 2004 as stated in the amendment to the Rights Plan dated September 27, 1995. The rights will entitle the holders to purchase either Sovereign's common stock or the common stock of the potential acquirer at a substantially reduced price. On May 17, 1995, Sovereign completed the sale of 2.0 million shares of Convertible Preferred Stock, raising $96.4 million in capital. The 6 1/4% non-voting, Cumulative Convertible Preferred Stock was convertible at the option of the holder at any time, unless previously redeemed, at a conversion rate (adjusted to reflect all stock dividends and stock splits) of 7.184 shares of common stock for each share of preferred stock; equivalent to a conversion price of $6.960 per share of common stock. On May 15, 1998, Sovereign redeemed all outstanding shares of its 6 1/4% Cumulative Convertible Preferred Stock, Series B. 63 (12) STOCK OPTION PLANS Sovereign grants stock options for a fixed number of shares to key officers and directors with an exercise price equal to the fair value of the shares at the date of grant. Sovereign's stock options expire not more than ten years after the date of grant and become fully vested and exercisable within a one to five year period after the date of grant. Sovereign accounts for stock option grants in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," and accordingly, recognizes no compensation expense for the stock option grants. There are 14.2 million shares of common stock reserved for issuance under the plans. These shares, along with the per share data in the following summary of option transactions, have been adjusted to reflect all stock dividends and stock splits.
Price Per Shares Share - --------- ---------- --------------- Options outstanding December 31, 1995 8,509,516 $ .96 - $ 7.51 ---------- --------------- Granted 767,921 $ 6.16 - $ 8.94 Exercised (1,051,867) $ .97 - $ 6.45 Forfeited (159,675) $ 3.84 - $ 7.51 ---------- --------------- Options outstanding December 31, 1996 (3,758,345 shares exercisable) 8,065,895 $ .96 - $ 8.94 ---------- --------------- Granted 1,382,278 $ 8.17 - $15.94 Exercised (3,388,704) $ .97 - $ 7.51 Forfeited (26,016) $ 3.84 - $10.54 --------- Options outstanding December 31, 1997 (4,351,317 shares exercisable) 6,033,453 $ .96 - $16.77 ----------- --------------- Granted 934,070 $13.38 - $20.25 Exercised (2,295,265) $ .97 - $10.54 Forfeited (172,550) $ 8.22 - $20.25 ---------- Options outstanding December 31, 1998 (3,371,038 shares exercisable) 4,499,708 $ .96 - $20.25 =========== ===============
64 (12) STOCK OPTION PLANS - (CONTINUED) The following table summarizes Sovereign's stock options outstanding at December 31, 1998:
Options Outstanding Options Exercisable ------------------------------------------ ----------------------- Wtd. Avg. Wtd. Avg. Wtd. Avg. Exercise Remaining Exercise Exercise Prices Shares Price Contractual Life Shares Price --------------- --------- ---------- ---------------- --------- --------- $.96-$5.90 2,485,494 $ 3.60 4.51 2,485,494 $ 3.60 $6.07-$12.71 636,264 $ 8.14 7.89 636,264 $ 8.14 $13.28-$20.25 1,377,950 $14.65 9.15 249,280 $13.59 --------- ------ ---- --------- ------ Total 4,499,708 $ 7.63 6.41 3,371,038 $ 5.19 ========= ====== ==== ========= ======
SFAS No. 123, "Accounting for Stock-Based Compensation," which provides companies with a choice either to expense the fair value of employee stock options over the vesting period (recognition method) or to continue the previous practice but disclose the pro forma effects on net income and earnings per share had the fair value method been used (disclosure only method). Sovereign adopted the disclosure only method during 1996. Pro forma information regarding net income and earnings per share is required by SFAS No. 123 and has been determined as if Sovereign had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions: Grant date year 1998 1997 1996 - --------------- ------------- ------------ ----------- Options granted 934,070 1,382,278 466,581 Options forfeited 72,600 103,169 5,325 Expected volatility .278 .200-.840 .239-.840 Expected life in years 6.00 4.00-7.50 5.00-7.50 Stock price on date of grant $13.38-$20.25 $8.17-$15.94 $6.16-$8.94 Exercise price $13.38-$20.25 $8.17-$15.94 $6.16-$8.94 Weighted average exercise price $15.25 $10.42 $6.55 Weighted average fair value $5.38 $4.47 $3.44 Expected dividend yield .67% .21%-3.00% .21%-2.42% Risk-free interest rate 4.65%-5.72% 5.76%-6.88% 5.23%-6.88% Vesting period in years 1 0-4 1-5 The Black-Scholes option valuation model was developed for use in estimating the fair market value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because Sovereign's employee stock options have characteristics significantly different from those traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide reliable single measure of fair value of its employee stock options. The pro forma reduction to net income for 1998, 1997 and 1996 was $2.9 million, $2.5 million and $426,000, respectively. The pro forma reduction to diluted earnings per share for 1998 was $.02, for 1997 was $.02 and for 1996 was $.00. (13) EMPLOYEE BENEFIT PLANS Sovereign sponsors a non-contributory defined benefit pension plan which covers substantially all employees who have attained the age of 21 and completed one year of service. Benefits under the plan are based upon years of service and the employees' average compensation computed based upon the five consecutive plan years of highest pay during the ten years preceding retirement or termination. At December 31, 1998, the Sovereign pension plan held approximately 79,000 shares of Sovereign common stock with a fair market value of $1.1 million. Dividends paid on these shares during 1998 totaled $6,000. 65 (13) EMPLOYEE BENEFIT PLANS - (CONTINUED) It is Sovereign's policy to fund the minimum contribution as determined by an actuarial valuation. The net periodic pension costs for this plan are comprised of the following components (in thousands):
