Item 1 - Business
General
Sovereign is the parent company of Sovereign Bank (“Sovereign Bank” or “the Bank”), a federally chartered savings bank. Sovereign had approximately 750 community banking offices, over 2,300 ATMs and 11,643 team members as of December 31, 2008 with principal markets in the Northeastern United States. Sovereign’s primary business consists of attracting deposits from its network of community banking offices, and originating small business and middle market commercial loans, multi-family loans, residential mortgage loans, home equity loans and lines of credit, and auto and other consumer loans in the communities served by those offices.
Sovereign is a Virginia business corporation and its principal executive offices are located at 75 State Street, Boston, Massachusetts. Sovereign Bank is headquartered in Wyomissing, Pennsylvania, a suburb of Reading, Pennsylvania.
Sovereign was incorporated in 1987 as a holding company for Sovereign Bank. 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 has acquired 28 financial institutions, branch networks and/or related businesses since 1990. Eighteen of these acquisitions, with assets totaling approximately $52 billion, have been completed since 1995. Sovereign’s latest acquisition was Independence Community Bank Corp. (“Independence”) effective June 1, 2006 for $42 per share in cash, representing an aggregate transaction value of $3.6 billion. Sovereign funded this acquisition using the proceeds from a $2.4 billion equity offering to Banco Santander S.A. (“Santander”), net proceeds from issuances of perpetual and trust preferred securities, and cash on hand. Sovereign issued 88.7 million shares to Santander, in connection with the equity offering which made Santander Sovereign’s largest shareholder.
On January 30, 2009, Sovereign became a wholly owned subsidiary of Santander. Pursuant to a Transaction Agreement, dated October 13, 2008, between Sovereign and Santander (the “Transaction Agreement”), Santander acquired all of the outstanding shares of the Company’s common stock that it did not already own in exchange for the right to receive 0.3206 Santander American Depository Shares, or ADSs, for each share of Company common stock. As a result of the Santander transaction, the Company’s state of incorporation changed from Pennsylvania to Virginia.
Subsidiaries
Sovereign had three direct consolidated wholly-owned subsidiaries at December 31, 2008: Sovereign Bank is the only material subsidiary.
Employees
At December 31, 2008, Sovereign had 10,235 full-time and 1,408 part-time employees. None of these employees are represented by a collective bargaining agreement, and Sovereign believes it enjoys good relations with its personnel.
Competition
Sovereign is subject to substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits include the ability to offer attractive rates, the convenience of office locations, and the availability of alternate channels of distribution. Direct competition for deposits comes primarily from national and state banks, thrift institutions, and broker dealers. Competition for deposits also comes from money market mutual funds, corporate and government securities, and credit unions. The primary factors driving commercial and consumer competition for loans are interest rates, loan origination fees, service levels and the range of products and services offered. Competition for origination of loans normally comes from other thrift institutions, national and state banks, mortgage bankers, mortgage brokers, finance companies, and insurance companies.
Environmental Laws
Environmentally related hazards have become a source of high risk and potentially significant 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 that is likely to have a material adverse effect on the financial condition or results of operations of the Company.
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 oversight and reporting with respect to certain matters. Sovereign Bank is chartered as a federal savings bank, and is highly regulated by the OTS as to all its activities, and subject to extensive OTS examination, supervision, and reporting.
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. The deposits of Sovereign Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”). 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, Boston and New York, which are part 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.
As a result of the investment in Sovereign by Santander in May, 2006 as described below under “Control of Sovereign,” Sovereign is also now considered a subsidiary of a bank holding company for purposes of the Bank Holding Company Act of 1956, as amended. As such, Sovereign is prohibited from engaging in any activity, directly or through a subsidiary, that is not permissible for subsidiaries of bank holding companies. Generally, financial activities are permissible, while commercial and industrial activities are not.
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.
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. 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 could be issued in the form of a directive having the legal efficacy of a cease and desist order.
Because Sovereign is also considered a subsidiary of Santander for Bank Holding Company Act purposes, Santander may be required to obtain approval from the Federal Reserve if Sovereign were to acquire shares of any depository institution (bank or savings institution) or any holding company of a depository institution. In addition, Santander may have to provide notice to the Federal Reserve if Sovereign acquires any financial entity that is not a depository institution, such as a lending company.
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 together 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 could be subject to certain ongoing reporting procedures and restrictions under federal law and regulations. Ownership of more than 10% of the capital stock may be deemed to constitute “control” if certain other control factors are present.
In May 2006, Sovereign and Santander entered into an Investment Agreement, pursuant to which, among other things, Santander purchased from Sovereign 88.7 million shares of Sovereign’s common stock for $2.4 billion in cash. In general the Investment Agreement contains a number of important restrictions on both Sovereign and Santander, including (i) certain standstill provisions that restrict Santander from purchasing securities of Sovereign, making an offer to purchase securities of Sovereign, or taking certain other actions, in each case unless certain conditions are satisfied and (ii) restrictions on the ability of Sovereign to solicit any acquisition proposals and on the manner in which Sovereign may respond to unsolicited acquisition proposals and obligations to provide Board representation to Santander. The proceeds of Santander’s investment were used to acquire the common stock of Independence. This investment was approved by the OTS. If Santander acquires 25% or more of Sovereign’s stock, Sovereign will no longer be a savings and loan holding company and will no longer be regulated by the OTS, although Sovereign Bank will continue to be regulated by the OTS as long as it remains a federal savings bank. For a more detailed description of the Investment Agreement, please see Part III - Item 12 of this Form 10-K.
On October 13, 2008, Sovereign and Santander entered into the Transaction Agreement whereby Santander agreed to acquire all the outstanding shares of Sovereign not currently owned by it. Sovereign Bancorp, Inc. will merge with and into a wholly owned subsidiary of Sovereign organized under the laws of the Commonwealth of Virginia and immediately thereafter, pursuant to a share exchange under Virginia law, become a wholly owned subsidiary of Santander.
In late January 2009, stockholders of both Santander and Sovereign agreed to the terms of the transaction agreement. On January 30, 2009, Sovereign was acquired by Santander.
Santander is one of the largest banks in the world by market capitalization. It has more than 14,000 branches and more than 90 million customers in over 40 countries. It is the largest financial group in Spain and Latin America, and has a significant presence elsewhere in Europe, including the United Kingdom through its Abbey subsidiary and Portugal, where it is the third largest banking group. It also operates a leading consumer finance franchise in Germany, Italy, Spain and thirteen other European countries.
Regulatory Capital Requirements. OTS regulations require savings associations to maintain minimum capital ratios. These standards are the same as the capital standards that are applicable to other insured depository institutions, such as banks. OTS regulations do not require savings and loan holding companies to maintain minimum capital ratios.
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 Tier 1 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. 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.
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, 2008, Sovereign Bank met the criteria to be classified as “well-capitalized.”
Standards for Safety and Soundness. The federal banking agencies adopted certain operational and managerial standards for depository institutions, including internal audit system components, loan documentation requirements, asset growth parameters, information technology and data security practices, 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 Accounts and Regulation by the FDIC. Sovereign Bank is a member of the Deposit Insurance Fund, which is administered by the FDIC. Deposits are insured up to the applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the Deposit Insurance Fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action, and may terminate an institution’s deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
In February 2006, the Federal Deposit Insurance Reform Act (the “Reform Act”) was enacted. The new law merged the old Bank Insurance Fund and Savings Insurance Fund into the single Deposit Insurance Fund, increased deposit insurance coverage for IRAs to $250,000, provided for the further increase of deposit insurance on all accounts by indexing the coverage to the rate of inflation, authorized the FDIC to set the reserve ratio of the combined Deposit Insurance Fund at a level between 1.15% and 1.50%, and permitted the FDIC to establish assessments to be paid by insured banks to maintain the minimum ratios.
In November 2006, the FDIC adopted final regulations to implement the Reform Act. The final regulations included the annual assessment rates that went into effect at the beginning of 2007. The new assessment rates for nearly all banks vary between five and eight cents for every $100 of domestic deposits. Prior to 2007, most banks, including Sovereign, had not been required to pay any deposit insurance premiums since 1995. As part of the Reform Act, Congress provided credits to institutions that paid high deposit insurance premiums in the past to bolster the FDIC’s insurance reserves. The assessment credit for Sovereign was calculated at $29 million. This credit was recognized in 2007 to reduce deposit insurance premiums. The level of annual deposit premiums is dependent on the amount of Sovereign’s deposit assessment base.
The FDIC charges financial institutions deposit premium assessments to ensure it has reserves to cover deposits that are under FDIC insured limits, which in early October 2008, the U.S. government increased to $250,000 per depositor interest bearing account and provided unlimited insurance on non-interest bearing accounts. The FDIC Board of Directors has established a reserve ratio target percentage of 1.25%. This means that their “target” balance for the reserves is 1.25% of estimated insured deposits. Due to recent bank failures, the reserve ratio is currently significantly below its target balance. The FDIC has recently announced that deposit assessment rates will double effective in the first quarter of 2009, and in the second quarter of 2009, additional fees will be assessed to institutions who have secured borrowings in excess of 15% of their deposits. Sovereign anticipates that these new assessments will increase our general and administrative costs by approximately $50 million to $73 million depending on factors such as our 2009 deposit and borrowing levels. Additionally, on February 27, 2009, the FDIC adopted an Emergency Special Assessment Rule under which all insured depository institutions would pay a one-time assessment fee of 20 basis points. The assessment would be made on June 30, 2009 using the institutions deposit base at that time. At our current deposit base, this one-time assessment would cost Sovereign approximately $90 million in 2009. The interim rule also permits the FDIC to impose an additional special assessment of 10 basis points after June 30, 2009, if necessary to maintain public confidence in federal deposit insurance, or if the insurance fund falls to or below zero. Although this interim rule was adopted by the FDIC, it is subject to a 30 day comment period before becoming final and it is possible that these fee assessments may be reduced. In early March 2009, the FDIC requested an increase in their line of credit with the U.S. Treasury from $30 billion to $100 billion. If the increase is approved the FDIC has indicated that they will reduce the one-time assessment from 20 basis points to 10 basis points. Sovereign may be able to pass part or all of this cost onto its customers in the form of lower interest rates on deposits depending on market conditions.
In addition to deposit insurance premiums, all insured institutions are required to pay a Financing Corporation assessment, in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. In 2008, Sovereign paid Finance Corporation Assessments of $5.3 million. The annual rate (as of the first quarter of 2009) for all insured institutions is $0.114 for every $1,000 in domestic deposits which is consistent with what was paid in 2008. These assessments are revised quarterly and will continue until the bonds mature in the year 2017.
Federal Restrictions on Transactions with Affiliates and Insiders. All savings institutions are subject to affiliate and insider transaction rules applicable to member banks of the Federal Reserve System set forth in the Federal Reserve Act or the Home Owners Loan Act (HOLA), as well as such additional limitations as the institutions’ primary federal regulator may adopt. These provisions prohibit or limit a savings institution from extending credit to, or entering into certain transactions with, affiliates, principal shareholders, directors and executive officers of the savings institution and its affiliates. For these purposes, the term “affiliate” generally includes a holding company such as Sovereign and any company under common control with the savings institution. In addition, the federal law governing unitary savings and loan holding companies prohibits Sovereign Bank from making any loan to any affiliate whose activity is not permitted for a subsidiary of a bank holding company. This law also prohibits Sovereign Bank from making any equity investment in any affiliate that is not its subsidiary.
Restrictions on Subsidiary Savings Institution Capital Distributions. Sovereign’s principal sources of funds are cash dividends paid to it by Sovereign Bank, investment income and borrowings. OTS regulations limit the ability of savings associations such as Sovereign Bank to pay dividends and make other capital distributions. Associations that are subsidiaries of a savings and loan holding company must file a notice with the OTS at least 30 days before the proposed declaration of a dividend or approval of the proposed capital distribution by its board of directors. In addition, a savings association must obtain prior approval from the OTS if it fails to meet certain regulatory conditions, or if, after giving effect to the proposed distribution, the association’s capital distributions in a calendar year would exceed its year-to-date net income plus retained net income for the preceding two years or the association would not be at least adequately capitalized or if the distribution would violate a statute, regulation, regulatory agreement or a regulatory condition to which the association is subject.
Qualified Thrift Lender. Prior to January 30, 2009, Sovereign Bank was required to meet a qualified thrift lender test to avoid certain restrictions on their operations. The test under HOLA requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments. As an alternative, the savings institution under HOLA may maintain 60% of its assets in those assets specified in Section 7701(a) (19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans, certain consumer and small business loans, as defined by the regulations, and mortgage related investments. At December 31, 2008, Sovereign was not in compliance with the QTL test. However, under HOLA, bank holding companies such as Santander, as well as any companies they control, are not subject to the QTL test. Consequently, effective upon the acquisition by Santander of all of Sovereign’s common stock, Sovereign Bank became exempt from the QTL test.
Other Loan Limitations. Federal law limits the amount of non-residential mortgage loans a savings institution, such as Sovereign Bank, may make. Separate from the qualified thrift lender test, the law limits a savings institution to a maximum of 20% of its total assets in commercial loans not secured by real estate, however, only 10% can be large commercial loans not secured by real estate (defined as loans in excess of $2 million), with another 10% of assets permissible in “small business loans.” Commercial loans secured by real estate can be made in an amount up to four times an institution’s total risk-based capital. An institution can also have commercial leases, in addition to the above items, up to 10% of its assets. Commercial paper, corporate bonds, and consumer loans taken together cannot exceed 35% of an institution’s assets. For this purpose, however, residential mortgage loans and credit card loans are not considered consumer loans, and are both unlimited in amount. The foregoing limitations are established by statute, and cannot be waived by the OTS.
In late 2006 and in the first quarter of 2007, Sovereign completed a balance sheet restructuring which involved the sale of approximately $8 billion of assets consisting of correspondent home equity loans, purchased residential loans, multi-family loans, and certain investments. These sales were completed to enable Sovereign to reduce lower yielding and/or higher credit risk assets classes and pay down higher cost borrowings. Additionally, Sovereign began to focus on increasing the amount of higher yielding commercial loans which was expected to improve profitability. Although, Sovereign continues to originate residential and multi-family loans, the loans are primarily sold after origination into the secondary markets. As a result of this change in strategy, Sovereign commercial loans in total and as a percentage of assets increased in 2007 and 2008.
Currently, Sovereign is in compliance with the loan limitation statutes described above; however, Sovereign has had to temporarily increase the amount of assets throughout the latter half of 2007 and in certain periods during 2008 that were not considered large commercial loans in order to comply with the above loan limitations. These temporary increases in assets was funded by increasing short-term borrowings with the FHLB. Towards the latter half of 2008, the Company began to aggressively manage its commercial loan portfolio to ensure that only our most profitable customers on a risk adjusted basis continued to transact with the Bank. This strategy has led to a reduction in the amount of HOLA eligible loans that reside on our balance sheet. We expect to be in compliance with this statute in 2009.
Federal Reserve Regulation. Under Federal Reserve Board regulations, Sovereign Bank is required to maintain a reserve against its transaction accounts (primarily interest-bearing and non interest-bearing checking accounts). Because reserves must generally be maintained in cash or in low-interest-bearing accounts, the effect of the reserve requirements is to reduce an institution’s asset yields.
Numerous other regulations promulgated by the Federal Reserve Board affect the business operations of Sovereign Bank. These include regulations relating to equal credit opportunity, electronic fund transfers, collection of checks, truth in lending, truth in savings, availability of funds, home mortgage disclosure and margin credit.
Federal Home Loan Bank System. The FHLB System was created in 1932 and consists of twelve regional FHLBs. The FHLBs are federally chartered but privately owned institutions created by U.S. Congress. The Federal Housing Finance Board is an agency of the federal government and is generally responsible for regulating the FHLB System. Each FHLB is owned by its member institutions. The primary purpose of the FHLBs is to provide funding to their members for making housing loans as well as for affordable housing and community development lending. FHLBs are generally able to make advances to their member institutions at interest rates that are lower than could otherwise be obtained by such institutions. As a member, Sovereign is required to make minimum investments in FHLB stock based on the level of borrowings from the FHLB. Sovereign Bank is a member of FHLB Pittsburgh, Boston, and New York and has investments of $644.4 million, $4.2 million and $25.9 million, respectively. Sovereign utilized advances from the FHLB to fund balance sheet growth and provide liquidity. Sovereign had access to advances with the FHLB of up to $24 billion and had outstanding advances of $13.3 billion at December 31, 2008. The level of borrowings capacity Sovereign Bank has with the FHLB is contingent upon the level of qualified collateral the Bank holds at a given time.
In December, the FHLB of Pittsburgh announced it was suspending dividends on its stock and that it would not repurchase any excess capital stock in order to maintain their liquidity and capital position. We have considered these developments and concluded that our investment in FHLB Pittsburgh is not impaired. However we will continue to closely monitor this investment in future periods.
Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of their delineated communities, including low to moderate-income neighborhoods within those communities, while maintaining safe and sound banking practices. A bank’s performance under the CRA is important in determining whether the bank may obtain approval for, or utilize streamlined procedures in, certain applications for acquisitions or to engage in new activities. Sovereign Bank’s lending activities are in compliance with applicable CRA requirements, and Sovereign Bank’s current CRA rating is “outstanding,” the highest category.
Other Legislation. The Fair and Accurate Credit Transactions Act (“FACTA”) was signed into law on December 4, 2003. This law extends the previously existing Fair Credit Reporting Act. New provisions added by FACTA address the growing problem of identity theft. Consumers will be able to initiate a fraud alert when they are victims of identity theft, and credit reporting agencies will have additional duties. Consumers will also be entitled to obtain free credit reports, and will be granted certain additional privacy rights. The Check 21 Act was also enacted in late 2003. This Act affects the way checks are processed in the banking system, allowing payments to be processed electronically rather than as traditional paper checks.
In addition to the legislation discussed above, Congress is often considering some financial industry legislation, and the federal banking agencies routinely propose new regulations. New legislation and regulation may include dramatic changes to the federal deposit insurance system. Sovereign cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.
Corporate Information. All reports filed electronically by Sovereign with the SEC, including the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as well as any amendments to those reports, are accessible at no cost on Sovereign’s Web site at www.sovereignbank.com as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. These filings are also accessible on the SEC’s Web site at www.sec.gov. Also, copies of the Company’s annual report will be made available, free of charge, upon written request.
Item 1A
Item 1A - Risk Factors
The following list describes several risk factors that are applicable to our Company:
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The Current Economic Downturn May Continue to Deteriorate Our Asset Quality and Adversely Affect Our Earnings and Cash Flow.
Our business faces various material risks, including credit risk and the risk that the demand for our products will decrease. In a recession or other economic downturn, these risks would probably become more acute. In an economic downturn, our credit risk and associated provision for credit losses and legal expense will increase. Also, decreases in consumer confidence, real estate values, and interest rates, usually associated with a downturn, could combine to make the types of loans we originate less profitable and could cause elevated levels of losses on our commercial and consumer loans. Current economic conditions may continue to deteriorate which would likely continue to adversely impact our results.
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Disruptions in the Global Financial Markets have Affected, and May Continue to Adversely Affect, Sovereign’s Business and Results of Operations.
Dramatic declines in the housing market during 2008, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivatives, have caused many financial institutions to seek additional capital and to merge with other financial institutions. Disruptions in the global financial markets have also adversely affected the corporate bond markets, debt and equity underwriting and other elements of the financial markets. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, some lenders and institutional investors have reduced and, in some cases, ceased to provide funding to certain borrowers, including other financial institutions. The impact on available credit, increased volatility in the financial markets and reduced business activity has adversely affected, and may continue to adversely affect, Sovereign’s businesses, capital, liquidity or other financial condition and results of operations, access to credit and the trading price of Sovereign preferred stock or debt securities.
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Sovereign May Experience Further Write-Downs of its Financial Instruments and Other Losses Related to Volatile and Illiquid Market Conditions.
Market volatility, illiquid market conditions and disruptions in the credit markets have made it extremely difficult to value certain of Sovereign’s assets. Subsequent valuations, in light of factors then prevailing, may result in significant changes in the values of these assets in future periods. In addition, at the time of any sales of these assets, the price Sovereign ultimately realizes will depend on the demand and liquidity in the market at that time and may be materially lower than their current fair value. Any of these factors could require Sovereign to take further write-downs in respect of these assets, which may have an adverse effect on the Company’s results of operations and financial condition in future periods.
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Liquidity is Essential to Sovereign’s Businesses, and Sovereign Relies on External Sources, Including Government Agencies to Finance a Significant Portion of its Operations.
Adequate liquidity is essential to Sovereign’s businesses. The Company’s liquidity could be materially adversely affected by factors Sovereign cannot control, such as the continued general disruption of the financial markets or negative views about the financial services industry in general. In addition, Sovereign’s ability to raise funding could be impaired if lenders develop a negative perception of the Company’s short-term or long-term financial prospects, or a perception that the Company is experiencing greater liquidity risk. Recent regulatory measures, such as the FDIC’s temporary guarantee of the newly issued senior debt are designed to stabilize the financial markets and the liquidity position of financial institutions such as Sovereign. It is unclear whether, or for how long, these facilities will be extended and what impact termination of any of these facilities could have on Sovereign’s ability to access funding in the future. Sovereign’s credit ratings are also important to its liquidity. A reduction in Sovereign’s credit ratings could adversely affect its liquidity, widen its credit spreads or otherwise increase its borrowing costs.
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Recently Enacted Legislation Authorizing the U.S. Government to Take Direct Action Within the Financial Services Industry, and Other Legislation and Regulation Currently Under Consideration, May Not Stabilize the U.S. Financial System in the Near Term.
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law. In addition, on February 17, 2009, the American Recovery and Reinvestment Act of 2009 (ARRA) was signed by President Obama. The purpose of these U.S. government actions is to stabilize and provide liquidity to the U.S. financial markets and jumpstart the U.S. economy. The U.S. government is currently considering, and may consider in the future, additional legislation and regulations with similar purposes. The EESA, ARRA and other governmental programs may not have their intended impact of stabilizing, providing liquidity to or restoring confidence in the financial markets. Further, the discontinuation and/or expiration of these or other governmental programs could result in a worsening of current market conditions.
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The Preparation of Sovereign’s Financial Statements Requires the Use of Estimates That May Vary From Actual Results.
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make significant estimates that affect the financial statements. One example of a significant critical estimate is the level of the allowance for credit losses. Due to the inherent nature of this estimate, Sovereign cannot provide absolute assurance that it will not significantly increase the allowance for credit losses and/or sustain credit losses that are significantly higher than the provided allowance.
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The Preparation of Sovereign’s Tax Returns Requires the Use of Estimates & Interpretations of Complex Tax Laws and Regulations and Are Subject to Review By Taxing Authorities.
Sovereign is subject to the income tax laws of the U.S., its states and municipalities and certain foreign countries. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. In establishing a provision for income tax expense and filing returns, the Company must make judgments and interpretations about the application of these inherently complex tax laws. Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) recently examined the Company’s federal income tax returns for the years 2002 through 2005. The IRS completed this review in 2008. Included in this examination cycle are two separate financing transactions with an international bank totaling $1.2 billion. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006 and 2007, Sovereign was subject to an additional $87.6 million and $22.5 million, respectively, of foreign taxes related to these financing transactions and claimed a corresponding foreign tax credit. The IRS issued a notification of adjustment disallowing the foreign tax credits taken in 2003-2005 in the amount of $154.0 million related to these transactions; disallowing deductions for issuance costs and interest expense related to the transaction which would result in an additional tax liability of $24.9 million; and assessed interest and penalties, the combined amount of which totaled approximately $71.0 million. In addition, the IRS has commenced its audit for the years 2006 and 2007. We expect that in the future the IRS will propose to disallow the foreign tax credits taken in 2006 and 2007 of $87.6 million and $22.5 million, respectively; disallow deductions for issuance costs and interest expense which would result in an additional tax liability of $37.1 million; and to assess interest and penalties. Sovereign expects that it will need to litigate this matter with the IRS. Sovereign continues to believe that it is entitled to claim these foreign tax credits and deductions and also believes that its recorded tax reserves for this position of $58.3 million adequately provides for any potential exposure to the IRS related to this item and other tax assessments. However, as the Company continues to go through the IRS administrative process, and if necessary litigation, we will continue to evaluate the appropriate tax reserve levels for this position and any changes made to the tax reserves may materially affect Sovereign’s income tax provision, net income and regulatory capital in future periods.
•
Changing Interest Rates May Adversely Affect Our Profits.
To be profitable, we must earn more money from interest on loans and investments and fee-based revenues than the interest we pay to our depositors and creditors and the amount necessary to cover the cost of our operations. Rising interest rates may hurt our income because they may reduce the demand for loans and the value of our investment securities and our loans, and increase the amount that we must pay to attract deposits and borrow funds. If interest rates decrease, our net interest income could be negatively affected if interest earned on interest-earning assets, such as loans, mortgage-related securities, and other investment securities, decreases more quickly than interest paid on interest-bearing liabilities, such as deposits and borrowings. This would cause our net interest income to go down. In addition, if interest rates decline, our loans and investments may prepay earlier than expected, which may also lower our income. Interest rates do and will continue to fluctuate, and we cannot predict future Federal Reserve Board actions or other factors that will cause rates to change. If the yield curve steepens or flattens, it could impact our net interest income in ways management may not accurately predict.
•
We Experience Intense Competition for Loans and Deposits.
Competition among financial institutions in attracting and retaining deposits and making loans is intense. Our most direct competition for deposits has come from commercial banks, savings and loan associations and credit unions doing business in our areas of operation, as well as from nonbanking sources, such as money market mutual funds and corporate and government debt securities. Competition for loans comes primarily from commercial banks, savings and loan associations, consumer finance companies, insurance companies and other institutional lenders. We compete primarily on the basis of products offered, customer service and price. A number of institutions with which we compete have greater assets and capital than we do and, thus, may have a competitive advantage.
•
We Are Subject to Substantial Regulation Which Could Adversely Affect Our Business and Operations.
As a financial institution, we are subject to extensive regulation, which materially affects our business. Statutes, regulations and policies to which we and Sovereign Bank are subject may be changed at any time, and the interpretation and the application of those laws and regulations by our regulators is also subject to change. There can be no assurance that future changes in regulations or in their interpretation or application will not adversely affect us.
The regulatory agencies having jurisdiction over banks and thrifts have under consideration a number of possible rulemaking initiatives which impact bank and thrift and bank and thrift holding company capital requirements. Adoption of one or more of these proposed rules could have an adverse effect on us and Sovereign Bank.
Existing federal regulations limit our ability to increase our commercial loans. We are required to maintain 65% of our assets in residential mortgage loans and certain other loans, including small business loans. We also cannot have more than 20% of our total assets in commercial loans that are not secured by real estate, however, only 10% can be large commercial loans not secured by real estate, more than 10% in small business loans, or more than four times our risk based capital in commercial real estate loans. A small business loan is one with an original amount of $2 million or less, and a large commercial loan is a loan with an original loan amount of more than $2 million. Our existing strategy is to focus loan growth on commercial loans which generally have higher yields and profitability. We may be limited in the amount of commercial loan growth that we can achieve based on the above regulations.
•
Changes in Accounting Standards Could Impact Reported Earnings.
The accounting standard setters, including the FASB, SEC and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of Sovereign’s consolidated financial statements. These changes can be hard to predict and can materially impact how it records and reports its financial condition and results of operations. In some cases, Sovereign could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.
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We Rely on Third Parties for Important Products and Services.
Third party vendors provide key components of our business infrastructure such as loan and deposit servicing systems, internet connections and network access. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Replacing these third party vendors could also entail significant delays and expense.
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Our Framework for Managing Risks May Not be Effective in Mitigating Risk and Loss to Our Company.
Our risk management framework is made up of various processes and strategies to manage our risk exposure. Types of risks to which we are subject include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal risk, compliance risk, reputation risk and fiduciary risk, among others. Our framework to manage risk, including the framework’s underlying assumptions, may not be effective under all conditions and circumstances. If our risk management framework proves ineffective, we could suffer unexpected losses and could be materially adversely affected.
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Our Disclosure Controls and Procedures May Not Prevent or Detect All Errors or Acts of Fraud.
Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by any unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.
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Integration Risks Exist Related to the Acquisition of the Company by Santander.
On January 30, 2009, Sovereign was acquired by Santander. Sovereign may not be integrated successfully into the existing businesses of Santander or the integration may be more difficult, time-consuming or costly than expected. The combined company may not realize, to the extent or at the time we expect, revenue synergies and cost savings from the transaction. Deposit attrition, operating costs, customer losses and business disruptions following the transaction, including difficulties in maintaining relationships with employees, could be greater than expected.
Item 1B
Item 1B - Unresolved Staff Comments
None.
Item 2
Item 2 - Properties
Sovereign Bank utilizes 833 buildings that occupy a total of 6.2 million square feet, including 237 owned properties with 1.8 million square feet and 596 leased properties with 4.4 million square feet. Eight major buildings contain 1.2 million square feet, which serve as the headquarters or house significant operational and administrative functions:
Columbia Park Operations Center - Dorchester, Massachusetts
195 Montague Street Regional Headquarters for New York Metro - Brooklyn, New York
East Providence Call Center and Operations and Loan Processing Center - East Providence, Rhode Island
75 State Street Bank Headquarters for Sovereign Bank of New England - Boston, Massachusetts
405 Penn Street Sovereign Plaza Call Center and Operations and Loan Processing Center - Reading, Pennsylvania
601 Penn Street Loan Processing Center - Reading, Pennsylvania
1130 Berkshire Boulevard Administrative Offices - Wyomissing, Pennsylvania
1125 Berkshire Boulevard Operations Center - Wyomissing, Pennsylvania
The majority of the eight properties of Sovereign outlined above are utilized by our Shared Services Consumer Bank segment and for general corporate purposes by our Other segment. The remaining 825 properties consist primarily of bank branches and lending offices used by our Retail Banking segments.
Item 3
Item 3 - Legal Proceedings
Sovereign is not involved in any pending material legal proceeding other than routine litigation occurring in the ordinary course of business. Sovereign does not expect that any amounts that it may be required to pay in connection with these matters would have a material adverse effect on its financial position.
In the first quarter of 2008 a voluntary mediation was held in connection with a claim made against Sovereign related to an investment advisor in Massachusetts who defrauded numerous victims over a long period of time. The fraud reportedly amounted to tens of millions of dollars. The investment advisor’s companies had accounts at Sovereign. The court appointed an ancillary receiver to pursue claims against Sovereign and another bank, and the ancillary receiver filed a complaint against Sovereign. Some of the victims joined in the action as plaintiffs, and some of the claims are putative class action claims. The ancillary receiver recently filed a motion seeking class certification. Little progress was made towards a settlement at the voluntary mediation that was held in the first quarter of 2008 and the trial for this claim was held in December 2008. The court ruled that Sovereign did not have any liability related to this matter.
In the first quarter of 2008, a former employee filed a putative class action in Pennsylvania federal court alleging that the Company violated ERISA in connection with the management of certain plans. The plaintiff alleges that the Company knew or should have known that the Company’s stock was not a prudent investment for the Company’s retirement plan beginning on or about January 1, 2007. The complaint also alleges that the Company provided the putative class and the investing community with inadequate disclosure concerning the Company’s financial condition, resulting in the stock having an inflated value until the Company’s disclosures in January 2008. In April 2008, a similar putative class action was filed in the same court by another former employee. The complaint in the second action asserts that the Company caused retirement plan assets to be invested in the Company’s stock when it was imprudent to do so, caused the plan to purchase the stock while not disclosing alleged financial problems and to pay above market interest rates for a Company loan, and failed to provide complete and accurate information to participants in the plan. In July 2008, counsel for the respective plaintiffs filed a consolidated amended complaint that expanded upon the allegations set forth in the prior two actions. The class period in the consolidated amended complaint was also expanded to include the period from January 1, 2002 to present. The Company believes that the claims are without merit and intends to vigorously defend the claims.
On October 13, 2008, Sovereign and Santander entered into the Transaction Agreement whereby Santander agreed to acquire all the outstanding shares of Sovereign not currently owned by it. Sovereign received various purported class action complaints from purported shareholders alleging that Sovereign’s directors breached their fiduciary duties by entering into the Transaction Agreement. Certain of these lawsuits also allege that Santander and certain directors of the Company serving by designation by Santander pursuant to the Investment Agreement (the “Santander Directors”) breached their fiduciary duties and that the remainder of Sovereign’s directors aided and abetted the Santander Directors’ breaches of fiduciary duties. All of the complaints seek an injunction preventing the consummation of the transaction contemplated by the Transaction Agreement.
On January 21, 2009, a settlement agreement was reached between the parties which covered all persons who owned shares of Sovereign common stock from October 13, 2008 to and including the effective date of the Proposed Transaction between Santander and Sovereign. A summary of the key terms of the settlement agreement was filed on a Form 8-K filed on January 22, 2009 with the SEC.
Item 4
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 the date of this filing are set forth below:
Gabriel Jaramillo - Age 58. Mr. Jaramillo became Chairman of the Board, President and Chief Executive Officer of the Company on January 30, 2009 and also currently serves as Chairman of each of the Executive and Risk Management Committees of the Board. He has served as a Director of Sovereign Bancorp since July 16, 2008. Mr. Jaramillo has 34 years of experience within the financial sector and served in various executive positions with Grupo Santander since 1996. Prior to his appointment to Sovereign, he most recently served as Advisor to the Chairman of Grupo Santander and was President of Banco Santander Brazil.
Kirk W. Walters - Age 53. Mr. Walters was appointed to the Sovereign Board on January 30, 2009, and also currently serves as a member of the Executive and Risk Management Committees of the Board. Mr. Walters became the Senior Executive Vice President, Chief Financial Officer and Chief Administration Officer of the Company on January 3, 2009. From September 30, 2008 to January 3, 2009, he served as the Interim President, Interim Chief Executive Officer and Chief Financial Officer of the Company. From March 3, 2008 to September 30, 2008, he served as the Chief Financial Officer of the Company. Mr. Walters joins Sovereign from Chittenden Corporation, headquartered in Burlington, VT, which was acquired by People’s United Financial, Inc., headquartered in Bridgeport, CT, in January 2008. At Chittenden, Mr. Walters served as Executive Vice President and Chief Financial Officer since 1996. Prior to joining Chittenden, he worked at Northeast Federal Corporation in Hartford, CT, from 1989-95 in a series of executive positions, including Chairman, Chief Executive Officer, President and Chief Operating Officer. From 1984-89, Mr. Walters worked for California Federal Bank in a variety of financial positions, including Senior Vice President and Controller. He began his career as an accountant at Coopers & Lybrand in Los Angeles.
Patrick J. Sullivan - Age 53. Mr. Sullivan was appointed to the position of Managing Director of Commercial Banking in 2008. Prior to being promoted to Managing Director of Commercial Banking, Mr. Sullivan was President and CEO of Massachusetts and New Hampshire. Mr. Sullivan has 30 years of experience in the banking industry and has held a variety of executive and management positions. He joined Sovereign in June of 2000 as Executive Vice President, Managing Director of Commercial Banking and Specialized Lending. Previously, he was President and Chief Executive Officer of Howard Bank.
Roy J. Lever - Age 57. Mr. Lever was appointed to the position of Managing Director of Retail Banking in 2008. Prior to joining Sovereign, Mr. Lever served nearly 33 years in a variety of senior positions with Bank of America and Fleet Bank. Most recently, he was a Senior Vice President for Global Consumer and Small Business Banking at Bank of America and where he had responsibility for the bank’s compliance, risk and operations at more than 6,000 branches.
PART II
Item 5
Item 5 - Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
During the 2008 fiscal year through January 29, 2009, Sovereign’s common stock was traded on the New York Stock Exchange (“NYSE”) under the symbol “SOV.” As of January 30,2009, all shares of Sovereign common stock were acquired by Santander and delisted from the NYSE, following which there is currently no established public trading market. As of the date of this filing, Santander was the sole holders of the Company common stock.
Market and dividend information for Sovereign’s common stock appear in Item 7 - Table 13 “Selected Consolidated Financial Data” of this Form 10-K. No dividends were paid on Sovereign’s common shares during 2008. In addition, for certain limitations on the ability of Sovereign Bank to pay dividends to Sovereign, see Part I, Item I, “Business Supervision and Regulation - Regulatory Capital Requirements” and Note 15 at Item 8, “Financial Statements and Supplementary Data.” For information regarding Sovereign’s equity compensation plans, see Part III - Item 11, “Equity Compensation Plan Information During and Prior to 2008.”
The table below summarizes the Company’s repurchases of common equity securities during the quarter ended December 31, 2008:
(1)
Sovereign had three stock repurchase programs in effect that allowed the Company to repurchase up to 40.5 million shares of Company common stock as of December 31, 2008. Twenty one million shares were purchased under these repurchase programs as of December 31, 2008. All of Sovereign’s stock repurchase programs have no prescribed time limit in which to fill the authorized repurchase amount.
