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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.
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(Exact name of Registrant as specified in its charter)
PENNSYLVANIA 23-2453088
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(State or other jurisdiction of incorporation or (I.R.S. Employer
organization) Identification No.)
1130 BERKSHIRE BOULEVARD, WYOMISSING, PENNSYLVANIA 19610
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(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.
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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.
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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.
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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.
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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.
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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
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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.
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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
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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.
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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.
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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.
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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
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA.
<TABLE>
<CAPTION>
Selected Financial Data(1)
At or for the Year Ended December 31,
-----------------------------------------------------------------------
1998 1997 1996 1995 1994
----------- ----------- ----------- ----------- -----------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
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%
</TABLE>
- ---------------
(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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------ ----------------------------- ------------------------------
Average Yield/ Average Yield/ Average Yield/
Balance Interest Rate Balance Interest Rate Balance Interest Rate
------------------------------ ------------------------------ ------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
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
===== ===== ====
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------------------------------------------
1998 vs. 1997 1997 vs. 1996
Increase/(Decrease) Increase/(Decrease)
----------------------------------- ---------------------------------
Volume Rate Total Volume Rate Total
--------- --------- --------- --------- --------- --------
<S> <C> <C> <C> <C> <C> <C>
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
========= ========= ========= ========= ========= ========
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- ---------
<S> <C> <C> <C> <C> <C>
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%
======== ======== ======== ======== ========
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------------------------
1998 1997 1996
----------------------- ------------------------ ----------------------
Balance Percent Balance Percent Balance Percent
----------------------- ------------------------ ----------------------
<S> <C> <C> <C> <C> <C> <C>
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%
============ ===== ============ ===== ========== =====
</TABLE>
<TABLE>
<CAPTION>
At December 31,
-----------------------------------------------------
1995 1994
------------------------ ----------------------
Balance Percent Balance Percent
------------------------ -----------------------
<S> <C> <C> <C> <C>
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%
============ ===== =========== =====
</TABLE>
- --------------------------------------------------------------------------------
(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
<TABLE>
<CAPTION>
At December 31, 1998, Maturing
---------------------------------------------------------
In One Year After One Year After
Or Less --Five Years Five Years Total
----------- -------------- ---------- ---------
<S> <C> <C> <C> <C>
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
======== ======== ========= ==========
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<PAGE>
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
<TABLE>
<CAPTION>
At December 31,
------------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
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
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------
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
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
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%
======= ===== ======= ==== ======= ==== ======== ====
- ---------------------------------------------------------------------------------------------------------------
</TABLE>
- --------------------------------------------------------
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
<PAGE>
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
<TABLE>
<CAPTION>
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
---------- ---------- ----------- ---------- ---------
<S> <C> <C> <C> <C> <C>
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%
========== ========== ======== ======== ==========
</TABLE>
- --------------------------------------------------------------------------------
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
<PAGE>
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
<TABLE>
<CAPTION>
At December 31, 1998, Due
-----------------------------------------------------------------
In One Year One Year/ Five Years/ After
or Less Five Years Ten Years Ten Years Total
---------- ----------- ----------- --------- ----------
<S> <C> <C> <C> <C> <C>
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%
======== ======== ======== ======= ==========
</TABLE>
25
<PAGE>
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
<TABLE>
<CAPTION>
At December 31,
---------------------------------------------------------------------------
1998 1997 1996
----------------------- ---------------------- ---------------------
% of % of % of
Balance Deposits Balance Deposits Balance Deposits
---------- -------- ---------- --------- ---------- --------
<S> <C> <C> <C> <C> <C> <C>
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%
=========== ===== ========== ===== ========== =====
</TABLE>
26
<PAGE>
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
<TABLE>
<CAPTION>
At December 31,
--------------------------------------------------------------------------------
1998 1997 1996
------------------------- ----------------------- ------------------------
Weighted Weighted Weighted
Balance Average Rate Balance Average Rate Balance Average Rate
---------- ------------ --------- ------------ ---------- ------------
<S> <C> <C> <C> <C> <C> <C>
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%
========== ==== ========== ==== ========== ====
</TABLE>
- --------------------------------------------------------------------------------
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
<PAGE>
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:
<TABLE>
<CAPTION>
Well
Sovereign Sovereign Minimum Capitalized
Bancorp(1) Bank Requirement Requirement
--------- --------- ----------- -----------
<S> <C> <C> <C> <C>
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
</TABLE>
- --------------------------------------------------------------------------------
(1) OTS capital regulations do not apply to holding companies. These ratios are
computed as if those regulations did apply to Sovereign Bancorp.