At December 31, --------------------------------- 1998 1997 1996 ------- ------- ------- Service cost benefits earned during the period $ 2,248 $ 1,928 $ 1,736 Interest cost on projected benefit obligation 2,498 2,550 2,311 Actual return on plan assets (7,028) (7,227) (4,824) Amortization of unrecognized net assets and other deferred amounts, net 3,761 3,037 1,390 Curtailment loss - - 542 Asset gain - 331 62 ------- ------- ------- Net periodic pension expense $ 1,479 $ 619 $ 1,217 ======= ======= =======
The following table sets forth the Change in Benefit Obligation, Change in Plan Assets and Funded Status for Sovereign's pension plan at December 31, 1998 and 1997 (in thousands): Year Ended December 31, ------------------------ 1998 1997 --------- -------- Change in Benifit Obligation Benifit obligation at beginning of year $ 37,303 $ 37,398 Service cost 2,248 1,928 Interest cost 2,498 2,550 Actuarial gains 895 233 Benefits paid (4,696) (4,806) -------- -------- Benefit obligation at end of year 38,248 37,303 -------- -------- Change in Plan Assets Fair value of plan assets at beginning of year 41,787 38,602 Actual return on plan assets 7,028 7,227 Company contributions 105 764 Benefits paid (4,696) (4,806) -------- -------- Fair value of plan assets at end of year 44,224 41,787 -------- -------- Funded Status of the Plan 5,976 4,484 Unrecognized net actuarial loss (5,351) (2,234) Unrecognized net transition asset 1,176 1,176 Unrecognized prior service cost 773 627 -------- -------- Prepaid benefit cost $ 2,574 $ 4,053 ======== ======== In determining the projected benefit obligation, the assumed discount rates at December 31, 1998, 1997 and 1996 were 6.75%, 6.77% and 7.18%, respectively. The weighted average rate of salary increase was 4.50% for 1998, 4.46% for 1997 and 5.17% for 1996. The expected long-term rate of return on assets used in determining net periodic pension expense was 9.00% for 1998, 8.92% for 1997 and 8.73% for 1996. The pension plan's assets consist primarily of common stock, fixed income securities such as corporate bonds and U.S. Treasury securities and units of certain common trust funds. 66 Notes to Consolidated Financial Statements (13) EMPLOYEE BENEFIT PLANS - (CONTINUED) Sovereign also maintains a 401(k) savings plan. Substantially all employees of Sovereign are eligible to participate in the 401(k) savings plan following their completion of one year of service and attaining age 21. Sovereign's contributions to this plan were $1.5 million, $753,000 and $728,000 during 1998, 1997 and 1996, respectively. Pursuant to this plan, employees can contribute up to 10% of their compensation to the plan. Sovereign contributes up to 50% of the employee contribution up to 6% of compensation in the form of Sovereign common stock. Sovereign maintains an Employee Stock Ownership Plan ("Sovereign ESOP"), and substantially all employees of Sovereign are eligible to participate in the Sovereign ESOP following their completion of one year of service and attaining age 21. The Sovereign ESOP is a deferred contribution plan which provides retirement benefits for participants and beneficiaries by purchasing Sovereign common stock in the open market. The amount of annual contributions to the Sovereign ESOP by Sovereign is determined by the Board of Directors based upon the financial performance of Sovereign each year. Sovereign recognized as expense $4.0 million, $7.7 million and $4.6 million to the ESOP during 1998, 1997 and 1996, respectively. On November 21, 1994, Sovereign's Board of Directors authorized an amendment to the Sovereign ESOP to add a leverage feature to purchase up to 6.7 million shares of Sovereign's outstanding common stock in the open market or in negotiated transactions. The Sovereign ESOP is funded through direct loans from Sovereign totaling approximately $38.0 million at year-end 1998. The proceeds from these loans were used to purchase outstanding shares of Sovereign's common stock. As the debt on these loans is repaid, shares of Sovereign common stock are released and become eligible for allocation to employee accounts. In addition, dividends are paid on all shares of Sovereign common stock, including unallocated shares held by the Sovereign ESOP. Dividends on the unallocated shares are allocated on a pro-rata basis when purchased shares are released. Compensation expense is recognized based on the fair value of the shares committed to be released to employees and the shares then become outstanding for earnings per share computations. Sovereign has committed to make contributions sufficient to provide for the ESOP debt requirements. At December 31, 1998, the Sovereign ESOP held 5.7 million shares of which 1.4 million shares were allocated to employee accounts. The unallocated ESOP shares are presented as a reduction of stockholders' equity in the consolidated financial statements. At December 31, 1998, the fair value of the unallocated shares held by the ESOP was $62.3 million. Sovereign also maintains an Employee Stock Purchase Plan which permits eligible employees to purchase Sovereign common stock directly from Sovereign. Purchases of common stock are limited to 15% of a participant's compensation. During 1998, 1997 and 1996, participants purchased Sovereign common stock at a price equal to 92.5% of the fair value of Sovereign common stock on the offering date. Compensation expense for this plan for the year ended December 31, 1998, 1997 and 1996 was $106,000, $46,000 and $41,000, respectively. ML Bancorp, previous to its merger with Sovereign, had established the ML ESOP for the benefit of certain eligible employees of ML Bancorp. ML Bancorp initially purchased 2.0 million shares of common stock on behalf of the ML ESOP, of which 885,000 shares were committed to be released as of February 