Item 6
Item 6 - Selected Financial Data
(1)
Our provisions for credit losses in 2008 and 2007 were negatively impacted by the deterioration in the credit quality of our loan portfolios which was impacted by the weakening of the United States economy as well as declines in residential real estate prices. See additional discussion in Management’s Discussion and Analysis. Non-interest income for 2008 includes a $602 million loss on the sale of our CDO portfolio and a $575 million other-than-temporary impairment charge on FNMA and FHLMC preferred stock and an other-than-temporary impairment charge of $308 million on certain non-agency mortgage backed securities. Non-interest income for 2007 includes a pretax other-than-temporary impairment charge of $180.5 million on FNMA and FHLMC preferred stock.
(2)
In connection with a strategic decision made in the fourth quarter of 2006, management decided to take several steps to improve the profitability and capital position of the Company. The Company decided to sell certain loans including $2.9 billion of low yielding residential real estate and $4.3 billion of correspondent home equity loans whose credit quality had deteriorated significantly in 2006. The proceeds from these sales were utilized to reduce FHLB borrowings and brokered certificate of deposits. In 2006, we recorded charges of $296 million through the provision for credit losses related to the correspondent home equity loan sale and recorded a $28.2 million reduction in mortgage banking revenues as a result of re-classifying these loans to held for sale at December 31, 2006 and carrying the loans at their market value which was less than cost. In the first quarter of 2007, Sovereign recorded and additional charge of $119.9 million on our correspondent home equity loan portfolio. See additional discussion in Management’s Discussion and Analysis. Also in the fourth quarter of 2006, several members of executive management resigned from the Company and approximately 360 employees were notified that their positions were being eliminated. In 2006, Sovereign recorded severance charges of $63.9 million related to these events which was recorded in other expenses. Finally, Sovereign sold approximately $1.5 billion of low yielding investment securities in connection with the restructuring plan. The proceeds from this sale were reinvested in higher yielding securities as they were needed for collateral on certain of our debt and deposit obligations. However, in 2006, we recorded a pre-tax loss of $43 million in connection with this sale which was recorded in non-interest income. Sovereign also recorded investment securities charges of $305.8 million during the second quarter of 2006 which was recorded in non-interest income. See Management’s Discussion and Analysis and Footnotes 6, 7 and 28 to the Consolidated Financial Statements for further discussion.
(3)
2008 results include an impairment charge of $95 million on an equity method investment. The impairment was caused by a decline in 2008 earnings compared to prior years from this investment as well as the expectation that future results will be significantly impacted by the current recessionary environment. 2007 results include a $1.58 billion goodwill impairment charge related to the Company’s Metro New York and Shared Services Consumer reporting units. See Management’s Discussion and Analysis and Footnote 4 to the Consolidated Financial Statements for further discussion.
(4)
Book value per share is calculated using stockholders’ equity divided by common shares outstanding at end of such period.
(5)
Common dividend payout ratio is calculated by dividing total common dividends paid by net income for the period. The ratios for 2008 and 2007 are not applicable due to the net losses recorded during these time periods.
(6)
Return on average assets is calculated by dividing net income by the average balance of total assets for the year.
(7)
Return on average equity is calculated by dividing net income by the average balance of stockholders’ equity for the year.
(8)
Average equity to average assets is calculated by dividing the average balance of stockholders’ equity for the year by the average balance of total assets for the year.
(9)
2008 results were negatively impacted by the establishment of a $1.43 billion valuation allowance against deferred tax assets. Given that Sovereign has recorded significant losses in recent periods and due to the challenging economic conditions anticipated in 2009, the Company concluded that it was more likely than not that the majority of our deferred tax assets would not be realized in future periods on a stand alone basis. This conclusion was made without regards to the anticipated benefits that our pending transaction with Santander will have on the company.
Management’s Discussion and Analysis
Item 7
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)
EXECUTIVE SUMMARY
Sovereign, is a $77 billion financial institution as of December 31, 2008, with community banking offices, operations and team members located principally in Pennsylvania, Massachusetts, New Jersey, Connecticut, New Hampshire, New York, Rhode Island, and Maryland. Sovereign gathers substantially all of its deposits in these market areas. We use these deposits, as well as other financing sources, to fund our loan and investment portfolios. We earn interest income on our loans and investments. In addition, we generate non-interest income from a number of sources including deposit and loan services, sales of loans and investment securities, capital markets products and bank-owned life insurance. Our principal non-interest expenses include employee compensation and benefits, occupancy and facility-related costs, technology and other administrative expenses. Our volumes, and accordingly our financial results, are affected by the economic environment, including interest rates, consumer and business confidence and spending, as well as the competitive conditions within our geographic footprint. On January 30, 2009, Sovereign was acquired by Santander.
Our customers select Sovereign for banking and other financial services based on our ability to assist customers by understanding and anticipating their individual financial needs and providing customized solutions. Our major strengths include a strong franchise value in terms of market share and demographics and diversified loan portfolio and products. Our weaknesses have included operating returns and capital ratios that are lower than certain of our peers. We have also not achieved our growth targets with respect to low cost core deposits.
We took proactive steps during the second quarter of 2008 to improve our capital position by raising $1.4 billion of common equity and $500 million of subordinated debt at Sovereign Bank. Furthermore, at September 30, 2008, we contributed $800 million of cash from our holding company in order to enhance our Bank’s capital ratios. Our capital position was negatively impacted in the second half of 2008 by the impairment charge on our Fannie Mae and Freddie Mac preferred stock of $575 million, an other than temporary impairment charge of $308 million on certain non-agency mortgage backed securities and the loss on the sale of our entire collateralized debt obligations (“CDO”) portfolio of $602 million combined with higher credit losses due to the continuing negative economic environment. The above items resulted in Sovereign recording a pre-tax loss of $1.6 billion in 2008. In 2007, Sovereign had a $1.3 billion pre-tax loss. As a result, Sovereign was in a cumulative loss position for the past three years and we expect that on a stand alone basis, without any consideration given to the merger transaction with Santander in accordance with U.S. accounting principles, 2009 results would continue to be negatively impacted by the difficult economic credit environment thus making it difficult to generate taxable income in the near term. Therefore, it was determined that on a stand alone basis it was more likely than not that deferred tax assets of $1.43 billion were not realizable and as such a valuation allowance was recorded via a charge to income tax expense. Our tangible common equity to tangible assets and tier 1 leverage for the Parent Company was 2.57% and 5.73% at December 31, 2008 compared to 4.04% and 5.89% at December 31, 2007, respectively. The Bank’s total risk based capital ratio was 10.20% compared to 10.40% a year ago. Our capital levels and ratios are in excess of the levels required to be considered well-capitalized. We continue to strengthen our balance sheet and position the Company for any further weakening in economic conditions by increasing the amount of loan loss reserves on our balance sheet. Reserves for credit losses as a percentage of total loans have increased to 2.10% at December 31, 2008 from 1.28% at December 31, 2007.
In order to further improve our operating returns, we continue to focus on acquiring and retaining customers by demonstrating convenience through our locations, technology and business approach while offering innovative and easy-to-use products and services. We are focused on a number of initiatives to improve the customer experience. During 2007, customer service personnel received refresher service training and we migrated back to having all customer service functions being domestically based. We realigned our consumer and commercial infrastructure by consolidating our commercial and retail banking management structure. We also rationalized and simplified our retail deposit product set by reducing the number of retail checking products we offer.
In the fourth quarter of 2007, we piloted a new retail deposit strategy called “Customer First” in certain markets within our footprint. The goal of Customer First is to increase deposit retention and growth rates and increase the number of products and services our customers maintain and use at Sovereign. Customer First, which is a sales model/methodology that drives consistent team member behavior in each of our 755 community banking offices, was implemented throughout our entire branch network in the first quarter of 2008. Additionally, in the first quarter of 2008, Sovereign hired a senior level executive who reports to our Chief Executive Officer to lead the Company’s Retail Banking Division. We experienced improved productivity within retail banking and improved deposit retention during the first half of 2008. In the third quarter of 2008, we experienced decreases in deposit levels, primarily in high cost money market and certificate of deposit accounts reflecting intense price competition in the marketplace for deposits and the uncertainty of the banking industry. We believe some of the deposit decreases were also due to unprecedented market events such as the failure of Washington Mutual, Inc., which was seized by the FDIC and the accelerated sale of Wachovia Corporation to Wells Fargo & Company. These events as well as other financial institution failures have led to an increase in deposit attrition, particularly for account balances in excess of FDIC insurance limits. We believe that the recent actions by the US government in early October (which included increasing deposit insurance to $250,000 per depositor interest bearing account and unlimited insurance on non-interest bearing accounts) as well as our transaction with Santander, helped the Company reclaim deposits as we were able to increase deposit balances at December 31, 2008 by $5.3 billion from September 30, 2008. Although we grew our total deposits, a large percentage of the growth was in higher cost money market and time deposit accounts which has put pressure on our net interest margin.
Market Conditions and Credit
In 2008, conditions in the housing market continued to deteriorate and there was a significant tightening of available credit in the marketplace. Declining real estate values and financial stress on borrowers resulted in higher delinquencies and greater charge-offs in 2008 compared to 2007. Credit spreads significantly widened on various asset classes in the secondary marketplace which has led to a reduction in liquidity for these asset classes.
These changing market conditions impacted our financial results in 2008 in a number of ways. We continued to see higher levels of losses on our remaining correspondent home equity portfolio due to a reduction in housing values and limited availability of credit in the marketplace which reduced refinancing options for these loan customers. Residential charge-offs totaled $26.2 million in 2008 ($14.0 million of which was related to our Alt-A portfolio which totaled $2.7 billion at December 31, 2008) compared to $7.5 million in 2007. In response to the deteriorating economic conditions and higher credit losses experienced in 2008, Sovereign increased its residential loan loss reserve to $105.8 million or 0.93% of total residential loans at December 31, 2008 compared to $38.3 million or 0.29% at December 31, 2007.
In addition to our residential and Alt-A residential loan portfolios, we saw elevated levels of losses in our auto loan portfolio in 2008. During 2007, Sovereign expanded its indirect auto loan business in the Southeastern and Southwestern United States (“the Southeast and Southwest production offices”). When we decided to expand our auto loan business into the Southeast and Southwest, we expected to see higher levels of losses than what we had historically experienced for our auto loan business in our geographic footprint given that it was a new market and economic conditions were different in these markets as compared to the Northeast. However, we had believed that our pricing was adjusted to consider this expected difference in risk. The Southeast and Southwest production offices experienced significant growth in auto loan balances in 2007. However, credit losses were significantly higher than our expectations and were the primary reasons for additional provisions for credit losses that were recorded in the second half of 2007. Charge-offs on our auto portfolio totaled $175.7 million during 2008 compared to $76.2 million in 2007. Additionally, $115.6 million of these losses were related to the Southeast and Southwest production offices. At December 31, 2008, our total auto loan portfolio was $5.3 billion of which $1.8 billion consisted of loans originated in the Southeast and Southwest production offices. At December 31, 2008 our total allowance for loan losses for the auto portfolio was $140.0 million.
Effective January 31, 2008, Sovereign ceased originating new auto loans from the Southeast and Southwest production offices. In January 2009, Sovereign ceased originating indirect auto loans within its geographic footprint as well. Sovereign has increased its reserves on its auto lending portfolios significantly over the past two years. We believe the additional provisions responds to the increased risk in our auto loan portfolio. However, deterioration in the economy of the regions where we extended these loans could have a significant continued adverse impact on the amount of credit losses we experience in 2009.
In addition to increasing the provision for credit losses for the auto loan and residential mortgage portfolios, Sovereign also increased the provision for credit losses to cover exposures in its commercial portfolio, as well as increased charge-offs. Our commercial reserves as a percentage of commercial loans increased to 2.37% at December 31, 2008, from 1.40% at December 31, 2007. This was due to an increase in the level of criticized and non-performing loans from the prior year and weakening market conditions. Additionally, we recorded additional provisions in 2008 due to growth of $0.6 billion on our commercial real estate and commercial and industrial loan portfolios.
Our total allowance for credit losses as a percentage of total loans increased to 2.10% at December 31, 2008 compared to 1.28% at December 31, 2007. We believe the reserves we have established are adequate to provide for inherent losses in our portfolio at this time. Although the credit quality of our loan portfolio will most likely have the most significant impact on our financial performance in 2009, we believe the recent steps we have taken with regards to our auto loan portfolio will reduce the credit risk in our consumer portfolio. Additionally, in 2008, we curtailed certain commercial lending related to the homebuilding industry which we believe will reduce the risk in our commercial loan portfolio.
The disruption in the residential real estate market also had a significant impact on Fannie Mae (FNMA) and Freddie Mac (FHLMC). On September 7, 2008 the U.S. Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) announced that the FHFA was putting Fannie Mae and Freddie Mac under conservatorship and giving management control to their regulator, the FHFA. In connection with this action, the dividends on our preferred shares were eliminated thereby significantly reducing the value of this investment which resulted in an other than temporary impairment charge we recorded in the third quarter of 2008 of $575 million.
The deteriorating economic conditions also have significantly impacted the fair value of certain non-agency mortgage backed securities. The collateral for these securities consists of residential loans originated by a diverse group of private label issuers. For the period ended December 31, 2008, it was concluded that the Company would not recover all of its outstanding principal on five bonds in our non-agency mortgage backed portfolio with a book value of $654.3 million whose fair value was $346.4 million. This resulted in a $307.9 million other than temporary impairment charge.
Sovereign also has an equity method investment in a multi-family loan broker that was determined to be impaired at December 31, 2008. This broker refers borrowers seeking financing of their multi-family and/or commercial real estate loans to Sovereign as well as other financial institutions. Substantially all of Sovereign’s multi-family loan originations are obtained through this relationship. Although this broker remained profitable in 2008, their earnings have declined from recent periods due to the current economic slowdown. Additionally, we believe earnings in future periods will remain under pressure due to the current recessionary environment. As a result, it was concluded that the fair value of this equity method investment was significantly below its carrying value and as a result recorded an impairment charge of $95 million which was recorded in “Minority interest expense and equity method investments” on the Consolidated Statement of Operations.
RECENT INDUSTRY CONSOLIDATION IN OUR GEOGRAPHIC FOOTPRINT
The banking industry has experienced significant consolidation in recent years, which is likely to continue in future periods. Consolidation may affect the markets in which Sovereign operates as new or restructured competitors integrate acquired businesses, adopt new business practices or change product pricing as they attempt to maintain or grow market share. Recent merger activity involving national, regional and community banks and specialty finance companies in the Northeastern United States, have affected the competitive landscape in the markets we serve. Management continually monitors the environment in which it operates to assess the impact of the industry consolidation on Sovereign, as well as the practices and strategies of our competitors, including loan and deposit pricing, customer expectations and the capital markets.
On January 30, 2009, the Company was acquired by Santander. We believe that the acquisition of the Company by Santander will further strengthen our financial position and enable us to continue to execute our strategy of focusing on our core retail and commercial customers in our geographic footprint.
CURRENT INTEREST RATE ENVIRONMENT
Net interest income represents a significant portion of the Company’s revenues. Accordingly, the interest rate environment has a substantial impact on Sovereign’s earnings. During the third quarter of 2008, we shortened the duration of our investment portfolio in order to mitigate the impact of interest rate changes on the market value of our balance sheet. Sovereign sold $4.2 billion of longer duration mortgage backed securities and $0.5 billion of longer duration municipal securities for a gain of $29.5 million. We reinvested $3.5 billion of these securities in shorter duration agency securities. Although this transaction reduces the risk of adverse market value changes in our available for sale investment portfolio due to changes in interest rates, this action, along with the elimination of the dividends received on our Fannie Mae and Freddie Mac preferred shares and FHLB stock reduced our net interest income in the fourth quarter and will continue to do so in future periods. Net interest margin in future periods will also be impacted by several factors such as but not limited to, our ability to grow and retain core deposits, the future interest rate environment, loan and investment prepayment rates and levels of non-accrual loans. See our discussion of Asset and Liability Management practices in a later section of this MD&A, including the estimated impact of changes in interest rates on Sovereign’s net interest income.
CREDIT RISK ENVIRONMENT
The credit quality of our loan portfolio had a significant impact on our operating results for 2008. We have experienced deterioration in certain key credit quality performance indicators in 2008. We had charge-offs of $477.1 million in 2008 compared to $143.8 million in 2007. Our provision for credit losses was $911.0 million in 2008 compared to $407.7 million in 2007. The increases were driven by deterioration in our consumer and commercial portfolios.
During 2007, Sovereign expanded its indirect auto loan portfolio into the Southeastern and Southwestern United States (“out-of-market loans”). Sovereign originated $2.8 billion of out-of-market loans in 2007 at a weighted average yield of 8.04%. Effective January 31, 2008, Sovereign ceased originating new auto loans from these markets. We also strengthened our underwriting standards in the second half of 2007 on our entire auto loan portfolio. However, losses remained elevated on these portfolios in 2008 as the newly originated loans continue to season and the US economy entered into a recession. Sovereign decided to exit its in footprint indirect auto portfolio and ceased originating these loans in January 2009. For the twelve-month period ended December 31, 2008, net losses on our auto loan portfolio were $175.7 million compared to $76.2 million for the twelve months ending December 31, 2007. Continued deterioration in the economy of the regions where we extended these loans could have a significant adverse impact on the amount of credit losses we experience in future periods. At December 31, 2008, our total auto loan portfolio was $5.3 billion of which $1.8 billion consisted of loans originated in the Southeast and Southwest production offices. At December 31, 2008 our total allowance for loan losses for the auto portfolio was $140.0 million.
As discussed previously, conditions in the housing market significantly impacted various areas of our business. Certain segments of our consumer and commercial loan portfolios have exposure to the housing market. Sovereign has residential real estate loans totaling $11.4 billion at December 31, 2008 of which $2.7 billion is comprised of Alt-A residential loans. Residential loan losses have been increasing since the prior year and actual credit losses on these loans totaled $26.2 million in 2008 compared to $7.5 million in the prior year. Non-performing assets and past due loans have been increasing particularly for the Alt-A portion of the residential portfolio. The increased loss experience and asset quality trends led us to increase our reserves for our residential portfolio. Future losses in our residential loan portfolio will continue to be significantly influenced by home prices in the residential real estate market, unemployment and general economic conditions.
The homebuilder industry also has been impacted by a decline in new home sales and a reduction in the value of residential real estate which has decreased the profitability and liquidity of these companies. Declines in real estate prices in 2008 and 2007 have been the most pronounced in certain states where previous increases were the largest, such as California, Florida and Nevada. Additionally, foreclosures have increased sharply in various other areas due to increasing levels of unemployment. Sovereign provided financing to various homebuilder companies which is included in our commercial loan portfolio. The Company has been working on de-emphasizing this loan portfolio during 2008 which has resulted in it declining to $0.8 billion at December 31, 2008 compared to $1.1 billion a year ago. Approximately eighty five percent of these loans at December 31, 2008 are to builders in our geographic footprint which generally have had more stable economic conditions on a relative basis compared to the national economy. We continue to monitor this portfolio in future periods given recent market conditions and determine the impact, if any, on the allowance for loan losses related to these homebuilder loans.
Sovereign also has $6.5 billion of home equity loans and lines of credit (excluding our correspondent home equity loans). Net charge-offs on these loans for the twelve-month period ended December 31, 2008 was $21.1 million compared with $8.1 million for the corresponding period in the prior year. This portfolio consists of loans with an average FICO at origination of 777 and an average loan to value of 58%. We have total reserves of $39.1 million for this loan portfolio at December 31, 2008.
During 2008, we have continued to experience increases in non-performing assets in our commercial lending and commercial real estate portfolios as a result of worsening credit and economic conditions. Non-performing assets for these portfolios increased to $244.8 million and $319.6 million at December 31, 2008 from $85.4 million and $61.8 million at December 31, 2007. Charge-offs on these portfolios were $169.0 million and $32.8 million in 2008 compared to $34.9 million and $15.5 million in 2007. Given these changes, we increased our allowance for loan losses for these portfolios by approximately $222.8 million and $80.9 million during 2008. This increase was a significant component of our provision for credit losses of $911 million for the twelve-month period ended December 31, 2008. We expect that the difficult housing environment as well as deteriorating economic conditions will continue to impact our commercial lending and commercial real estate portfolios which may result in elevated levels of provisions for credit losses in future periods.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
The major factors affecting comparison of earnings and diluted earnings per share between 2008 and 2007 were:
Net Interest Income. Net interest income for 2008 was $1.90 billion compared to $1.86 billion for 2007, or an increase of 2.1%. The increase in net interest income in 2008 was due to the reduction in market rates which reduced our deposit and borrowing costs in excess of reductions in yields on earning assets since we are liability sensitive.
Interest on investment securities and interest-earning deposits was $584 million for 2008 compared to $792 million for 2007. In connection with management’s plan that was announced at the end of 2006, Sovereign has been focused on reducing the size of its investment portfolio as a percentage of total assets. Our average investment portfolio declined by $2.5 billion during 2008 to 14.9% of our total average assets in 2008 compared to 17% in 2007. Additionally, the Company has been working on reducing the duration of its investment portfolio to reduce interest rate risk. The average life of our investment portfolio has declined to 4.62 years at December 31, 2008 compared to 5.24 years at December 31, 2007. Reducing the average life of our investment portfolio has negatively impacted the overall yield on this asset class; however, it reduces the impact that changes in interest rates have on the market value of our balance sheet.
Interest on loans was $3.34 billion and $3.86 billion for 2008 and 2007, respectively. The average balance of loans was $57.5 billion with an average yield of 5.84% for 2008 compared to an average balance of $58.0 billion with an average yield of 6.69% for 2007. The decrease in average yields year to year is due primarily to decreased yields on our commercial loan portfolios which is due to decreases in the one-month and three-month LIBOR rates throughout 2008. At December 31, 2008, approximately 31% of our total loan portfolio reprices monthly or more frequently.
Interest on total deposits was $952 million for 2008 compared to $1.63 billion for 2007. The average balance of deposits was $40.3 billion with an average cost of 2.36% for 2008 compared to an average balance of $44.4 billion with an average cost of 3.67% for 2007. Additionally, the average balance of non-interest bearing deposits increased to $6.5 billion in 2008 from $6.4 billion in 2007. The decrease in interest expense is due to the impact of Fed rate cuts in 2008. The decrease in the average balance of deposits was primarily due to a decision to de-emphasize non-core wholesale deposits.
Interest on borrowings and other debt obligations was $1.07 billion for 2008 compared to $1.16 billion for 2007. The average balance of total borrowings and other debt obligations was $22.7 billion with an average cost of 4.70% for 2008 compared to an average balance of $22.2 billion with an average cost of 5.24% for 2007. The decrease in the cost of funds on borrowings and other debt obligations resulted principally from the lower rates on short-term sources of funding including repurchase agreements and overnight FHLB advances due to an increase in short-term interest rates. Part of the increase in average balances is the result of the issuance of $1.6 billion of senior unsecured debt in December 2008 under the FDIC’s Temporary Liquidity Guarantee Program (“TLG Program”), which consisted of $1.35 billion in 3 year fixed rate unsecured notes at 2.75% issued by the Bank and $250 million in 3.5 year fixed rate senior unsecured notes at 2.5% issued by Sovereign. This debt is backed by the full faith and credit worthiness of the U.S. government. In order to obtain this guarantee, an upfront payment of $41.5 million and $8.7 million was made to the FDIC. These amounts were deferred and are being amortized over the contractual life of the debt. This cost, along with other transaction costs and a slight discount on the issuance of these notes results in these borrowings having an effective rate of 3.92% and 3.73%, respectively.
Table 1 presents a summary on a tax equivalent basis of Sovereign’s average balances, the yields earned on average assets and the cost of average liabilities for the years indicated (in thousands):
Table 1: Net Interest Margin
Table 2 presents, on a tax equivalent basis, the relative contribution of changes in volumes and in rates to changes in net interest income for the periods indicated. The change in interest income not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):
Table 2: Volume/Rate Analysis
(1)
Includes non-accrual loans and loans held for sale.
Provision for Credit Losses. The provision for credit losses is based upon actual credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimation of losses inherent in the current loan portfolio. The provision for credit losses for 2008 was $911.0 million compared to $407.7 million for 2007. The provision in 2008 was impacted by the following items discussed below.
During 2008, we have continued to experience increases in non-performing assets in our commercial lending and commercial real estate portfolios. Non-performing assets for these portfolios increased to $244.8 million and $319.6 million at December 31, 2008 from $85.4 million and $61.8 million at December 31, 2007. Charge-offs on these portfolios were $169.0 million and $32.8 million in 2008 compared to $34.9 million and $15.5 million in 2007. Given these changes, we increased our allowance for loan losses for these portfolios by approximately $222.8 million and $80.9 million during 2008. This increase was a significant component of our provision for credit losses of $911 million for the twelve-month period ended December 31, 2008. A large portion of these increases is tied to companies that are in housing related industries. We have decreased the amount of loan originations to these borrower types in 2008; however, we expect that the difficult housing environment as well as deteriorating economic conditions will continue to impact our commercial lending and commercial real estate portfolios which may result in elevated levels of provisions for credit losses in future periods.
It was determined during 2008 that the U.S. economy entered into a recession in December 2007. When we established our allowance for loan loss at the end of 2007 we anticipated that economic conditions would continue to weaken. However, the contraction in the U.S. economy in the latter half of 2008 has been at a pace not seen in approximately 30 years. This harsh environment further depressed asset values and led to increases in unemployment which are anticipated to continue into 2009. Net charge offs increased substantially in 2008 to $477.1 million from $143.8 million. Given the current and anticipated economic weakness, Sovereign increased its provision for credit losses by $503 million from the prior year. Our allowance for credit losses to total loans coverage ratio now stands at 2.10% which is a historically high level for the company. Further instability in residential real estate prices and increases in unemployment particularly within our geographic footprint may lead to continued elevated levels of provisions for credit losses in future periods.
Our provision for credit losses in 2007 was impacted by the following items discussed below.
During 2007, Sovereign’s outstanding auto loan portfolio increased from $4.8 billion at December 31, 2006 to $7.0 billion at December 31, 2007. The majority of this growth was obtained through the Southwest and Southeast production offices, which had total originations of $2.8 billion in 2007. The average yield on this portfolio was 8.04%, compared to 7.61% on our 2007 loan originations within our geographic footprint. Although credit losses were expected to be higher in the Southeast and Southwest, we saw an increase in losses during the second half of 2007 in excess of what was expected. Management decided to cease originations in the Southeast and Southwest auto lending business effective January 31, 2008 as a result of the low profitability on these loans. We increased the overall allowance for loan loss on the auto loan portfolio by $85 million during the second half of 2007 to provide for additional credit losses anticipated to be incurred on our auto loan portfolio.
In 2007, Sovereign recorded $50.5 million of additional reserves to cover higher expected losses on the correspondent home equity portfolio that was not sold due to adverse market conditions in the housing market. In 2007, Sovereign also experienced further deterioration in the credit quality of certain commercial loans due to weakening market conditions. As a result of market conditions, an increase in criticized and non-accrual loans and growth of $2 billion in our commercial real estate loans and commercial industrial loans, Sovereign increased the provision for credit losses by approximately $59 million for our commercial portfolio.
Finally, weakening credit conditions increased charge-offs in 2007 by $48.1 million (after removing the impact our correspondent home equity loan portfolio had on credit losses in 2006). The majority of our loan portfolios had higher loss rates in the current year compared to the prior year. This necessitated Sovereign to increase its credit reserves in 2007 to provide for the increased inherent credit risk in our loan portfolio.
The ratio of net loan charge-offs to average loans, including loans held for sale, was 0.83% for 2008, compared to 0.25% for 2007. The consumer loans secured by real estate net charge-off rate was 0.36% for 2008, compared to 0.07% for 2007. The consumer loans not secured by real estate (primarily auto loans) net charge-off rate was 2.80% for 2008 and 1.19% for 2007. Commercial loan net charge-offs as a percentage of average commercial loans were 0.70% for 2008, compared to 0.20% for 2007. Charge-off trends for our entire portfolio have been increasing throughout 2008 and were 1.32% in the fourth quarter.
Table 3 presents the activity in the allowance for credit losses for the years indicated (in thousands):
Table 3: Reconciliation of the Allowance for Credit Losses
(1)
The 2006 consumer secured by real estate charge-offs included $389.6 million of charge-offs or 71 basis points related to the lower of cost or market valuation adjustment recorded for the correspondent home equity loans ($382.5 million) and purchased residential mortgage loans ($7.1 million) that were classified as held for sale at December 31, 2006.
(2)
The provision for credit losses on the consolidated statement of operations consists of the sum of the provision for loan losses and the provision for unfunded lending commitments.
(3)
The reserve for unfunded commitments is classified in other liabilities on the consolidated balance sheet.
See Note 1 for Sovereign’s charge-off policy with respect to its various loan types.
Non-interest Income/(Loss). Total non-interest income/(loss) was $(818.7) million for 2008 compared to $354.4 million for 2007. Several factors contributed to this change as discussed below.
Consumer banking fees were $312.6 million for 2008 compared to $295.8 million in 2007. This increase was primarily due to an increase of $15.2 million in deposit fees as we were able to implement certain pricing changes and reduced the amount of fee waivers granted to our customers. Commercial banking fees were $213.9 million for 2008 compared to $202.3 million in 2007. This increase of 5.8% was due to growth in average commercial loans which increased 8.2% in 2008.
Mortgage banking results consist of fees associated with servicing loans not held by Sovereign, as well as amortization and changes in the fair value of mortgage servicing rights. Mortgage banking results also include gains or losses on the sales of mortgage, home equity loans and lines of credit and multi-family loans and mortgage-backed securities that were related to loans originated or purchased and held by Sovereign, as well as gains or losses on mortgage banking derivative and hedging transactions. Mortgage banking revenues had a net loss of $13.2 million for 2008 compared to a net loss of $67.8 million for 2007. The 2008 net loss was driven by a residential mortgage servicing rights impairment charge due to increased prepayment speed assumptions at year end from lower market interest rates. The 2007 net loss was due to charges related to the sale of our correspondent home equity portfolio. The table below summarizes the components of net mortgage banking revenues (in thousands):
During 2008, Sovereign sold $2.6 billion of multi-family loans and recorded gains of $1.1 million in connection with the sales compared to $3.7 billion of multi-family loans and related gains of $26.2 million in 2007. Current year results were negatively impacted by increases to recourse reserve levels of $19.7 million in the latter half of the year. In 2008 and 2007, Sovereign sold $3.2 billion and $3.1 billion of mortgage loans and recorded gains of $19.0 million and $18.3 million, respectively.
In 2007, Sovereign securitized $687.7 million and $327.0 million of multi-family and commercial real estate loans, respectively and retained certain subordinated certificates in this transaction. In connection with the $1.0 billion securitization, Sovereign recorded a net gain of $10.5 million. This gain was determined based on the carrying amount of the loans sold, including any related allowance for loan loss, and was allocated to the loans sold and the retained interests, based on their relative fair values at the sale date. Additionally, Sovereign recorded hedge losses of $7.8 million during 2007 related to certain multi-family and commercial real estate loans held for sale.
At December 31, 2008, Sovereign serviced approximately $13.1 billion of residential mortgage loans for others and our net mortgage servicing asset was $112.5 million, compared to $11.2 billion of loans serviced for others and a net residential mortgage servicing asset of $141.1 million, at December 31, 2007. The most important assumptions in the valuation of mortgage servicing rights are anticipated loan prepayment rates (CPR speed) and the positive spread we receive on holding escrow related balances. Increases in prepayment speeds (which are generally driven by lower long term interest rates) result in lower valuations of mortgage servicing rights, while lower prepayment speeds result in higher valuations. The escrow related credit spread is the estimated reinvestment yield earned on the serviced loan escrow deposits. Increases in escrow related credit spreads result in higher valuations of mortgage servicing rights while lower spreads result in lower valuations. For each of these items, Sovereign must make assumptions based on future expectations. All of the assumptions are based on standards that we believe would be utilized by market participants in valuing mortgage servicing rights and are consistently derived and/or benchmarked against independent public sources. Additionally, an independent appraisal of the fair value of our mortgage servicing rights is obtained at least annually and is used by management to evaluate the reasonableness of our discounted cash flow model. For 2008, Sovereign recorded mortgage servicing right impairment charges of $47.3 million due to an increase in prepayment speed assumptions and changes in interest rates compared to impairment charges of $1.4 million in 2007.
Listed below are the most significant assumptions that were utilized by Sovereign in its evaluation of mortgage servicing rights for the periods presented.
Sovereign will periodically sell qualifying mortgage loans to FHLMC, GNMA, and FNMA in return for mortgage-backed securities issued by those agencies. Sovereign reclassifies the net book balance of the loans sold to such agencies from loans to investment securities available for sale. For those loans sold to the agencies in which Sovereign retains servicing rights, Sovereign allocates the net book balance transferred between servicing rights and investment securities based on their relative fair values. If Sovereign sells the mortgage-backed securities which relate to underlying loans previously held by the Company, the gain or loss on the sale is recorded in mortgage banking income in the accompanying consolidated statement of operations.
The gain or loss on the sale of all other mortgage-backed securities is recorded in gains on sales of investment securities on the consolidated statement of operations.
Sovereign originates and sells multi-family loans in the secondary market to Fannie Mae while retaining servicing. Under the terms of the sales program with Fannie Mae, we retain a portion of the credit risk associated with such loans. As a result of this agreement with Fannie Mae, Sovereign retains a 100% first loss position on each multi-family loan sold to Fannie Mae under such program until the earlier to occur of (i) the aggregate losses on the multi-family loans sold to Fannie Mae reaching the maximum loss exposure for the portfolio as a whole ($249.8 million as of December 31, 2008) or (ii) until all of the loans sold to Fannie Mae under this program are fully paid off. The maximum loss exposure is available to satisfy any losses on loans sold in the program subject to the foregoing limitations.
The Company has established a liability which represents the fair value of the retained credit exposure. This liability represents the amount that the Company estimates that it would have to pay a third party to assume the retained recourse obligation. The estimated liability represents the present value of the estimated losses that the portfolio is projected to incur based upon an industry-based default curve with a range of estimated losses. At December 31, 2008, Sovereign had a $38.3 million liability related to the fair value of the retained credit exposure for loans sold to Fannie Mae under this sales program.
At December 31, 2008 and December 31, 2007, Sovereign serviced $13.0 billion and $10.9 billion, respectively, of loans for Fannie Mae that had been sold to Fannie Mae pursuant to this program with a maximum potential loss exposure of $249.8 million and $206.8 million, respectively. As a result of retaining servicing, the Company had loan servicing assets of $14.7 million and $20.4 million at December 31, 2008 and 2007, respectively. Sovereign recorded servicing asset amortization of $7.7 million and $10.7 million related to the multi-family loans sold to Fannie Mae for 2008 and recognized servicing assets of $5.7 million.
Capital markets revenues increased to $23.8 million for 2008 compared to a net loss of $19.3 million in 2007. In 2007, we recorded charges of $46.9 million within capital markets revenue related to losses on repurchase agreements and other financing obligations that Sovereign provided to a number of mortgage companies who declared bankruptcy and/or defaulted on their agreements. These mortgage companies were impacted by adverse developments in the non-prime sector. The repurchase agreements and other financing obligations were secured by rated and non-rated investment securities and/or mortgage loans. The charge Sovereign recorded on the repurchase agreements and other financing obligations was necessary since the value of the underlying collateral was less than the outstanding amount of the repurchase agreement.
Income related to bank owned life insurance decreased to $76.0 million for 2008 compared to $85.9 million in 2007. This $9.9 million, or 11.5% decrease, was due to decreased death benefits in 2008 as well as lower interest rates received on our insurance policies.
Net losses on investment securities were $1.5 billion for 2008, compared to $176.4 million for 2007. Included in 2008 was an other-than-temporary impairment charge of $575 million on FNMA and FHLMC preferred stock, an other-than-temporary impairment charge of $308 million on certain non-agency mortgage backed securities and a $602 million loss on the sale of our CDO portfolio. On September 7, 2008, the U.S. Department of the Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) announced that the FHFA was putting Fannie Mae and Freddie Mac under conservatorship and giving management control to their regulator, the FHFA. In connection with this action, the dividends on our preferred shares were eliminated thereby significantly reducing the value of our investment. During the third quarter of 2008, Sovereign, in order to reduce risk in its investment portfolio, decided to sell its entire CDO portfolio. This portfolio had experienced significant volatility over the past year as a result of conditions in the credit markets. Finally, in the fourth quarter of 2008, it was determined that a principal loss on certain non-agency mortgage backed securities was likely which resulted in an other than temporary impairment charge. See Note 6 for further discussion and analysis of our determination that the unrealized losses in the investment portfolio at December 31, 2008 were considered temporary. In the first quarter of 2008, we recorded net cash proceeds of $14.1 million on the mandatory redemption of approximately half of our Visa Initial Public Offering (IPO) shares. Our remaining Visa shares are required to be held for 3 years pending settlement of other possible litigation that Visa and its member banks are exposed to. These shares are required to be valued at their historical cost of $0. In March 2011, we will no longer have any restrictions on these shares.