28
<PAGE>
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
<PAGE>
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
<TABLE>
<CAPTION>
At December 31, 1998, Repricing
---------------------------------------------------------------
0-3 4 Months Year 2
Months -1 Year & over Total
------------ ------------ ----------- -----------
<S> <C> <C> <C> <C>
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%
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
Table 14 presents selected quarterly consolidated financial data (in
thousands, except per share data):
Table 14: Selected Quarterly Consolidated Financial Data
<TABLE>
<CAPTION>
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
-------- -------- -------- --------- -------- --------- -------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
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
</TABLE>
- --------------------------------------------------------------------------------
(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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
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
<PAGE>
Consolidated Balance Sheets
(IN THOUSANDS EXCEPT FOR SHARE DATA)
<TABLE>
<CAPTION>
Year Ended December 31,
1998 1997
------------- ------------
<S> <C> <C>
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
============ ===========
</TABLE>
See accompanying notes to consolidated financial statements.
39
<PAGE>
Consolidated Statements of Operations
(IN THOUSANDS EXCEPT FOR SHARE DATA)
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------------------------------
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
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
=========== =========== ===========
</TABLE>
- --------------------
(1) All per share data have been adjusted to reflect all stock dividends and
stock splits.
See accompanying notes to consolidated financial statements.
40
<PAGE>
Consolidated Statements of Stockholders' Equity
(IN THOUSANDS)
<TABLE>
<CAPTION>
Common Preferred
Shares Shares Common Preferred Retained Treasury
Outstanding Outstanding Stock Stock Earnings Stock
----------- ----------- ----------- --------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
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)
</TABLE>
<TABLE>
<CAPTION>
Unallocated Accumulated
Stock Other Total
Held By Comprehensive Stockholders'
ESOP Income Equity
----------- ------------- -------------
<S> <C> <C> <C>
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
</TABLE>
See accompanying notes to consolidated financial statements.
41
<PAGE>
Consolidated Statements of Cash Flows
(IN THOUSANDS)
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------------------------
1998 1997 1996
---------- -------- ----------
<S> <C> <C> <C>
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
========== ========= ==========
</TABLE>
42
<PAGE>
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
<PAGE>
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):
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
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
======== ======== ========
</TABLE>
- --------------------------------------------------------------------------------
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
<PAGE>
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
<PAGE>
(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
<PAGE>
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
<PAGE>
(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
<PAGE>
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):
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
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
========= ========= =========
</TABLE>
(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
<PAGE>
(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
<PAGE>
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):
<TABLE>
<CAPTION>
Sovereign MLBancorp(1) Carnegie(2) First Home(2) Combined
---------- ------------ ----------- ------------- ----------
<S> <C> <C> <C> <C> <C>
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
========== ======= ======== ======= ==========
</TABLE>
- ----------
(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
<PAGE>
(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
<PAGE>
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
<PAGE>
(4) INVESTMENT SECURITIES
The amortized cost and estimated fair value of investment securities are as
follows (in thousands):
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------
1998
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ ----------
<S> <C> <C> <C> <C>
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
========== ======= ======= ==========
</TABLE>
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------
1997
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ ----------
<S> <C> <C> <C> <C>
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
========== ======= ====== ==========
</TABLE>
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------
1998
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ ----------
<S> <C> <C> <C> <C>
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
---------- ------- ------ ----------
</TABLE>
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------
1997
----------------------------------------------------------
Amortized Unrealized Unrealized Fair
Cost Appreciation Depreciation Value
---------- ------------ ------------ ----------
<S> <C> <C> <C> <C>
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
========== ======= ====== ==========
</TABLE>
54
<PAGE>
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):
<TABLE>
<CAPTION>
Available-for-Sale Held-to-Maturity
Year Ended December 31, Year Ended December 31,
------------------------------------ --------------------------------------
1998 1997 1996 1998 1997 1996
---------- -------- -------- -------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
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) $ --
========== ======== ======== ======== ========= =========
</TABLE>
- ----------
(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
<PAGE>
(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
<PAGE>
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
<PAGE>
(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):
<TABLE>
<CAPTION>
At December 31,
----------------------------------------------------------------------
1998 1997
-------------------------------- --------------------------------
Balance Percent Rate Balance Percent Rate
----------- ------- ---- ---------- ------- ----
<S> <C> <C> <C> <C> <C> <C>
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%
=========== === ==== ========== === ====
</TABLE>