28, 1998. During 1997 and 1996, ML Bancorp recorded compensation expense related to the ML ESOP of $3.0 million and $1.9 million, respectively. The cost basis of the unallocated ML ESOP shares equaled $17.6 million, and were presented as a reduction to stockholders' equity in the consolidated financial statements. As required by the plan, Sovereign terminated the ML ESOP and satisfied its obligation related to the initial share purchase. The remaining unallocated shares were distributed to the former participants of the ML ESOP, and the excess of fair value over the cost of those remaining shares was recognized in the first quarter of 1998 as a merger-related expense. ML Bancorp, previous to its merger with Sovereign, had a Recognition and Retention Plan and Trust ("ML RRP") for the benefit of ML Bancorp's Board of Directors and executive officers. At February 28, 1998, Sovereign reflected $2.4 million of deferred cost of unearned ML RRP shares as a reduction of stockholders' equity. During 1997 and 1996, ML Bancorp recorded compensation expense related to the ML RRP of $459,000 and $617,000, respectively. As required by the plan, Sovereign terminated the ML RRP. Pursuant to the merger, the remaining $2.4 million of deferred compensation was paid to ML Bancorp's Board of Directors and executive officers and was recognized in the first quarter of 1998 as a merger-related expense. 67 (14) INCOME TAXES The provision for income taxes in the consolidated statement of operations is comprised of the following components (in thousands): Year Ended December 31, --------------------------------------- 1998 1997 1996 -------- -------- ------- Current: Federal $ 92,311 $ 73,431 $42,282 State 1,121 4,282 4,219 -------- -------- ------- 93,432 77,713 46,501 Deferred (18,681) (10,389) 1,008 -------- -------- ------- Total income tax expense $ 74,751 $ 67,324 $47,509 ======== ======== ======= The following is a reconciliation of the actual tax provisions with taxes computed at the federal statutory rate of 35% for each of the years indicated:
Year Ended December 31, ---------------------------- 1998 1997 1996 ---- ---- ---- Federal income tax at statutory rate 35.0% 35.0% 35.0% Increase/(decrease) in taxes resulting from: Tax-exempt interest (5.2) (2.0) (1.3) State income taxes, net of federal tax benefit .3 1.6 2.0 Amortization of intangible assets and other purchase accounting adjustments .8 1.0 1.2 Non-deductible, merger-related costs 3.1 2.1 .1 Other 1.4 1.9 (2.5) ---- ---- ---- 35.4% 39.6% 34.5% ==== ==== ====
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below (in thousands):
Year Ended December 31, --------------------------------- 1998 1997 1996 ------- ------- ------- Deferred tax assets: Allowance for possible loan losses $37,849 $37,390 $25,344 Purchased mortgage servicing rights 4,356 5,364 2,079 Employee benefits 888 2,593 706 Merger related liabilities 2,313 1,104 1,006 Purchase accounting adjustments 370 1,071 2,460 Unrealized loss on available-for-sale portfolio -- 89 697 Net operating loss carry forwards 1,393 1,810 1,939 Other 847 5,621 6,188 ------- ------- ------- Total gross deferred tax assets $48,016 $55,042 $40,419 ------- ------- ------- Deferred tax liabilities: Purchase accounting adjustments $ 5,402 $ 6,473 $ 7,188 Deferred loan fees 7,144 5,739 5,716 Tax bad debt reserve recapture 2,406 2,888 2,888 Originated mortgage servicing rights 3,843 2,678 1,398 Option premiums 2,716 9,799 7,927 Unrealized gain on available-for-sale portfolio 9,757 9,625 2,021 Other 4,163 6,609 6,018 ------- ------- ------- Total gross deferred tax liabilities $35,431 $43,811 $33,156 ------- ------- ------- Net deferred tax asset $12,585 $11,231 $ 7,263 ======= ======= =======
68 Notes to Consolidated Financial Statements (14) INCOME TAXES - (CONTINUED) The Small Business Job Protection Act of 1996 ("the Act") repealed the tax bad debt deduction computed under the percentage of taxable income method for tax years beginning after December 31, 1995 and requires thrifts to recapture into income, over a six-year period, the amount by which their tax bad debt reserves exceed their base year reserves. As a result of its acquisition of ML Bancorp, Sovereign is required to recapture $8.3 million related to ML Bancorp's tax bad debt reserve in excess of its base year reserve. ML Bancorp had previously recorded a deferred tax liability for this excess and therefore, the recapture will not impact the statement of operations. Sovereign has determined that it is not required to establish any valuation reserve for deferred tax assets since it is more likely than not that deferred tax assets will be principally realized through carry back to taxable income in prior years. Sovereign's conclusion that it is "more likely than not" that the deferred tax assets will be realized is based on a history of growth in earnings and the prospects for continued growth including an analysis of potential uncertainties that may affect future operating results. Sovereign will continue to review the criteria related to the recognition of deferred tax assets on a quarterly basis. (15) COMMITMENTS AND CONTINGENCIES Financial Instruments 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. The following schedule summarizes Sovereign's off-balance sheet financial instruments (in thousands):
Contract or Notional Amount At December 31, --------------------------- 1998 1997 ---------- ---------- Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $1,191,599 $1,079,300 Standby letters of credit 21,153 14,045 Loans sold with recourse 35,375 139,899 Financial instruments whose notional or contract amounts exceed the amount of credit risk: Forward contracts 608,104 51,872 Interest rate swaps 2,955,164 3,609,376 Interest rate caps 1,200,000 1,200,000 Notional or contract amounts of off-balance sheet financial instruments not constituting credit risk: Forward commitments to sell in the secondary market -- 161,285