General and Administrative Expenses. Total general and administrative expenses were $1.54 billion for 2008 compared to $1.35 billion in 2007, or an increase of 14.5%. The increase in 2008 is primarily related to increases of $101.4 million, $28.5 million and $22.9 million in compensation and benefits, deposit insurance premiums and marketing expenses, respectively. Compensation costs were negatively impacted by severance charges of $25.8 million. Deposit insurance premiums were negatively impacted by increased assessments from the FDIC to replenish the agencies insurance reserve fund and marketing costs were higher than the prior year for deposit gathering initiatives throughout 2008 as well as adverting associated with the Santander acquisition of Sovereign. At December 31, 2008, Sovereign had total employees of 11,634 compared to 11,976 in 2007, a 2.8% decrease. Sovereign’s efficiency ratio, (all general and administrative expenses as a percentage of net interest income and total fees and other income) for 2008 was 60.7% compared to 56.2% for 2007.
Other Expenses. Total other expenses were $265.8 million for 2008 compared to $1.9 billion for 2007. In 2007, we recorded a $1.58 billion goodwill impairment charge related to the Company’s Metro New York and Consumer reporting units. See Note 4 for details on this impairment charge. Other expenses included amortization expense of core deposit intangibles of $103.6 million for 2008 compared to $126.7 million for 2007. This decrease is due to decreased core deposit intangible amortization expense on previous acquisitions. In 2008, Sovereign recorded legal and investment advisory fees of $12.8 million related to Santander’s acquisition of Sovereign. Additionally, in 2008, Sovereign recorded a $95 million charge related to an equity method investment as it was determined that this investment’s fair value was significantly below its cost. In 2007, Sovereign recorded restructuring charges of $62.0 million which was associated with executive and other employee severance arrangements and other restructuring charges activities. See Note 29 for details on these charges.
During 2007, Sovereign’s executive management team and Board of Directors decided to freeze the Company’s Employee Stock Ownership Plan (ESOP). The debt owed by the ESOP was repaid with the proceeds from the sale of a portion of the unallocated shares held by the ESOP and all remaining shares were allocated to the eligible participants. Sovereign recorded a non-deductible, non-cash charge of $40.1 million during 2007 based on the value of its common stock on the date that the ESOP was repaid.
Other expense related to equity method investments includes an investment that Sovereign has in a synthetic fuel partnership that generates Section 29 tax credits for the production of fuel from a non-conventional source (“the Synthetic Fuel Partnership”). Reductions in the investment value and our allocation of the partnership’s earnings or losses totaled $26.2 million for 2007 and is included as expense in the line “Minority interest expense and equity method investment expense” in our consolidated statement of operations, while the alternative energy tax credits we received were included as a reduction of income tax expense. This investment matured at the end of 2007; therefore, Sovereign did not incur any expenses or receive any tax credits related to the Synthetic Fuel Partnership in 2008.
Income Tax Expense/(Benefit). Sovereign recorded a provision of $723.6 million for 2008 compared to a benefit of $60.5 million for 2007. The effective tax rate for 2008 was 44.3% compared to (4.3)% for 2007. Current year provision levels were negatively impacted by the previously discussed valuation allowance on deferred taxes. See Note 18 for a reconciliation of our effective tax rate to the statutory federal rate of 35%.
Sovereign is subject to the income tax laws of the U.S., its states and municipalities and certain foreign countries. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws.
Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) recently examined the Company’s federal income tax returns for the years 2002 through 2005. The IRS completed this review in 2008. Included in this examination cycle are two separate financing transactions with an international bank totaling $1.2 billion. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006 and 2007, Sovereign was subject to an additional $87.6 million and $22.5 million, respectively, of foreign taxes related to these financing transactions and claimed a corresponding foreign tax credit. The IRS issued a notification of adjustment disallowing the foreign tax credits taken in 2003-2005 in the amount of $154.0 million related to these transactions;
disallowing deductions for issuance costs and interest expense related to the transaction which would result in an additional tax liability of $24.9 million; and assessed
interest and penalties, the combined amount of which totaled approximately $71.0 million. In addition, the IRS has commenced its audit for the years 2006 and 2007. We expect that in the future the IRS will propose to disallow the foreign tax credits taken in 2006 and 2007 of $87.6 million and $22.5 million, respectively; disallow deductions for issuance costs and interest expense which would result in an additional tax liability of $37.1 million; and to assess interest and penalties. Sovereign expects that it will need to litigate this matter with the IRS. Sovereign continues to believe that it is entitled to claim these foreign tax credits and deductions and also believes that its recorded tax reserves for this position of $58.3 million adequately provides for any potential exposure to the IRS related to this item and other tax assessments. However, as the Company continues to go through the IRS administrative process, and if necessary litigation, we will continue to evaluate the appropriate tax reserve levels for this position and any changes made to the tax reserves may materially affect Sovereign’s income tax provision, net income and regulatory capital in future periods.
Line of Business Results. Segment results are derived from the Company’s business unit profitability reporting system by specifically attributing managed balance sheet assets, deposits and other liabilities and their related interest income or expense. Funds transfer pricing methodologies are utilized to allocate a cost for funds used or a credit for funds provided to business line deposits, loans and selected other assets using a matched funding concept. The provision for credit losses recorded by each segment is based on the net charge-offs of each line of business. The difference between the provision for credit losses recognized by the Company on a consolidated basis and the provision recorded by the business lines at the time of charge-off is allocated to each business line based on a risk profile of their loan portfolio. Other income and expenses directly managed by each business line, including fees, service charges, salaries and benefits, and other direct expenses as well as certain allocated corporate expenses are accounted for within each segment’s financial results. Where practical, the results are adjusted to present consistent methodologies for the segments. Accounting policies for the lines of business are the same as those used in preparation of the consolidated financial statements with respect to activities specifically attributable to each business line. However, the preparation of business line results requires management to establish methodologies to allocate funding costs and benefits, expenses and other financial elements to each line of business.
During the first quarter of 2008, as previously discussed in our 2008 first quarter Form 10-Q, certain changes to our executive management were announced such as the hiring of a new head of Retail Banking and a new Chief Financial Officer. In addition, we centralized the responsibility for the major businesses within the Company naming a new head of Retail, Commercial Lending, Corporate Specialty Businesses and Corporate Support Services. The head of these business units report directly to the Chief Executive Officer and, along with our Chief Financial Officer and Chief Risk Officer, comprise the Executive Management Group. These events changed how our executive management team measures and assesses business performance. During the second quarter we finalized the process of updating our business unit profitability system to reflect our new organizational structure.
As a result of the changes discussed above, Sovereign now has four reportable segments. The Company’s segments are focused principally around the customers Sovereign serves. The Retail Banking Division is primarily comprised of our branch locations. Our branches offer a wide range of products and services to customers and each attracts deposits by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposits and retirement savings plans. Our branches also offer certain consumer loans such as home equity loans and other consumer loan products. The Corporate Specialties Group segment is primarily comprised of mortgage banking, multi-family and national commercial real estate lending, automobile dealer floor plan lending group and indirect automobile lending. It also provides capital market services and cash management services to our customers. The Commercial Lending segment provides the majority of Sovereign’s commercial lending platforms such as commercial real estate loans, commercial industrial loans, leases to commercial customers and small business loans. The Other segment includes earnings from the investment portfolio, interest expense on Sovereign’s borrowings and other debt obligations, minority interest expense, amortization of intangible assets and certain unallocated corporate income and expenses. For additional discussion of these business lines and the Company’s related accounting policies, see Note 27 of the Notes to the Consolidated Financial Statements.
The Retail Banking Division’s net interest income decreased $183.2 million to $1.04 billion in 2008. The decrease in net interest income was principally due to margin compression on a matched funded basis due to the recent Federal Reserve interest rate cuts which have reduced the spreads that our Retail Banking Division receives on their deposits. The net spread on a match funded basis for this segment was 2.23% in 2008 compared to 2.61% in 2007. The average balance of Retail Banking Division’s loans was $6.5 billion and $5.7 billion during 2008 and 2007, respectively. The average balance of deposits was $41.1 billion in 2008 compared to $42.2 billion in 2007. The provision for credit losses increased in 2008 to $93.4 million from $33.6 million in 2007 due to increased net loan charge-offs in 2008. General and administrative expenses (including allocated corporate and direct support costs) increased from $1.07 billion for 2007 to $1.10 billion for 2008. The increase in general and administrative expenses is due to increased marketing and deposit insurance premiums of $21.2 million and $26.4 million, respectively. The increase in deposit insurance premiums was due to the FDIC assessments on deposits that began in 2008 and the increase in marketing costs was related to the roll out of our “Customer First” initiative in the first half of 2008 as well as targeted campaigns in the fourth quarter of 2008 to reclaim deposits lost at the end of the third quarter.
The Corporate Specialty Group segment net interest income decreased $54.2 million to $385.1 million in 2008. The decrease in net interest income was principally due to the reduction in our loan portfolio. The net spread on a match funded basis for this segment was 1.31% in 2008 compared to 1.36% in 2007. The average balance of Corporate Specialty Group loans was $28.5 billion and $31.8 billion during 2008 and 2007, respectively. The average balance of deposits was $1.5 billion in 2008 compared to $1.4 billion in 2007. The increase in fees and other income of $80.7 million to $39.4 million for 2008 was primarily generated by increased mortgage banking revenues which was primarily due to the previously mentioned charge of $119.9 million on our correspondent home equity loan portfolio in 2007. The provision for credit losses increased in 2008 to $403.5 million from $253.0 million in 2007 due primarily to a higher level of losses on our indirect auto portfolio particularly related to out-of-market auto loans. Credit losses in this segment were much higher than anticipated due primarily to auto loans that were originated by our Southeast and Southwest production offices. General and administrative expenses (including allocated corporate and direct support costs) increased from $172.5 million for 2007 to $183.0 million for 2008. The net loss before income taxes for the Corporate Specialty Group segment decreased from a loss of $662.0 million in 2007 to a loss of $182.2 million in 2008 due to the $634 million goodwill impairment charge attributable to this segment in 2007.
The Commercial Lending segment net interest income increased $88.4 million to $520.1 million for 2008 compared to 2007 due to growth in our commercial loan portfolios due to our emphasis on this asset class and a de-emphasis on wholesale residential loans, investment securities and other lower yielding asset classes. The average balance of Commercial Lending segment loans was $22.3 billion in 2008 versus $20.4 billion during 2007. The net spread on a match funded basis for this segment was 2.36% in 2008 compared to 2.25% in 2007. Fees and other income have decreased by $3.8 million to $121.9 million principally due to decreased precious metals commercial banking fee income. The provision for credit losses increased by $292.9 million in 2008 to $414.1 million due to higher levels of commercial charge-offs in 2008 which was due to an increase in criticized assets, primarily in the construction lending, commercial real estate and commercial industrial lending portfolios. General and administrative expenses (including allocated corporate and direct support costs) increased from $182.7 million for 2007 to $211.7 million in 2008 due to increased salaries and bonuses related to the increased workforce to support the increase in commercial loans.
The net loss before income taxes for the Other segment increased from $522.2 million in 2007 to $1.7 billion in 2008. Net interest expense decreased from $230.0 million in 2007 to $41.6 million for 2008. The Other segment includes net losses on securities of $1.5 billion and $176.3 million in 2008 and 2007, respectively. The 2008 loss resulted from the previously discussed $602 million loss on the sale of our CDO portfolio, $308 million other-than-temporary impairment charge on non-agency mortgage backed securities and $575 million other-than-temporary impairment charge on FNMA and FHLMC preferred stock. The 2007 loss resulted from the previously discussed $180.5 million other-than-temporary impairment charge on FNMA and FHLMC preferred stock. The 2008 and 2007 results included charges associated with executive and other employee severance arrangements and certain other restructuring activities of $23.4 million and $62.0 million, respectively. Finally, the Other segment included $0 and $26.2 million of expense associated with the Synthetic Fuel Partnership in 2007 compared to none in 2008, a deferred tax asset valuation allowance of $1.43 billion and a $95 million impairment charge related to our equity method investments. The 2008 and 2007 results included amortization of intangibles of $103.6 million and $126.7 million, respectively.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2007 AND 2006
The major factors affecting comparison of earnings and diluted earnings per share between 2007 and 2006 were:
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Net interest income increased 2% during 2007 due to the full year impact of the Independence acquisition as well as organic balance sheet growth, which was offset by the impact of our balance sheet restructuring in the first quarter of 2007.
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Included in non-interest income:
Net Interest Income. Net interest income for 2007 was $1.86 billion compared to $1.82 billion for 2006, or an increase of 2.3%. The increase in net interest income in 2007 was due to an increase in average interest-earning assets of $2.3 billion, which was related to the full year impact of the 2006 Independence acquisition and organic loan growth primarily in the commercial and auto portfolios offset by our balance sheet restructuring that was completed in the first quarter of 2007 in which we sold approximately $8.0 billion of low margin and/or high risk assets to reduce higher cost wholesale liabilities.
Interest on investment securities and interest-earning deposits was $792 million for 2007 compared to $775 million for 2006. The increase in interest income was due to higher yields in 2007 which averaged 6.15% compared to 5.82% in 2006. The increase in yield was primarily due to a rise in market interest rates and due to the investment restructurings Sovereign executed in the second and fourth quarters of 2006. This increase in yield in 2007 was offset by a decrease in average investments of $420 million during 2007 as a result of a balance sheet restructuring.
Interest on loans was $3.86 billion and $3.55 billion for 2007 and 2006, respectively. The average balance of loans was $58.0 billion with an average yield of 6.69% for 2007 compared to an average balance of $55.2 billion with an average yield of 6.45% for 2006. The overall growth in total loans resulted from the Independence acquisition and from origination activity in commercial and auto loans. The increase in average yields year to year is due primarily to increased yields on our auto loan portfolios. Auto loan yields increased 102 basis points due to the previously mentioned expansion resulting from our Southeast and Southwest production offices. The Southeast and Southwest auto loans totaled $2.6 billion at the end of 2007 compared to $0.4 billion at December 31, 2006. At December 31, 2007, approximately 34% of our total loan portfolio reprices monthly or more frequently.
Interest on total deposits was $1.63 billion for 2007 compared to $1.37 billion for 2006. The average balance of deposits was $44.4 billion with an average cost of 3.67% for 2007 compared to an average balance of $41.2 billion with an average cost of 3.33% for 2006. Additionally, the average balance of non-interest bearing deposits increased to $6.4 billion in 2007 from $6.0 billion in 2006. The increase in the average balance of deposits was due to the acquisition of Independence.
Interest on borrowings and other debt obligations was $1.16 billion for 2007 compared to $1.13 billion for 2006. The average balance of total borrowings and other debt obligations was $22.2 billion with an average cost of 5.24% for 2007 compared to an average balance of $23.4 billion with an average cost of 4.85% for 2006. The increase in the cost of funds on borrowings and other debt obligations resulted principally from the higher rates on short-term sources of funding including repurchase agreements and overnight FHLB advances due to an increase in short-term interest rates. The decrease in average balances is the result of the balance sheet restructuring.
Provision for Credit Losses. The provision for credit losses is based upon actual credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimation of losses inherent in the current loan portfolio. The provision for credit losses for 2007 was $407.7 million compared to $484.5 million for 2006. Our provision for credit losses in 2006 includes the previously mentioned provision of $296.0 million on the transfer of $4.3 billion of correspondent home equity loans to held for sale status at December 31, 2006. See Note 7 for additional details. The provision in 2007 was impacted by the following items discussed below.
During 2007, Sovereign’s outstanding auto loan portfolio increased from $4.8 billion at December 31, 2006 to $7.0 billion at December 31, 2007. The majority of this growth was obtained through the Southwest and Southeast production offices, which had total originations of $2.8 billion in 2007. The average yield on this portfolio was 8.04%, compared to 7.61% on our 2007 loan originations within our geographic footprint. Although credit losses were expected to be higher in the Southeast and Southwest, we saw an increase in losses during the second half of 2007 in excess of what was expected. Management has decided to cease originations in the Southeast and Southwest auto lending business effective January 31, 2008 as a result of the low profitability on these loans. We increased the overall allowance for loan loss on the auto loan portfolio by $85 million during the second half of 2007 to provide for additional credit losses anticipated to be incurred on our auto loan portfolio.
In 2007, Sovereign recorded $50.5 million of additional reserves to cover higher expected losses on the correspondent home equity portfolio that was not sold due to adverse market conditions in the housing market. In 2007, Sovereign also experienced further deterioration in the credit quality of certain commercial loans due to weakening market conditions. As a result of market conditions, an increase in criticized and non-accrual loans and growth of $2 billion in our commercial real estate loans and commercial industrial loans, Sovereign increased the provision for credit losses by approximately $59 million for our commercial portfolio. Although we believe current levels of reserves are adequate to cover the inherent losses for these loans, future changes in housing values, interest rates and economic conditions could impact the provision for credit losses for these loans in future periods.
Finally, weakening credit conditions increased charge-offs in 2007 by $48.1 million (after removing the impact our correspondent home equity loan portfolio had on credit losses in 2006). The majority of our loan portfolios had higher loss rates in the current year compared to the prior year. This necessitated Sovereign to increase its credit reserves in 2007 to provide for the increased inherent credit risk in our loan portfolio.
Non-interest Income. Total non-interest income was $354.4 million for 2007 compared to $285.6 million for 2006. Several factors contributed to this change as discussed below.
Consumer banking fees were $295.8 million for 2007 compared to $276.0 million in 2006. This increase was primarily due to the growth in our investment services business where fees increased $12.0 million from $37.5 million in 2006 to $49.5 million in 2007, as well as the full year impact of the Independence acquisition which closed on June 1, 2006.
Commercial banking fees were $202.3 million for 2007 compared to $179.1 million in 2006. This increase of 13% was due to growth in average commercial loans which increased 22% in 2007 and expanded cash management capabilities and product offerings. Additionally, commercial banking fees were benefited by the full year impact of the Independence acquisition.
Mortgage banking results consist of fees associated with servicing loans not held by Sovereign, as well as amortization and changes in the fair value of mortgage servicing rights. Mortgage banking results also include gains or losses on the sales of mortgage, home equity loans and lines of credit and multi-family loans and mortgage-backed securities that were related to loans originated or purchased and held by Sovereign, as well as gains or losses on mortgage banking derivative and hedging transactions. Mortgage banking derivative instruments include principally interest rate lock commitments and forward sale commitments. Sovereign had a mortgage banking loss of $67.8 million for 2007 compared to net revenues of $24.2 million for 2006. The table below summarizes the components of net mortgage banking revenues (in thousands):
During 2007, Sovereign sold $3.7 billion of multi-family loans and recorded gains of $26.2 million in connection with the sales compared to $1.6 billion of multi-family loans and related gains of $17.8 million for the seven month period in 2006, which began with the acquisition of Independence Community Bank in June of 2006. Sovereign also sold $7.6 billion of mortgage loans with related gains of $2.0 million in 2006. 2006 results were negatively impacted by a charge of $23 million on the decision to sell $2.9 billion of residential loans as part of our balance sheet restructuring. In 2007, Sovereign sold $3.1 billion of mortgage loans and recorded gains of $18.3 million. Mortgage banking revenues declined from the prior year due to the losses on the correspondent home equity portfolio.
In 2007, Sovereign securitized $687.7 million and $327.0 million of multi-family and commercial real estate loans, respectively and retained certain subordinated certificates in this transaction. In connection with the $1.0 billion securitization, Sovereign recorded a net gain of $10.5 million. This gain was determined based on the carrying amount of the loans sold, including any related allowance for loan loss, and was allocated to the loans sold and the retained interests, based on their relative fair values at the sale date. Additionally, Sovereign recorded hedge losses of $7.8 million during 2007 related to certain multi-family and commercial real estate loans held for sale.
Capital markets revenues decreased to a loss of $19.3 million for 2007 compared to net gains of $17.6 million in 2006. In 2007, we recorded charges of $46.9 million within capital markets revenue related to losses on repurchase agreements and other financing obligations that Sovereign provided to a number of mortgage companies who declared bankruptcy and/or defaulted on their agreements. These mortgage companies have been impacted by adverse developments in the non-prime sector. The repurchase agreements and other financing obligations are secured by rated and non-rated investment securities and/or mortgage loans. The charge Sovereign recorded on the repurchase agreements and other financing obligations was necessary since the value of the underlying collateral was less than the outstanding amount of the repurchase agreement.
Income related to bank owned life insurance increased to $85.9 million for 2007 compared to $67.0 million in 2006. This $18.9 million, or 28% increase, was due to the acquisition of Independence, which increased bank owned life insurance assets by $343 million, as well as increased death benefits in 2007.
Net losses on sales of investment securities were $176.4 million for 2007, compared to $312.0 million for 2006. Included in 2007 was an other-than-temporary impairment charge of $180.5 million on FNMA and FHLMC preferred stock. In the fourth quarter of 2007, FNMA and FHLMC announced a number of significant charges which impacted their financial results, and FHLMC and FNMA also announced reductions in their common stock dividends and raised additional capital via preferred stock issuances at rates in excess of what we are receiving on our investments. These events caused the unrealized losses on our FNMA and FHLMC preferred stock portfolio to increase significantly in the fourth quarter to $180.5 million from $9.5 million at September 30, 2007. As a result, we recorded an other-than-temporary impairment charge. Included in 2006 was an investment restructuring charge of $238.3 million and an other-than-temporary impairment charge of $67.5 million on FNMA and FHLMC preferred stock in the second quarter and a $43.0 million loss on the sale of $1.5 billion of available for sale investments as part of the balance sheet restructuring in the fourth quarter of 2006.
General and Administrative Expenses. Total general and administrative expenses were $1.35 billion for 2007 compared to $1.29 billion in 2006, or an increase of 4.7%. The increase in 2007 is primarily related to the full year effect of the Independence acquisition, partially offset by savings associated with our 2007 cost saving initiative. At December 31, 2007, Sovereign had total employees of 11,976 compared to 12,513 in 2006, a 4% decrease. Sovereign’s efficiency ratio, (all general and administrative expenses as a percentage of net interest income and total fees and other income) for 2007 was 56.2% compared to 53.3% for 2006. The increase is primarily due to a reduction in revenue in 2007 compared to 2006 due to the impact of the previously discussed capital market and correspondent home equity charges which negatively impacted fee income.
Other Expenses. Total other expenses were $1.9 billion for 2007 compared to $313.5 million for 2006. In 2007, we recorded a $1.58 billion goodwill impairment charge related to the Company’s Metro New York and Consumer reporting units. See Note 4 for details on this impairment charge. Other expenses included amortization expense of core deposit intangibles of $126.7 million for 2007 compared to $109.8 million for 2006. This increase is due to the full year effect of amortization expense associated with core deposit intangible established in connection with the Independence acquisition. In 2007, net merger-related expenses were $2.2 million, compared to $42.4 million in 2006 which was primarily associated with the Independence acquisition. In 2007, Sovereign recorded restructuring charges of $62.0 million, compared to $78.7 million in 2006 which was associated with executive and other employee severance arrangements and other restructuring charges activities. See Note 29 for details on these charges.
During 2007, Sovereign’s executive management team and Board of Directors decided to freeze the Company’s Employee Stock Ownership Plan (ESOP). The debt owed by the ESOP was repaid with the proceeds from the sale of a portion of the unallocated shares held by the ESOP and all remaining shares were allocated to the eligible participants. Sovereign recorded a non-deductible, non-cash charge of $40.1 million during 2007 based on the value of its common stock on the date that the ESOP was repaid.
Other expense related to equity method investments includes an investment that Sovereign has in a synthetic fuel partnership that generates Section 29 tax credits for the production of fuel from a non-conventional source (“the Synthetic Fuel Partnership”). Reductions in the investment value and our allocation of the partnership’s earnings or losses totaled $26.2 million and $26.3 million for 2007 and 2006, respectively, and are included as expense in the line “Minority interest expense and equity method investment expense” in our consolidated statement of operations, while the alternative energy tax credits we receive are included as a reduction of income tax expense. This investment matured at the end of 2007; therefore, Sovereign will not incur any expenses or receive any tax credits related to the Synthetic Fuel Partnership in future periods.
During the fourth quarter of 2005, Sovereign terminated $211.3 million of receive fixed-pay variable interest rate swaps that were hedging the fair value of $211.3 million of junior subordinated debentures due to capital trust entities. The fair value adjustment to the basis of the debt was $11.6 million at the date of termination. Sovereign had utilized the short-cut method of assessing hedge effectiveness under SFAS No. 133 when this hedge was in place. On July 21, 2006, in connection with the SEC’s review of the Company’s filings, it was determined that this hedge did not qualify for the short-cut method due to the fact that the junior subordinated debentures contained an interest deferral feature. As a result, Sovereign recorded a pretax charge of $11.4 million in 2006 to write-off the remaining fair value adjustment.
Also impacting other expenses in 2006 were proxy and related professional fees of $14.3 million related to the Relational Investors LLC (“Relational”) matter which was settled. During 2007, Sovereign recouped $0.5 million of this charge from insurance carriers.
Income Tax Provision/(Benefit). The income tax benefit was $60.5 million for 2007 compared to a benefit of $117.8 million for 2006. The effective tax rate for 2007 was (4.3)% compared to (615.8)% for 2006. The current year tax rate differs from the statutory rate of 35% due to the fact that the $1.58 billion goodwill charge and the ESOP charge of $40.1 million are both not deductible for tax purposes. The impact of this on the effective tax rate is slightly mitigated by our favorable permanent tax-free items which are principally due to income from tax- exempt investments, non-taxable income related to bank-owned life insurance and tax credits received on low income housing partnerships and the Synthetic Fuel Partnership.
Line of Business Results. During the first quarter of 2008, the business unit profitably reporting unit system was reorganized to centralize the responsibility for the major businesses within the Company naming a new head of Retail, Commercial Lending, Corporate Specialty Businesses and Corporate Support Services. The head of these business units report directly to the Chief Executive Officer and, along with our Chief Financial Officer and Chief Risk Officer, comprise the Executive Management Group. These events changed how our executive management team measures and assesses business performance. During the second quarter we finalized the process of updating our business unit profitability system to reflect our new organizational structure.
The Retail Banking Division’s net interest income increased $94.6 million to $1.2 billion in 2007. The increase in net interest income was principally due to increases in loan and deposit balances. The net spread on a match funded basis for this segment was 2.61% in 2007 compared to 2.87% in 2006. The average balance of Retail Banking Division’s loans was $5.7 billion and $4.5 billion during 2007 and 2006, respectively. The average balance of deposits was $42.2 billion in 2007 compared to $35.5 billion in 2006. The provision for credit losses increased in 2007 to $33.6 million from $14.8 million in 2006 due to increased net loan charge-offs in 2007. General and administrative expenses (including allocated corporate and direct support costs) increased from $929.4 million for 2006 to $1.1 billion for 2007.
The Corporate Specialty Group segment net interest income increased $12.8 million to $439.4 million in 2007. The increase in net interest income was principally due to increases in average loans. The net spread on a match funded basis for this segment was 1.36% in 2007 compared to 1.39% in 2006. The average balance of Corporate Specialty Group loans was $31.8 billion and $30.1 billion during 2007 and 2006, respectively. The average balance of deposits was $1.41 billion in 2007 compared to $704.1 million in 2006. The decrease in fees and other income of $116.0 million to $(41.3) million for 2007 was primarily generated by decreased mortgage banking revenues driven by the $119.9 million lower of cost or market adjustment related to the previously mentioned correspondent home equity loan transaction in 2007. The provision for credit losses decreased in 2007 to $253.0 million from $427.9 million in 2006 due primarily to the $296.0 million additional provision for our correspondent home equity portfolio in 2006. However, 2007 losses on our indirect auto portfolio totaled $76.2 million in 2007, compared to $30.5 million in 2006. Credit losses were much higher than anticipated due primarily to auto loans that were originated by our Southeast and Southwest production offices. General and administrative expenses (including allocated corporate and direct support costs) increased from $156.0 million for 2006 to $172.5 million for 2007.
The Commercial Lending segment net interest income increased $60.9 million to $431.8 million for 2007 compared to 2006 due to increases in average commercial assets. The average balance of Commercial Lending segment loans was $20.4 billion in 2007 versus $16.9 billion during 2006. The net spread on a match funded basis for this segment was 2.25% in 2007 compared to 2.33% in 2006. Fees and other income have increased by $11.9 million to $125.7 million principally due to an increase in commercial loan fee income. The provision for credit losses increased by $79.4 million in 2007 to $121.2 million compared to 2006 due to higher levels of commercial charge-offs in 2007 which was due to an increase in criticized assets, primarily in the construction lending, commercial real estate and commercial industrial lending portfolios. General and administrative expenses (including allocated corporate and direct support costs) increased from $162.5 million for 2006 to $182.7 million in 2007.
The net loss before income taxes for the Other segment decreased from $599.5 million in 2006 to $522.2 million in 2007. Net interest expense increased from $104.1 million in 2006 to $230.0 million for 2007. The Other segment includes net losses on securities of $176 million and $312 million in 2007 and 2006, respectively. The 2007 loss resulted from the previously discussed $180.5 million other-than-temporary impairment charge on FNMA and FHLMC preferred stock. The 2006 loss resulted from the previously discussed $67.5 million other-than-temporary impairment charge on the FNMA and FHLMC preferred stock in our investment portfolio, as well as the $238.3 million and $43.0 million of securities losses recorded in the second and fourth quarters of 2006. The 2007 and 2006 results included charges associated with executive and other employee severance arrangements and certain other restructuring activities of $62.0 million and $78.7 million, respectively. The 2007 and 2006 results also included net charges of $2.2 million and $42.4 million for merger and integration charges, respectively. Finally, the Other segment included $26.2 million and $26.3 million of expense associated with the Synthetic Fuel Partnership, as well as amortization of intangibles of $126.7 million and $109.8 million in 2007 and 2006, respectively.
Critical Accounting Policies
MD&A is based on the consolidated financial statements and accompanying notes that have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). Our significant accounting policies are described in Note 1 to the consolidated financial statements. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments, and, as such, have a greater possibility of producing results that could be materially different than originally reported. However, the Company is not currently aware of any reasonably likely events or circumstances that would result in materially different results. We have identified accounting for the allowance for loan losses and reserve for unfunded lending commitments, securitizations, goodwill, derivatives and hedging activities and income taxes as our most critical accounting policies and estimates in that they are important to the portrayal of our financial condition and results, and they require management’s most difficult, subjective or complex judgments as a result of the need to make estimates about the effects of matters that are inherently uncertain.
The Company’s senior management has reviewed these critical accounting policies and estimates with its Audit Committee. Information concerning the Company’s implementation and impact of new accounting standards issued by the Financial Accounting Standards Board (FASB) is discussed in Note 2.
Allowance for Loan Losses and Reserve for Unfunded Lending Commitments. The allowance for loan losses and reserve for unfunded lending commitments represent management’s best estimate of probable losses inherent in the loan portfolio. The adequacy of Sovereign’s allowance for loan losses and reserve for unfunded lending commitments is regularly evaluated. This evaluation process is subject to numerous estimates and applications of judgment. Management’s evaluation of the adequacy of the allowance to absorb loan losses takes into consideration the risks inherent in the loan portfolio, past loan loss experience, specific loans which have loss potential, geographic and industry concentrations, delinquency trends, economic conditions, the level of originations and other relevant factors. Management also considers loan quality, changes in the size and character of the loan portfolio, amount of non-performing loans, and industry trends. During 2008 and 2007, we recorded significant increases to the provision for credit losses and the allowance for loan losses and reserve for unfunded lending commitments as a result of higher credit losses and deterioration in asset quality statistics for the commercial and consumer loan portfolios. Changes in these estimates could have a direct material impact on the provision for credit losses recorded in the income statement and could result in a change in the recorded allowance and reserve for unfunded lending commitments. For example, a change in the estimate resulting in a 5% to 10% difference in the allowance for loan losses and reserve for unfunded lending commitments would have resulted in an additional provision for credit losses of $58.4 million to $116.8 million as of December 31, 2008. The loan portfolio also represents the largest asset on our consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan losses and reserve for unfunded lending commitments and a discussion of the factors driving changes in the amount of the allowance for loan losses and reserve for unfunded lending commitments is included in the Credit Risk Management section of this MD&A.
Securitizations. Securitization is a process by which a legal entity issues certain securities to investors, which pay a return based on the cash flows from a pool of loans or other financial assets. Sovereign has securitized mortgage loans, multi-family and commercial real estate loans, home equity loans, and other consumer loans, as well as automotive floor plan loans that it originated and/or purchased from certain other financial institutions. After receivables or loans are securitized, the Company continues to maintain account relationships with its customers. As a result, the Company continues to consider these securitized assets to be part of the business it manages. Sovereign may provide administrative, liquidity facilities and/or other services to the resulting securitization entities, and may continue to service the financial assets sold to the securitization entity.
In the case where Sovereign transferred financial assets to a special purpose entity, a decision must be made as to whether that transfer should be considered a sale and whether the assets transferred to the special purpose entity should be consolidated into the Company’s financial statements or whether the non-consolidation criteria have been met according to generally accepted accounting principles. The accounting guidance governing sale and consolidation of securitized financial assets is included in SFAS No. 140.
Accounting for the valuation of retained interests in securitizations requires management judgment since these assets are established and accounted for based on discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, credit loss experience, and servicing costs, as well as discount rates that consider the risk involved.
Because the values of these assets are sensitive to changes to assumptions, the valuation of retained interests is considered a critical accounting estimate. Note 1 and Note 23 to the consolidated financial statements include further discussion on the accounting for these assets and provide sensitivity analysis showing how the fair value of these assets would respond to adverse changes in the key assumptions utilized to value these assets.
Goodwill. The purchase method of accounting for business combinations requires the Company to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the assets acquired and liabilities assumed. The excess of the purchase price of an acquired business over the fair value of the identifiable assets and liabilities represents goodwill. Goodwill totaled $3.4 billion at December 31, 2008.
The Company follows SFAS No. 142, “Goodwill and Other Intangible Assets,” to account for its goodwill. This statement provides that goodwill and other indefinite lived intangible assets will not be amortized on a recurring basis, but rather will be subject to periodic impairment testing. Other than goodwill, Sovereign has no indefinite lived intangible assets.
The impairment test for goodwill requires the Company to compare the fair value of business reporting units to their carrying value including assigned goodwill. SFAS No. 142 requires an annual impairment test. In addition, goodwill is tested more frequently if changes in circumstances or the occurrence of events indicate impairment potentially exists. During 2007, Sovereign’s financial results were impacted by an increase in credit losses, slower than anticipated growth in low cost core deposits, and a continued unfavorable interest rate environment. Sovereign recorded a number of significant charges in 2007 as previously discussed which caused current year results to be less than our internal plan. These events, as well as decreases in valuations for all banks and the decision to cease originating loans from our Southeast and Southwest production offices, had a negative impact on the fair value of our segments.
Determining the fair value of its reporting units requires management to allocate assets and liabilities to such units and make certain judgments and assumptions related to various items, including discount rates, future estimates of operating results, etc. If alternative assumptions or estimates had been used, the fair value of each reporting unit determined by the Company may have been different. However, management believes that the estimates or assumptions used in the goodwill impairment analysis for its business units were reasonable. Additionally, management engaged a valuation specialist to assist management in its fair value assessment of its reporting units. As a result of the finalization of our 2007 goodwill impairment analysis, Sovereign recorded a goodwill impairment charge of $1.58 billion related to our Shared Services Consumer and Metro New York segments.
During the first quarter of 2008, as previously discussed in Sovereign’s 2008 first quarter Form 10-Q, certain changes to our executive management were announced such as the hiring of a new head of Retail Banking and a new Chief Financial Officer. In addition, Sovereign centralized the responsibility for the major businesses within the Company naming a new head of Retail, Commercial Lending, Corporate Specialty Businesses and Corporate Support Services. The head of these business units report directly to the Chief Executive Officer and, along with our Chief Financial Officer and Chief Risk Officer, comprise the Executive Management Group. These events changed how our executive management team measures and assesses business performance. During the second quarter we finalized the process of updating our business unit profitability system to reflect our new organizational structure.
As a result of the changes discussed above, Sovereign now has four reportable segments. The Company’s segments are focused principally around the customers Sovereign serves. The Retail Banking Division is comprised of our branch locations. Our branches offer a wide range of products and services to customers and each attracts deposits by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposits and retirement savings plans. Our branches also offer certain consumer loans such as home equity loans and other consumer loan products. The Corporate Specialties Group segment is primarily comprised of our mortgage banking group, our New York multi-family and national commercial real estate lending group, our automobile dealer floor plan lending group and our indirect automobile lending group. It also provides capital market services and cash management services. The Commercial Lending segment provides the majority of Sovereign’s commercial lending platforms such as commercial real estate loans, commercial industrial loans, leases to commercial customers and small business loans. The Other segment includes earnings from the investment portfolio, interest expense on Sovereign’s borrowings and other debt obligations, minority interest expense, amortization of intangible assets and certain unallocated corporate income and expenses.
During 2008, Sovereign’s financial results were impacted by an increase in credit losses, and losses on our investment portfolio which caused current year results to be less than our internal plan. Additionally on October 13, 2008 we entered into a Transaction agreement with Santander which valued Sovereign at approximately $2.5 billion on the announcement date.