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):
<TABLE>
<CAPTION>
Within Six Six Mos./ One/ Three/ Five/ Over
Mos. One Yr. Three Yrs. Five Yrs. Ten Yrs. Ten Yrs. Total
---------- ---------- ---------- --------- -------- -------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
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
========== ========== ======== ======== ======= ====== ==========
</TABLE>
58
<PAGE>
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
<PAGE>
(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):
<TABLE>
<CAPTION>
December 31,
----------------------------------------
1998 1997 1996
-------- ---------- ----------
<S> <C> <C> <C>
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%
</TABLE>
The following table summarizes information regarding short-term FHLB
advances (in thousands):
<TABLE>
<CAPTION>
December 31,
------------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
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%
</TABLE>
The following table summarizes information regarding short-term federal
funds purchased (in thousands):
<TABLE>
<CAPTION>
December 31,
------------------------------------
1998 1997 1996
---- ------- ---------
<S> <C> <C> <C>
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%
</TABLE>
60
<PAGE>
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
<PAGE>
(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):
<TABLE>
<CAPTION>
Tangible Leverage Leverage Risk-Based
Capital to Capital to Capital to Capital to
Tangible Tangible Risk-Adjusted Risk-Adjusted
Assets Assets Assets Assets
---------- ---------- ------------- -------------
<S> <C> <C> <C> <C>
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%
</TABLE>
62
<PAGE>
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):
<TABLE>
<CAPTION>
Tangible Leverage Leverage Risk-Based
Capital to Capital to Capital to Capital to
Tangible Tangible Risk-Adjusted Risk-Adjusted
Assets Assets Assets Assets
---------- ---------- ------------- -------------
<S> <C> <C> <C> <C>
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%
</TABLE>
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
<PAGE>
(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.
<TABLE>
<CAPTION>
Price Per Shares Share
- --------- ---------- ---------------
<S> <C> <C>
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
=========== ===============
</TABLE>
64
<PAGE>
(12) STOCK OPTION PLANS - (CONTINUED)
The following table summarizes Sovereign's stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------------------------ -----------------------
Wtd. Avg. Wtd. Avg. Wtd. Avg.
Exercise Remaining Exercise
Exercise Prices Shares Price Contractual Life Shares Price
--------------- --------- ---------- ---------------- --------- ---------
<S> <C> <C> <C> <C> <C>
$.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
========= ====== ==== ========= ======
</TABLE>
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
<PAGE>
(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):
<TABLE>
<CAPTION>
At December 31,
---------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
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
======= ======= =======
</TABLE>
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
<PAGE>
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
<PAGE>
(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:
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
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%
==== ==== ====
</TABLE>
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):
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
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
======= ======= =======
</TABLE>
68
<PAGE>
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):
<TABLE>
<CAPTION>
Contract or Notional Amount
At December 31,
---------------------------
1998 1997
---------- ----------
<S> <C> <C>
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
</TABLE>
69
<PAGE>
(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
<PAGE>
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):
<TABLE>
<CAPTION>
At December 31,
-----------------------------------------------------------------
1998 1997
----------------------------- -----------------------------
Carrying Fair Carrying Fair
Value Value Value Value
----------- ------------ ----------- ------------
<S> <C> <C> <C> <C>
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)
</TABLE>
- -----------
(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
<PAGE>
(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
<PAGE>
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):
<TABLE>
<CAPTION>
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
---------- -------- ---------- ---------- ---------- -------- ---------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
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)
========== ======== ======== ========== ======== ========
</TABLE>
- ----------
(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):
<TABLE>
<CAPTION>
Amortizing Non-Amortizing
Interest Interest Interest
Rate Swaps Rate Swaps Rate Swaps Total
------------- --------------- ---------- ----------
<S> <C> <C> <C> <C>
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
========== ========== ========== ==========
</TABLE>
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
<PAGE>
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
========== ==========
<TABLE>
<CAPTION>
Statements of Operations
--------------------------------------
Year Ended December 31,
--------------------------------------
1998 1997 1996
--------- --------- --------
<S> <C> <C> <C>
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
========= ========= ========
</TABLE>
74
<PAGE>
Notes to Consolidated Financial Statements
(18) PARENT COMPANY FINANCIAL INFORMATION - (CONTINUED)
<TABLE>
<CAPTION>
Statements of Cash Flows
--------------------------------------
Year Ended December 31,
--------------------------------------
1998 1997 1996
--------- --------- --------
<S> <C> <C> <C>
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
========= ========= ========
</TABLE>
75
<PAGE>
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
<PAGE>
(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
<PAGE>
(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
<PAGE>
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
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
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
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
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
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
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
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