69 (15) COMMITMENTS AND CONTINGENCIES - (CONTINUED) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Sovereign evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held usually consists of real estate but may include securities, accounts receivable, inventory and property, plant and equipment. Standby letters of credit are conditional commitments issued by Sovereign to guarantee the performance of a customer to a third party. The guarantees are primarily issued to support public and private borrowing arrangements. Most guarantees expire by March 2001 and one guarantee for $1.4 million expires in January 2011. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Sovereign holds various collateral to support the commitments. Loans sold with recourse primarily represent single-family residential loans. These are seasoned loans with decreasing balances and historical loss experience has been minimal. The forward contracts used by Sovereign in its mortgage banking activities are contracts for delayed delivery of securities in which Sovereign agrees to make delivery of a specified instrument, at a specified future date, at a specified price or yield. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from movements in securities' values and interest rates. Interest rate swaps, caps and floors enable Sovereign to transfer, modify or reduce its interest rate risk and are used as part of asset and liability management. Sovereign may become a principal in the exchange of interest payments with another party and therefore, is exposed to loss should one of the counterparties default. Sovereign minimizes this risk by performing credit reviews on counterparties. Notional principal amounts often are used to express the volume of these transactions, but the amounts potentially subject to credit risk are significantly smaller. Litigation At December 31, 1998, Sovereign was party to a number of lawsuits, which arise during the normal course of business. While any litigation has an element of uncertainty, management, after reviewing these actions with legal counsel, is of the opinion that the liability, if any, resulting from these actions will not have a material effect on the financial condition or results of operations of Sovereign. 70 Notes to Consolidated Financial Statements (16) FAIR VALUE OF FINANCIAL INSTRUMENTS The following table presents disclosures about the fair value of financial instruments as defined by SFAS No. 107, "Fair Value of Financial Instruments." These fair values are presented based upon subjective estimates of relevant market conditions at a specific point in time and information about each financial instrument. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. These techniques involve uncertainties resulting in variability in estimates affected by changes in assumptions and risks of the financial instruments at a certain point in time. Therefore, the derived fair value estimates presented below cannot be substantiated by comparison to independent markets. In addition, the fair values do not reflect any premium or discount that could result from offering for sale at one time an entity's entire holdings of a particular financial instrument nor does it reflect potential taxes and the expenses that would be incurred in an actual sale or settlement. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of Sovereign (in thousands):
At December 31, ----------------------------------------------------------------- 1998 1997 ----------------------------- ----------------------------- Carrying Fair Carrying Fair Value Value Value Value ----------- ------------ ----------- ------------ Financial Assets: Cash and amounts due from depository institutions $ 471,074 $ 471,074 $ 238,623 $ 238,623 Interest-earning deposits 82,650 82,650 17,314 17,314 Loans held for sale 296,930 297,414 310,678 310,750 Investment securities available-for-sale 6,662,427 6,662,427 1,956,262 1,956,262 Investment securities held-to-maturity 1,839,655 1,860,583 3,416,451 3,446,863 Loans, net 11,152,038 11,180,004 11,207,299 11,276,514 Financial Liabilities: Deposits 12,322,716 12,314,608 9,515,294 9,521,379 Borrowings(1) 7,907,805 7,887,676 6,874,070 6,886,421 Unrecognized Financial Instruments:(2) Commitments to extend credit 5,875 5,880 16,569 16,575 Standby letters of credit 25 244 306 310 Loans sold with recourse 177 71 244 98 Interest rate swaps, caps and floors 7,213 (55,755) 9,963 (12,861)
- ----------- (1) Borrowings are shown without unamortized cap premiums, as cap premiums are reflected separately below in "Interest rate swaps, caps and floors." (2) The amounts shown under "carrying value" represent accruals or deferred income arising from those unrecognized financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and amounts due from depository institutions and interest-earning deposits. For these short-term instruments, the carrying amount is a reasonable estimate of fair value. Loans held for sale. Fair values are estimated using quoted rates based upon secondary market sources for securities backed by similar loans. Fair value estimates include consideration of all open positions (including forward contracts), outstanding commitments and related fees paid. 71 (16) FAIR VALUE OF FINANCIAL INSTRUMENTS - (CONTINUED) Investment securities available-for-sale. The fair value of investment securities available-for-sale are based on quoted market prices as of the balance sheet date. In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," changes in fair value are reflected in the carrying value of the asset and are shown as a separate component of stockholders' equity. Investment securities held-to-maturity. The carrying amounts for short-term investment securities held-to-maturity approximate fair value because of the short maturity of these instruments