We utilize a discounted cash flow analysis to estimate the fair value of our reporting units using market based assumptions which valued the entire Company at a level consistent with the consideration paid by Santander. At December 31, 2008, the date of our annual required assessment, the fair value of our retail bank was in excess of its book value. This reporting unit has limited credit exposure and continues to be profitable. The fair value of our corporate specialty and commercial lending reporting units were negative due to the deterioration in their operating results in the current year and in particular the second half of 2008 from increased credit losses on their loan portfolios. Of these two segments, only our commercial segment had goodwill assigned to it. After completing step 2 of the goodwill impairment analysis, no goodwill charge was required due to the significant discount on the commercial loans that reside in this reporting unit which caused its implied fair value of goodwill to be in excess of its allocated goodwill amount of $342 million. At September 30, 2008, because there were indicators of impairment, we performed an interim evaluation and formed the same conclusion.
Derivatives and Hedging Activities. Sovereign uses various derivative financial instruments to assist in managing interest rate risk. Sovereign accounts for these derivative instruments in accordance with the provisions of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended (SFAS No. 133). Under SFAS No. 133, derivative financial instruments are recorded at fair value as either assets or liabilities on the balance sheet. The accounting for changes in the fair value of a derivative instrument is determined by whether it has been designated and qualifies as part of a hedging relationship and on the type of hedging relationship. Transactions hedging changes in the fair value of a recognized asset, liability, or firm commitment are classified as fair value hedges. Derivative instruments hedging exposure to variable cash flows of recognized assets, liabilities or forecasted transactions are classified as cash flow hedges.
Fair value hedges result in the immediate recognition in earnings of gains or losses on the derivative instrument, as well as corresponding losses or gains on the hedged item, to the extent they are attributable to the hedged risk. The effective portion of the gain or loss on a derivative instrument designated as a cash flow hedge is reported in accumulated other comprehensive income, and reclassified to earnings in the same period that the hedged transaction affects earnings. The ineffective portion of the gain or loss, if any, is recognized in current earnings for both fair value and cash flow hedges. Derivative instruments not qualifying for hedge accounting treatment are recorded at fair value and classified as trading assets or liabilities with the resultant changes in fair value recognized in current earnings during the period of change.
During 2008 and 2007, Sovereign had both fair value hedges and cash flow hedges recorded in the consolidated balance sheet as “other assets” or “other liabilities” as applicable. For both fair value and cash flow hedges, certain assumptions and forecasts related to the impact of changes in interest rates on the fair value of the derivative and the item being hedged must be documented at the inception of the hedging relationship to demonstrate that the derivative instrument will be effective in hedging the designated risk. If these assumptions or forecasts do not accurately reflect subsequent changes in the fair value of the derivative instrument or the designated item being hedged, Sovereign might be required to discontinue the use of hedge accounting for that derivative instrument. Once hedge accounting is terminated, all subsequent changes in the fair market value of the derivative instrument must be recorded in earnings, possibly resulting in greater volatility in Sovereign’s earnings. If Sovereign’s outstanding derivative positions that qualified as hedges at December 31, 2008, were no longer considered effective, and thus did not qualify as hedges, the impact in 2008 would have been to lower pre-tax earnings by approximately $332.8 million.
Income Taxes. The Company accounts for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes”. Under this pronouncement, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. See Note 18 for details on the Company’s income taxes.
The Company periodically reviews the carrying amount of its deferred tax assets to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of the Company’s deferred tax assets will not be realized in future periods, a deferred tax valuation allowance would be established. Consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.
In evaluating this available evidence, management considers historical financial performance, expectation of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with operating loss and tax credit carry forwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences. The Company’s evaluation is based on current tax laws as well as management’s expectations of future performance on a standalone basis. We did not consider the potential economic benefits associated with our transaction with Santander.
SFAS No. 109 suggests that additional scrutiny should be given to deferred tax assets of an entity with cumulative pre-tax losses during the three most recent years. This is widely considered to be significant negative evidence that is objective and verifiable; and therefore, difficult to overcome. During the three years ended December 31, 2008, Sovereign had cumulative pre-tax losses and the company considered this factor in our analysis of deferred tax assets. Additionally, based on the continued economic uncertainty that persists at this time, we believed that it was probable that the Company would not generate significant pre-tax income in the near term on a standalone basis. As a result of these two significant facts, Sovereign recorded a $1.43 billion valuation allowance against its deferred tax assets for the year-ended December 31, 2008.
Sovereign is subject to the income tax laws of the U.S., its states and municipalities as well as certain foreign countries. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. Sovereign adopted the provisions of Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109, Accounting for Income Taxes on January 1, 2007. FIN 48 prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under FIN 48, tax positions shall initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. FIN 48 also revises disclosure requirements to include an annual tabular roll forward of unrecognized tax benefits. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws within the framework of FIN 48 and SFAS 109.
Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) recently examined the Company’s federal income tax returns for the years 2002 through 2005. The IRS completed this review in 2008. Included in this examination cycle are two separate financing transactions with an international bank totaling $1.2 billion. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006 and 2007, Sovereign was subject to an additional $87.6 million and $22.5 million, respectively, of foreign taxes related to these financing transactions and claimed a corresponding foreign tax credit. The IRS issued a notification of adjustment disallowing the foreign tax credits taken in 2003-2005 in the amount of $154.0 million related to these transactions;
disallowing deductions for issuance costs and interest expense related to the transaction which would result in an additional tax liability of $24.9 million; and assessed
interest and penalties, the combined amount of which totaled approximately $71.0 million. In addition, the IRS has commenced its audit for the years 2006 and 2007. We expect that in the future the IRS will propose to disallow the foreign tax credits taken in 2006 and 2007 of $87.6 million and $22.5 million, respectively;
disallow deductions for issuance costs and interest expense which would result in an additional tax liability of $37.1 million;
and to assess interest and penalties. Sovereign expects that it will need to litigate this matter with the IRS. Sovereign continues to believe that it is entitled to claim these foreign tax credits and deductions and also believes that its recorded tax reserves for this position of $58.3 million adequately provides for any potential exposure to the IRS related to this item and other tax assessments. However, as the Company continues to go through the IRS administrative process, and if necessary litigation, we will continue to evaluate the appropriate tax reserve levels for this position and any changes made to the tax reserves may materially affect Sovereign’s income tax provision, net income and regulatory capital in future periods.
Recent Acquisitions
On June 1, 2006, Sovereign acquired Independence for $42 per share in cash, representing an aggregate transaction value of $3.6 billion and the results of their operations are included in the accompanying financial statements subsequent to the acquisition date. Sovereign funded this acquisition using the proceeds from the $2.4 billion equity offering to Santander, net proceeds from issuances of perpetual and trust preferred securities and cash on hand. Sovereign issued 88.7 million shares to Santander, which made Santander its largest shareholder. Independence was headquartered in Brooklyn, New York, with 125 community banking offices in the five boroughs of New York City, Nassau and Suffolk Counties and New Jersey and had total assets and deposits of $17.1 billion and $11.0 billion, respectively. Sovereign’s acquisition of Independence connected our Mid-Atlantic and New England geographic footprints and created new markets in certain areas of New York. Sovereign recorded merger-related and integration charges of $42.8 million pre-tax ($27.8 million after-tax), or $0.06 per diluted share, in 2006.
Financial Condition
Loan Portfolio. Sovereign’s loan portfolio at December 31, 2008 was $55.7 billion and was comprised of $31.8 billion of commercial loans (includes $4.5 billion of multi-family loans), $18.3 billion of consumer loans secured by real estate and $5.6 billion of consumer loans not secured by real estate. This compares to $30.9 billion of commercial loans (including $4.2 billion of multi-family loans), $19.5 billion of consumer loans secured by real estate, and $7.3 billion of consumer loans not secured by real estate at December 31, 2007.
Commercial real estate loans and commercial and industrial loans grew by 2.2% or $594 million during 2008 to $27.3 billion. The increase in commercial loans has been driven by organic loan growth. The increase in commercial loans as a percentage of the total loan portfolio is consistent with management’s restructuring plan to de-emphasize lower yielding residential and multi-family loans and increase our commercial loan portfolio.
Multi-family loans increased by 6.6% or $280 million in 2008 to $4.5 billion. The increase from the prior year is due to a decrease of the amount of loans sold to Fannie Mae or the secondary markets. In the second quarter of 2007, Sovereign sold $687.7 million of this loan portfolio as part of a commercial mortgage backed securitization. In the first quarter of 2007, Sovereign sold $1.3 billion of this loan portfolio as part of the Company’s previously discussed balance sheet restructuring plan.
Consumer loans secured by real estate decreased by 6.3% or $1.2 billion in 2008 to $18.3 billion primarily as a result of a $780 million mortgage securitization in the second quarter of 2008, as well as a $102 million decline in our correspondent home equity portfolio.
Consumer loans not secured by real estate decreased by 23.1% or $1.7 billion in 2008 to $5.6 billion as a result of cessation of out-of-market auto lending on January 31, 2008. Additionally, the Company has tightened its underwriting standards on its in-market auto loans portfolio which slowed originations. Sovereign ceased originating substantially all indirect auto loans within its geographic footprint during the fourth quarter of 2008.
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 5 presents the contractual maturity of Sovereign’s commercial loans at December 31, 2008 (in thousands):
Table 5: Commercial Loan Maturity Schedule
Investment Securities. Sovereign’s investment portfolio is concentrated in highly rated mortgage-backed securities and collateralized mortgage obligations issued by federal agencies or private institutions. The portfolio is concentrated in 15-year contractual life mortgage-backed securities issued by Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) and other non agency issuers and short duration CMO’s. Sovereign’s available for sale investment strategy is to purchase liquid investments with intermediate maturities (average duration of 3-4 years). This strategy helps ensure that the Company’s overall interest rate risk position stays within policy requirements. The average life of our investment portfolio has declined to 4.62 years at December 31, 2008 versus 5.24 years at December 31, 2007.
In determining if and when a decline in market value below amortized cost is other-than-temporary, Sovereign considers the duration and severity of the unrealized loss, the financial condition and near-term prospects of the issuers, and Sovereign’s intent and ability to hold the investments to allow for a recovery in market value in a reasonable period of time. When such a decline in value is deemed to be other-than-temporary, an impairment loss is recognized in current period operating results to the extent of the decline. See Note 6 for further discussion and analysis of our determination that the unrealized losses in the investment portfolio at December 31, 2008 were considered temporary.
In the third quarter of 2008 and the fourth quarter of 2007, Sovereign determined that certain unrealized losses on perpetual preferred stock of FNMA and FHLMC were other-than-temporary in accordance with SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities” and the SEC’s Staff Accounting Bulletin No. 59 “Accounting for Non-current Marketable Equity Securities”. The Company’s assessment considered the duration and severity of the unrealized losses, the financial condition and near term prospects of the issuers, and the likelihood of the market value of these instruments increasing to our initial cost basis within a reasonable period of time based upon the anticipated interest rate environment. As a result of these factors, Sovereign concluded that the unrealized losses were other-than-temporary and recorded a non-cash impairment charge of $575 million and $180.5 million in the third quarter of 2008 and the fourth quarter of 2007, respectively. The significant charge recorded in the third quarter of 2008 was due to the announcement by the U.S. Department of the Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) that the FHFA was putting Fannie Mae and Freddie Mac under conservatorship and giving management control to their regulator, the FHFA. In connection with this action, the dividends on our preferred shares were eliminated thereby significantly reducing the value of our investment. The remaining value of our shares was $10.6 million at December 31, 2008.
In order to reduce risk in the investment portfolio, Sovereign sold its entire portfolio of collateralized debt obligations (“CDOs”) during the third quarter of 2008. The CDO portfolio has experienced significant volatility over the past year as a result of conditions in the credit markets. Sovereign recorded a pretax loss of $602.3 million in connection with the sale of these securities.
Additionally, during the latter half of the third quarter of 2008, Sovereign sold $4.7 billion of longer duration agency mortgage backed securities and municipal securities for a gain of $29.5 million. Sovereign sold these securities to reduce the duration of our investment portfolio and reduce the Company’s interest rate risk position in a rising rate environment.
During the second quarter of 2006 following the acquisition of Independence, Sovereign sold $3.5 billion of investment securities with a combined effective yield of 4.40% for asset/liability management purposes and to offset, in part, the negative effect of the current yield curve on net interest margin for future periods and incurred a pre-tax loss of $238.3 million ($154.9 million after-tax or $0.36 per diluted share). Of the total $3.5 billion of investments sold, $1.8 billion had been previously classified as held-to-maturity and Sovereign recorded a pretax loss of $130.1 million related to the sale of the held-to-maturity securities. As a result of the sale of the held-to-maturity securities, Sovereign concluded that we were required to reclassify the remaining $3.2 billion of held to maturity investment securities to the available for sale investment category.
The unrealized losses on the Company’s state and municipal bond portfolio increased to $211.0 million at December 31, 2008 from $26.4 million at December 31, 2007. This portfolio consists of 100% general obligation bonds of states, cities, counties and school districts. The portfolio has a weighted average underlying credit risk rating of AA-. These bonds are insured with various companies and as such, carry additional credit protection. The Company has determined that the unrealized losses on the portfolio are due to an increase in credit spreads and liquidity issues in the marketplace and concerns with respect to the financial strength of third party insurers. However, even if it was assumed that the insurers could not honor their obligation, our underlying portfolio is still investment grade and the Company believes that we will collect all scheduled principal and interest. The Company has concluded these unrealized losses are temporary in nature since they are not related to the underlying credit quality of the issuers, and the Company has the intent and ability to hold these investments for a time necessary to recover its cost, which may be at maturity.
The unrealized losses on the non-agency securities portfolio increased to $552.4 million at December 31, 2008 from $98.2 million at December 31, 2007. This portfolio consists primarily of investment grade non-agency mortgage-backed securities from a diverse group of issuers in the private-label market. The Company has determined that the unrealized losses on the portfolio are due to an increase in credit spreads and liquidity issues in the marketplace. The Company has concluded these unrealized losses are temporary in nature on the majority of this portfolio since they are not related to the underlying credit quality of the issuers and the Company has the intent and ability to hold these investments for a time necessary to recover its cost. Additionally, our investments are in subordinated positions that are in excess of current and expected cumulative loss positions. For the period ended December 31, 2008, it was concluded that the Company would not recover the full outstanding principal on five bonds in our non-agency mortgage backed portfolio with a book value of $654.3 million and whose fair value was $346.4 million. This resulted in a $307.9 million other than temporary impairment charge.
During the fourth quarter of 2006 as part of the balance sheet restructuring, Sovereign sold $1.5 billion of investment securities with a combined effective yield of 4.60% for asset/liability management purposes and incurred a pre-tax loss of $43.0 million ($28 million after tax or $0.06 per diluted share). The proceeds from the sale of the available for sale investment securities were reinvested in higher yielding securities since they were required as collateral for certain debt and deposit obligations.
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, unless a decline in value is deemed to be other-than-temporary in which case the decline is recorded in current period operating results. The majority of our securities have readily determinable market prices that are derived from third party pricing services. Decisions to purchase or sell these securities are based on economic conditions, including changes in interest rates, 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 6 to the Consolidated Financial Statements. The actual maturities of mortgage-backed securities available for sale will differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.
Table 6 presents the book value of investment securities by obligor and Table 7 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 that were held by Sovereign at December 31, 2008 (dollars in thousands):
Table 6: Investment Securities by Obligor
Table 7: Investment Securities of Single Issuers
Goodwill and Intangible Assets. Goodwill and other intangible assets decreased to $3.7 billion at December 31, 2008 from $3.8 billion in 2007. Goodwill and other intangibles represented 4.8% of total assets and 66.1% of stockholders’ equity at December 31, 2008, and are comprised of goodwill of $3.4 billion, core deposit intangible assets of $252.3 million and other intangibles of $16.2 million.
Sovereign establishes core deposit intangibles (CDI) in instances where core deposits are acquired in purchase business combinations. Sovereign determines the value of its CDI based on the present value of the difference in expected future cash flows between the cost to replace such deposits (based on applicable equivalent borrowing rates) versus the ongoing cost of the core deposits acquired. The aggregate future cash flows are based on the average expected life of the deposits acquired for each product less the cost to service them. The CDI associated with our various acquisitions are being amortized on an accelerated basis over the expected life of the underlying deposits, which is for periods up to 10 years.
Other Assets. Other assets at December 31, 2008 were $2.3 billion compared to $2.9 billion at December 31, 2007. Included in other assets at December 31, 2008 and December 31, 2007 were $148 million and $493 million of assets associated with our precious metals business, respectively, $336 million and $379 million, respectively, of prepaid assets, $141 million and $245 million of investments in low income housing partnerships and other equity method investment partnerships, respectively, and net deferred tax assets of $234 million and $717 million, respectively.
Deposits and Other Customer Accounts. Sovereign attracts deposits within its primary market area by offering a variety of deposit instruments, including demand and NOW accounts, money market accounts, savings accounts, customer repurchase agreements, certificates of deposit and retirement savings plans. Sovereign also issues wholesale deposit products such as brokered deposits and government deposits on a periodic basis which serve as an additional source of liquidity for the Company. Total deposits and other customer accounts at December 31, 2008 were $48.4 billion compared to $49.9 billion at December 31, 2007. Comparative detail of average balances and rates by deposit type is included in Table 1: Net Interest Margin is in a prior section of this MD&A.
Borrowings and Other Debt Obligations. Sovereign utilizes borrowings and other debt obligations 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, Boston, and New York (“FHLB”) provided certain standards related to creditworthiness have been met. Sovereign also utilizes reverse repurchase agreements, which are short-term obligations collateralized by securities fully guaranteed as to principal and interest by the U.S. Government or an agency thereof, and federal funds lines with other financial institutions. Total borrowings and other debt obligations at December 31, 2008 were $20.8 billion compared to $26.1 billion at December 31, 2007. The decrease in our level of borrowings in 2008 is due to a reduction in our asset size as the Company has been focusing on reducing its exposure to interest rate sensitive investment securities and high risk loan categories.
Table 8 summarizes information regarding borrowings and other debt obligations (in thousands):
Table 8: Details of Borrowings
Refer to Note 12 in the Notes to Consolidated Financial Statements for more information related to Sovereign’s borrowings.
In December 2008, Sovereign Bank issued $1.35 billion in 3 year fixed rate FDIC-guaranteed senior unsecured notes under the TLG Program. The fixed rate note bears interest at a rate of 2.75% and matures on January 17, 2012. At the same time, Sovereign Bancorp issued $250 million in 3.5 year fixed rate senior unsecured notes with the FDIC-guarantee under the TLG Program at a rate of 2.50% which mature on June 15, 2012.
This debt is backed by the full faith and credit worthiness of the U.S. government. In order to obtain this guarantee, an upfront payment of $41.5 million and $8.7 million was made to the FDIC. These amounts were deferred and are being amortized over the contractual life of the debt. This cost, along with other transaction costs and a slight discount on the issuance of these notes results in these borrowings having an effective rate of 3.92% and 3.73, respectively.
In order to increase its sources of liquidity in the third quarter of 2008, Sovereign pledged certain loans and investments to the Federal Reserve Bank which generated incremental borrowing capacity of $3.3 billion. At December 31, 2008, Sovereign had no borrowings outstanding with the Federal Reserve Bank.
In May 2008, Sovereign Bank issued $500 million of non-callable fixed rate subordinated notes which have an effective interest rate of 8.83%. These notes are due in May 2018 and are not subject to redemption prior to that date except in the case of the insolvency or liquidation of Sovereign Bank, and then only with prior regulatory approval. These subordinated notes qualify as Tier 2 regulatory capital for Sovereign Bank. Under the current OTS rules, 5 years prior to maturity, 20% of the balance of the subordinated note will no longer qualify as Tier 2 capital. In each successive year prior to maturity, an additional 20% of the subordinated note will no longer qualify as Tier 2 capital.
Concurrently, in May 2008, Sovereign Bancorp issued 179.9 million shares of common stock which raised net proceeds of $1.39 billion. Sovereign utilized the proceeds of this offering and the subordinated debt issued by Sovereign Bank to pay down $1.7 billion of FHLB advances and $180 million outstanding under the senior credit facility.
On March 23, 2007, Sovereign issued $300 million of 3 year, floating rate senior notes. The floating rate notes bear interest at a rate of 3 month LIBOR plus 23 basis points (adjusted quarterly) and mature on March 23, 2010. The notes are not redeemable at Sovereign’s option nor are they repayable prior to maturity at the option of the holders. The proceeds of the offering were used for general corporate purposes.
In connection with the balance sheet restructuring, Sovereign redeemed certain asset backed floating rate notes and junior subordinated debentures due to Capital Trust Entities totaling approximately $2.3 billion. In connection with these transactions, Sovereign incurred debt extinguishment charges of $14.7 million during the twelve-month period ended December 31, 2007.
On June 13, 2006, Sovereign’s wholly owned subsidiary, Sovereign Capital Trust VI issued $300 million capital securities which are due June 13, 2036. Principal and interest on Trust VI Capital Securities are paid by junior subordinated debentures due to Trust VI from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities will represent preferred beneficial interests in Trust VI. Distributions on the capital securities accrue from the original issue date and are payable, semiannually in arrears on the 13th day of June and December of each year, beginning on December 13, 2006 at an annual rate of 7.91%. The capital securities are not redeemable prior to June 13, 2016. The proceeds from the offering were used for general corporate purposes. Sovereign presents the junior subordinated debentures due to Trust VI as a component of borrowings.
On May 31, 2006, Sovereign’s wholly-owned subsidiary, Sovereign Capital Trust IX (the “Trust”) issued $150 million capital securities which are due July 7, 2036. Principal and interest on Trust IX Capital Securities are paid by junior subordinated debentures due to Trust IX from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities represent preferred beneficial interests in Trust IX. Distributions on the capital securities accrue from the original issue date and are payable, quarterly in arrears on the 7th day of January, April, July and October of each year, beginning on July 7, 2006 at an annual rate of three-month LIBOR plus 1.75%. The capital securities are callable at a redemption price of 105% of par during the first five years, after which they are callable at par. The proceeds from the offering were used to finance a portion of the purchase price for Sovereign’s pending acquisition of Independence, which closed on June 1, 2006. Sovereign presents the junior subordinated debentures due to Trust IX as a component of borrowings.
On May 22, 2006, Sovereign’s wholly-owned subsidiary, Sovereign Capital Trust V issued $175 million capital securities which are due May 22, 2036. Principal and interest on Trust V Capital Securities are paid by junior subordinated debentures due to Trust V from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities represent preferred beneficial interests in Trust V. Distributions on the capital securities accrue from the original issue date and are payable, quarterly in arrears on the 15th day of February, May, August and November of each year, beginning on August 15, 2006 at an annual rate of 7.75%. The capital securities are not redeemable prior to May 22, 2011. The proceeds from the offering were used to finance a portion of the purchase price for Sovereign’s acquisition of Independence, which closed on June 1, 2006. Sovereign presents the junior subordinated debentures due to Trust V as a component of borrowings.
On February 26, 2004, Sovereign completed the offering of $700 million of Trust PIERS, and in March 2004, Sovereign raised an additional $100 million of Trust PIERS under this offering. The offering was completed through Sovereign Capital Trust IV (the ''Trust’’), a special purpose entity established to issue the Trust PIERS. Each Trust PIERS had an issue price of $50 and represents an undivided beneficial ownership interest in the assets of the Trust, which consist of:
•
A junior subordinated debentures issued by Sovereign, each of which will have a principal amount at maturity of $50, and which have a stated maturity of March 1, 2034; and
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Warrants to purchase shares of common stock from Sovereign at any time prior to the close of business on March 1, 2034, by delivering junior subordinated debentures (or, in the case of warrant exercises before March 5, 2007, cash equal to the accreted principal amount of a junior subordinated debenture).
As a result of the acquisition of Santander, which closed on January 30, 2009, the warrant holders are entitled to receive Santander ADR’s instead of Sovereign common stock upon the exercise of their warrants. Holders may convert each of their Trust PIERS into ADRs representing 0.5482 ordinary shares of Santander, which is equivalent to the conversion ratio of 1.71 shares of Sovereign common stock per warrant prior to the acquisition if: (1) during any calendar quarter if the closing sale price of Santander ADRs over a specified measurement period meet certain criteria; (2) prior to March 1, 2029, during the five-business-day period following any 10-consecutive-trading-day period in which the average daily trading price of the Trust PIERS for such 10-trading-day period was less than 105% of the average conversion value of the Trust PIERS during that period and the conversion value for each day of that period was less than 98% of the issue price of the Trust PIERS; (3) during any period in which the credit rating assigned to the Trust PIERS by either Moody’s or Standard & Poor’s is below a specified level; (4) if the Trust PIERS have been called for redemption or (5) upon the occurrence of certain corporate transactions. The Trust PIERS and the junior subordinated debentures will have a distribution rate of 4.375% per annum of their issue price, subject to deferral. In addition, contingent distributions of $.08 per $50 issue price per Trust PIERS will be due during any three-month period commencing on or after March 1, 2007 under certain conditions. The Trust PIERS may not be redeemed by Sovereign prior to March 5, 2007, except upon the occurrence of certain special events. On any date after March 5, 2007, Sovereign may, if specified conditions are satisfied, redeem the Trust PIERS, in whole but not in part, for cash for a price equal to 100% of their issue price plus accrued and unpaid distributions to the date of redemption, if the closing price of Santander ADSs has exceeded a price per share that is equal to 130% of the effective conversion price, subject to adjustment, for a specified period. The effective conversion price as of January 30,2009 was $91.21 per share.
The proceeds from the Trust PIERS of $800 million, net of transaction costs of approximately $16.3 million, were allocated pro rata between “Junior Subordinated debentures due Capital Trust Entities” in the amount of $498.3 million and “Warrants and employee stock options issued” in the amount of $285.4 million based on estimated fair values. The difference between the carrying amount of the subordinated debentures and the principal amount due at maturity is being accreted into interest expense using the effective interest method over the period to maturity of the Trust PIERS which is March 2, 2034. The effective interest rate of the subordinated debentures is 6.75%.
The Capital Trusts above are variable interest entities as defined by FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51”. Sovereign has determined that it is not the primary beneficiary of any of these trusts, and as a result, they are not consolidated by the Company.
In connection with the acquisition of Independence, Sovereign assumed $250 million of senior notes and $400 million of subordinated borrowing obligations. The senior notes mature in September 2010 and carry a fixed rate of interest of 4.90%. The $400 million of subordinated notes include $250 million of 3.75% Fixed Rate/ Floating Rate Subordinated Notes Due March 2014 (“2004 Notes”) which bear interest at a fixed rate of 3.75% per annum for the first five years, and convert to a floating rate thereafter until maturity based on the US Dollar three-month LIBOR plus 1.82%. Beginning on April 1, 2009 Sovereign has the right to redeem the 2004 Notes at par plus accrued interest. The subordinated notes also include $150.0 million aggregate principal amount of 3.50% Fixed Rate/ Floating Rate Subordinated Notes Due June 2013 (“2003 Notes”). The 2003 Notes bear interest at a fixed rate of 3.50% per annum for the first five years, and convert to a floating rate thereafter until maturity based on the US Dollar three-month LIBOR plus 2.06%. Beginning on June 20, 2008 Sovereign has the right to redeem the 2003 Notes at par plus accrued interest.
On September 1, 2005, Sovereign issued $200 million of 3.5 year, floating rate Senior notes and $300 million of 5 year non-callable, fixed rate Senior notes at 4.80%. The floating rate notes bear interest at a rate of 3 month LIBOR plus 28 basis points (adjusted quarterly) and mature on March 1, 2009. The fixed rate notes mature on September 1, 2010. The proceeds of the offering were used to pay off $225 million of a line of credit at LIBOR plus 90 basis points, provide additional holding company cash for a previously announced stock repurchase program, enhance the short-term liquidity of the company, and for general corporate purposes.
During March of 2003, Sovereign Bank issued $500 million of subordinated notes (the “March subordinated notes”), at a discount of $4.7 million, which have a coupon of 5.125%. In August 2003, Sovereign Bank issued $300 million of subordinated notes (the “August subordinated notes”), at a discount of $0.3 million, which have a coupon of 4.375%. The August subordinated notes mature in August 2013 and are callable at par in August 2008. The March subordinated notes are due in March 2013 and are not subject to redemption prior to that date except in the case of the insolvency or liquidation of Sovereign Bank, and then only with prior regulatory approval. These subordinated notes qualify as Tier 2 regulatory capital for Sovereign Bank. Under the current OTS rules, 5 years prior to maturity, 20% of the balance of the subordinated notes will no longer qualify as Tier 2 capital. In each successive year prior to maturity, an additional 20% of the subordinated notes will no longer qualify as Tier 2 capital.
Off-Balance Sheet Arrangements. Securitization transactions contribute to Sovereign’s overall funding and regulatory capital management. These transactions involve periodic transfer of loans or other financial assets to special purpose entities (SPEs) and are either recorded on Sovereign’s Consolidated Balance Sheet or off-balance sheet depending on whether the transaction qualifies as a sale of assets in accordance with SFAS No.140,“Transfers of Financial Assets and Liabilities”.
In certain transactions, Sovereign has transferred assets to a special purpose entity qualifying for non-consolidation (QSPE), and has accounted for these transactions as sales in accordance with SFAS No. 140. Sovereign also has retained interests and servicing assets in the QSPEs. At December 31, 2008, off-balance sheet QSPEs had $1.9 billion of assets that Sovereign sold to the QSPEs that are not included in Sovereign’s Consolidated Balance Sheet. Sovereign’s retained interests and servicing assets in such QSPEs were $55.2 million at December 31, 2008, and this amount represents our maximum exposure to credit losses related to unconsolidated securitizations. Sovereign does not provide contractual legal recourse to third party investors that purchase debt or equity securities issued by the QSPEs beyond retained interests and servicing rights inherent in the QSPEs. See Note 23 to the Consolidated Financial Statements for a discussion of Sovereign’s policies concerning valuation and impairment for such retained interests and servicing assets, as well as a discussion of the assumptions used and sensitivity to changes in those assumptions.
Minority Interests. Minority interests represent the equity and earnings attributable to that portion of consolidated subsidiaries that are owned by parties independent of Sovereign. Earnings attributable to minority interests are reflected in “Other minority interest expense and equity method investments” on the Consolidated Statement of Operations.
Preferred Stock. On May 15, 2006, Sovereign issued 8 million shares of Series C non-cumulative perpetual preferred stock and received net proceeds of $195.4 million. The perpetual preferred stock ranks senior to our common stock. Our perpetual preferred stockholders are entitled to receive dividends when and if declared by our board of directors at a rate of 7.30% per annum, payable quarterly, before we may declare or pay any dividend on our common stock. The dividends on the perpetual preferred stock are non-cumulative. The Series C preferred stock is not redeemable prior to May 15, 2011. On or after May 15, 2011, the Series C preferred stock is redeemable at par.
The dividends on our preferred stock are recorded against retained earnings; however, for earnings per share purposes, they are deducted from net income available to common shareholders. See Note 24 for the calculation of earnings per share.
Credit Risk Management
Extending credit to our customers exposes Sovereign to credit risk, which is the risk that the principal balance of a loan and any related interest will not be collected due to the inability or unwillingness 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 the Credit Policy Committee and approved by the Board of Directors. 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 other key credit attributes, have also been established. In addition to being subject to the judgment and dual approval of experienced loan officers and their managers, loans over a certain dollar size also require the co-approval of credit officers independent of the loan officer to ensure consistency and quality in accordance with Sovereign’s credit standards. The largest loans require approval by the Credit Policy Committee.
The Internal Asset Review Group, both Retail and Commercial conduct ongoing, independent reviews of Sovereign’s loan portfolios and the lending process to ensure accurate risk ratings and adherence to established policies and procedures, monitor compliance with applicable laws and regulations, provide objective measurement of the risk inherent in the loan portfolio, and ensure that proper documentation exists. The results of these periodic reviews are reported to line management, and to the Board of Directors of both Sovereign and Sovereign Bank. Sovereign also maintains a watch list for certain loans identified as requiring a higher level of monitoring by management because of one or more factors, borrower performance, business conditions, industry trends, nature of collateral, collateral margin, economic conditions, or other factors. Commercial loan credit quality is always subject to scrutiny by line management, credit officers and the independent Internal Asset Review Group.
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. Commercial loans principally represent commercial real estate loans (including multi-family loans), loans to commercial and industrial customers, automotive dealer floor plan loans, and loans to auto lessors. 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 both assessing the borrower’s capacity and willingness 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 Mid-Atlantic, New York and New England market areas and are secured by real estate at specified 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 borrowers or industries do not exist. At December 31, 2008 and 2007, 8% and 7% of the commercial loan portfolio was unsecured, respectively.
The Company originates multi-family (five or more units) residential mortgage loans, which are secured primarily by apartment buildings, cooperative apartment buildings and mixed-use (combined residential and commercial) properties through its Metro New York market. Credit risk associated with multi-family 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 credit, Sovereign follows a set of underwriting standards which generally require a maximum loan-to-value ratio of 80% based on an appraisal performed by either one of the Company’s in-house licensed and certified appraisers or by a Company-approved licensed and certified independent appraiser (whose appraisal is reviewed by a Company licensed and certified appraiser), and sufficient cash flow from the underlying property to adequately service the debt. A minimum debt service ratio of 1.25 generally is required on multi-family residential mortgage loans. The Company also considers the financial resources of the borrower, the borrower’s experience in owning or managing similar properties, the market value of the property and the Company’s lending experience with the borrower. For loans sold in the secondary market to Fannie Mae, the maximum loan-to-value ratio is 80% and the minimum debt service ratio is 1.25.
Consumer Loans Secured by Real Estate. Credit risk in the direct and indirect consumer loan portfolio is controlled by strict adherence to underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values. In the home equity loan portfolio, combined loan-to-value ratios are generally limited to 90%, or credit insurance is purchased to limit exposure. Sovereign originates and purchases fixed rate and adjustable rate residential mortgage loans that are secured by the underlying 1-4 family residential property. Credit risk exposure in this area of lending is minimized by the evaluation of the creditworthiness of the borrower, including debt-to-equity ratios, credit scores, and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans originated or purchased in excess of an 80% loan-to-value ratio 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 FHLMC or the FNMA. Credit risk is further reduced since a portion of Sovereign’s fixed rate mortgage loan production is sold to investors in the secondary market without recourse. Additionally, Sovereign entered into a credit default swap in 2006 on a portion of its residential real estate loan portfolio through a synthetic securitization structure. Under the terms of the credit default swap, Sovereign is responsible for the first $4.1 million of losses on the remaining loans in the structure which totaled $3.0 billion at December 31, 2008. Sovereign is reimbursed for the next $53.3 million of losses under the terms of the credit default swap. Losses above $57.4 million are bourn by Sovereign. This credit default swap term is equal to the term of the loan portfolio.
Consumer Loans Not Secured by Real Estate. Credit risk in the auto loan portfolio has been higher then expected in the current year for our in-footprint loans due to increasing levels of unemployment and declining values on automobiles. Loans originated by our Southeast and Southwest production offices exhibited higher than anticipated loss rates during 2007. We began originating these loans in the third quarter of 2006 and grew this portfolio significantly. Management strengthened the underwriting standards for our entire auto loan portfolio in the second half of 2007 and decided to cease originating new loans from our Southeast and Southwest production offices effective January 31, 2008. Management also decided to cease originating in-footprint loans during the fourth quarter of 2008. The remaining auto loan portfolio of $5.3 billion will liquidate over their estimated life of approximately two and a half to three years.
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 by attempting 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. Sovereign monitors delinquency trends at 30, 60, and 90 days past due. These trends are discussed at monthly Management Asset Review Committee and Sovereign Bank Board of Directors meetings.
Non-performing Assets. At December 31, 2008, Sovereign’s non-performing assets were $985.4 million, compared to $361.6 million at December 31, 2007. Non-performing assets as a percentage of total assets (excluding loans held for sale) weakened to 1.28% at December 31, 2008 from the prior year level of 0.43%. Non-performing residential loans increased in 2008 by $142.3 million to $233.2 million and non-performing commercial and commercial real estate loans increased in 2008 by $417.3 million to $564.4 million. All of the non-performing asset increases were impacted by the deterioration in our loan portfolios as the credit quality of loans has dropped significantly in 2008 from prior year levels due to the current severe recessionary environment. Future credit performance of our portfolios is dependent upon the strength of our underwriting practices as well as the regions of the U.S. economy where our loans were originated.
Sovereign generally places all commercial loans on non-performing status at 90 days delinquent or sooner, if management believes the loan has become impaired (unless return to current status is expected imminently). All consumer and residential loans continue to accrue interest until they are 120 days delinquent, at which point they are either charged-off or placed on non-accrual status. Consumer loans secured by real estate with loan to values of 50% or less, based on current valuations, are considered well secured and in the process of collection and therefore continue to accrue interest. At 180 days delinquent, anticipated losses on residential real estate loans are fully reserved or charged off.
Table 9 presents the composition of non-performing assets at the dates indicated (in thousands):
Table 9: Non-Performing Assets
Loans that are past due 90 days or more and still accruing interest increased from $68.8 million at December 31, 2007 to $123.3 million at December 31, 2008 due to the current recessionary environment. Ninety-day consumer secured by real estate loan delinquencies increased by $53.7 million. Ninety-day delinquencies increased in the auto and other consumer category by $0.8 million.