and they do not present unanticipated credit concerns. The fair value of long-term investment securities held-to-maturity is estimated based upon bid quotations received from securities dealers and an independent pricing servicing bureau. Loans. Fair value is estimated by discounting cash flows using estimated market discount rates at which similar loans would be made to borrowers and reflect similar credit ratings and interest rate risk for the same remaining maturities. Mortgage servicing rights. The fair value of mortgage servicing rights are estimated using quoted rates based upon secondary market sources. The estimated fair value approximates the amount for which the servicing could currently be sold. Deposits. The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, NOW accounts, savings accounts and certain money market accounts, is equal to the amount payable on demand as of the balance sheet date. The fair value of fixed-maturity certificates of deposit is estimated by discounting cash flows using currently offered rates for deposits of similar remaining maturities. Borrowings. Fair value is estimated by discounting cash flows using rates currently available to Sovereign for other borrowings with similar terms and remaining maturities. Commitments to extend credit. The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. Standby letters of credit. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. Loans sold with recourse. The fair value of loans sold with recourse is estimated based upon the cost to terminate Sovereign's obligations under the recourse provisions. Interest rate swaps, caps and floors. The fair value of interest rate swaps, caps and floors which represent the estimated amount Sovereign would receive or pay to terminate the contracts or agreements, taking into account current interest rates and when appropriate, the current creditworthiness of the counterparties are obtained from dealer quotes. 72 Notes to Consolidated Financial Statements (17) INTEREST RATE EXCHANGE AGREEMENTS Amortizing and non-amortizing interest rate swaps are generally used to convert fixed rate assets and liabilities to variable rate assets and liabilities and vice versa. Interest rate caps are generally used to limit the exposure from the repricing and maturity of liabilities. Interest rate floors are generally used to limit the exposure from repricing and maturity of assets. Interest rate caps and floors are also used to limit the exposure created by other interest rate swaps. In certain cases, interest rate caps and floors are simultaneously bought and sold to create a range of protection against changing interest rates while limiting the cost of that protection. The following table presents information regarding interest rate exchange agreements at the dates indicated (in thousands):
At December 31, 1998 At December 31, 1997 ---------------------------------------------- --------------------------------------------- Weighted Weighted Average Average Notional Book Estimated Maturity Notional Book Estimated Maturity Amount Value Fair Value In Years Amount Value Fair Value In Years ---------- -------- ---------- ---------- ---------- -------- ---------- -------- Amortizing interest rate swaps: Pay variable-receive fixed(1) $ -- $ -- $ -- $ 602,116 $ -- $ 1,436 2.8 Pay fixed-receive variable(2) 175,164 -- (617) .3 208,761 -- (9) 1.3 Non-amortizing interest rate swaps: Pay variable-receive fixed(3) -- -- -- 28,499 -- (561) 2.7 Pay fixed-receive variable(4) 2,780,000 -- (48,382) 4.8 2,770,000 -- (9,293) 2.3 Interest rate caps/floors(5) 1,200,000 7,213 (6,756) 3.2 1,200,000 9,963 (4,434) 4.0 ---------- -------- -------- ---------- -------- -------- $4,155,164 $ 7,213 $(55,755) $4,809,376 $ 9,963 $(12,861) ========== ======== ======== ========== ======== ========
- ---------- (1)The weighted average pay rate was 5.58% and the weighted average receive rate was 5.97% at December 31, 1997. (2)The weighted average pay rate was 6.87% and 6.87% and the weighted average receive rate was 5.99% and 6.80% at December 31, 1998 and 1997, respectively. (3)The weighted average pay rate was 7.28% and the weighted average receive rate was 6.75% at December 31, 1997. (4)The weighted average pay rate was 5.42% and 5.89% and the weighted average receive rate was 5.26% and 4.48% at December 31, 1998 and 1997, respectively. (5)The weighted average strike price range was 5.25%-9.00% at December 31, 1998 and 5.25% - 7.50% at December 31, 1997. The following table summarizes by notional amounts the activity of Sovereign's interest rate exchange agreements (in thousands):
Amortizing Non-Amortizing Interest Interest Interest Rate Swaps Rate Swaps Rate Swaps Total ------------- --------------- ---------- ---------- Balance, December 31, 1995 $ 881,130 $ 330,000 $1,446,000 $2,657,130 ---------- ---------- ---------- ---------- Additions 300,000 1,125,000 500,000 1,925,000 Maturities/Amortization 69,117 -- 450,000 519,117 Terminations -- 50,000 996,000 1,046,000 ---------- ---------- ---------- ---------- Balance, December 31, 1996 1,112,013 1,405,000 500,000 3,017,013 ---------- ---------- ---------- ---------- Additions -- 4,145,000 700,000 4,845,000 Maturities/Amortization 151,136 151,501 -- 302,637 Terminations 150,000 2,600,000 -- 2,750,000 ---------- ---------- ---------- ---------- Balance, December 31, 1997 810,877 2,798,499 1,200,000 4,809,376 ---------- ---------- ---------- ---------- Additions -- 1,650,000 -- 1,650,000 Maturities/Amortization 86,497 100,000 -- 186,497 Terminations 549,216 1,568,499 -- 2,117,715 ---------- ---------- ---------- ---------- Balance, December 31, 1998 $ 175,164 $2,780,000 $1,200,000 $4,155,164 ========== ========== ========== ==========