Potential Problem Loans. Potential problem loans are loans not currently classified as non-performing loans, for which management has doubts as to the borrowers’ ability to comply with present repayment terms. These assets are principally commercial loans delinquent more than 30 days but less than 90 days. Potential problem loans amounted to approximately $557.8 million and $140.3 million at December 31, 2008 and 2007, respectively. The principal reason for the increase has been a weakening of the credit quality in our commercial loan portfolio particularly in the commercial & industrial (“C & I”) and commercial real estate portfolios. Management has evaluated these loans and reserved for these loans at higher rates during the current year.
Delinquencies. Sovereign’s loan delinquencies (all performing loans held for investment 30 or more days delinquent) at December 31, 2008 were $1.4 billion compared to $817 million at December 31, 2007. As a percentage of total loans held for investment, performing delinquencies were 2.53% at December 31, 2008, an increase from 1.43% at December 31, 2007. Consumer secured by real estate performing loan delinquencies increased from $451 million to $621 million during the same time periods, and increased as a percentage of total consumer secured by real estate loans from 2.35% to 3.45%. Consumer not secured by real estate performing loan delinquencies remained constant at $226 million and increased as a percentage of total consumer loans from 3.09% to 4.00%. Commercial performing loan delinquencies increased from $140 million to $558 million and increased as a percentage of total commercial loans from 0.46% to 1.76%. The reason for the increase in consumer loans, primarily those secured by real estate, was due to a weakening of the credit quality of our loan portfolio in 2008 due to declining home values. Additionally, consumer delinquencies were impacted by increased delinquencies in our auto loan portfolio. Commercial loan delinquencies have increased due to the weakening of the credit quality of our commercial loan portfolio particularly related to commercial real estate and C & I loans.
Allowance for Credit Losses
Allowance for Loan Losses. Sovereign maintains an allowance for loan losses that management believes is sufficient to absorb inherent losses in the loan portfolio. The adequacy of Sovereign’s allowance for loan losses is regularly evaluated. In addition to past loss experience, management’s evaluation of the adequacy of the allowance to absorb loan losses takes into consideration the risks inherent in the loan portfolio, 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, amount of non-performing loans, and industry trends. At December 31, 2008, Sovereign’s total allowance was $1.1 billion.
The allowance for loan losses consists of two elements: (i) an allocated allowance, which for non-homogeneous loans is comprised of allowances established on specific classified loans, and class allowances for both homogeneous and non-homogeneous loans based on risk ratings, and historical loss experience and current trends, and (ii) unallocated allowances, which provides coverage for unexpected losses in Sovereign’s loan portfolios, and to account for a level of imprecision in management’s estimation process.
The allowance recorded for our consumer portfolio is based on an analysis of product mix, risk composition of the portfolio, collateral coverage and bankruptcy experiences, economic conditions and historical and expected delinquency and past and anticipated charge-off statistics for each homogeneous category or group of loans. Based on this information and analysis, an allowance is established in an amount sufficient to cover estimated inherent losses in this portfolio.
The allowance recorded for commercial loans is based on an analysis of the individual credits and relationships and is separated into two parts, the specific allowance and the class allowance. The specific allowance element of the commercial loan allowance is based on a regular analysis of classified commercial loans where certain inherent weaknesses exist, loans regulatory rated substandard through loss. This analysis is performed by the Managed Asset Division, where loans with recognized deficiencies are administered. This analysis is periodically reviewed by other parties, including the Commercial Asset Review Department. The specific allowance established for these criticized loans is based on a careful analysis of related collateral value, cash flow considerations, and, if applicable, guarantor capacity and other sources of repayment. Specific reserves are also evaluated by Commercial Asset Review and Credit Risk Management.
The specific allowance element is calculated in accordance with SFAS No. 114 “Accounting by Creditors for Impairment of a Loan” and SFAS No. 118 “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure” and is based on a regular analysis of criticized commercial loans where internal credit ratings are below a predetermined quality level. This analysis is performed by the Managed Assets Division, and periodically reviewed by other parties, including the Commercial Asset Review Department. The specific allowance established for these criticized loans is based on a careful analysis of related collateral value, cash flow considerations and, if applicable, guarantor capacity.
The class allowance element of the commercial loan allowance is determined by an internal loan grading process in conjunction with associated allowance factors. These class allowance factors are updated quarterly and are based primarily on actual historical loss experience and an analysis of product mix, risk composition of the portfolio, underwriting trends and growth projections, collateral coverage and bankruptcy experiences, economic conditions, historical and expected delinquency and anticipated loss rates for each group of loans. While this analysis is conducted at least quarterly, the Company has the ability to revise the class allowance factors whenever necessary in order to address improving or deteriorating credit quality trends or specific risks associated with a given loan pool classification.
Regardless of the extent of the Company’s analysis of customer performance, portfolio evaluations, trends or risk management processes established, certain inherent, but undetected, losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends, and the sensitivity of assumptions utilized to establish allocated allowances for homogeneous groups of loans among other factors. The Company maintains an unallocated allowance to recognize the existence of these exposures.
These risk factors are continuously reviewed and revised by management where conditions indicate that the estimates initially applied are different from actual results. A comprehensive analysis of the allowance for loan losses and reserve for unfunded lending commitments is performed by the Company on a quarterly basis. In addition, a review of allowance levels based on nationally published statistics is conducted on at least an annual basis.
Reserve for Unfunded Lending Commitments. In addition to the Allowance for Loan and Lease Losses, we also estimate probable losses related to unfunded lending commitments. Unfunded lending commitments are subject to individual reviews, and are analyzed and segregated by risk according to the Corporation’s internal risk rating scale. These risk classifications, in conjunction with an analysis of historical loss experience, current economic conditions and performance trends within specific portfolio segments, and any other pertinent information, result in the estimation of the reserve for unfunded lending commitments. Additions to the reserve for unfunded lending commitments are made by charges to the provision for credit losses. The reserve for unfunded lending commitments of $65.2 million at December 31, 2008 increased $36.9 million from $28.3 million at December 31, 2007, due to an increase in reserve factors on this category due to increases in the amount of criticized lines at December 31, 2008, as well as an increase in the amount of unfunded lending commitments.
The factors supporting the allowance for loan losses and the reserve for unfunded lending commitments do not diminish the fact that the entire allowance for loan losses and the reserve for unfunded lending commitments are available to absorb losses in the loan portfolio and related commitment portfolio, respectively. The Company’s principal focus, therefore, is on the adequacy of the total allowance for loan losses and reserve for unfunded lending commitments.
The allowance for loan losses and the reserve for unfunded lending commitments are subject to review by banking regulators. The Company’s primary bank regulators conduct examinations of the allowance for loan losses and reserve for unfunded lending commitments and make assessments regarding their adequacy and the methodology employed in their determination.
Table 10 summarizes Sovereign’s allowance for credit losses for allocated and unallocated allowances by loan type, and the percentage of each loan type of total portfolio loans (in thousands):
Table 10: Allocation of the Allowance for Credit Losses by Product Type
Commercial Portfolio. The allowance for loan losses for the commercial portfolio increased from $434.0 million at December 31, 2007 to $752.8 million at December 31, 2008 due to an increase in criticized assets and 2.2% growth in the commercial loan portfolio (excluding multi-family loans). As a percentage of the total commercial portfolio, the allowance increased from 1.40% to 2.37%. This increase is due to continued weakening of the commercial loan portfolio in 2008 compared to the prior year, primarily in construction lending, commercial real estate and commercial industrial lending. During 2008, net charge-offs in this portfolio totaled $225.1 million or 82 basis points, as compared to $50.5 million or 20 basis points in 2007. This deterioration was factored into the Company’s calculation of its allowance for loan losses. Non-accrual commercial loans to total commercial loans was 191 basis points at December 31, 2008 compared to 50 basis points at the end of 2007. During the latter half of 2008 the Company has begun to slow the pace of commercial loan originations as the recessionary environment has led to decreased loan demand.
Consumer Loans Secured by Real Estate Portfolio. The allowance for the consumer loans secured by real estate portfolio increased from $117.4 million at December 31, 2007 to $193.4 million at December 31, 2008 or 65%. As a percentage of the total consumer secured by real estate portfolio, the allowance increased from 0.60% to 1.06%. This increase is due primarily to deterioration in our Alt-A residential loan portfolio. We have also increased the amount of reserves we hold on our in-footprint home equity loans and residential real estate loans compared to the prior year because of the decline in home prices that was experienced in 2008 throughout the country and deteriorating economic conditions.
Consumer Loans Not Secured by Real Estate Portfolio. The allowance for the consumer loans not secured by real estate portfolio decreased from $149.8 million at December 31, 2007 to $149.1 million at December 31, 2008 due to a decrease of $1.7 billion in auto loans. As a percentage of the total consumer not secured by real estate portfolio, the allowance increased from 2.04% to 2.65% since we are no longer originating auto loans. Additionally, Sovereign increased the pass allocation reserve factor in light of recent deterioration in this segment of our loan portfolio due to the current economic weakness.
Unallocated Allowance. The unallocated allowance is maintained to account for a level of imprecision in management’s estimation process. The unallocated allowance decreased from $8.3 million at December 31, 2007 to $7.4 million at December 31, 2008. As a percentage of the total reserve, the unallocated portion decreased from 1.1% to 0.6%. Management continuously evaluates its class allowance reserving methodology; however the unallocated allowance is subject to changes each reporting period due to certain inherent but undetected losses, which are probable of being realized within the loan portfolio.
Bank Regulatory Capital
Federal law requires institutions regulated by the Office of Thrift Supervision to have a minimum tangible capital ratio equal to 1.5% of tangible assets and a minimum leverage ratio equal to 4% of tangible assets, and a risk-based capital ratio equal to 8% of risk-adjusted assets. Federal law also requires OTS regulated institutions to have a minimum tangible capital equal to 2% of total tangible assets. For a detailed discussion on regulatory capital requirements, see Note 15 in the Notes to Consolidated Financial Statements.
Table 11 presents thrift regulatory capital requirements and the capital ratios of Sovereign Bank at December 31, 2008. It also presents capital ratios for Sovereign Bancorp, Inc.
Table 11: Regulatory Capital Ratios
(1)
OTS capital regulations do not apply to savings and loan holding companies. These ratios are computed as if those regulations did apply to Sovereign Bancorp.
(2)
Accumulated other comprehensive income
Liquidity and Capital Resources
Liquidity represents the ability of Sovereign to obtain cost effective funding to meet the needs of customers, as well as Sovereign’s financial obligations. Factors that impact the liquidity position of Sovereign include loan origination volumes, loan prepayment rates, maturity structure of existing loans, core deposit growth levels, certificate of deposit maturity structure and retention, Sovereign’s credit ratings, investment portfolio cash flows, maturity structure of wholesale funding, etc. These risks are monitored and centrally managed. This process includes reviewing all available wholesale liquidity sources. As of December 31, 2008, Sovereign had $21.5 billion in unused available overnight liquidity in the form of unused federal funds purchased lines, unused FHLB borrowing capacity, unused borrowing lines with the Federal Reserve Bank and unencumbered investment portfolio securities. Sovereign also forecasts future liquidity needs and develops strategies to ensure adequate liquidity is available at all times.
Sovereign Bank has several sources of funding to meet its liquidity requirements, including the liquid investment securities portfolio, the core deposit base, the ability to acquire large deposits, FHLB borrowings, Federal Reserve borrowings, wholesale deposit purchases, federal funds purchased, reverse repurchase agreements, and to a lessor extent given the current economic environment, issue public debt and equity securities in the local and national markets and the capability to securitize or package loans for sale.
Sovereign’s holding company has the following major sources of funding to meet its liquidity requirements: dividends and returns of investment from its subsidiaries, short-term investments held by nonbank affiliates and access to the capital markets. Sovereign Bank may pay dividends to its parent subject to approval of the OTS. Sovereign Bank declared and paid dividends to the parent company of $30 million in 2008, $240 million in 2007, and $600 million in 2006. During the second quarter of 2008, Sovereign issued $1.39 billion of common stock. During the third quarter of 2008, Sovereign Bancorp contributed $800 million of cash to the Bank to help bolster its capital ratios. At December 31, 2008, our holding company liquidity to meet debt payments, debt service and debt maturities was in excess of 12 months.
The Company has been aggressively working to increase its liquidity position, and, as of December 31, 2008, we had over $30.8 billion in committed liquidity from the FHLB and the Federal Reserve Bank. Of this amount, $15 billion is unused and therefore provides additional borrowing capacity and liquidity for the Company. During the latter half of 2008 we pledged additional assets to the Federal Reserve which resulted in an increase in available liquidity. We believe that our committed liquidity levels provide adequate liquidity in this difficult economic environment.
As previously mentioned Sovereign adopted FAS 157 on January 1, 2008. Sovereign’s level 3 investments are comprised of certain non-agency mortgage backed securities and FNMA/FHLMC preferred stock, which are not actively traded. In certain instances, Sovereign is the sole investor of the issued security. Sovereign receives third party broker quotes to determine their estimated fair value. The prices of our securities are benchmarked against similar securities that are more actively traded to validate the reasonableness of their fair value. Our fair value estimates assume liquidation in an orderly market and not under distressed circumstances. If Sovereign was required to sell these securities in an unorderly fashion, actual proceeds received could potentially be significantly less than their estimated fair values. However, due to the sale of our CDO portfolio and the impairment charge recorded on our Fannie Mae and Freddie Mac preferred stock in 2008 the outstanding balance of our level 3 assets on our balance sheet has declined significantly from a year ago.
Towards the end of the third quarter of 2008, Sovereign decided to exit its entire CDO portfolio in an expedited manner due to unprecedented levels of economic uncertainty. This resulted in a pretax loss of $602 million on this sale which was significantly in excess of the unrealized loss on this portfolio at June 30th. Due to the rapidly developing negative economic conditions at the end of the third quarter, the unrealized loss on this portfolio increased significantly and executive management and the Board of Directors decided it was in the best interests of the Company to remove this high risk asset class from the Company’s balance sheet as it would most likely continue to be a volatile asset in future periods and distract management and the Board from our core business efforts.
Cash and cash equivalents increased $624 million in 2008. Net cash provided by operating activities was $2.0 billion for 2008. Net cash provided by investing activities for 2008 was $4.0 billion, which consisted primarily of proceeds from the sale of investment securities of $5.2 billion. We also had repayments or maturities of investments of $4.5 billion and purchased $8.3 billion of investments in 2008. Net cash used by financing activities for 2008 was $5.4 billion, which was primarily due to a $7.2 million decrease in borrowing and other debt obligations. See the consolidated statement of cash flows for further details on our sources and uses of cash.
Sovereign’s debt agreements impose customary limitations on dividends, other payments and transactions.
Contractual Obligations and Other Commitments
Sovereign enters into contractual obligations in the normal course of business as a source of funds for its asset growth and its asset/liability management, to fund acquisitions, and to meet its capital needs. These obligations require Sovereign to make cash payments over time as detailed in the table below. (For further information regarding Sovereign’s contractual obligations, refer to Footnotes 11 and 12 of our Consolidated Financial Statements, herein.):
Contractual Obligations
(1)
Includes interest on both fixed and variable rate obligations. The interest associated with variable rate obligations is based upon interest rates in effect at December 31, 2008. The contractual amounts to be paid on variable rate obligations are affected by changes in market interest rates. Future changes in market interest rates could materially affect the contractual amounts to be paid.
(2)
Includes all carrying value adjustments, such as unamortized premiums or discounts and hedge basis adjustments.
(3)
The commitments to fund investment partnerships represent future cash outlays for the construction and development of properties for low-income housing and historic tax credit projects. The timing and amounts of these commitments are projected based upon the financing arrangements provided in each project’s partnership or operating agreement and could change due to variances in the construction schedule, project revisions, or the cancellation of the project.
Excluded from the above table are deposits of $31.9 billion that are due on demand by customers. Additionally, $86.7 million of tax liabilities associated with unrecognized tax benefits under FIN 48 have been excluded due to the high degree of uncertainty regarding the timing of future cash outflows associated with such obligations.
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 may 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 may 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. Commitments to extend credit, including standby letters of credit, do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.
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.
OTHER COMMERCIAL COMMITMENTS
(1)
Of this amount, $4.6 billion represents the unused portion of home equity lines of credit.
For further information regarding Sovereign’s commitments, refer to Note 19 to the Notes to the Consolidated Financial Statements.
Asset and Liability Management
Interest rate risk arises primarily through Sovereign’s traditional business activities of extending loans and accepting deposits. Many factors, including economic and financial conditions, movements in market interest rates and consumer preferences, affect the spread between interest earned on assets and interest paid on liabilities. Interest rate risk is managed centrally by the treasury group with oversight by the Asset and Liability Committee. In managing its interest rate risk, the Company seeks to minimize the variability of net interest income across various likely scenarios while at the same time maximizing its net interest income and net interest margin. To achieve these objectives, the treasury group works closely with each business line in the Company and guides new business. The treasury group also uses various other tools to manage interest rate risk including wholesale funding maturity targeting, investment portfolio purchase strategies, asset securitization/sale, and financial derivatives.
Interest rate risk focuses on managing four elements of risk associated with interest rates: basis risk, repricing risk, yield curve risk and option risk. Basis risk stems from rate index timing differences with rate changes, such as differences in the extent of changes in fed funds compared with three month LIBOR. Repricing risk stems from the different timing of contractual repricing such as, one month versus three month reset dates. Yield curve risk stems from the impact on earnings and market value due to different shapes and levels of yield curves. Optionality risk stems from prepayment or early withdrawal risk embedded in various products. These four elements of risk are analyzed through a combination of net interest income simulations, shocks to the net interest income simulations, scenarios and market value analysis and the subsequent results are reviewed by management. Numerous assumptions are made to produce these analyses including, but not limited to, assumptions on new business volumes, loan and investment prepayment rates, deposit flows, interest rate curves, economic conditions, and competitor pricing.
Sovereign simulates the impact of changing interest rates on its expected future interest income and interest expense (net interest income sensitivity). This simulation is run monthly and it includes various scenarios that help management understand the potential risks in net interest income sensitivity. These scenarios include both parallel and non-parallel rate shocks as well as other scenarios that are consistent with quantifying the four elements of risk. This information is then used to develop proactive strategies to ensure that Sovereign’s risk position remains close to neutral so that future earnings are not significantly adversely affected by future interest rates.
The table below discloses the estimated sensitivity to Sovereign’s net interest income based on interest rate changes:
Sovereign also focuses on calculating the market value of equity (“MVE”). This analysis is very useful as it measures the present value of all estimated future interest income and interest expense cash flows of the Company over the estimated remaining life of the balance sheet. MVE is calculated as the difference between the market value of assets and liabilities. The MVE calculation utilizes only the current balance sheet and therefore does not factor in any future changes in balance sheet size, balance sheet mix, yield curve relationships, and product spreads which may mitigate the impact of any interest rate changes.
Management then looks at the effect of interest rate changes on MVE. The sensitivity of MVE to changes in interest rates is a measure of longer-term interest rate risk and also highlights the potential capital at risk due to adverse changes in market interest rates. The following table discloses the estimated sensitivity to Sovereign’s MVE at December 31, 2008 and December 31, 2007:
Because the assumptions used are inherently uncertain, Sovereign cannot precisely predict the effect of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, the difference between actual experience and the assumed volume and characteristics of new business and behavior of existing positions, and changes in market conditions and management strategies, among other factors.
Pursuant to its interest rate risk management strategy, Sovereign enters into derivative relationships such as interest rate exchange agreements (swaps, caps, and floors) and forward sale or purchase commitments. Sovereign’s objective in managing its interest rate risk is to provide sustainable levels of net interest income while limiting the impact that changes in interest rates have on net interest income.
Interest rate swaps are generally used to convert fixed rate assets and liabilities to variable rate assets and liabilities and vice versa. Sovereign utilizes interest rate swaps that have a high degree of correlation to the related financial instrument.
As part of its overall business strategy, Sovereign originates fixed rate residential mortgages. It sells a portion of this production 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 against changes in interest rate on the mortgages that are originated for sale and on interest rate lock commitments.
To accommodate customer needs, Sovereign enters into customer-related financial derivative transactions primarily consisting of interest rate swaps, caps, floors and foreign exchange contracts. Risk exposure from customer positions is managed through transactions with other dealers.
Through the Company’s capital markets, mortgage-banking and precious metals activities, it is subject to trading risk. The Company employs various tools to measure and manage price risk in its trading portfolios. In addition, the Board of Directors has established certain limits relative to positions and activities. The level of price risk exposure at any given point in time depends on the market environment and expectations of future price and market movements, and will vary from period to period.
Table 12 presents selected quarterly consolidated financial data (in thousands, except per share data):
Table 12: Selected Quarterly Consolidated Financial Data
2008 Fourth Quarter Results
On February 3, 2009, Sovereign released a current report on Form 8-K announcing its preliminary and unaudited results for the fourth quarter of 2008 and reported net income for the fourth quarter of 2008 of $87.7 million, or $0.13 per diluted share, which was $1.1 billion or $1.61 per diluted share higher than the third quarter and $1.7 billion or $3.47 per diluted share higher than the fourth quarter of 2007 reported amount of $(1.6) billion, or $(3.34) per diluted share. Full year results indicated a loss of $666.3 million compared to a net loss of $1.35 billion in 2007. The results reported in this Annual Report on Form 10-K have been adjusted from the amounts reflected in our previously released Form 8-K to reflect three additional charges.
Subsequent to filing of our Form 8-K, it was concluded that Sovereign on a stand alone basis (i.e. management did not contemplate any potential benefits which may arise from our transaction with Santander in accordance with U.S. generally accepted accounting principles) would not generate pretax income in 2009 based upon revised earning expectations given the continued deteriorating economic conditions which are not showing signs of stabilizing. Given that Sovereign was in a cumulative pretax loss position for the past three years, it was concluded that these two facts made it more likely than not that $1.29 billion of deferred taxes would not be realized.
The other than temporary impairment analysis of certain non-agency mortgage securities was also completed after considering the continuing deteriorating condition of the real estate market through the first two months of 2009. Upon the conclusion of this effort it was determined that it was likely that Sovereign would not recover all of its outstanding principal of five securities which had a book value of $654.3 million whose fair value was $346.4 million. Under SFAS 115, if an entity determines that the principal value of the securities will not be collected in full, an impairment charge is required to be recorded to write down that security to its current fair market value even if the entity believes it will collect principal and interest well in excess of this amount. As a result, an other than temporary impairment charge was recorded of $307.9 million which was not tax effected given the conclusion on deferred tax asset realization as discussed above.
Finally the conclusions related to the fair value of our equity method investments was finalized after considering the continued deteriorating performance of this investment through the first two months of 2009. Given the expectation that current economic conditions will continue to negatively impact these investment’s results in future periods it was determined that the estimated fair value of our investment was significantly less than our cost basis and as a result a $95 million impairment charge which was not tax effected given the conclusion on deferred tax asset realization as discussed above was recorded.
The third quarter of 2008 included a $602 million loss on the sale of our CDO portfolio and a $575 million other-than-temporary impairment charge on FNMA and FHLMC preferred stock. The results for the fourth quarter of 2007 included the previously discussed $1.58 billion non-deductible goodwill impairment charge and an other-than-temporary impairment charge of $180.5 million on FNMA/FHLMC preferred stock. The returns on average equity and average assets were (85.40)% and (8.33)%, respectively, for the fourth quarter of 2008, compared to (48.18)% and (5.02)%, respectively, for the third quarter of 2008, and (72.92)% and (7.74)%, respectively, for the fourth quarter of 2007.
Net interest margin for the fourth quarter of 2008 was 2.66%, compared to 3.02% from the third quarter of 2008, and 2.77% in the fourth quarter of 2007. The decrease in margin in the fourth quarter of 2008 compared to the prior year was due the impact of Fed rate cuts in 2008 which resulted in lower yields on our variable rate commercial loan portfolio, our decision to shorten the duration of our investment portfolio, and the lack of dividends from our FHLB Pittsburgh stock and our Fannie Mae and Freddie Mac perpetual preferred stock. Additionally, during the fourth quarter, Sovereign deposits increased $5.3 billion primarily in higher cost money market and time deposit accounts which kept our funding costs stable despite a declining rate environment. Our 2009 net interest margin will continue to be influenced by the interest rate yield environment, levels of non-performing loans, and our ability to originate high quality loans and organically grow low cost deposits.
General and administrative expenses for the fourth quarter of 2008 were $412.8 million, compared to $387.5 million in the third quarter and $337.6 million in the fourth quarter of 2007. The primary reason for the increase quarter over quarter is a $15.8 million severance charge related to the reduction in the workforce, as well as an $5.5 million write-off of collateral related to terminated swap positions. The increase in year-over-year fourth quarter general and administrative expenses was largely driven by higher deposit insurance premiums and severance charges.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 in the Consolidated Financial Statements for a discussion on this topic.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Incorporated by reference from Part II, Item 7, “Management’s Discussion and Analysis of Financial Conditions and Results of Operations - Asset and Liability Management” hereof.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Management’s Assessment of
Internal Control Over Financial Reporting
Sovereign Bancorp, Inc. (“Sovereign”) is responsible for the preparation, integrity, and fair presentation of its published financial statements as of December 31, 2008, and the year then ended. The consolidated financial statements and notes included in this annual report have been prepared in accordance with United States generally accepted accounting principles and, as such, include some amounts that are based on management’s best judgments and estimates.
Management is responsible for establishing and maintaining effective internal control over financial reporting. The system of internal control over financial reporting, as it relates to the financial statements, is evaluated for effectiveness by management and tested for reliability through a program of internal audits and management testing and review. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation.
Management assessed the Corporation’s system of internal control over financial reporting as of December 31, 2008, in relation to criteria for effective internal control over financial reporting as described in “Internal Control - Integrated Framework”, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concludes that, as of December 31, 2008, its system of internal control over financial reporting is effective and meets the criteria of the “Internal Control - Integrated Framework”. Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation report on the effectiveness of internal control over financial reporting.
/s/ Gabriel Jaramillo
/s/ Kirk W. Walters
Gabriel Jaramillo
Kirk W. Walters
Chairman and Chief Executive Officer
Chief Financial Officer and Executive Vice President
March 17, 2009
Report of Independent Registered Public Accounting Firm
THE BOARD OF DIRECTORS AND STOCKHOLDERS OF
SOVEREIGN BANCORP, INC.
We have audited the accompanying consolidated balance sheets of Sovereign Bancorp, Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of Sovereign Bancorp Inc.’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sovereign Bancorp, Inc. at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Sovereign Bancorp Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 17, 2009 expressed an unqualified opinion thereon.
Philadelphia, Pennsylvania
March 17, 2009
Report of Independent Registered Public Accounting Firm
THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
SOVEREIGN BANCORP, INC.
We have audited Sovereign Bancorp Inc.’s internal control over financial reporting as of December 31, 2008 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Sovereign Bancorp Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report of Management’s Assessment of Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Sovereign Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Sovereign Bancorp, Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 and our report dated March 17, 2009 expressed an unqualified opinion thereon.
Philadelphia, Pennsylvania
March 17, 2009
Consolidated Balance Sheets
See accompanying notes to the consolidated financial statements.
Consolidated Statements of Operations
See accompanying notes to the consolidated financial statements.
Consolidated Statements of Stockholders’ Equity
See accompanying notes to the consolidated financial statements.
Consolidated Statements of Stockholders’ Equity (continued)
See accompanying notes to the consolidated financial statements.
Consolidated Statements of Cash Flow
See accompanying notes to the consolidated financial statements.
Supplemental Disclosures:
Non-cash Transactions: In the second quarter of 2008, Sovereign completed an on-balance sheet securitization which had the impact of reclassifying $781 million of residential mortgage loans to investments available for sale.
In the first quarter of 2007, Sovereign reclassified $658 million of correspondent home equity loans that were previously classified as held for sale to its loans held for investment portfolio. See Note 7 for further discussion.
In the second quarter of 2006, Sovereign reclassified $3.2 billion of held to maturity securities to available for sale. See Note 6 for additional discussion.
In 2006, Sovereign transferred $7.2 billion of loans held for investment to loans held for sale in connection with balance sheet restructuring. See Note 7 for further discussion.
In 2006, Sovereign securitized $0.9 billion of dealer floor plan loans. In connection with this securitization, Sovereign retained $56.1 million of securitized retained interests in the form of subordinated certificates, cash reserve accounts and interest only strips which are reflected as a non-cash transaction between loans and investments available for sale.
See accompanying notes to the consolidated financial statements.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies
Sovereign is a Virginia corporation and is the holding company of Sovereign Bank (“Sovereign Bank” or “the Bank”). Sovereign is headquartered in Boston, Massachusetts and Sovereign Bank is headquartered in Wyomissing, Pennsylvania. Sovereign’s primary business consists of attracting deposits from its network of community banking offices, located throughout eastern Pennsylvania, New Jersey, New York, New Hampshire, Massachusetts, Connecticut, Rhode Island and Maryland, and originating commercial, home equity loans and residential mortgage loans in those communities. On January 30, 2009, Sovereign was acquired by Banco Santander, SA. (“Santander”). Sovereign shareholders received .3206 shares of Santander ADS for each share of Sovereign stock. See Note 31 for further details. These financial statements have been prepared assuming Sovereign Bancorp continued as a going concern and therefore the effects of the Santander acquisition are not reflected in these financial statements.
The following is a description of the significant accounting policies of Sovereign. Such accounting policies are in accordance with United States generally accepted accounting principles.
a. Principles of Consolidation - The accompanying financial statements include the accounts of the parent company, Sovereign Bancorp, Inc., and its subsidiaries, including the following wholly-owned subsidiaries: Sovereign Bank, Independence Community Bank Corp. and Sovereign Delaware Investment Corporation. All intercompany balances and transactions have been eliminated in consolidation.
b. Use of Estimates - The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Our most significant estimates pertain to our allowance for loan losses, impaired loans, and fair value measurements related to our investment portfolio. Actual results could differ from those estimates.
c. Per Share Information - Basic earnings per share is calculated by dividing net income by the weighted average common shares outstanding, excluding options and warrants. The dilutive effect of options is calculated using the treasury stock method, the dilutive effect of our warrants issued in connection with our contingently convertible debt issuance is calculated under the if-converted method. However, due to the net losses recorded in 2008 and 2007 and the low level of earnings recorded in 2006, Sovereign has excluded the impact of these instruments since the result would have been anti-dilutive.
d. Revenue Recognition - Non-interest income includes fees from deposit accounts, loan commitments, standby letters of credit and financial guarantees, interchange income, mortgage servicing (net of amortization and write-downs of servicing rights), underwriting gains or losses from capital markets investment and derivative trading activities and other financial service-related products. These fees are generally recognized over the period that the related service is provided. Also included in non-interest income are gains or losses on sales of investment securities and loans. Gains or losses on sales of investment securities are recognized on the trade date, while gains on sales of loans are recognized when the sale is complete. Gains or losses on the sales of mortgage, multi-family and home equity loans are included within mortgage banking revenues. Income from bank-owned life insurance represents increases in the cash surrender value of the policies, as well as insurance proceeds.
e. Investment Securities and Other Investments - Investment 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 temporary unrealized gains and losses reported as a component of accumulated other comprehensive income within stockholders’ equity, net of estimated income taxes. Gains or losses on the sales of securities are recognized at the trade date utilizing the specific identification method. In determining if and when a decline in market value below amortized cost is other-than-temporary for its investments in marketable equity securities and debt instruments, Sovereign considers the duration and severity of the unrealized loss, the financial condition and near term prospects of the issuers, and Sovereign’s intent and ability to hold the investments to allow for a recovery in market value in a reasonable period of time which for debt securities may mean maturity. When such a decline in value is deemed to be other-than-temporary, the Company recognizes an impairment loss in the current period operating results to the extent of the decline.
Other investments include $0.7 billion and $0.9 billion at December 31, 2008 and 2007, respectively, of Sovereign’s investment in the stock of the Federal Home Loan Bank (FHLB) of Boston, New York and Pittsburgh. Although FHLB stock is an equity interest in a FHLB, it does not have a readily determinable fair value for purposes of FASB Statement No. 115, because its ownership is restricted and it lacks a market. FHLB stock can be sold back only at its par value of $100 per share and only to the FHLBs or to another member institution.. Sovereign evaluates this investment for impairment under the provisions of AICPA Statement of Position 01-6 “Accounting by Certain Entities (Including Entities With Trade Receivables) That Lend to or Finance the Activities of Others” and bases our impairment evaluation on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. In December, the FHLB of Pittsburgh announced it was suspending dividends on its stock and that it would not repurchase any excess capital stock in order to maintain their liquidity and capital positions We have considered these developments and concluded that our investment in FHLB Pittsburgh is not impaired. However we will continue to closely monitor this investment in future periods.
f. Loans Held for Sale - Loans held for sale are recorded at the lower of cost or estimated fair value on an aggregate basis at the time a decision is made to sell the loan with any decline in value attributable to credit deterioration below its carrying amount charged to the allowance for loan losses. Any declines in value attributable to interest rates below its carrying amount are recorded as reductions to non-interest income and typically is recorded within mortgage banking revenues as the majority of our loans held for sale are residential and home equity loans. Any subsequent decline in the estimated fair value of loans held for sale is included as a reduction of non-interest income in the consolidated statements of operations. Residential mortgage loans classified as held for sale that were originated subsequent to January 1, 2008 are recorded at fair value since Sovereign adopted SFAS No. 159 for these assets. See Note 2.
g. Mortgage Servicing Rights - Sovereign sells mortgage loans in the secondary market and typically retains the right to service the loans sold. Upon sale, a mortgage servicing right (MSR) asset is established, which represents the then current fair value of future net cash flows expected to be realized for performing the servicing activities. MSRs are carried at the lower of the initial capitalized amount, net of accumulated amortization, or fair value. The carrying values of MSRs are amortized in proportion to, and over the period of, estimated net servicing income.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies (continued)
Mortgage servicing rights are evaluated for impairment in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” For purposes of determining impairment, the mortgage servicing rights are stratified by certain risk characteristics and underlying loan strata that include, but are not limited to, interest rate bands, and further into residential real estate 30-year and 15-year fixed rate mortgage loans, adjustable rate mortgage loans and balloon loans. A valuation reserve is recorded in the period in which the impairment occurs through a charge to income equal to the amount by which the carrying value of the strata exceeds the fair value. If it is later determined that all or a portion of the temporary impairment no longer exists for a particular strata, the valuation allowance is reduced with an offsetting credit to income.
Mortgage servicing rights are also reviewed for permanent impairment. Permanent impairment exists when the recoverability of a recorded valuation allowance is determined to be remote taking into consideration historical and projected interest rates and loan pay-off activity. When this situation occurs, the unrecoverable portion of the valuation reserve is applied as a direct write-down to the carrying value of the mortgage servicing right. Unlike a valuation allowance, a direct write-down permanently reduces the carrying value of the mortgage servicing asset and the valuation allowance, precluding subsequent recoveries. See Note 8 for additional discussion.
h. Allowance for Loan Losses and Reserve for Unfunded Lending Commitments - The allowance for loan losses and reserve for unfunded lending commitments collectively “the allowance for credit losses” are maintained at levels that management considers adequate to provide for 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 with 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 for credit losses may be necessary if conditions differ substantially from the assumptions used in making the evaluations.
The allowance for loan losses consists of two elements: (i) an allocated allowance, which is comprised of allowances established on specific loans, and class allowances based on historical loan loss experience adjusted for current trends and adjusted for both general economic conditions and other risk factors in the Company’s loan portfolios, and (ii) an unallocated allowance to account for a level of imprecision in management’s estimation process.
The specific allowance element is calculated in accordance with SFAS No. 114 “Accounting by Creditors for Impairment of a Loan” and SFAS No. 118 “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure” and is based on a regular analysis of criticized commercial loans where internal credit ratings are below a predetermined quality level. This analysis is performed by the Managed Assets Division, and periodically reviewed by other parties, including the Commercial Asset Review Department. The specific allowance established for these criticized loans is based on a careful analysis of related collateral value, cash flow considerations and, if applicable, guarantor capacity.
The class allowance element is determined by an internal loan grading process in conjunction with associated allowance factors. These class allowance factors are evaluated at least quarterly and are based primarily on actual historical loss experience and an analysis of product mix, risk composition of the portfolio, underwriting trends and growth projections, collateral coverage and bankruptcy experiences, economic conditions, historical and expected delinquency and anticipated loss rates for each group of loans. While this analysis is conducted at least quarterly, the Company has the ability to revise the class allowance factors whenever necessary in order to address improving or deteriorating credit quality trends or specific risks associated with a given loan pool classification.
Regardless of the extent of the Company’s analysis of customer performance, portfolio evaluations, trends or risk management processes established, certain inherent, but undetected, losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends, and the sensitivity of assumptions utilized to establish allocated allowances for homogeneous groups of loans among other factors. The Company maintains an unallocated allowance to recognize the existence of these exposures.
These risk factors are continuously reviewed and revised by management where conditions indicate that the estimates initially applied are different from actual results. A comprehensive analysis of the allowance for loan losses and reserve for unfunded lending commitments is performed by the Company on a quarterly basis. In addition, a review of allowance levels based on nationally published statistics is conducted on at least an annual basis.
In addition to the allowance for loan losses, we also estimate probable losses related to unfunded lending commitments. Unfunded lending commitments are subject to individual reviews, and are analyzed and segregated by risk according to the Corporation’s internal risk rating scale. These risk classifications, in conjunction with an analysis of historical loss experience, current economic conditions and performance trends within specific portfolio segments, and any other pertinent information result in the estimation of the reserve for unfunded lending commitments. Additions to the reserve for unfunded lending commitments are made by charges to the provision for credit losses and this reserve is classified within other liabilities on Sovereign’s Consolidated Balance Sheet.
The factors supporting the allowance for loan losses and the reserve for unfunded lending commitments do not diminish the fact that the entire allowance for loan losses and the reserve for unfunded lending commitments are available to absorb losses in the loan portfolio and related commitment portfolio, respectively. The Company’s principal focus, therefore, is on the adequacy of the total allowance for loan losses and reserve for unfunded lending commitments.
The allowance for loan losses and the reserve for unfunded lending commitments are subject to review by banking regulators. The Company’s primary bank regulators conduct examinations of the allowance for loan losses and reserve for unfunded lending commitments and make assessments regarding their adequacy and the methodology employed in their determination.
i. Loans - Loans are reported net of loan origination fees, direct origination costs and discounts and premiums associated with purchased loans and unearned income. Interest on loans is credited to income as it is earned. Loan origination fees and certain direct loan origination costs are deferred and recognized as adjustments to interest income in the consolidated statement of operations over the contractual life of the loan utilizing the effective interest rate method. Premiums and discounts associated with purchased loans are deferred and amortized as adjustments to interest income utilizing the effective interest rate method using estimated prepayment speeds, which are updated on a quarterly basis. Interest income is not recognized on loans when the loan payment is 90 days or more delinquent for commercial loans and 120 days or more delinquent for consumer loans (except consumer loans secured by real estate with loan to values less than 50%) or sooner if management believes the loan has become impaired.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies (continued)
A non-accrual loan is a loan in which it is probable that scheduled payments of principal and interest will not be received when due according to the contractual terms of the loan agreement. 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. 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.
Consumer loans and any portion of a consumer loan secured by real estate mortgage loans not adequately secured are generally charged-off when deemed to be uncollectible or delinquent 180 days or more (120 days for closed-end consumer loans not secured by real estate), whichever comes first, unless it can be clearly demonstrated that repayment will occur regardless of the delinquency status. Examples that would demonstrate repayment include; a loan that 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. Charge-offs of commercial loans are made on the basis of management’s ongoing evaluation of non-performing loans.
As set forth by the provisions of SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure,” Sovereign defines impaired loans as non-accrual, non-homogeneous loans and certain other loans that are still accruing, that management has specifically identified as being impaired.
j. Premises and Equipment - Premises and equipment are carried at cost, less accumulated depreciation. Depreciation is calculated utilizing the straight-line method. Estimated useful lives are as follows:
Office buildings
10 to 30 years
Leasehold improvements
Remaining lease term
Furniture, fixtures and equipment
3 to 10 years
Automobiles
5 years
Expenditures for maintenance and repairs are charged to expense as incurred.
k. Other Real Estate Owned - Other real estate owned (“OREO”) consists of properties acquired by, or in lieu of, foreclosure in partial or total satisfaction of non-performing loans. OREO obtained in satisfaction of a loan is recorded at the lower of cost or estimated fair value minus estimated costs to sell based upon the property’s appraisal value at the date of transfer. The excess of the carrying value of the loan over the fair value of the property minus estimated costs to sell are charged to the allowance for loan losses. Any decline in the estimated fair value of OREO that occurs after the initial transfer from the loan portfolio and costs of holding the property are recorded as operating expenses, except for significant property improvements that are capitalized to the extent that carrying value does not exceed estimated fair value. OREO is classified within other assets on the consolidated balance sheet and totaled $71.4 million and $56.8 million at December 31, 2008 and December 31, 2007, respectively.
l. Bank Owned Life Insurance - Bank owned life insurance (“BOLI”) represents the cash surrender value for life insurance policies for certain employees who have provided positive consent allowing the Bank to be the beneficiary of such policies. Increases in the net cash surrender value of the policies, as well as insurance proceeds received, are recorded in non-interest income, and are not subject to income taxes.
m. Income Taxes - The Company accounts for income taxes in accordance with SFAS No. 109 “Accounting for Income Taxes”. Under this pronouncement, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. See Note 18 for detail on the Company’s income taxes.
Periodic reviews of the carrying amount of deferred tax assets are made to determine if the establishment of a valuation allowance is necessary. If based on the available evidence in future periods, it is more likely that not that all or a portion of the Company’s deferred tax assets will not be realized, a deferred tax valuation allowance would be established. Consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.
Items considered in this evaluation include historical financial performance, expectation of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with operating loss and tax credit carry forwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences. The evaluation is based on current tax laws as well as expectations of future performance on a standalone basis (i.e. Management did not consider the potential economic benefits associated with our transaction with Santander in accordance with U.S. generally accepted accounting principles). The transaction with Santander was signed on October 12, 2008 and closed on January 30th 2009
SFAS No. 109 suggests that additional scrutiny should be given to deferred tax assets of an entity with cumulative pre-tax losses during the three most recent years and is widely considered significant negative evidence that is objective and verifiable and therefore, difficult to overcome. During the three years ended December 31, 2008, we had cumulative pre-tax losses and considered this factor in our analysis of deferred tax assets. Additionally, based the continued economic uncertainty that currently exists at this time, it was determined that it was probable that the Company would not generate significant pre-tax income in the near term on a standalone basis. As a result of these facts, Sovereign recorded a $1.43 billion valuation allowance against its deferred tax assets for the year-ended December 31, 2008.
Sovereign is subject to the income tax laws of the U.S., its states and municipalities as well as certain foreign countries. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies (continued)
Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) recently examined the Company’s federal income tax returns for the years 2002 through 2005. The IRS completed this review in 2008. Included in this examination cycle are two separate financing transactions with an international bank totaling $1.2 billion. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006 and 2007, Sovereign was subject to an additional $87.6 million and $22.5 million, respectively, of foreign taxes related to these financing transactions and claimed a corresponding foreign tax credit. The IRS issued a notification of adjustment disallowing the foreign tax credits taken in 2003-2005 in the amount of $154.0 million related to these transactions; disallowing deductions for issuance costs and interest expense related to the transaction which would result in an additional tax liability of $24.9 million; and assessed interest and penalties, the combined amount of which totaled approximately $71.0 million. In addition, the IRS has commonced its audit for the years 2006 and 2007. We expect that in the future the IRS will propose to disallow the foreign tax credits and deductions taken in 2006 and 2007 of $87.6 million and $22.5 million, respectively; disallow deductions for issuance costs and interest expense which would result in an additional tax liability of $37.1 million; and to assess interest and penalties. Sovereign expects that it will need to litigate this matter with the IRS. Sovereign continues to believe that it is entitled to claim these foreign tax credits and deductions and also believes that its recorded tax reserves for this position of $58.3 million adequately provides for any potential exposure to the IRS related to this item and other tax assessments. However, as the Company continues to go through the IRS administrative process, and if necessary litigation, we will continue to evaluate the appropriate tax reserve levels for this position and any changes made to the tax reserves may materially affect Sovereign’s income tax provision, net income and regulatory capital in future periods.
n. Derivative Instruments and Hedging Activity - Sovereign enters into certain derivative transactions principally to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on expected future cash flows. The Company recognizes the fair value of the contracts when the characteristics of those contracts meet the definition of a derivative.
Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. The Company formally documents the relationships of certain qualifying hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking each hedge transaction.
Fair value hedges are accounted for by recording the change in the fair value of the derivative instrument and the related hedged asset, liability or firm commitment on the balance sheet with the corresponding income or expense recorded in the consolidated statement of operations. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as an other asset or other liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense associated with the hedged asset or liability.
Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as an asset or liability, with a corresponding charge or credit, net of tax, recorded in accumulated other comprehensive income within stockholders’ equity, in the accompanying consolidated balance sheet. Amounts are reclassified from accumulated other comprehensive income to the statement of operations in the period or periods the hedged transaction affects earnings. In the case where certain cash flow hedging relationships have been terminated, the Company continues to defer the net gain or loss in accumulated other comprehensive income and reclassifies it into interest expense as the future cash flows occur, unless it becomes probable that the future cash flows will not occur. See Note 23 for further discussion.
The Company, through its precious metals financing business, enters into gold bullion and other precious metals financing arrangements with customers for use in the customer’s operations. The customer is required to settle the arrangement at all times either in the metal received or in the fair value of the metal at the time of settlement. We have recorded the fair value of the customer settlement arrangement as a precious metals customer forward settlement arrangement in our statement of financial condition. The company economically hedges its customer forward settlement arrangements with forward sale agreements to mitigate the impact of the changes in the fair value of the precious metals in which it transacts with customers. Changes in fair value of precious metals forward sale agreements are reflected in commercial banking fees.
The portion of gains and losses on derivative instruments not considered highly effective in hedging the change in fair value or expected cash flows of the hedged item, or derivatives not designated in hedging relationships, are recognized immediately in the statement of operations.
o. Forward Exchange - Sovereign enters into forward exchange contracts to provide for the needs of its customers. Forward exchange contracts are recorded at fair value based on current exchange rates. All gains or losses on forward exchange contracts are included in capital markets revenue.
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.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies (continued)
q. Goodwill and Core Deposit Intangibles - Goodwill is the excess of the purchase price over the fair value of the tangible and identifiable intangible assets and liabilities of companies acquired through business combinations accounted for under the purchase method. Core deposit intangibles are a measure of the value of checking, savings and other-low cost deposits acquired in business combinations accounted for under the purchase method. Core deposit intangibles are amortized over the estimated useful lives of the existing deposit relationships acquired, but not exceeding 10 years. The Company evaluates its identifiable intangibles for impairment when an indicator of impairment exists, but not less than annually. Separable intangible assets that are not deemed to have an indefinite life continue to be amortized over their useful lives.
Sovereign follows the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” to account for its goodwill. We perform our annual goodwill impairment test in the fourth quarter and whenever events occur or circumstances change that indicate the fair value of a reporting unit may be below its carrying value. Sovereign performed goodwill impairment testing during each quarter of 2008 and concluded goodwill was not impaired. Goodwill is reviewed for impairment utilizing a two-step process. The first step requires Sovereign to identify the reporting units and compare the fair value of each reporting unit to its respective carrying amount, including its allocated goodwill. If the carrying value is higher than the fair value, there is an indication that an impairment may exist and a second step must be performed. The second step entails calculating the implied fair value of goodwill as if a reporting unit is purchased at its step 1 fair value. This is determined in the same manner as goodwill in a business combination. If the implied fair value of goodwill is in excess of the reporting units allocated goodwill amount then no impairment charge is required. See Note 4 for additional discussion.
r. Asset Securitizations - Sovereign has securitized multi-family and commercial real estate loans, mortgage loans, home equity and other consumer loans, as well as automotive floor plan receivables that it originated and/or purchased from certain other financial institutions. After receivables or loans are securitized, the Company continues to maintain account relationships with its customers. Sovereign may provide administrative, liquidity facilities and/or other services to the resulting securitization entities, and may continue to service the financial assets sold to the securitization entity.
If the securitization transaction meets the accounting requirements for deconsolidation and sale treatment under SFAS No. 140, the securitized receivables or loans are removed from the balance sheet and a net gain or loss is recognized in income at the time of initial sale and each subsequent sale. Net gains or losses resulting from securitizations are recorded in non-interest income.
Retained interests in the subordinated tranches and interest-only strips are recorded at their estimated fair value and included in the available for sale securities portfolio. Any decline in the estimated fair value below the carrying amount that is determined to be other-than-temporary is charged to earnings in the statement of operations. The Company uses assumptions and estimates in determining the fair value allocated to the retained interests at the time of sale and each subsequent accounting period in accordance with SFAS No. 140. These assumptions and estimates include projections concerning rates charged to customers, the expected life of the receivables, credit loss experience, loan repayment rates, the cost of funds, and discount rates commensurate with the risks involved. On a quarterly basis, management reviews the historical performance of each retained interest and the assumptions used to project future cash flows. Refer to Note 23 for further analysis of the assumptions used in the determination of fair value.
s. Marketing expense - Marketing costs are expensed as incurred.
t. Stock Based Compensation - Sovereign adopted the expense recognition provisions of SFAS No. 123, “Accounting for Stock Based Compensation,” for stock based employee compensation awards issued on or after January 1, 2002. Sovereign accounted for all options granted prior to January 1, 2002, in accordance with the intrinsic value model of APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Sovereign estimates the fair value of option grants using a Black-Scholes option pricing model and, for options issued subsequent to January 1, 2002, expenses this value over the vesting periods as required in SFAS No. 123. Reductions in compensation expense associated with forfeited options are estimated at the date of grant, and this estimated forfeiture rate is adjusted quarterly based on actual forfeiture experience. Effective January 1, 2006, Sovereign adopted SFAS No.123R which did not have a material impact on Sovereign’s financial statements since we had previously adopted SFAS No. 123.
The fair value for our stock option grants were estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions:
Expected volatility is based on the historical volatility of Sovereign’s stock price. Sovereign utilizes historical data to predict options’ expected lives. The risk-free interest rate is based on the yield on a U.S. treasury bond with a similar maturity of the expected life of the option.
The amount of stock-based compensation expense, net of related tax effects, included in the determination of net income if the expense recognition provisions of SFAS No. 123 had been applied to all stock option awards in 2008, 2007 and 2006 did not differ from our annual results since substantially all options granted prior to 2002 were fully vested by the end of 2004.
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies (continued)
u. Equity Method Investments - Sovereign had an equity method investment in a synthetic fuel partnership that generated Section 29 tax credits for the production of fuel from a non-conventional source (“the Synthetic Fuel Partnership”). Reductions in the investment value and our allocation of the partnership’s earnings or losses totaled $26.2 million and $26.3 million for 2007 and 2006, respectively, and were included as expense in the line “Equity method investment expense” in our consolidated statement of operations, while the alternative energy tax credits we receive are included as a reduction of income tax expense. Sovereign amortized this investment through December 31, 2007 since this is the period through which we received alternative energy tax credits. We do not have any remaining asset on the balance sheet at December 31, 2008 related to this investment and will not incur any expenses or receive any tax credits related to the Synthetic Fuel Partnership in future periods.
The Company also has other investments in entities accounted for under the equity method including low-income housing tax credit partnerships which totaled $295.0 million at December 31, 2008. Given expectations that the current economic conditions will continue to adversely impact this broker’s results in future periods it was determined that the estimated fair value of our investment was significantly less than our cost basis and as a result an impairment charge of $95 million was recorded to write this investment down to approximately $10 million.
Note 2 - Recent Accounting Pronouncements
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS No. 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under generally accepted accounting principles. As a result of SFAS 157, there is now a common definition of fair value to be used throughout GAAP.
On January 1, 2008, the Company adopted SFAS No. 157. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.
SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.
Sovereign’s adoption of SFAS No. 157 did not have a significant impact on its financial condition or results of operations. See further discussion and analysis of Sovereign’s adoption of SFAS No. 157 in Note 20.
On February 15, 2007, the FASB issued FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115.” (“SFAS 159”), which allows entities, at specified election dates, to choose to measure certain financial instruments at fair value that are not currently required to be measured at fair value. The fair value option is applied on an instrument-by-instrument basis, is irrevocable and can only be applied to an entire instrument and not to specified risks, specific cash flows, or portions of that instrument. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings at each subsequent reporting date and upfront fees and costs related to those items will be recognized in earnings as incurred and not deferred. SFAS No. 159 is effective in fiscal years beginning after November 15, 2007 and may not be applied retrospectively. Effective January 1, 2008, Sovereign adopted the fair value option allowed by SFAS No. 159 on residential mortgage loans classified as held for sale that were originated subsequent to January 1, 2008. See further discussion and analysis of Sovereign’s adoption of this standard at Note 20 (Fair Value).
On December 4, 2007 the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51”. SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a non-controlling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the non-controlling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the non-controlling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its non-controlling interest. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. Management does not anticipate that this statement will have a material impact on Sovereign’s financial condition and results of operations.
Notes to Consolidated Financial Statements
Note 2 - Recent Accounting Pronouncements (continued)
On December 4, 2007 the FASB issued FASB Statement No. 141 (Revised 2007) (FAS 141(R)), Business Combinations. FAS 141(R) will significantly change the accounting for business combinations. Under Statement 141(R) an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. FAS 141(R) will change the accounting treatment for certain specific items, including:
•
Acquisition costs will be generally expensed as incurred;
•
Non-controlling interests (formerly known as “minority interests”) will be valued at fair value at the acquisition date;
•
Acquired contingent liabilities will be recorded at fair value at the acquisition date and subsequently measured at the higher of such amount determined under existing guidance for non-acquired contingencies. Changes in the value of these contingent liabilities will be recorded through earnings;
•
In process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date;
•
Restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date; and
•
Changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense.
This statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 31, 2008. The statement may not be adopted before that date.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (“SFAS 161”), which requires enhanced disclosures about an entity’s derivative and hedging activities intended to improve the transparency of financial reporting. Under SFAS 161, entities will be required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. Sovereign will adopt the disclosure provisions related to this pronouncement for its first quarter 2009 Form 10Q filing.
In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities” (“FSP FAS 140-4 and FIN 46(R)-8”). FSP FAS 140-4 and FIN 46(R)-8 amends FAS 140 and FIN 46(R) to require additional disclosures regarding transfers of financial assets and interest in variable interest entities. FSP FAS 140-4 and FIN 46(R)-8 is effective for interim or annual reporting periods ending after December 15, 2008. Sovereign included the disclosures required by these pronouncements in this Form 10-K.
Note 3 - Business Combinations
Sovereign closed on its acquisition of Independence effective June 1, 2006 for $42 per share in cash, representing an aggregate transaction value of approximately $3.6 billion. Sovereign funded this acquisition using the proceeds from the $2.4 billion equity offering to Banco Santander Central Hispano (“Santander”), net proceeds from issuances of perpetual and trust preferred securities and cash on hand. Sovereign issued 88.7 million shares to Santander, which made Santander its largest shareholder. Independence was headquartered in Brooklyn, New York, with 125 community banking offices in the five boroughs of New York City, Nassau and Suffolk Counties and New Jersey. Sovereign’s acquisition of Independence connected our Mid-Atlantic and New England geographic footprints and created new markets in certain areas of New York.
Notes to Consolidated Financial Statements
Note 3 - Business Combinations (continued)
The purchase price was allocated to the acquired assets and assumed liabilities of Independence based on estimated fair value as of June 1, 2006 (dollars in millions):
(1)
Includes liabilities of $26.2 million directly associated with the transaction which were recorded as part of the purchase price which is primarily comprised of $14.4 million of termination penalties for canceling certain long-term Independence contracts related to redundant services and $2.8 million related to branch consolidation.
In connection with the Independence acquisition, Sovereign recorded charges against its earnings for the twelve-month period ended December 31, 2007 and 2006 for merger related expenses of $2.2 million pre-tax and $42.8 million pre-tax, respectively.
These merger-related expenses include the following (in thousands):
The branch and office consolidation charge relates to lease obligations for Sovereign branch and office locations that were vacated by Sovereign in the third quarter of 2006 as a result of the Independence acquisition since management determined that these locations would no longer be required due to branch overlap or the creation of excess office space. This charge was based on the present values of the remaining lease obligations, or portions thereof, that were associated with lease abandonments, net of the estimated fair value of sub-leasing the properties. The fair value was estimated by comparing current market lease rates for comparable properties. If the actual proceeds from any subleases on these properties are different than our estimate, then the difference will be reflected as either additional merger-related expense or a reversal thereof.
The system conversion costs are related to transferring Independence’s customer data from their core application system to Sovereign’s core application systems. These conversions were completed in the fourth quarter of 2006. The retail banking conversion costs consist primarily of replacing and/or converting customer account data such as welcoming kits, ATM cards, checks, credit cards, etc. The marketing costs are related to media and promotional advertising campaigns that were primarily incurred in connection with the rebranding of the former Independence branches. Retention bonuses and other employee related costs represented stay bonuses for former Independence employees that continued to work for Sovereign from the acquisition date of June 1, 2006 through the fourth quarter of 2006 to assist with the system conversion which occurred on September 8, 2006.
Notes to Consolidated Financial Statements
Note 3 - Business Combinations (continued)
The status of reserves related to business acquisitions are summarized as follows (in thousands):
Note 4 - Goodwill and Other Intangible Assets
During the first quarter of 2008, as previously discussed in Sovereign’s 2008 first quarter Form 10-Q, certain changes to our executive management were announced such as the hiring of a new head of Retail Banking and a new Chief Financial Officer. In addition, Sovereign centralized the responsibility for the major businesses within the Company naming a new head of Retail, Commercial Lending, Corporate Specialty Businesses and Corporate Support Services. The head of these business units report directly to the Chief Executive Officer and, along with our Chief Financial Officer and Chief Risk Officer, comprise the Executive Management Group. These events changed how our executive management team measures and assesses business performance. During the second quarter we finalized the process of updating our business unit profitability system to reflect our new organizational structure.
As a result of the changes discussed above, Sovereign now has four reportable segments. The Company’s segments are focused principally around the customers Sovereign serves. The Retail Banking Division is comprised of our branch locations. Our branches offer a wide range of products and services to customers and each attracts deposits by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposits and retirement savings plans. Our branches also offer certain loans such as home equity loans and other consumer loan products and certain small business loans. The Corporate Specialties Group segment is primarily comprised of our mortgage banking group, our New York multi-family and national commercial real estate lending group, our automobile dealer floor plan lending group and our indirect automobile lending group. It also provides capital market services and cash management services. The Commercial Lending segment provides the majority of Sovereign’s commercial lending platforms such as commercial real estate loans, commercial industrial loans, leases to commercial customers, and small business loans. The Other segment includes earnings from the investment portfolio, interest expense on Sovereign’s borrowings and other debt obligations, minority interest expense, amortization of intangible assets and certain unallocated corporate income and expenses.
The Commercial Lending Segment is similar to our prior Shared Services Commercial segment with the exception of the automobile floor plan lending group which was transferred to the Corporate Specialties Group. The automobile floor plan lending business is a low margin business with negative valuations in the marketplace today given the credit environment in 2008 and the uncertainty of the auto-making industry. Accordingly, no goodwill was assigned to this operation and it was transferred at book value. The Commercial Lending Division’s goodwill balance of $342 million is unchanged from goodwill balance of the Shared Services Commercial Segment prior to the re-organization.
The Corporate Specialties Group segment is primarily comprised of our mortgage banking group, our New York multi-family and national commercial real estate lending group, our automobile dealer floor plan lending group and our indirect automobile lending group. It also provides capital market services and cash management services. During 2007, we had written off all of the goodwill for our Shared Services Consumer segment and there was no goodwill associated with the asset, liabilities, and certain operations that were transferred into the Corporate Specialties Group.
During 2008, Sovereign’s financial results were impacted by an increase in credit losses, and losses on our investment portfolio which caused current year results to be less than our internal plan. Additionally on October 13, 2008 we entered into a Transaction agreement with Santander which valued Sovereign at approximately $2.5 billion on the announcement date. Based on these events we performed our goodwill impairment testing during the third quarter of 2008 in addition to the annual test in the fourth quarter of 2008.
We utilized a discounted cash flow analysis to estimate the fair value of our reporting units using market based assumptions which valued the entire Company at a level consistent with the consideration paid by Santander. The fair value of our retail bank was in excess of its book value. This reporting unit has limited credit exposure and continues to be profitable. The fair value of our corporate specialty and commercial lending reporting units were negative due to the deterioration in their operating results in the current year and in particular the latter half of 2008 from increased credit losses on their loan portfolios. Of these two segments, only our commercial lending reporting unit had goodwill assigned to it. After completing step 2 of the goodwill impairment analysis for this unit, no goodwill charge was required in part due to the significant discount on the commercial loans that reside in this reporting unit. This discount caused its implied fair value of goodwill to be in excess of its allocated goodwill amount of $342 million.
Notes to Consolidated Financial Statements
Note 4 - Goodwill and Other Intangible Assets (continued)
Sovereign’s core deposit intangible assets balance decreased to $252.3 million at December 31, 2008 from $352.8 million at December 31, 2007 as a result of core deposit intangible amortization of $100.5 million in 2008. The weighted average life of our core deposit intangibles is 2.5 years and the estimated aggregate amortization expense related to core deposit intangibles for each of the five succeeding calendar years ending December 31 is (in thousands):
Sovereign also recorded other intangibles of $25.1 million in connection with its acquisition of Independence related to fair market value adjustments associated with operating lease agreements of $22.3 million and certain non-competition agreements with key employees totaling $2.8 million. These intangibles are amortized on a straight-line basis over the term of the lease and the non-competition term, respectively. Sovereign recorded intangible asset amortization of $3.2 million and $3.8 million for the years ended December 31, 2008 and 2007, respectively related to these two items.
Note 5 - 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 at December 31, 2008 and 2007 were $346 million and $334 million, respectively.
Notes to Consolidated Financial Statements
Note 6 - Investment Securities
The amortized cost and estimated fair value of Sovereign’s available for sale investment securities are as follows (in thousands):
During the third quarter, Sovereign recorded a $575 million other-than-temporary impairment on our FNMA and FHLMC preferred stock portfolio as a result of the actions described below. On September 7, 2008, the U.S. Department of the Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) announced that the FHFA was putting Fannie Mae and Freddie Mac under conservatorship and giving management control to their regulator, the FHFA. In connection with this action, the dividends on our preferred shares were eliminated thereby significantly reducing the value of our investment which resulted in the impairment charge. We believe the remaining balance is recoverable and the unrealized loss is temporary given the volatility in the stock price since September 30, 2008, at which time the fair value equaled its book value.
In order to reduce risk in the investment portfolio, Sovereign sold its entire portfolio of collateralized debt obligations (“CDOs”) during the third quarter of 2008. The CDO portfolio has experienced significant volatility over the past year as a result of conditions in the credit markets. Sovereign recorded a pretax loss of $602.3 million in connection with the sale of these securities.
The unrealized losses on the Company’s state and municipal bond portfolio increased to $211.0 million at December 31, 2008 from $26.4 million at December 31, 2007. This portfolio consists of 100% general obligation bonds of states, cities, counties and school districts. The portfolio has a weighted average underlying credit risk rating of AA-. These bonds are insured with various companies and as such, carry additional credit protection. The Company has determined that the unrealized losses on the portfolio are due to an increase in credit spreads (but not expected losses) and liquidity issues in the marketplace and concerns with respect to the financial strength of third party insurers. However, even if it was assumed that the insurers could not honor their obligation, our underlying portfolio is still investment grade and the Company believes that we will collect all scheduled principal and interest. The Company has concluded these unrealized losses are temporary in nature since they are not related to the underlying credit quality of the issuers, and the Company has the intent and ability to hold these investments for a time necessary to recover its cost, which may be at maturity.
The unrealized losses on the non-agency securities portfolio increased to $552.4 million December 31, 2008 from $98.2 million at December 31, 2007. Other than what is described in the following paragraph, this portfolio consists primarily of highly rated non-agency mortgage-backed securities from a diverse group of issuers in the private-label market. The Company has determined that the unrealized losses on the portfolio are due to an increase in credit spreads and liquidity issues in the marketplace. The Company has concluded these unrealized losses are temporary in nature on the majority of this portfolio since we believe based on modeled projections, that there is sufficient credit subordination associated with these securities and the Company has the intent and ability to hold these investments for a time necessary to recover its cost, which may be maturity. Additionally, our investments are in senior positions that are in excess of current and expected cumulative loss positions.
Notes to Consolidated Financial Statements
Note 6 - Investment Securities (continued)
For the period ended, December 31, 2008, it was concluded that the Company would not recover the full outstanding principal on five bonds in our non-agency mortgage backed portfolio with a book value of $654.3 million whose fair value was $346.4 million. Under SFAS No. 115, in the event that it is concluded that all of the investment securities principal cash flows will not be collected, a charge to earnings is required to write-down the investment to its fair market value even if the entity expects to collect principal cash flows in excess of this amount. As a result, Sovereign recorded a $307.9 million other than temporary impairment charge.
The following table discloses the age of gross unrealized losses in our portfolio as of December 31, 2008 and 2007 (in thousands):
Notes to Consolidated Financial Statements
Note 6 - Investment Securities (continued)
As of December 31, 2008, the Company has concluded that the unrealized losses on its remaining investment securities (which totaled 260 individual securities) are temporary in nature since they are not related to the underlying credit quality of the issuers, and the Company has the intent and ability to hold these investments for a time necessary to recover its cost and will ultimately recover its cost at maturity (i.e. these investments have contractual maturities that, absent a credit default, ensure Sovereign will ultimately recover its cost). In making its other-than-temporary impairment evaluation, Sovereign considered the fact that the principal and interest on these securities are from issuers that are investment grade.
Proceeds from sales of investment securities and the realized gross gains and losses from those sales are as follows (in thousands):
Not included in the 2008, 2007 and 2006 amounts above were other-than-temporary impairment charges of $575.3 million, $180.5 million and $67.5 million, respectively, on FNMA and FHLMC preferred stock. Results in 2008 do not include the previously mentioned other-than-temporary impairment charge of $307.9 million on certain non-agency mortgage backed securities.
The 2008 gross realized losses were primarily related to the previously mentioned loss on our CDO portfolio. The gross realized losses in 2006 of $282.8 million include a $238.3 million ($154.9 million after tax or $0.36 per share) loss on the sale of $3.5 billion of investment securities following the Independence acquisition. During the fourth quarter of 2006, as part of a balance sheet restructuring, Sovereign sold $1.5 billion of investment securities with a combined effective yield of 4.60% and incurred a pre-tax loss of $43.0 million. The proceeds were reinvested in higher yielding securities to improve future net interest margin and for collateral on certain of our borrowing and deposit obligations.
Notes to Consolidated Financial Statements
Note 6 - Investment Securities (continued)
Contractual maturities and yields of Sovereign’s investment securities available for sale at December 31, 2008 are as follows (in thousands):
(1)
The maturities above do not represent the effective duration of Sovereign’s portfolio since the amounts above are based on contractual maturities and do not contemplate anticipated prepayments, with the exception of the securities identified in Note 2 below.
(2)
Mortgage-backed and state and municipal securities are assigned to maturity categories based on their estimated average lives.
(3)
Weighted-average yields are based on amortized cost. Yields on tax-exempt securities are calculated on a tax equivalent basis and are based on an effective tax rate of 35%.
Nontaxable interest and dividend income earned on investment securities was $122.6 million, $149.4 million and $140.0 million for years ended December 31, 2008, 2007 and 2006, respectively. Tax expense/ (benefit) related to net realized gains and losses from sales of investment securities for the years ended December 31, 2007 and 2006 were $(1.5) million and $(85.8) million, respectively. Investment securities with an estimated fair value of $8.0 billion were pledged as collateral for borrowings, standby letters of credit, interest rate agreements and public deposits at December 31, 2008 and 2007.
Notes to Consolidated Financial Statements
Note 7 - Loans
A summary of loans held for investment included in the Consolidated Balance Sheets is as follows (in thousands):
In connection with the Company’s balance sheet restructuring our 2007 asset mix strategy was to de-emphasize lower yielding assets such as residential and multi-family loans and increase higher yielding commercial loans. This caused the mix of our loan categories to change which is demonstrated in the table above.
A summary of loans held for sale included in the Consolidated Balance Sheets is as follows (in thousands):
In the fourth quarter of 2006, Sovereign reclassified $4.3 billion of correspondent home equity and $2.9 billion of mortgage loans to loans held for sale as part of our announced balance sheet restructuring. The loans were written-down to fair value. The lower of cost of market adjustments resulted in a charge-off of $382.5 million and an increase to our provision for credit losses of $296 million. This was required since it was determined that this reduction in fair value was associated with credit factors and not interest rates. Sovereign also recorded a $35.3 million write-down on the mortgage loans. Approximately $7.1 million of this write-down to fair value was due to credit quality deterioration and the remaining adjustment of $28.2 million was due to changes in interest rates, and as a result we charged the interest-related portion of the discount to earnings as a reduction to mortgage banking revenues.
Notes to Consolidated Financial Statements
Note 7 - Loans (continued)
The activity in the allowance for credit losses is as follows (in thousands):
Impaired, non-performing, and past due loans are summarized as follows (in thousands):
Notes to Consolidated Financial Statements
Note 8 - Mortgage Servicing Rights
At December 31, 2008, 2007, and 2006, Sovereign serviced residential real estate loans for the benefit of others totaling $13.1 billion, $11.2 billion, and $9.2 billion, respectively. The following table presents a summary of the activity of the asset established for Sovereign’s mortgage servicing rights for the years indicated (in thousands). See discussion of Sovereign’s accounting policy for mortgage servicing rights in Note 1. Sovereign had net gains on the sales of residential mortgage loans and mortgage backed securities that were related to loans originated or purchased and held by Sovereign of $18.9 million, $47.8 million, and $6.4 million in 2008, 2007 and 2006, respectively.
The fair value of our residential mortgage servicing rights is estimated using a discounted cash flow model. The fair value of our residential mortgage servicing rights was $113.2 million, $151.4 million and $123.1 million at December 31, 2008, 2007 and 2006, respectively. This model estimates the present value of the future net cash flows of the servicing portfolio based on various assumptions. The most important assumptions in the valuation of residential mortgage servicing rights are anticipated loan prepayment rates (CPR speed) and the positive spread we receive on holding escrow related balances. Increases in prepayment speeds result in lower valuations of residential mortgage servicing rights. The escrow related credit spread is the estimated reinvestment yield earned on the serviced loan escrow deposits. Increases in escrow related credit spreads result in higher valuations of mortgage servicing rights. For each of these items, Sovereign must make assumptions based on future expectations. All of the assumptions are based on standards that we believe would be utilized by market participants in valuing residential mortgage servicing rights and are consistently derived and/or benchmarked against independent public sources. Additionally, an independent appraisal of the fair value of our residential mortgage servicing rights is obtained annually and is used by management to evaluate the reasonableness of our discounted cash flow model.
Listed below are the most significant assumptions that were utilized by Sovereign in its evaluation of residential mortgage servicing right for the periods presented.
A valuation allowance is established for the excess of the cost of each residential mortgage servicing asset stratum over its estimated fair value. Activity in the valuation allowance for residential mortgage servicing rights for the years indicated consisted of the following (in thousands):
A valuation allowance of $48.8 million was recorded in the fourth quarter of 2008 due to increased prepayment speed assumptions at December 31, 2008 as a result of lower market interest rates.
Notes to Consolidated Financial Statements
Note 8 - Mortgage Servicing Rights (continued)
For year ended December 31, 2008, mortgage servicing fee income was $50.0 million, compared with $42.2 million in 2007. Sovereign had (losses)/gains on mortgage loans, multi-family loans and home equity loans of $20.1 million for the twelve-month period ended December 31, 2008, compared with a loss of $76.3 million for the corresponding period ended December 31, 2007. The loss recorded for the twelve-month period ended December 31, 2007 is a result of a $119.9 million charge recorded on the correspondent home equity loan portfolio. Sovereign had planned on selling $4.3 billion of correspondent home equity loans as of December 31, 2006. However, we were not able to sell $658 million of loans and as a result wrote them down to fair value incurring a charge of $84.2 million which was recorded within mortgage banking revenue. In addition, Sovereign also established a reserve for any potential loan repurchases that may result from certain representation and warranty clauses contained within the sale agreement. Finally, we were required to further write down the loans that we sold in the first quarter due to lower pricing on the execution of the sales which resulted from increases in delinquencies on the loan portfolio since year-end and lower pricing in the market place for non-prime loans. The total charge recorded in connection with these two items was $35.7 million.
During 2007 and 2006 Sovereign wrote off $1.2 million and $5.9 million of mortgage servicing rights due to the realization that certain loan stratifications had become permanently impaired. Each reporting period, Sovereign analyzes each loan stratification’s current book value compared against its fair value. The stratum are based on interest rate bands by loan product type and these stratum have been consistently applied over the last several years. A determination is then made as to whether this decline is permanent by analyzing various factors such as the duration of the impairment and our expectation of future assumptions that impact the fair value of the loan stratification. If the impairment is deemed permanent the mortgage servicing asset is written off against the mortgage servicing valuation reserve.
Sovereign originates and sells multi-family loans in the secondary market to Fannie Mae while retaining servicing. Under the terms of the sales program with Fannie Mae, we retain a portion of the credit risk associated with such loans. As a result of this agreement with Fannie Mae, Sovereign retains a 100% first loss position on each multi-family loan sold to Fannie Mae under such program until the earlier to occur of (i) the aggregate losses on the multi-family loans sold to Fannie Mae reaching the maximum loss exposure for the portfolio as a whole ($249.8 million as of December 31, 2008) or (ii) until all of the loans sold to Fannie Mae under this program are fully paid off. The maximum loss exposure is available to satisfy any losses on loans sold in the program subject to the foregoing limitations.