At December 31, 1998, Sovereign's balance sheet included a net deferred loss of $389,000 related to interest rate exchange agreements terminated in January 1998 which were originally accounted for as hedges. This net deferred loss will amortize into interest expense in 1999. 73 Net interest income resulting from interest rate exchange agreements included $6.8 million of income and $4.5 million of expense for 1998, $4.8 million of income and $4.8 million of expense for 1997 and $5.1 million of income and $7.4 million of expense for 1996. (18) PARENT COMPANY FINANCIAL INFORMATION Condensed financial information for Sovereign Bancorp is as follows (in thousands): Balance Sheets --------------------------- At December 31, --------------------------- 1998 1997 ---------- ---------- Assets Interest-earning deposits $ 162 $ 9,001 Investment securities 110,779 104,091 Investment in subsidiaries 1,560,766 1,202,941 Other assets 16,611 13,793 ---------- ---------- Total Assets $1,688,318 $1,329,826 ========== ========== Liabilities Short-term borrowings $ 199,480 $ -- Long-term borrowings 146,646 147,905 Other liabilities 9,074 5,154 ---------- ---------- Total Liabilities 355,200 153,059 ---------- ---------- Trust Preferred Securities 129,050 128,972 ---------- ---------- Stockholders' Equity 1,204,068 1,047,795 ---------- ---------- Total Liabilities, Minority Interests and Stockholders' Equity $1,688,318 $1,329,826 ========== ==========
Statements of Operations -------------------------------------- Year Ended December 31, -------------------------------------- 1998 1997 1996 --------- --------- -------- Interest income $ 11,347 $ 8,907 $ 2,906 Other income 6,159 8,684 46,251 --------- --------- -------- Total income 17,506 17,591 49,157 --------- --------- -------- Interest expense 16,521 13,089 13,117 Other expense 8,704 9,666 6,333 Trust Preferred Securities expense 12,528 11,677 274 --------- --------- -------- Total expense 37,753 34,432 19,724 --------- --------- -------- (Loss)/income before taxes, dividends and undistributed earnings of subsidiaries (20,247) (16,841) 29,433 Income taxes (6,135) (8,387) (5,554) --------- --------- -------- (Loss)/income before earnings of subsidiaries (14,112) (8,454) 34,987 Distributed earnings from subsidiaries -- 1,771 1,300 Undistributed earnings of subsidiaries 150,567 109,221 54,091 --------- --------- -------- Net Income $ 136,455 $ 102,538 $ 90,378 ========= ========= ========
74 Notes to Consolidated Financial Statements (18) PARENT COMPANY FINANCIAL INFORMATION - (CONTINUED)
Statements of Cash Flows -------------------------------------- Year Ended December 31, -------------------------------------- 1998 1997 1996 --------- --------- -------- Cash Flows from Operating Activities: Net income $ 136,455 $ 102,538 $ 90,378 Adjustments to reconcile net income to net cash provided by operating activities: Dividends received from subsidiaries -- 9,771 30,900 Earnings from subsidiaries (150,567) (110,992) (55,391) Allocation of Employee Stock Ownership Plan shares 19,612 8,573 5,597 Change in other assets (2,818) 10,181 25,968 Change in other liabilities 3,998 (455) 1,215 --------- --------- -------- Net cash provided by operating activities 6,680 19,616 98,667 --------- --------- -------- Cash Flows from Investing Activities: Investment in subsidiaries (207,258) (32,439) (98,000) Maturity and repayments of investment securities 749 6,053 1,259 Net change in investment securities (8,261) (85,074) 13,400 Other, net (4,228) (4,897) 3,853 --------- --------- -------- Net cash used by investing activities (218,998) (116,357) (79,488) --------- --------- -------- Cash Flows from Financing Activities: Net change in short-term borrowings 199,480 -- (714) Net change in long-term borrowings (1,259) (21,390) 477 Proceeds from issuance of Trust Preferred Securities -- 97,574 30,000 Cash dividends paid to stockholders (14,286) (23,777) (24,606) Net proceeds from issuance of common stock 20,451 17,919 6,052 Redemption of preferred stock (6) -- -- Purchase of Employee Stock Ownership Plan shares -- -- (4,559) (Purchase)/issuance of treasury stock (901) 34,632 (29,574) --------- --------- -------- Net cash provided (used) by financing activities 203,479 104,958 (22,924) --------- --------- -------- (Decrease)/increase in cash and cash equivalents (8,839) 8,217 (3,745) Cash and cash equivalents at beginning of period 9,001 784 4,529 --------- --------- -------- Cash and cash equivalents at end of period $ 162 $ 9,001 $ 784 ========= ========= ========
75 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information relating to executive officers of Sovereign is included under Item 4A in Part I hereof. The information required by this item relating to directors of Sovereign is incorporated herein by reference to (i) that portion of the section captioned "Election of Directors" located in the definitive Proxy Statement to be used in connection with Sovereign's 1999 Annual Meeting of Shareholders (the "Proxy Statement"). The information required by this item relating to compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the section captioned "Additional Information Regarding Directors and Officers" in the Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is incorporated herein by reference to (i) the sections captioned "Compensation Paid to Directors" through "Indemnification" in the Proxy Statement and (ii) the section captioned "Performance Graph" in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is incorporated herein by reference to (i) the section captioned "Principal Shareholders" in the Proxy Statement and (ii) that portion of the section captioned "Election of Directors" in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated herein by reference to the sections captioned "Indebtedness of Management" in the Proxy Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) 1. FINANCIAL STATEMENTS. The following financial statements are filed as part of this report: Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES. Financial statement schedules are omitted because the required information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto. 3. EXHIBITS. (3.1) Articles of Incorporation, as amended and restated, of Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Sovereign's Annual Report on Form 10-K for the fiscal year ended December 31, 1995.) (3.2) By-Laws of Sovereign Bancorp, Inc.