The Company has established a liability which represents the fair value of the retained credit exposure. This liability represents the amount that the Company estimates that it would have to pay a third party to assume the retained recourse obligation. The estimated liability represents the present value of the estimated losses that the portfolio is projected to incur based upon an industry-based default curve with a range of estimated losses. At December 31, 2008, Sovereign had a $38.3 million liability related to the fair value of the retained credit exposure for loans sold to Fannie Mae under this sales program The Company has established a liability related to the fair value of the retained credit exposure for loans sold to Fannie Mae. This liability represents the amount that the Company estimates that it would have to pay a third party to assume the retained recourse obligation. The estimated liability represents the present value of the estimated losses that the portfolio is projected to incur based upon an industry-based default curve with a range of estimated losses. At December 31, 2008 and 2007, Sovereign had $38.3 million and $23.5 million of liabilities related to the fair value of the retained credit exposure for loans sold to Fannie Mae under this sales program. The reason for the increase from the prior year is due to the deteriorating economic environment which has weakened the credit quality of this portfolio, as well as, an increase of $2.1 billion of loans sold to Fannie Mae outstanding to $13.0 billion compared with the prior year.
Notes to Consolidated Financial Statements
Note 9 - Premises and Equipment
A summary of premises and equipment, less accumulated depreciation and amortization, follows (in thousands):
Included in occupancy and equipment expense for 2008, 2007 and 2006 was depreciation expenses of $82.8 million, $88.0 million and $83.4 million, respectively.
Note 10 - Accrued Interest Receivable
Accrued interest receivable is summarized as follows (in thousands):
Notes to Consolidated Financial Statements
Note 11 - Deposits
Deposits are summarized as follows (in thousands):
Interest expense on deposits is summarized as follows (in thousands):
The following table sets forth the maturity of Sovereign’s certificates of deposit of $100,000 or more at December 31, 2008 as scheduled to mature contractually (in thousands):
The following table sets forth the maturity of all of Sovereign’s certificates of deposit at December 31, 2008 as scheduled to mature contractually (in thousands):
Deposits collateralized by investment securities, loans, and other financial instruments totaled $1.5 billion and $2.4 billion at December 31, 2008 and December 31, 2007, respectively.
Notes to Consolidated Financial Statements
Note 12 - Borrowings and Other Debt Obligations
The following table presents information regarding Sovereign Bank and Holding Company borrowings and other debt obligations at the dates indicated (in thousands). All Sovereign Bank obligations have priority over Holding Company obligations:
Included in borrowings and other debt obligations are sales of securities under repurchase agreements. Repurchase agreements are treated as financings with the obligations to repurchase securities sold reflected as a liability in the balance sheet. The dollar amount of securities underlying the agreements remains recorded as an asset, 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 deliver 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.
FHLB advances are collateralized by qualifying mortgage-related assets as defined by the FHLB.
In December 2008, Sovereign Bank issued $1.35 billion in 3 year fixed rate FDIC-guaranteed notes under the Temporary Liquidity Guarantee Program (“TLG Program”). The fixed rate note bears interest at a rate of 2.75% and matures on January 17, 2012. At the same time, Sovereign Bancorp issued $250 million in 3.5 year fixed rate senior unsecured notes with the FDIC-guarantee under the TLG Program at a rate of 2.50%. The bonds mature on June 15, 2012. This debt is backed by the full faith and credit worthiness of the U.S. government. In order to obtain this guarantee, an upfront payment of $41.5 million and $8.7 million was made to the FDIC. These amounts were deferred and are being amortized over the contractual life of the debt. This cost, along with other transaction costs and a slight discount on the issuance of these notes results in these borrowings having an effective rate of 3.92% and 3.73%, respectively.
In May 2008, Sovereign Bank issued $500 million of non-callable fixed rate subordinated notes which have an effective interest rate of 8.83%. These notes are due in May 2018 and are not subject to redemption prior to that date except in the case of the insolvency or liquidation of Sovereign Bank, and then only with prior regulatory approval. These subordinated notes qualify as Tier 2 regulatory capital for Sovereign Bank. Under the current OTS rules, 5 years prior to maturity, 20% of the balance of the subordinated note will no longer qualify as Tier 2 capital. In each successive year prior to maturity, an additional 20% of the subordinated note will no longer qualify as Tier 2 capital.
During the first quarter of 2007, Sovereign issued $300 million of 3 year, floating rate senior notes. The floating rate notes bear interest at a rate of 3 month LIBOR plus 23 basis points (adjusted quarterly) and mature on March 23, 2010. The notes are not redeemable at Sovereign’s option nor are they repayable prior to maturity at the option of the holders. The proceeds of the offering were used to for general corporate purposes.
On June 13, 2006, Sovereign’s wholly owned subsidiary, Sovereign Capital Trust VI issued $300 million capital securities which are due June 13, 2036. Principal and interest on Trust VI Capital Securities are paid by junior subordinated debentures due to Trust VI from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities will represent preferred beneficial interests in Trust VI. Distributions on the capital securities accrue from the original issue date and are payable, semiannually in arrears on the 13th day of June and December of each year, beginning on December 13, 2006 at an annual rate of 7.91%. The capital securities are not redeemable prior to June 13, 2016. The proceeds from the offering were used for general corporate purposes. Sovereign presents the junior subordinated debentures due to Trust VI as a component of borrowings.
Notes to Consolidated Financial Statements
Note 12 - Borrowings and Other Debt Obligations (continued)
On May 31, 2006, Sovereign’s wholly-owned subsidiary, Sovereign Capital Trust IX (the “Trust”) issued $150 million capital securities which are due July 7, 2036. Principal and interest on Trust IX Capital Securities are paid by junior subordinated debentures due to Trust IX from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities represent preferred beneficial interests in Trust IX. Distributions on the capital securities accrue from the original issue date and are payable, quarterly in arrears on the 7th day of January, April, July and October of each year, beginning on July 7, 2006 at an annual rate of three-month LIBOR plus 1.75%. The capital securities are callable at a redemption price of 105% of par during the first five years, after which they are callable at par. The proceeds from the offering were used to finance a portion of the purchase price for Sovereign’s pending acquisition of Independence, which closed on June 1, 2006. Sovereign presents the junior subordinated debentures due to Trust IX as a component of borrowings.
On May 22, 2006, Sovereign’s wholly-owned subsidiary, Sovereign Capital Trust V issued $175 million capital securities which are due May 22, 2036. Principal and interest on Trust V Capital Securities are paid by junior subordinated debentures due to Trust V from Sovereign whose terms and conditions mirror the Capital Securities. The capital securities represent preferred beneficial interests in Trust V. Distributions on the capital securities accrue from the original issue date and are payable, quarterly in arrears on the 15th day of February, May, August and November of each year, beginning on August 15, 2006 at an annual rate of 7.75%. The capital securities are not redeemable prior to May 22, 2011. The proceeds from the offering were used to finance a portion of the purchase price for Sovereign’s acquisition of Independence, which closed on June 1, 2006. Sovereign presents the junior subordinated debentures due to Trust V as a component of borrowings.
In connection with the acquisition of Independence, Sovereign assumed $250 million of senior notes and $400 million of subordinated borrowing obligations. The senior notes mature in September 2010 and carry a fixed rate of interest of 4.90%. The $400 million of subordinated notes include $250 million of 3.75% Fixed Rate/ Floating Rate Subordinated Notes Due March 2014 which bear interest at a fixed rate of 3.75% per annum for the first five years, and convert to a floating rate thereafter until maturity based on the US Dollar three-month LIBOR plus 1.82%. Beginning on April 1, 2009 Sovereign has the right to redeem these obligations at par plus accrued interest. The subordinated notes also include $150.0 million aggregate principal amount of 3.50% Fixed Rate/ Floating Rate Subordinated Notes Due June 2013. These obligations bear interest at a fixed rate of 3.50% per annum for the first five years, and convert to a floating rate thereafter until maturity based on the US Dollar three-month LIBOR plus 2.06%. Beginning on June 20, 2008 Sovereign has the right to redeem these obligations at par plus accrued interest.
During the third quarter of 2005, Sovereign issued $200 million of 3.5 year, floating rate senior notes and $300 million of 5 year, fixed rate senior notes at 4.80%. The floating rate notes bear interest at a rate of 3 month LIBOR plus 28 basis points (adjusted quarterly) and mature on March 1, 2009. The fixed rate notes mature on September 1, 2010. The proceeds of the offering were used to pay off $225 million of a line of credit at LIBOR plus 90 basis points, provide additional holding company cash for a previously announced stock repurchase program, enhance the short-term liquidity of the company, and for general corporate purposes.
On February 26, 2004, Sovereign issued $700 million of Contingent Convertible Trust Preferred Equity Income Redeemable Securities (“PIERS”). On March 8, 2004, Sovereign raised an additional $100 million of PIERS under this offering. The offering was completed through Sovereign Capital Trust IV (the “Trust”), a special purpose entity established to issue the PIERS. Each PIERS had an issue price of $50 and represents an undivided beneficial ownership interest in the assets of the Trust, which consist of:
As a result of the acquisition of Santander, which closed on January 30, 2009, the warrant holders are entitled to receive Santander ADRs instead of Sovereign common stock upon the exercise of their warrants. Holders may convert each of their Trust PIERS into ADRs representing 0.5482 ordinary shares of Santander, which is equivalent to the conversion ratio of 1.71 shares of Sovereign common stock per warrant prior to the acquisition if: (1) during any calendar quarter if the closing sale price of Santander ADRs over a specified measurement period meet certain criteria; (2) prior to March 1, 2029, during the five-business-day period following any 10-consecutive-trading-day period in which the average daily trading price of the Trust PIERS for such 10-trading-day period was less than 105% of the average conversion value of the Trust PIERS during that period and the conversion value for each day of that period was less than 98% of the issue price of the Trust PIERS; (3) during any period in which the credit rating assigned to the Trust PIERS by either Moody’s or Standard & Poor’s is below a specified level; (4) if the Trust PIERS have been called for redemption or (5) upon the occurrence of certain corporate transactions. The Trust PIERS and the junior subordinated debentures will have a distribution rate of 4.375% per annum of their issue price, subject to deferral. In addition, contingent distributions of $.08 per $50 issue price per Trust PIERS will be due during any three-month period commencing on or after March 1, 2007 under certain conditions. The Trust PIERS may not be redeemed by Sovereign prior to March 5, 2007, except upon the occurrence of certain special events. On any date after March 5, 2007, Sovereign may, if specified conditions are satisfied, redeem the Trust PIERS, in whole but not in part, for cash for a price equal to 100% of their issue price plus accrued and unpaid distributions to the date of redemption, if the closing price of Santander ADSs has exceeded a price per share that is equal to 130% of the effective conversion price, subject to adjustment, for a specified period. The effective conversion price as of January 30, 2009 was $91.21 per share.
The proceeds from the PIERS of $800 million, net of transaction costs of approximately $16.3 million, were allocated pro rata between “Junior Subordinated debentures due to Capital Trust Entities” in the amount of $498.3 million and “Warrants and employee stock options issued” in the amount of $285.4 million based on their relative fair values. The difference between the carrying amount of the subordinated debentures and the principal amount due at maturity is being accreted into interest expense using the effective interest method over the period to maturity of the PIERS which is March 2, 2034. The effective interest rate of this financing is 6.71% and 6.75% at December 31, 2008 and 2007, respectively.
Notes to Consolidated Financial Statements
Note 12 - Borrowings and Other Debt Obligations (continued)
Sovereign has an additional $72.5 million of Junior Subordinated debentures due to Capital Trust Entities. These securities have a weighted average interest rate of 8.29% and 8.49% at December 31, 2008 and 2007, respectively and they are redeemable at the Company’s election beginning July 2006 through March 2010 at a price equal to 100% of the principal amount plus accrued interest to the date of redemption. These securities must be redeemed in the periods between March 2027 through April 2033. Periodic cash payments and payments upon liquidation or redemption with respect to Trust Securities are guaranteed by the Corporation to the extent of funds held by the Trusts (the Preferred Securities Guarantee). The Preferred Securities Guarantee, when taken together with the Corporation’s other obligations, including its obligations under the Notes, will constitute a full and unconditional guarantee, on a subordinated basis, by the Corporation of payments due on the Trust Securities.
During March of 2003, Sovereign Bank issued $500 million of subordinated notes (the “March subordinated notes”), at a discount of $4.7 million, which have a coupon of 5.125%. In August 2003, Sovereign Bank issued $300 million of subordinated notes (the “August subordinated notes”), at a discount of $0.3 million, which have a coupon of 4.375%. The August subordinated notes mature in August 2013 and are callable at par beginning in August 2008. The March subordinated notes are due in March 2013 and are not subject to redemption prior to that date except in the case of the insolvency or liquidation of Sovereign Bank, and then only with prior regulatory approval. These subordinated notes qualify as Tier 2 regulatory capital for Sovereign Bank. Under the current OTS rules, 5 years prior to maturity, 20% of the balance of the subordinated notes will no longer qualify as Tier 2 capital. In each successive year prior to maturity, an additional 20% of the subordinated notes will no longer qualify as Tier 2 capital.
The following table sets forth the maturities of Sovereign’s borrowings and debt obligations (including the impact of expected cash flows on interest rate swaps) at December 31, 2008 (in thousands):
Note 13 - Minority Interests
Minority interests represent the net assets and earnings attributable to the equity of consolidated subsidiaries that are owned by parties independent of Sovereign. Earnings attributable to minority interests are reflected in and other minority interest expense and equity method investments on the Consolidated Statements of Operations.
On August 21, 2000, Sovereign received approximately $140 million of net proceeds from the issuance of $161.8 million of 12% Series A Noncumulative Preferred Interests in Sovereign Real Estate Investment Trust (“SREIT”), a subsidiary of Sovereign Bank, that holds primarily residential real estate loans. The preferred stock was issued at a discount, and is being amortized over the life of the preferred shares using the effective yield method. The preferred shares may be redeemed at any time on or after May 16, 2020, at the option of Sovereign subject to the approval of the OTS. Under certain circumstances, the preferred shares are automatically exchangeable into preferred stock of Sovereign Bank. The offering was made exclusively to institutional investors. The proceeds of this offering were principally used to repay corporate debt.
Notes to Consolidated Financial Statements
Note 14 - Stockholders’ Equity
On May 16, 2008, Sovereign issued 179.9 million shares of common stock which raised net proceeds of $1.39 billion to enhance its capital and liquidity positions. We utilized the proceeds to pay down certain FHLB borrowings and our revolving credit facility.
On May 31, 2006, Sovereign issued common stock to Santander and received net proceeds of $2.4 billion which was used to fund a portion of the Independence acquisition. For further discussion, see Note 3.
On May 15, 2006, Sovereign issued 8,000 shares of Series C non-cumulative perpetual preferred stock and received net proceeds of $195.4 million. The perpetual preferred stock ranks senior to our common stock. Our perpetual preferred stockholders are entitled to receive dividends when and if declared by our board of directors at the rate of 7.30% per annum, payable quarterly, before we may declare or pay any dividend on our common stock. The dividends on the perpetual preferred stock are non-cumulative. The Series C preferred stock is not redeemable prior to May 15, 2011. On or after May 15, 2011, the Series C preferred stock is redeemable at par.
The dividends on our preferred stock are recorded against retained earnings, however for earnings per share purposes they are deducted from net income available to common shareholders. See Note 24 for the calculation of earnings per share.
Sovereign maintained an Employee Stock Purchase Plan allowing employees with at least six months of employment and who average over 20 hours per week to purchase shares through a payroll deduction at a discount from fair market value of 7.5% subject to a maximum of the lesser of 15% of pay or $25,000. Compensation expense recorded in connection with this plan for 2008, 2007 and 2006 was immaterial. Sovereign discontinued this plan in the fourth quarter of 2008.
Retained earnings at December 31, 2008 included $112.1 million in bad debt reserves, for which no deferred taxes have been provided due to the indefinite nature of the recapture provisions.
Sovereign’s debt agreements impose certain limitations on dividends, other payments and transactions and we are currently in compliance with these limitations.
At December 31, 2008, Sovereign had 37.8 million capital shares reserved for future issuance, which includes shares issuable upon the exercise of the warrants related to the PIERS financing, shares issuable for unexercised stock options, and employee stock purchase plans.
During 2007, Sovereign’s executive management team and Board of Directors decided to freeze the Company’s Employee Stock Ownership Plan (ESOP). The debt owed by the ESOP was repaid with the proceeds from the sale of a portion of the unallocated shares held by the ESOP and all remaining shares were allocated to the eligible participants. Sovereign recorded a non-deductible, non-cash charge of $40.1 million during 2007 based on the value of its common stock on the date that the ESOP was repaid.
Note 15 - Regulatory Matters
The Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA”) requires institutions regulated by the Office of Thrift Supervision (“OTS”) to have a minimum tangible capital ratio equal to 1.5% of tangible assets, and a minimum leverage ratio equal to 4% of tangible assets, and a risk-based capital ratio equal to 8% as defined. The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) requires OTS regulated institutions to have a minimum tangible capital equal to 2% of total tangible assets. As of December 31, 2008 and 2007, Sovereign Bank met all capital adequacy requirements to which it is subject to in order to be well-capitalized.
The FDICIA established five capital tiers: well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. A depository institution’s capital tier depends upon its capital levels in relation to various relevant capital measures, which include leverage and risk-based capital measures and certain other factors. Depository institutions that are not classified as well-capitalized or adequately-capitalized are subject to various restrictions regarding capital distributions, payment of management fees, acceptance of brokered deposits and other operating activities.
Federal banking laws, regulations and policies also limit Sovereign Bank’s ability to pay dividends and make other distributions to Sovereign. Sovereign Bank must obtain prior OTS approval to declare a dividend or make any other capital distribution if, after such dividend or distribution; (1) Sovereign Bank’s total distributions to the holding company within that calendar year would exceed 100% of its net income during the year plus retained net income for the prior two years; (2) Sovereign Bank would not meet capital levels imposed by the OTS in connection with any order, or (3) if Sovereign Bank is not adequately capitalized at the time. In addition, OTS prior approval would be required if Sovereign Bank’s examination or CRA ratings fall below certain levels or Sovereign Bank is notified by the OTS that it is a problem association or an association in troubled condition.
Any dividends declared and paid have the effect of reducing the Bank’s tangible capital to tangible assets, Tier 1 leverage capital to tangible assets and Tier 1 risk-based capital ratios. Total dividends from Sovereign Bank to Sovereign or its affiliates during the years ended December 31, 2008 and 2007 were $30 million and $240 million, respectively.
Notes to Consolidated Financial Statements
Note 15 - Regulatory Matters (continued)
The following schedule summarizes the actual capital balances of Sovereign Bank at December 31, 2008 and 2007:
The Sovereign Bank capital ratios at December 31, 2008 have decreased from December 31, 2007 levels due to the net loss recorded in 2008, partially offset by $800 million of capital pushed down to the Bank from our Holding Company related to our 2008 common stock issuance.
Notes to Consolidated Financial Statements
Note 16 - Stock-Based Compensation
Sovereign has plans, which are shareholder approved, that grant restricted stock and stock options for a fixed number of shares to key officers, certain employees and directors with an exercise price equal to the fair market value of the shares at the date of grant. Sovereign believes that such awards better align the interest of its employees with those of its shareholders. Sovereign’s stock options expire not more than 10 years and one month after the date of grant and generally become fully vested and exercisable within a five year period after the date of grant and, in certain limited cases, based on the attainment of specified targets. Restricted stock awards vest over a period of three to five years. Stock option and restricted stock awards provide for accelerated vesting in certain circumstances, such as a change in control and in certain cases upon an employee’s retirement. Sovereign records compensation expense over the shorter of the contractual vesting term or the employee’s retirement date in the event the award vests. These circumstances are defined in the plan agreements.
The following table provides a summary of Sovereign’s stock option activity for the years ended December 31, 2008, 2007 and 2006 and stock options exercisable at the end of each of those years.
The weighted average grant date fair value of options granted during the years ended December 31, 2008, 2007, and 2006 was $2.54, $6.24 and $6.42, respectively. The total intrinsic value of options exercised during the years ended December 31, 2008, 2007, and 2006, was $1.9 million, $28.6 million and $19.1 million, respectively.
The following table summarizes Sovereign’s stock options outstanding at December 31, 2008:
Cash received from option exercises for all share-based payment arrangements for the years ended December 31, 2008, 2007 and 2006, was $6.7 million, $26.3 million and $20.6 million, respectively. The tax deductions from option exercises of the share-based payment arrangements totaled $1.8 million, $24.1 million and $16.5 million, respectively for the years ended December 31, 2008, 2007 and 2006. At December 31, 2008, Sovereign had $5.1 million of unrecognized compensation cost related to employee stock option awards. In connection with the transaction with Santander on January 30, 2009, any option holders whose awards had intrinsic value on January 30th would have received cash proceeds equal to their intrinsic value. However, Sovereign’s stock price on the transaction date was $2.47, and as such none of the awards had any intrinsic value and all of them expired worthless.
Notes to Consolidated Financial Statements
Note 16 - Stock-Based Compensation (continued)
From September 2005 through February 2007, Sovereign issued treasury shares to satisfy option exercises, and as such, has issued approximately 1.1 million treasury shares in 2007 at a weighted average cost of $21.00, and 1.6 million treasury shares in 2006 at a weighted average cost of $21.64. Subsequent to February 2007, Sovereign issued new authorized shares to satisfy option exercises. Additionally, the Company repurchased approximately 213,000 shares at an average cost of $12.01 during 2008, 175,000 shares at an average cost of $24.75 during 2007, and 249,000 shares at an average cost of $21.24 during 2006 for the vestings of restricted stock.
The table below summarizes the changes in Sovereign’s non-vested restricted stock during the past year.
Since 2001, Sovereign has issued shares of restricted stock to certain key officers and employees that vest over a three-year or five-year period. Pre-tax compensation expense associated with these amounts totaled $20.6 million, $19.2 million and $13.1 million in 2008, 2007 and 2006, respectively. As of December 31, 2008, there was $48.1 million of total unrecognized compensation cost related to restricted stock awards. The weighted average grant date fair value of restricted stock granted in 2008, 2007 and 2006 was $10.89 per share, $25.14 per share and $20.16 per share, respectively. All non-vested restricted stock vested on January 30, 2009 in connection with the acquisition of Sovereign by Santander.
Note 17 - Employee Benefit Plans
In the first quarter of 2007, Sovereign’s executive management team and Board of Directors decided to freeze the Company’s Employee Stock Ownership Plan (“ESOP”). The debt owed by the ESOP was repaid with the proceeds from the sale of a portion of the unallocated shares held by the ESOP and all remaining shares were allocated to the eligible participants. Sovereign recorded a non-deductible non-cash charge of $40.1 million in connection with this action based on the value of its common stock on the final price of Sovereign’s common stock on the date that the ESOP was repaid.
Substantially all employees of Sovereign are eligible to participate in the 401(k) portion of the Retirement Plan following their completion of six months service and attaining age 21. Effective January 31, 2008, Sovereign employees are eligible to participate in the 401(k) portion of the Retirement Plan following 30 days of employment. Additionally, there is no longer an age requirement to join the 401(k) portion of the Retirement Plan. Sovereign recognized expense for contributions to the 401(k) portion of the Retirement Plan of $17.2 million, $15.5 million and $12.9 million during 2008, 2007 and 2006, respectively. Employees can contribute up to 100% of their compensation to the 401(k) portion of the Retirement Plan subject to IRS limitations. Sovereign matches 100% of the employee contributions up to 3% of compensation and 50% of the employee contribution in excess of 3% to 5% in the form of Sovereign common stock. Participants may transfer the matching contribution to other investment vehicles available under the 401(k) portion of the Retirement Plan.
Sovereign maintained a bonus deferral plan for selected management and executive employees. This plan allowed certain employees to defer 25% to 50% of their bonus to purchase Sovereign stock. The deferred amount is placed in a grantor trust and invested in Sovereign common stock. Matching contributions of 100% are made by Sovereign into the trust and are also invested in Sovereign common stock. Dividends on Sovereign shares held in the trust are also invested in Sovereign stock. Benefits vest after 5 years or earlier in the event of termination by reason of death, disability, retirement, involuntary termination or the occurrence of a change of control as defined. Voluntary termination or termination for cause (as defined) generally results in forfeiture of the unvested balance including employee deferrals. Expense is recognized over the vesting period of 5 years or to the employee’s retirement date, whichever is shorter. Sovereign recognized as expense $0.5 million, $1.4 million, and $2.8 million for these plans in 2008, 2007 and 2006, respectively. Effective for compensation earned after January 1, 2007, Sovereign terminated future deferrals into this plan as part of a cost savings initiative. However, prior year contributions will continue to vest and be expensed over the applicable vesting period.
Sovereign sponsors a supplemental executive retirement plan (“SERP”) for certain retired executives of Sovereign. Sovereign’s benefit obligation related to its SERP plan was $56.4 million and $38.5 million at December 31, 2008 and 2007, respectively. The primary reason for the increase in our SERP obligations from the prior year is due to market declines in the investments underlying certain plans which resulted in an underfunded status on these plans. Additionally, Sovereign is required to pay $0.5 million per year for life to an executive officer who resigned in December 2006.
Sovereign’s benefit obligation related to its post-employment plans was $9.3 million and $12.9 million at December 31, 2008 and 2007, respectively. The SERP and the post-employment plans are unfunded plans and are reflected as liabilities on our balance sheet.
Notes to Consolidated Financial Statements
Note 17 - Employee Benefit Plans (continued)
Sovereign also acquired a pension plan from its acquisition of Independence. Sovereign does not expect any plan assets to be returned to us in 2009, nor do we expect to contribute any amounts to this plan in 2009. The following tables summarizes the benefit obligation, change in plan assets and components of net periodic pension expense for the plan as of December 31, 2008 and 2007 (in thousands):
The assumptions utilized to calculate the projected benefit obligation and net periodic pension expense at December 31, 2008 and 2007 were:
The following table sets forth the expected benefit payments to be paid in future years:
Included in accumulated other comprehensive income at December 31, 2008 and 2007 are the following amounts that had not yet been recognized in net periodic pension cost: unrecognized prior service costs of $0 and $1.8 million; and unrecognized actuarial losses of $21.1 million and $2.4 million. The prior service cost and actuarial loss included in accumulated other comprehensive income and expected to be recognized in net periodic pension cost during the fiscal year-ended December 31, 2009 are $0 and $1.6 million, respectively.
Notes to Consolidated Financial Statements
Note 18 - Income Taxes
The (benefit)/provision for income taxes in the consolidated statement of operations is comprised of the following components (in thousands):
(1)
Current foreign income tax expense in 2007 and 2006 relates to interest income on assets that Sovereign transferred to a consolidated foreign special purpose entity to support a borrowing arrangement that Sovereign has with an international bank. Foreign taxes paid on this income are credited against United States income taxes for federal income tax purposes. See Note 12 for further discussion.
The following is a reconciliation of the United States federal statutory rate of 35% to the company’s effective tax rate for each of the years indicated:
Notes to Consolidated Financial Statements
Note 18 - Income Taxes (continued)
The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are presented below (in thousands):
Periodic reviews of the carrying amount of deferred tax assets are made to determine if the establishment of a valuation allowance is necessary. If based on the available evidence in future periods, it is more likely that not that all or a portion of the Company’s deferred tax assets will not be realized, a deferred tax valuation allowance would be established. Consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.
Items considered in this evaluation include historical financial performance, expectation of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with operating loss and tax credit carry forwards not expiring unused, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences. The evaluation is based on current tax laws as well as expectations of future performance on a standalone basis (i.e. Management did not consider the potential economic benefits associated with our transaction with Santander in accordance with U.S. generally accepted accounting principles). The transaction with Santander was signed on October 12, 2008 and closed on January 30th 2009
SFAS No. 109 suggests that additional scrutiny should be given to deferred tax assets of an entity with cumulative pre-tax losses during the three most recent years and is widely considered significant negative evidence that is objective and verifiable and therefore, difficult to overcome. During the three years ended December 31, 2008, we had cumulative pre-tax losses and considered this factor in our analysis of deferred tax assets. Additionally, based the continued economic uncertainty that currently exists at this time, it was determined that it was probable that the Company would not generate significant pre-tax income in the near term on a standalone basis. As a result of these facts, Sovereign recorded a $1.43 billion valuation allowance against its deferred tax assets for the year-ended December 31, 2008.
Notes to Consolidated Financial Statements
Note 18 - Income Taxes (continued)
At December 31, 2008, Sovereign had net unrecognized tax benefit reserves related to uncertain tax positions of $86.7 million. Of this amount, approximately $13.7 million related to reserves established for uncertain tax positions from the acquisition of Independence. Any adjustments to these reserves in future periods will be required to be recorded through earnings as an adjustment to Sovereign’s income tax provision. The remaining balance of $73.0 million represents the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
Sovereign recognizes penalties and interest accrued related to unrecognized tax benefits within income tax expense on the Consolidated Statement of Operations. During 2008, 2007 and 2006, Sovereign recognized approximately $4.8 million, $2.8 million and $1.7 million, respectively, in interest and penalties. Included in gross unrecognized tax benefits at December 31, 2008 was approximately $14.9 million for the payment of interest and penalties at December 31, 2008.
At December 31, 2008, the Company has net operating loss carry forwards of $190.5 million, net of tax, which may be offset against future taxable income. If not utilized in future years, $0.6 million will expire in December 2013 and the remaining $189.9 million will expire in December 2028. Sovereign also has tax credit carry-forwards of $173.8 million, net of tax, which may be offset against future taxable income. If not utilized in future years, they will expire as follows: $20.8 million in December 2025, $59.4 million in December 2026, $48.9 million in December 2028, and $44.6 million in December 2027. Sovereign also has foreign tax credit carry-forwards of $72.9 million, net of tax, which may be offset against future taxable income. If not utilized in future years, $50.4 million will expire in December 2016 and the remaining $22.5 million will expire in December 2017. The Company has concluded that it is more likely than not that all of the deferred tax assets related to these items will not be realized. The Company has not recognized a deferred tax liability of $46.4 million related to earnings that are considered permanently reinvested in a consolidated foreign special purpose entity related to the indirect automobile loan securitization (see Note 12).
Sovereign is subject to the income tax laws of the U.S., its states and municipalities and certain foreign countries. These tax laws are complex and are potentially subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws.
Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) recently examined the Company’s federal income tax returns for the years 2002 through 2005. The IRS completed this review in 2008. Included in this examination cycle are two separate financing transactions with an international bank totaling $1.2 billion. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006 and 2007, Sovereign was subject to an additional $87.6 million and $22.5 million, respectively, of foreign taxes related to these financing transactions and claimed a corresponding foreign tax credit. The IRS issued a notification of adjustment disallowing the foreign tax credits taken in 2003-2005 in the amount of $154.0 million related to these transactions; disallowing deductions for issuance costs and interest expense related to the transaction which would result in an additional tax liability of $24.9 million and assessed interest and penalties, the combined amount of which totaled approximately $71.0 million. In addition, the IRS has commenced its audit for the years 2006 and 2007. We expect that in the future the IRS will propose to disallow the foreign tax credits and deductions taken in 2006 and 2007 of $87.6 million and $22.5 million, respectively; disallow deductions for issuance costs and interest expense which would result in an additional tax liability of $37.1 million; and to assess interest and penalties. Sovereign expects that it will need to litigate this matter with the IRS. Sovereign continues to believe that it is entitled to claim these foreign tax credits and deductions and also believes that its recorded tax reserves for this position of $58.3 million adequately provides for any potential exposure to the IRS related to this item and other tax assessments. However, as the Company continues to go through the IRS administrative process, and if necessary litigation, we will continue to evaluate the appropriate tax reserve levels for this position and any changes made to the tax reserves may materially affect Sovereign’s income tax provision, net income and regulatory capital in future periods.
Notes to Consolidated Financial Statements
Note 19 - Commitments and Contingencies
Financial Instruments. Sovereign is a party to financial instruments in the normal course of business, including instruments with off-balance sheet exposure, 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 may 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.
The following schedule summarizes Sovereign’s off-balance sheet financial instruments (in thousands):
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 credit worthiness on a case-by-case basis. The amount of collateral required is based on management’s evaluation of the credit of the counterparty. Collateral usually consists of real estate but may include securities, accounts receivable, inventory and property, plant and equipment.
Sovereign’s standby letters of credit meet the definition of a guarantee under FASB Interpretation No. 45, “Guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others.” These transactions 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. The weighted average term of these commitments is 3.0 years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending a loan to customers. In the event of a draw by the beneficiary that complies with the terms of the letter of credit, Sovereign would be required to honor the commitment. Sovereign has various forms of collateral, such as real estate assets and customers’ business assets. The maximum undiscounted exposure related to these commitments at December 31, 2008 was $2.8 billion, and the approximate value of the underlying collateral upon liquidation that would be expected to cover this maximum potential exposure was $2.4 billion. Substantially all the fees related to standby letters of credits are deferred and are immaterial to Sovereign’s financial position. We believe that the utilization rate of these standby letters of credit will continue to be substantially less than the amount of these commitments, as has been our experience to date.
Loans sold with recourse primarily represent single-family residential loans and multi-family loans. These are seasoned loans and historical loss experience has been minimal.
Sovereign’s forward buy commitments primarily represent commitments to purchase loans, investment securities and derivative instruments for our customers.
Sovereign has entered into risk participation agreements that provide for the assumption of credit and market risk by Sovereign for the benefit of one party in a derivative transaction upon the occurrence of an event of default by the other party to the transaction. Sovereign’s participation in risk participation agreements has been in conjunction with its participation in an underlying credit agreement led by another financial institution. The term of the performance guarantee will typically match the term of the underlying credit and derivative agreements, which range from 3 to 10 years for transactions outstanding as of December 31, 2008. Sovereign estimates the maximum undiscounted exposure on these agreements at $42.3 million and the total carrying value of liabilities associated with these commitments was $1.0 million at December 31, 2008.
Litigation. Sovereign is not involved in any pending material legal proceeding other than routine litigation occurring in the ordinary course of business other than the matters discussed below. Sovereign does not expect that any amounts that it may be required to pay in connection with these matters would have a material adverse effect on its financial position.
In the first quarter of 2008 a voluntary mediation was held in connection with a claim made against Sovereign related to an investment advisor in Massachusetts who defrauded numerous victims over a long period of time. The fraud reportedly amounted to tens of millions of dollars. The investment advisor’s companies had accounts at Sovereign. The court appointed an ancillary receiver to pursue claims against Sovereign and another bank, and the ancillary receiver filed a complaint against Sovereign. Some of the victims joined in the action as plaintiffs, and some of the claims are putative class action claims. The ancillary receiver recently filed a motion seeking class certification. Little progress was made towards a settlement at the voluntary mediation that was held in the first quarter of 2008 and the trial for this claim was held in December 2008. The court ruled that Sovereign did not have any liability related to this matter.
Notes to Consolidated Financial Statements
Note 19 - Commitments and Contingencies (continued)
In the first quarter of 2008, a former employee filed a putative class action in Pennsylvania federal court alleging that the Company violated ERISA in connection with the management of certain plans. The plaintiff alleges that the Company knew or should have known that the Company’s stock was not a prudent investment for the Company’s retirement plan beginning on or about January 1, 2007. The complaint also alleges that the Company provided the putative class and the investing community with inadequate disclosure concerning the Company’s financial condition, resulting in the stock having an inflated value until the Company’s disclosures in January 2008. In April 2008, a similar putative class action was filed in the same court by another former employee. The complaint in the second action asserts that the Company caused retirement plan assets to be invested in the Company’s stock when it was imprudent to do so, caused the plan to purchase the stock while not disclosing alleged financial problems and to pay above market interest rates for a Company loan, and failed to provide complete and accurate information to participants in the plan. In July 2008, counsel for the respective plaintiffs filed a consolidated amended complaint that expanded upon the allegations set forth in the prior two actions. The class period in the consolidated amended complaint was also expanded to include the period from January 1, 2002 to present. The Company believes that the claims are without merit and intends to vigorously defend the claims.
On October 13, 2008, Sovereign and Santander entered into the Transaction Agreement whereby Santander agreed to acquire all the outstanding shares of Sovereign not currently owned by it. Sovereign received various purported class action complaints from purported shareholders alleging that Sovereign’s directors breached their fiduciary duties by entering into the Transaction Agreement. Certain of these lawsuits also allege that Santander and certain directors of the Company serving by designation by Santander pursuant to the Investment Agreement (the “Santander Directors”) breached their fiduciary duties and that the remainder of Sovereign’s directors aided and abetted the Santander Directors’ breaches of fiduciary duties. All of the complaints sought an injunction preventing the consummation of the transaction contemplated by the Transaction Agreement. On January 21,2009, a settlement agreement was reached between the parties which covered all persons who owned shares of Sovereign common stock from October 13, 2008 to and including the effective date of the Transaction between Santander and Sovereign.
Leases. Sovereign is committed under various non-cancelable operating leases relating to branch facilities having initial or remaining terms in excess of one year. Future minimum annual rentals under non-cancelable operating leases, net of expected sublease income, at December 31, 2008, are summarized as follows (in thousands):
Sovereign recorded rental expenses of $118.3 million, $117.7 million and $105.5 million, net of $14.0 million, $17.5 million and $16.9 million of sublease income, in 2008, 2007, and 2006, respectively.