* (4.1) Sovereign Bancorp, Inc. has certain long-term debt outstanding. None of the instruments evidencing such debt authorizes an amount of securities in excess of 10% of the total assets of Sovereign Bancorp, Inc. and its subsidiaries on a consolidated basis; therefore, copies of such instruments are not included as exhibits to this Annual Report on Form 10-K. Sovereign Bancorp, Inc. agrees to furnish copies of such instruments to the Commission on request. 76 (10.1) Sovereign Bancorp, Inc. Stock Option Plan. (Incorporated by reference to Exhibit 10.1 to Sovereign's Annual Report on Form 10-K for the fiscal year ended December 31, 1994.) (10.2) Sovereign Bancorp, Inc. Employee Stock Purchase Plan. (Incorporated by reference to Exhibit 4.1 to Sovereign's Registration Statement No. 33-44108 on Form S-8.) (10.3) Agreement dated as of March 1, 1997, between Sovereign Bancorp, Inc., Sovereign Bank, and Jay S. Sidhu. (Incorporated by reference to Exhibit 10.1 to Sovereign's Quarterly Report on Form 10-Q for the quarter ended December 31, 1997.) (10.4) Agreement dated as of May 1, 1997, between ML Bancorp, Inc. (a predecessor company of Sovereign Bancorp, Inc.) and Dennis S. Marlo.* (10.5) Agreement dated as of September 25, 1997, between Sovereign Bank and Lawrence M. Thompson, Jr.(incorporated by reference to exhibit 10.5 to Sovereign's Annual Report on Form 10-K for the year ended December 31, 1997.)* (10.6) Penn Savings Bank Senior Officer Incentive Plan. (Incorporated by reference to Exhibit 10.6 to Sovereign's Annual Report on Form 10-K for the year ended December 31, 1994.) (10.11) Rights Agreement dated September 19, 1989, between Sovereign Bancorp, Inc. and Harris Trust Company of New York. (Incorporated by reference to Exhibit 4.3 to Sovereign's Registration Statement No. 33-89586 on Form S-8). (10.12) Sovereign Bancorp, Inc. Non-Employee Director Incentive Compensation Plan. (Incorporated by reference to Exhibit 10.12 to Sovereign's Registration Statement No. 33-43195 on Form S-1). (10.14) 1993 Sovereign Bancorp, Inc. Stock Option Plan. (Incorporated by reference to Exhibit 10.23 to Sovereign's Annual Report on Form 10-K for the year ended December 31, 1992). (10.15) Indemnification Agreement dated December 21, 1993, between Sovereign Bank and Jay S. Sidhu. (Incorporated by reference to Exhibit 10.25 to Sovereign's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.) (10.16) Employment Agreement dated as of August 8, 1988, between Charter Federal Savings Bank and Patrick J. Petrone. (Incorporated by reference to Exhibit 10.23 to Sovereign's Annual Report on Form 10-K for the fiscal year ended December 31, 1994.) (10.17) Amendment to Employment Agreement between Patrick J. Petrone and Charter Federal Savings Bank, dated October 17, 1994. (Incorporated by reference to Exhibit 10.24 to Sovereign's Annual Report on Form 10-K for the fiscal year ended December 31, 1994.) (10.18) Amendment to Rights Agreement, dated as of September 27, 1995, between Sovereign Bancorp, Inc. and Chemical Bank, as successor to Harris Trust Company of New York, as Rights Agent. (Incorporated by reference to Exhibit 2.2 of Amendment No. 1 of Sovereign's Registration Statement on Form 8-A.) (10.19) Sovereign Bancorp, Inc. 1997 Non-Employee Directors' Stock Option Plan. (Incorporated by reference to Exhibit "A" to Sovereign's definitive proxy statement dated March 16, 1998.) (10.20) Sovereign Bancorp, Inc. 1996 Stock Option Plan. (Incorporated by reference to Exhibit "A" to Sovereign's definitive proxy statement dated March 15, 1996.) (11.1) Computation of Per Share Earnings.* (21) Subsidiaries of the Registrant* (23.1) Consent of Ernst & Young LLP, Independent Auditors. (23.2) Consent of KPMG Peat Marwick LLP, Independent Auditors. (23.3) Consent of KPMG Peat Marwick LLP, Independent Auditors. (23.4) Consent of KPMG Peat Marwick LLP, Independent Auditors. (23.5) Consent of PricewaterhouseCoopers LLP, Independent Accountants. (23.6) Consent of Arthur Andersen LLP, Independent Public Accountants. (27) Financial Data Schedule (as revised) (99.1) Report of KPMG Peat Marwick LLP, Independent Auditors.* (99.2) Report of KPMG Peat Marwick LLP, Independent Auditors.* (99.3) Report of KPMG Peat Marwick LLP, Independent Auditors.* (99.4) Report of PricewaterhouseCoopers LLP, Independent Accountants.* (99.5) Report of Arthur Andersen LLP, Independent Public Accountants.* 77 (B) REPORTS ON FORM 8-K. 1. Report on Form 8-K, dated February 19, 1998 (date of earliest event -- January 20, 1998), contained a press release announcing Sovereign's earnings for the year ended December 31, 1997. 2. Report on Form 8-K, dated February 20, 1998 (date of earliest event -- January 20, 1998), contained a press release announcing Sovereign's earnings for the year ended December 31, 1997. 3. Report on Form 8-K, dated April 20, 1998 (date of earliest event -- April 14, 1998), contained a press release announcing Sovereign's expected earnings for the first quarter of 1998. 4. Report on Form 8-K, dated April 20, 1998 (date of earliest event -- April 15, 1998), contained a press release announcing the resignation of Karl D. Gerhart as Sovereign's Chief Financial Officer and the appointment of Dennis S. Marlo as Sovereign's new Chief Financial Officer. 5. Report on Form 8-K, dated June 23, 1998 (date of earliest event -- June 23, 1998), contained Sovereign's 1997 Form 10-K restated to include the merger of ML Bancorp, Inc. with and into Sovereign Bancorp, Inc. ML Bancorp's Audited Financial Statements were also presented. 6. Report on Form 8-K, dated September 10, 1998 (date of earliest event -- September 7, 1998), contained a press release announcing the execution of a Definitive Agreement for Sovereign to acquire Peoples Bancorp, Inc. 78 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amendment to report to be signed on its behalf by the undersigned, thereunto duly authorized. SOVEREIGN BANCORP, INC. (Registrant) May 28, 1999 By /s/ JAY S. SIDHU -------------------------------- Jay S. Sidhu, President and Chief Executive Officer 79 EX-23.1 2 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23.1 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements (Form S-8 No. 33-20186, Form S-8 No. 33-29038, Form S-8 No. 33-39453, Form S-8 No. 33-44108, Form S-8 No. 33-89526, Form S-8 No. 33-89592, Form S-8 No. 333-05251, Form S-8 No. 333-05309, Form S-3 No. 33-46870, Form S-3 No. 333-09113, and Form S-3 No. 333-74743) of Sovereign Bancorp, Inc. of our report dated March 11, 1999, with respect to the consolidated financial statements, as amended, of Sovereign Bancorp, Inc. included in its Annual Report on Form 10-K/A for the year ended December 31, 1998. /s/ Ernst & Young LLP Philadelphia, Pennsylvania May 25, 1999 EX-23.2 3 INDEPENDENT AUDITORS' CONSENT EXHIBIT 23.2 Independent Auditors' Consent The Board of Directors Sovereign Bancorp, Inc. (Successors of First State Financial Services, Inc.): We consent to the incorporation by reference in the Registration Statements (Form S-8 No. 33-20186, Form S-8 No. 33-29038, Form S-8 No. 33-39453, Form S-8 No. 33-44108, Form S-8 No. 33-89526, Form S-8 No. 33-89592, Form S-8 No. 333-05251, Form S-8 No. 333-05309, Form S-3 No. 33-46870, Form S-3 No. 333-74743 and Form S-3 No. 333-09113) of Sovereign Bancorp, Inc. and in the related prospectus of our report dated November 26, 1996 relating to the consolidated statements of operations, stockholders' equity and cash flows of First State Financial Services, Inc. for the year ended September 30, 1996, which report appears in the amendment to the 1998 Annual Report on Form 10-K/A of Sovereign Bancorp, Inc. /s/ KPMG LLP Short Hills, New Jersey May 25, 1999 EX-23.3 4 INDEPENDENT AUDITORTS' CONSENT EXHIBIT 23.3 Independent Auditors' Consent The Board of Directors Sovereign Bancorp, Inc. (Successors of Bankers Corp.): We consent to the incorporation by reference in the Registation Statements (Form S-8 No. 33-20186, Form S-8 No. 33-29038, Form S-8 No. 33-39453, Form S-8 No. 33-44108, Form S-8 No. 33-89526, Form S-8 No. 33-89592, Form S-8 No. 333-05251, Form S-8 No. 333-05309, Form S-3 No. 33-46870, Form S-3 No. 333-74743 and Form S-3 No. 333-09113) of Sovereign Bancorp, Inc. and in the related prospectus of our report dated January 31, 1997, except as to Note 2, which is as of February 5, 1997, relating to the consolidated statements of income, changes in stockholders' equity and cash flows of Bankers Corp. and subsidiary for the year ended December 31, 1996, which report appears in the amendment to the 1998 Annual Report on Form 10-K/A of Sovereign Bancorp, Inc. /s/ KPMG LLP Short Hills, New Jersey May 25, 1999 EX-23.4 5 INDEPENDENT AUDITORS' CONSENT EXHIBIT 23.4 Independent Auditors' Consent The Board of Directors Sovereign Bancorp, Inc.: We consent to the incorporation by reference in the Form 10K/A, of Sovereign Bancorp, Inc. of our report dated June 15, 1998, relating to the consolidated statements of financial condition of ML Bancorp, Inc. and subsidiaries as of February 27, 1998, and March 31, 1997, and the related consolidated statements of operations, cash flows and changes in stockholders' equity for the eleven-month period ended February 27, 1998 and for the year ended March 31, 1997, which report appeared in the Form 8-K on June 23, 1998. /s/ KPMG LLP Philadelphia, Pennsylvania May 25, 1999 EX-23.5 6 CONSENT OF INDEPENDENT ACCOUNTANTS EXHIBIT 23.5 Consent of Independent Accountants We consent to the incorporation by reference in the registration statements of Sovereign Bancorp, Inc. on Forms S-8 (File Nos. 33-20186, 33-29038, 33-39453, 33-44108, 33-89526, 33-89592, 333-05251 and 333-05309) and on Forms S-3 (File Nos. 33-46870, 333-09113 and 333-74743) of our report dated February 2, 1998, on our audits of the consolidated financial statements of Carnegie Bancorp and Subsidiaries as of December 31, 1997, and for the years ended December 31, 1997 and 1996, which report is included in this Annual Report on Form 10-K/A. /s/ PricewaterhouseCoopers LLP Princeton, New Jersey May 27, 1999 EX-23.6 7 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS EXHIBIT 23.6 Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation by reference, of our report dated February 9,1998 on the December 31, 1997 financial statements of First Home Bancorp, Inc. and subsidiaries, included in Sovereign Bancorp, Inc.'s Form 10-K/A filed on or about May 25, 1999, into the Registration Statements on Form S-8 (Nos. 33-20186,33-29038,33-39453,33-44108, 33-89526,33-89592, 333-05251,333-05309) and on Form S-3 ( Nos. 33-46870, 333-09113, 333-74743) of Sovereign Bancorp, Inc. It should be noted that we have not audited any financial statements of First Home Bancorp, Inc. and subsidiaries subsequent to December 31, 1997 or performed any audit procedures subsequent to the date of our report. /s/ Arthur Andersen LLP Philadelphia, Pennsylvania May 25, 1999 EX-27 8 FDS --
9 1,000 U.S.$ 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 1.000 471,074 82,650 0 0 6,662,427 1,839,655 1,860,583 11,285,840 133,802 21,913,873 12,322,716 3,921,684 486,497 3,978,908 0 0 622,449 581,619 21,913,873 881,083 474,288 0 1,355,371 440,300 861,759 493,612 27,961 44,582 82,265 211,206 211,206 0 0 136,455 .88 .85 2.79 96,555 6,571 141 40,977 116,823 46,330 12,688 133,802 133,802 0 24,938
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