Notes to Consolidated Financial Statements
Note 20 - Fair Value Disclosures
As discussed in Note 2, “Recent Accounting Pronouncements”, to the Consolidated Financial Statements Sovereign adopted SFAS No. 159 on its residential mortgage loans classified as held for sale that were originated subsequent to January 1, 2008 which allows us to record our mortgage loan held for sale portfolio at fair market value versus the lower of cost or market. Sovereign hedges its residential held for sale portfolio with forward sale agreements which are reported at fair value under SFAS No. 133. We historically did not apply hedge accounting to this loan portfolio because of the complexity of these accounting provisions. Under our historical lower of cost or market accounting treatment, we were unable to record the excess of our fair market value over book value but were required to record the corresponding reduction in value on our hedges. Under SFAS No. 159, both the loans and related hedges are carried at fair value which reduces earnings volatility as the amounts more closely offset, particularly in environments when interest rates are declining.
Sovereign’s residential loan held for sale portfolio had an aggregate fair value of $313.8 million at December 31, 2008. The contractual principal amount of these loans totaled $310.1 million. The difference in fair value compared to principal balance of $3.7 million was recorded in mortgage banking revenues during the twelve-month period ended December 31, 2008. Substantially all of these loans are current and none are in non-accrual status. Interest income on these loans is credited to interest income as earned. The fair value of these loans is estimated based upon the anticipated exit price for these loans in the secondary market to agency buyers such as Fannie Mae and Freddie Mac. Practically our entire residential loan held for sale portfolio is sold to these two agencies.
The most significant instruments that the Company fair values include investment securities, derivative instruments and loans held for sale. The majority of the securities in the Company’s available for sale portfolios are priced via independent providers, whether those are pricing services or quotations from market-makers in the specific instruments. In obtaining such valuation information from third parties, the Company has evaluated the valuation methodologies used to develop the fair values in order to determine whether such valuations are representative of an exit price in the Company’s principal markets. The Company’s principal markets for its investment securities are the secondary institutional markets with an exit price that is predominantly reflective of bid level pricing in these markets.
Currently, the Company uses derivative instruments to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs.
To comply with the provisions of SFAS No. 157, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurement of its derivatives. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings and guarantees.
Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2008, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy. The Company does not have any fair value measurements for derivatives using significant unobservable input (Level 3) as of December 31, 2008.
When estimating the fair value of its loans held for sale portfolio, interest rates and general conditions in the principal markets for the loans are the most significant underlying variables that will drive changes in the fair values of the loans, not borrower-specific credit risk since substantially all of the loans are current.
The following table presents the assets that are measured at fair value on a recurring basis by level within the fair value hierarchy (see Note 17 for further information on the fair value hierarchy) as reported on the consolidated balance sheet at December 31, 2008. As required by SFAS No. 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement (in thousands).
Notes to Consolidated Financial Statements
Note 20 - Fair Value Disclosures (continued)
Sovereign’s Level 3 assets are primarily comprised of FNMA/FHLMC preferred stock and certain non-agency mortgage backed securities. These investments are thinly traded and, in certain instances, Sovereign is the sole investor in these securities. Sovereign receives third party broker quotes for these securities to determine their estimated fair value. These quotes are benchmarked against similar securities that are more actively traded in order to assess the reasonableness of the estimated fair values. The fair market value estimates we assign to these securities assume liquidation in an orderly fashion and not under distressed circumstances. Due to the continued illiquidity and credit risk of certain securities, the market value of these securities is highly sensitive to assumption changes and market volatility.
The table below presents the changes in our Level 3 balances since year-end (in thousands).
Note 21 - 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 for certain instruments 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 for certain instruments 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 below do not represent the underlying value of Sovereign (in thousands):
(1)
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 equals the fair value.
Notes to Consolidated Financial Statements
Note 21 - Fair Value of Financial Instruments (continued)
Investment securities available for sale. The fair value of investment securities available for sale are based on a third party pricing service which utilizes matrix pricing on securities who actively trade in the marketplace. For investment securities that do not actively trade in the marketplace, (primarily our collateralized debt obligations and our preferred stock in FNMA and FHLMC) fair value is obtained from third party broker quotes. 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.
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 internal cash flow models. For additional discussion see Note 8.
Mortgage interest rate lock commitments. Fair value is estimated based on a net present value analysis of the anticipated cash flows associated with the rate lock commitments.
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 and other debt obligations. Fair value is estimated by discounting cash flows using rates currently available to Sovereign for other borrowings with similar terms and remaining maturities. Certain other debt obligations instruments are valued using available market quotes.
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 counter parties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.
Precious metals customer forward settlement arrangements and precious metals forward sale agreements. The fair value of these contracts is based on the price of the metals based on published sources, taking into account when appropriate, the current credit worthiness of the counterparties.
Interest rate derivative instruments. The fair value of interest rate swaps, caps and floors that 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.
Notes to Consolidated Financial Statements
Note 22 - Derivative Instruments and Hedging Activities
Sovereign uses derivative instruments as part of its interest rate risk management process to manage risk associated with its financial assets and liabilities, its mortgage banking activities, and to assist its commercial banking customers with their risk management strategies and for certain other market exposures.
One of Sovereign’s primary market risks is interest rate risk. Management uses derivative instruments to mitigate the impact of interest rate movements on the value of certain liabilities, and/or assets and on probable future cash outflows. These instruments primarily include interest rate swaps that have underlying interest rates based on key benchmark indices. Note 1 provides a summary of our accounting policy for derivative instruments in the financial statements. The Company designates derivative instruments used to manage interest rate risk into SFAS No. 133 hedge relationships with the specific assets, liabilities, or forecasted cash flows.
Our derivative transactions encompass credit risk to the extent that a counterparty to a derivative contract with which Sovereign has an unrealized gain fails to perform according to the terms of the agreement. Credit risk is managed by limiting the aggregate amount of net unrealized gains in agreements outstanding, monitoring the size and the maturity structure of the derivative portfolio, applying uniform credit standards maintained for all activities with credit risk, and collateralizing gains.
Fair Value Hedges. Sovereign has entered into pay-variable, receive-fixed interest rate swaps to hedge changes in fair values of certain brokered certificate of deposits and certain debt obligations. For the year ended December 31, 2008 and 2007, respectively, hedge ineffectiveness of $1.5 million and $0.9 million was recorded as a reduction to miscellaneous general and administrative expense associated with fair value hedges.
During the second quarter of 2006, Sovereign terminated certain derivative positions that were previously designated as fair value hedges against $500 million of subordinated notes maturing in March 2013. The $41.3 million basis adjustment is being amortized under the effective yield method over the remaining term of the debt.
During the fourth quarter of 2005, Sovereign terminated $211.3 million of receive fixed-pay variable interest rate swaps that were hedging the fair value of $211.3 million of junior subordinated debentures due to capital trust entities. The fair value adjustment to the basis of the debt was $11.6 million at the date of termination. Sovereign had utilized the short-cut method of assessing hedge effectiveness under SFAS No. 133 when this hedge was in place. On July 21, 2006, in connection with the SEC’s review of the Company’s filings, it was determined that this hedge did not qualify for the short-cut method due to the fact that the junior subordinated debentures contained an interest deferral feature. As a result, Sovereign recorded a pretax charge of $11.4 million in the second quarter of 2006 to write-off the remaining fair value adjustment. This charge was recorded within other expenses on Sovereign’s consolidated statement of operations as losses from economic hedges.
Cash Flow Hedges. Sovereign hedges exposure to changes in cash flows associated with forecasted interest payments on variable-rate liabilities through the use of pay-fixed, receive variable interest rate swaps. The last of the hedges is scheduled to expire in January 2016. Sovereign includes all components of each derivatives gain or loss in the assessment of hedge effectiveness. For the years ended December 31, 2008 and 2007, no hedge ineffectiveness was recognized in earnings associated with cash flow hedges. During the first quarter of 2007, Sovereign terminated $3.2 billion of pay-fixed interest rate swaps that were hedging the future cash flows on $3.2 billion of borrowings, resulting in a net after-tax gain of $1.6 million. The gain will continue to be deferred in accumulated other comprehensive income (AOCI) and will be reclassified into interest expense as the future cash flows occur, unless it becomes probable that the forecasted interest payments originally hedged will not occur, in which case the losses in AOCI will be recognized immediately. Sovereign has $44.8 million of deferred after tax losses on terminated derivative instruments that were hedging the future cash flows on certain borrowings. These losses will continue to be deferred in accumulated other comprehensive income and will be reclassified into interest expense as the future cash flows occur, unless it becomes probable that the forecasted interest payments will not occur. As of December 31, 2008, Sovereign expects approximately $94.1 million of the deferred net after-tax loss on derivative instruments included in accumulated other comprehensive income will be reclassified to earnings during the next 12 months. See Note 25 for further detail of the amounts included in accumulated other comprehensive income.
Other Derivative Activities. Sovereign’s derivative portfolio also includes derivative instruments not designated in SFAS 133 hedge relationships. Those derivatives include mortgage banking interest rate lock commitments and forward sale commitments used for risk management purposes, and derivatives executed with commercial banking customers, primarily interest rate swaps and foreign exchange futures, to facilitate customer risk management strategies. The Company also enters into precious metals customer forward agreements and forward sale agreements.
Notes to Consolidated Financial Statements
Note 22 - Derivative Instruments and Hedging Activities (continued)
All derivative contracts are valued using either cash flow projection models or observable market prices. Pricing models used for valuing derivative instruments are regularly validated by testing through comparison with third parties.
Following is a summary of the derivatives designated as hedges under SFAS No. 133 at December 31, 2008 and 2007 (in thousands):
Summary information regarding other derivative activities at December 31, 2008 and December 31, 2007 follows (in thousands):
Notes to Consolidated Financial Statements
Note 22 - Derivative Instruments and Hedging Activities (continued)
The following financial statement line items were impacted by Sovereign’s derivative activity as of, and for the twelve months ended, December 31, 2008:
The following financial statement line items were impacted by Sovereign’s derivative activity as of, and for the twelve months ended December 31, 2007:
Balance Sheet Effect
Income Statement Effect For
at
The Twelve Months Ended
Derivative Activity
December 31, 2007
December 31, 2007
Fair value hedges:
Receive fixed-pay variable
interest rate swaps
Decrease to CDs of $1.8 million and an increase to other assets and other liabilities of $0.4 million and $2.2 million, respectively.
Resulted in a decrease of net interest income of $10.5 million.
Cash flow hedges:
Pay fixed-receive floating
interest rate swaps
Increase to other liabilities and deferred taxes of $214.5 million and $75.1 million, respectively and a decrease to stockholders’ equity of $139.5 million.
Resulted in an increase in net interest income of $19.0 million.
Forward commitments to sell loans
Increase to other liabilities of $4.7 million.
Decrease to mortgage banking revenues of $5.0 million.
Interest rate lock commitments
Increase to mortgage loans of $2.1 million.
Increase to mortgage banking revenues of $2.1 million.
Net customer related hedges
Increase to other assets of $34.8 million.
Decrease in capital markets revenue of $7.3 million.
Forward commitments to sell precious metals inventory
Increase to other liabilities of $1.0 million.
Decrease to commercial banking revenues of $1.3 million.
Foreign Exchange
Increase to other assets of $1.9 million.
Increase in commercial banking revenue of $1.7 million.
Notes to Consolidated Financial Statements
Note 23 - Interests that Continue to be Held by Sovereign in Asset Securitizations
During the first quarter of 2008, Sovereign exercised its cleanup call option on its securitized mortgage loan portfolio. This did not have a significant impact on our consolidated statement of operations or financial condition.
During the second quarter of 2007, Sovereign executed a commercial mortgage backed securitization which consisted of approximately $687.7 million of multi-family loans and $327.0 million of commercial real estate loans. Sovereign retained certain subordinated certificates issued in connection with the securitization which were valued in the market place at approximately $15.6 million as well as certain servicing responsibilities for the assets that were sold. In connection with this transaction, Sovereign recorded a pretax gain of $10.5 million in 2007, which is included in mortgage banking revenues. This gain was determined based on the carrying amount of the loans sold, including any related allowance for loan loss, and was allocated to the loans sold and the retained interests based on their relative fair values at the sale date. The value of the retained subordinated certificates is subject to credit and prepayment risk. In accordance with SFAS No. 140, the subordinated certificates are classified in investments available for sale on our Consolidated Balance Sheet. The investors have no recourse to the Company’s other assets, other than the retained subordinated certificates, to serve as additional collateral to protect their interests in the securitization. In 2008, due to declining market conditions, management wrote down the fair value of its retained interests to $0.5 million.
During the third quarter of 2006, Sovereign securitized $900 million of automotive floor plan loans under a three-year revolving term securitization. Sovereign retained servicing responsibilities for the loans and maintained other retained interests in the securitized loans. These retained interests include an interest-only strip, a cash reserve account and a subordinated note. The Company estimated the fair value of these retained interests by determining the present value of the expected future cash flows using modeling techniques that incorporate management’s best estimates of key assumptions, including prepayment speeds, credit losses and discount rates. The investors and the trusts have no recourse to the Company’s assets, other than the retained interests, if the off-balance sheet loans are not paid when due. Sovereign receives annual contractual servicing fees of 1% for servicing the securitized loans. However, no servicing asset or liability was recorded for these rights since the contractual servicing fee represents adequate compensation for these types of loans. In connection with the $900 million securitization, Sovereign recorded a gain of $0.8 million, which is included in commercial banking revenues. This gain was determined based on the carrying amount of the loans sold, including any related allowance for loan loss, and was allocated to the loans sold and the retained interests, based on their relative fair values at the sale date. The transaction costs involved in this securitization are being amortized over the three year revolving period in accordance with SFAS No. 140.
The types of assets underlying securitizations for which Sovereign owns and continues to own a retained interest and the related balances and delinquencies at December 31, 2008 and 2007, and the net credit losses for the year ended December 31, 2008 and 2007, are as follows (in thousands):
Notes to Consolidated Financial Statements
Note 23 - Interests that Continue to be Held by Sovereign in Asset Securitizations (continued)
The components of retained interests and key economic assumptions used in measuring the retained interests resulting from securitizations completed during the year were as follows (in thousands):
The table below summarizes certain cash flows received from and paid to off-balance sheet securitization trusts (in thousands):
Notes to Consolidated Financial Statements
Note 23 - Interests that Continue to be Held by Sovereign in Asset Securitizations (continued)
At December 31, 2008 and 2007, key economic assumptions and the sensitivity of the fair value of the retained interests to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows (in thousands):
(1)
During 2008, the credit spreads on CMBS investment securities widened significantly which had a severe negative impact on our retained interest. Additionally the credit quality of these assets weakened and losses are now projected to be substantially worse than a year ago. Due to these events, Sovereign wrote down its retained interest by $15.2 million during 2008. A sensitivity analysis was not performed on the remaining CMBS asset of $0.5 million at year end since it is not material.
These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.
Sovereign enters into partnerships, which are variable interest entities under FIN 46, with real estate developers for the construction and development of low-income housing. The partnerships are structured with the real estate developer as the general partner and Sovereign as the limited partner. We are not the primary beneficiary of these variable interest entities. Our risk of loss is limited to our investment in the partnerships, which totaled $156.2 million at December 31, 2008 and any future cash obligations that Sovereign is committed to the partnerships. Future cash obligations related to these partnerships totaled $10.3 million at December 31, 2008. Our investments in these partnerships are accounted for under the equity method.
Notes to Consolidated Financial Statements
Note 24 - (Loss)/Earnings Per Share
The following table presents the computation of (loss)/earnings per share based on the provisions of SFAS No.128 for the years indicated (in thousands, except per share data):
Note 25 - Comprehensive (Loss)/Income
The following table presents the components of comprehensive (loss)/income, net of related tax, based on the provisions of SFAS No. 130 for the years indicated (in thousands):
Accumulated other comprehensive losses, net of related tax, consisted of net unrealized losses on securities of $506.0 million, net accumulated losses on unfunded pension liabilities of $21.0 million and net accumulated losses on derivatives of $258.8 million at December 31, 2008, compared to net unrealized losses on securities of $153.5 million, net accumulated losses on unfunded pension liabilities of $4.2 million and net accumulated losses on derivatives of $168.4 million at December 31, 2007.
Notes to Consolidated Financial Statements
Note 26 - Parent Company Financial Information
Condensed financial information for Sovereign Bancorp, Inc. is as follows (in thousands):
BALANCE SHEET
STATEMENT OF OPERATIONS
Notes to Consolidated Financial Statements
Note 26 - Parent Company Financial Information (continued)
STATEMENT OF CASH FLOWS
Notes to Consolidated Financial Statements
Note 27 - Business Segment Information
Segment results are derived from the Company’s business unit profitability reporting system by specifically attributing managed balance sheet assets, deposits and other liabilities and their related interest income or expense. Funds transfer pricing methodologies are utilized to allocate a cost for funds used or a credit for funds provided to business line deposits, loans and selected other assets using a matched funding concept. The provision for credit losses recorded by each segment is based on the net charge-offs of each line of business. The difference between the provision for credit losses recognized by the Company on a consolidated basis and the provision recorded by the business lines at the time of charge-off is allocated to each business line based on a risk profile of their loan portfolio. Other income and expenses directly managed by each business line, including fees, service charges, salaries and benefits, and other direct expenses as well as certain allocated corporate expenses are accounted for within each segment’s financial results. Where practical, the results are adjusted to present consistent methodologies for the segments. Accounting policies for the lines of business are the same as those used in preparation of the consolidated financial statements with respect to activities specifically attributable to each business line. However, the preparation of business line results requires management to establish methodologies to allocate funding costs and benefits, expenses and other financial elements to each line of business.
During the first quarter of 2008, certain changes to our executive management were announced such as the hiring of a new head of Retail Banking and a new Chief Financial Officer. In addition, we centralized the responsibility for the major businesses within the Company naming a new head of Retail, Commercial Lending, Corporate Specialty Businesses and Corporate Support Services. The head of these business units report directly to the Chief Executive Officer and, along with our Chief Financial Officer and Chief Risk Officer, comprise the Executive Management Group. These events changed how our executive management team measures and assesses business performance. During the second quarter we finalized the process of updating our business unit profitability system to reflect our new organizational structure.
As a result of the changes discussed above, Sovereign now has four reportable segments. The Company’s segments are focused principally around the customers Sovereign serves. The Retail Banking Division is primarily comprised of our branch locations. Our branches offer a wide range of products and services to customers and each attracts deposits by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposits and retirement savings plans. Our branches also offer certain consumer loans such as home equity loans and other consumer loan products. The Corporate Specialties Group segment is primarily comprised of our mortgage banking group, our New York multi-family and national commercial real estate lending group, our automobile dealer floor plan lending group and our indirect automobile lending group. It also provides capital market services and cash management services to our customers. The Commercial Lending segment provides the majority of Sovereign’s commercial lending platforms such as commercial real estate loans, commercial industrial loans, leases to commercial customers and small business loans. The Other segment includes earnings from the investment portfolio, interest expense on Sovereign’s borrowings and other debt obligations, minority interest expense, amortization of intangible assets and certain unallocated corporate income and expenses.
The following tables present certain information regarding the Company’s segments (in thousands):
Notes to Consolidated Financial Statements
Note 27 - Business Segment Information (continued)
Goodwill assigned to our reporting units which are equivalent to our reportable segments as of December 31, 2008 was as follows:
As discussed in Note 3, Sovereign recorded goodwill impairment charges of $943 million and $634 million, respectively in the Metro New York and Shared Services Consumer segments in 2007 which are reflected in our Retail Banking Division and Corporate Specialty Group segments.
Note 28 - Transaction Related and Integration Charges, Net
Following is a summary of amounts charged to earnings related to our transaction with Santander which closed on January 30, 2009, and our acquisition of Independence (in thousands):
In 2008, Sovereign incurred legal and investment advisory costs of $12.8 million associated with the Santander transaction. Results for 2007 included merger-related and integration charges related to the Independence acquisition of $2.2 million for system conversion costs and other expenses.
In 2006, Sovereign recorded merger-related and integration charges related to the Independence acquisition of $42.8 million. Of this amount, $12.9 million was recorded for retail banking conversion costs and other costs, $12.5 million was related to marketing expense, $9.4 million was related to system conversions, $5.7 million was related to retention bonuses and other employee-related costs and $2.3 million was related to branch and office consolidations. There was $0.4 million of merger-related and integration reversals related to prior acquisitions in 2006 based on favorable conversion costs and other merger-related items being lower than amounts initially estimated.
The status of reserves associated with business acquisitions is summarized in Note 3.
Notes to Consolidated Financial Statements
Note 29 - Employee Severance Charges and Other Restructuring Costs
Sovereign’s management completed a comprehensive review of Sovereign’s operating cost structure in the fourth quarter of 2006. As a result of this review, approximately 360 team members were notified in December 2006 that their positions had been eliminated. Additionally, certain members of executive management resigned from the Company during the fourth quarter, including the Company’s Chief Executive Officer. These actions resulted in a $78.7 million charge, which consisted of $63.9 million of severance, and $14.8 million in contract termination and other charges.
During the first quarter of 2007, Sovereign finalized a decision to close or consolidate approximately 40 underperforming branch locations. This action was executed in the second quarter of 2007. As a result, Sovereign incurred charges related to lease obligations of $16 million during the twelve-month period ended December 31, 2007. Sovereign also terminated additional employees in 2007, resulting in severance charges of $13.7 million for the twelve-month period ended December 31, 2007. These charges are included in restructuring, other employee severance and debt extinguishment charges on the consolidated income statement and recorded in the Other segment.
In 2008, two members of executive management were terminated which resulted in severance charges of a $7.5 million. In December 2008, Sovereign announced that an additional 1,000 positions were being eliminated which resulted in additional severance charges of $15.8 million. These charges are included in general and administrative expense on the consolidated income statement and recorded in the Other segment. A rollforward of the restructuring and severance accrual is summarized below:
Also included in restructuring, other employee severance and debt extinguishment charges during 2007 was $14.7 million of debt extinguishment charges on the retirement of $2.3 billion asset backed floating rate notes and junior subordinated debentures due to Capital Trust Entities, as well as $11.5 million of fixed asset write-offs related to the closing of the branches mentioned above. Sovereign’s executive management team and Board of Directors elected to freeze the Company’s Employee Stock Ownership Plan (ESOP) in 2007. The debt owed by the ESOP was repaid with the proceeds from the sale of a portion of the unallocated shares held by the ESOP and all remaining shares were allocated to the eligible participants. Sovereign recorded a non-deductible non-cash charge of $40.1 million in connection with this action based on the value of its common stock on the date that the ESOP was repaid.
Note 30 - Related Party Transactions
Loans to related parties include loans made to certain officers, directors and their affiliated interests. These loans were made on terms similar to non-related parties. The following table discloses the changes in Sovereign’s related party loan balances since December 31, 2008.
The Company is engaged in certain activities with a mortgage broker due to its acquisition of Independence. This broker is deemed to be a “related party” of the Company as such term in defined in SFAS No. 57 since Sovereign has a 35% minority equity investment in it. This mortgage broker refers and receives fees from borrowers seeking financing of their multi-family and/or commercial real estate loans to Sovereign as well as to numerous other financial institutions. Sovereign recognized a loss $95.9 million and $8.7 million of income due to its investment in the broker during 2008 and 2007, respectively. The current year loss was due to an impairment charge of $95 million as previously discussed in Note 1. Additionally, substantially all of Sovereign’s multi-family loan originations are obtained via our relationship with this broker. Sovereign recognized gains on the sale of multi-family loans of $1.1 million in 2008 and $26.2 million in 2007, and our multi-family loan balance at December 31, 2008 and December 31, 2007, totaled $4.5 billion and $4.2 billion, respectively.
As discussed in Note 3, Sovereign raised $2.4 billion of equity by issuing 88.7 million shares to Santander, which made Santander the largest shareholder and a related party.
In 2006, Santander extended a total of $425 million in unsecured lines of credit to Sovereign Bank for federal funds and Eurodollar borrowings and for the confirmation of standby letters of credit issued by Sovereign Bank. This line is at a market rate and in the ordinary course of business and can be cancelled by either Sovereign or Santander at any time and can be replaced by Sovereign at any time. During 2008 and 2007, the average balance outstanding under these commitments was $411.9 million and $228.3 million. As of December 31, 2008, there was no outstanding balance on the unsecured lines of credit for federal funds and Eurodollar borrowings. Sovereign Bank paid approximately $2.4 million in fees to Santander in 2008 in connection with these commitments compared to $0.6 million in fees and $0.5 million in interest in the prior year.
Additionally, in May 2006, Santander’s capital markets group received approximately $800,000 in underwriting discounts in connection with Sovereign’s capital markets initiatives to finance the acquisition of Independence.
Notes to Consolidated Financial Statements
Note 30 - Related Party Transactions (continued)
In February 2007, Sovereign entered into an agreement with Isban U.K., Ltd. (“Isban”), an information technology subsidiary of Santander, under which Isban performed a review of, and recommend enhancements to, Sovereign’s banking information systems. Sovereign has paid Isban $475,000, excluding expenses, for this review. In June 2007, Sovereign and Isban entered into an agreement whereby Isban will provide Sovereign certain consulting services through December 31, 2008. Sovereign has agreed to pay Isban $2.2 million, excluding expenses for these services.
As discussed in Note 12, Sovereign issued $300 million of senior notes during the first quarter of 2007 and Santander was a co-issuer of this issuance. Santander received underwriting fees of $37,500 in connection with this transaction.
Note 31 - Subsequent Event
On October 13, 2008, Sovereign and Santander entered into a Transaction Agreement whereby Santander agreed to acquire all the outstanding shares of Sovereign’s common stock not currently owned by it. Sovereign received various purported class action complaints from purported shareholders alleging that Sovereign’s directors breached their fiduciary duties by entering into the Transaction Agreement. Certain of these lawsuits also allege that Santander and the Santander Directors breached their fiduciary duties and that the remainder of Sovereign’s directors aided and abetted the Santander Directors’ breaches of fiduciary duties. All of the complaints sought an injunction preventing the consummation of the transaction contemplated by the Transaction Agreement. On January 21, 2009, a settlement agreement was reached between the parties which covered all persons who owned Sovereign common stock from October 13, 2008 to and including the effective date of the Transaction between Santander and Sovereign.
On January 28, 2009, Sovereign announced that shareholders at a special meeting held on January 28, 2009, voted to approve and adopt the Transaction Agreement. On January 30, 2009 Santander acquired all of the outstanding shares of Sovereign’s common stock not already owned by it pursuant to the terms of the Transaction Agreement. In connection with the acquisition which closed on Janauary 30, 2009, certain changes to our board of directors and executive management have been made.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
The Company’s management, with the participation of the Company’s principal executive officer and principal financial officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of December 31, 2008. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of December 31, 2008.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) promulgated under the Exchange Act. The Company’s management, with the participation of the Company’s principal executive officer and principal financial officer, has evaluated the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, the Company’s management concluded that our internal control over financial reporting was effective as of December 31, 2008.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Directors of Sovereign
Information with respect to each of Sovereign’s directors is below. Except (i) for entities affiliated with Santander as described elsewhere in this Form 10-K or (ii) as otherwise indicated, none of the corporations or organizations listed below are a parent, subsidiary or other affiliate of Sovereign or Santander. Each of the directors shall hold their offices for terms of one year and until their successors are elected.
Gabriel Jaramillo - Age 58. Mr. Jaramillo was appointed to the Sovereign Board on July 16, 2008. Mr. Jaramillo became the Chairman of the Board, President and Chief Executive Officer of the Company on January 30, 2009, and also currently serves as Chairman of each of the Executive and Risk Management Committees of the Board. For additional information regarding Mr. Jaramillo, including his business experience during the past five years, please see Part I - Item 4A - “Executive Officers of the Registrant”.
Kirk Walters - Age 53. Mr. Walters was appointed to the Sovereign Board on January 30, 2009, and also currently serves as a member of the Executive and Risk Management Committees of the Board. Mr. Walters became the Senior Executive Vice President, Chief Financial Officer and Chief Administration Officer of the Company on January 3, 2009. From September 30, 2008 to January 3, 2009, he served as the Interim President, Interim Chief Executive Officer and Chief Financial Officer of the Company. From March 3, 2008 to September 30, 2008, he served as the Chief Financial Officer of the Company. For additional information regarding Mr. Walters, including his business experience during the past five years, please see Part I - Item 4A - “Executive Officers of the Registrant”.
Gonzalo de Las Heras - Age 69. Mr. de Las Heras was appointed to the Sovereign Board on October 6, 2006. Mr. de Las Heras joined Santander in 1990. He is Executive Vice President of Grupo Santander, supervising its U.S. business. He is Chairman of Santander Bancorp, Puerto Rico; Banco Santander International, Miami; Santander Trust & Bank (Bahamas) Limited; and Banco Santander (Suisse). Prior to that, Mr. de Las Heras held various positions at J.P. Morgan, lastly as Senior Vice President and Managing Director heading its Latin American division. He served as a Director of First Fidelity Bancorporation until its merger with First Union. From 1993 to 1997, Mr. de Las Heras served on the New York State Banking Board. He is chairman of the Foreign Policy Association, a Trustee and past chairman of the Institute of International Bankers, and a director of both The Spanish Institute and the Spain-US Chamber of Commerce. Mr. de Las Heras has a law degree from the University of Mid and as a Del Amo Scholar pursued postgraduate studies in Business Administration and Economics at the University of Southern California.
Marian Heard - Age 69. Mrs. Heard was elected to the Sovereign Board in 2005. Mrs. Heard currently serves as a member of the Audit Committee of the Board. Mrs. Heard is currently the President and Chief Executive Officer of Oxen Hill Partners, which specializes in leadership development programs. Mrs. Heard has served as a director of CVS Caremark Corporation since 1999, a publicly held corporation listed on the NYSE and the largest retail pharmacy in the United States. She has served on the Audit, Nominating and Corporate Governance Committees of CVS Caremark Corporation since 2000 and recently rotated off of the Management Planning Committee. On June 2, 2006, Mrs. Heard was elected to the board of BioSphere Medical, Inc., which specializes in certain bioengineering applications, and serves on its Compensation Committee. She has served as a director of Liberty Mutual Holding Company, Inc., a holding company for the family of Liberty Mutual Group insurance companies since 1994. Mrs. Heard has served as a director of Blue Cross and Blue Shield of Massachusetts since 1992 and chairs its Compensation Committee. Mrs. Heard served as a director of Fleet Bank of Massachusetts from 1992 to 1998 and subsequently Fleet Financial Corporation from 1998 until it was acquired by Bank of America in 2004. Mrs. Heard was appointed President and Chief Executive Officer of the United Way of Massachusetts Bay and Chief Executive Officer of the United Way of New England in February 1992. Mrs. Heard retired from the United Way in July 2004.
Keith Morgan - Age 45. Mr. Morgan was appointed to the Sovereign Board on January 30, 2009. Mr. Morgan is Senior Vice President, Retail Acquisitions US at Santander. From May 2004 to November 2007, Mr. Morgan was Director, Strategy & Planning Director at Abbey National, PLC, the fifth largest bank in the United Kingdom.
Alberto Sánchez - Age 45. Mr. Sánchez was reappointed to the Sovereign Board on January 30, 2009, and currently serves as a member of the Executive Committee of the Board. Mr. Sánchez previously served on the Board from March 16, 2007 to October 12, 2008. Mr. Sánchez is Head of Strategy for the Americas of Banco Santander, S.A. Since 1997, Mr. Sánchez has held the following positions within the Santander organization: Head of Equity Research; Head of Latin American Equities; and Head of Spanish Equities and Macroeconomics Research. Mr. Sánchez serves as a Director of Santander Consumer USA. He also serves as a Director of the Greenwich Village Orchestra.
Wolfgang Schoellkopf - Age 76. Mr. Schoellkopf was appointed to the Sovereign Board on January 30, 2009, and currently serves as a member of each of the Executive, Audit and Risk Management Committees of the Board. From 2004 to 2008, Mr. Schoellkopf served as the Managing Partner of Lykos Capital Management, LLC, a private equity management company. From 2000 to 2002, he served as the General Manager of Bank Austria Group’s U.S. operations. On July 31, 1997, Mr. Schoellfkopf was elected as a director of SLM Corporation, commonly known as Sallie Mae, a leading provider of student loans. He served as a member of the Finance and Operations Committees of SLM Corporation from 1997 to 2007, and currently serves as the Chairman of the Compensation Committee. Since March 3, 2008, Mr. Schoellkopf has been a director of BPW Acquisition Corporation and has served on its Audit Committee. BPW Acquisition Corporation does not currently have significant operations. It intends to acquire one or more operating businesses in the financial services or business services industries through a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, or other similar business combination.
Anthony Terracciano - Age 70. Mr. Terracciano was appointed to the Sovereign Board on January 30, 2009, and currently serves as a member of the Executive Committee of the Board and as Chairman of the Audit Committee of the Board. On January 7, 2008, Mr. Terracciano was elected non-executive Chairman of SLM Corporation, commonly known as Sallie Mae, a leading provider of student loans. From April 2008 through October 2008, Mr. Terracciano was a director of IKON Office Solutions, Inc., a provider of document management solutions, and was a member of its Corporate Governance, Human Resources and Audit Committees. From April 2002 to October 2007, he was a director of Avaya, Inc., a provider of communications related products, and served on its Corporate Governance and Audit and Finance Committees. From October 2004 through March 2008, he was a director of Knoll, Inc., a furniture manufacturer, and served on its Audit and Corporate Governance Committees. From June 2004 to May 2005, Mr. Terracciano served as the Chairman of the Board of Riggs National Corporation, a bank holding company the principal subsidiary of which was Riggs Bank N.A. Mr. Terracciano has also previously served on the boards of Dime Bancorporation from 1999 to 2002, American Water Works Company, Inc. from 1997 to 2003, First Union Bank from 1995 to 1997, First Fidelity Bank from 1990 to 1995 and Chase Manhattan Bank from 1986 to 1987.
Executive Officers of the Registrant
Information required by this Item 10 relating to Sovereign’s executive officers is included in Part I - Item 4A - “Executive Officers of the Registrant”. All executive officers of the Company are elected by the Sovereign Board and serve at the Board’s discretion, subject to the agreements, as applicable, described in Part III - Item 11
Item 11. Executive Compensation.
Compensation Discussion and Analysis
Explanatory Note
On January 30, 2009, we became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement and, in connection with the Santander transaction, many of our compensation plans and programs were eliminated. As a result, the discussion below of the compensation awarded or paid to the named executive officers for periods ending on or prior to December 31, 2008, includes information with respect to various compensation plans, programs and other arrangements that are no longer in effect as of the date hereof.
Periods Ending On or Prior to December 31, 2008
This section of the Compensation Discussion and Analysis provides information regarding (i) our general philosophy and objectives behind executive compensation, (ii) the role and involvement of the parties in the analysis and decisions regarding our executive compensation, (iii) the general process of determining our executive compensation, (iv) the rationale behind the components of our executive compensation and (v) each component of our executive compensation, each as in effect for periods ending on or prior to December 31, 2008.
General Philosophy and Objectives
At and prior to the 2008 fiscal year end, the fundamental principles we followed in designing and implementing our executive compensation programs were to (i) link pay to performance, (ii) align to an appropriate extent the interests of management with those of our shareholders and (iii) use our compensation practices to support our core values and strategic mission and vision. In addition, the following principles influenced and guided the compensation decisions of the Compensation Committee of our Board (the “Compensation Committee”):
The Compensation Committee examined our business plan and strategic objectives in order to ensure that its compensation decisions attracted and retained leaders and rewarded them for achieving our strategic objectives.
At the core of our compensation philosophy was our belief that we should link pay directly to performance. This philosophy guided our compensation-related decisions as follows:
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A substantial portion of executive officer compensation was contingent upon achievement of objective corporate and/or individual performance objectives, with awards ranging depending on the levels of advancement.
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The Compensation Committee believed that total compensation should generally increase with position, responsibility, and greater ability to influence our achievement of targeted results and strategic initiatives.
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As position and responsibility increased, a greater portion of the executive officer’s total compensation became performance-based and contingent on the achievement of performance objectives.
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Equity-based compensation was higher for persons with higher levels of responsibility, making a significant portion of their total compensation dependent on long-term appreciation in the value of our common stock.
The Parties Involved in Determining Executive Compensation During and Prior to 2008
The Role of the Compensation Committee
In connection with the consummation of the Santander transaction, our Board no longer has a Compensation Committee. As a result, the following describes the role of the Compensation Committee prior to the consummation of the Santander transaction.
Prior to the Santander transaction, the Compensation Committee had the responsibility for adopting and reviewing our executive compensation philosophy so that it reflected our mission, vision, values, and long-term strategic objectives. More specifically, the fundamental authority and responsibilities of the Compensation Committee were to:
Administer our executive compensation programs in a manner that furthered our strategic goals and served the interests of our shareholders;
Establish compensation-related performance objectives for executive officers that supported our strategic goals and initiatives;
Evaluate the job performance of the Chief Executive Officer in light of the established goals and objectives;
Determine the total compensation levels of the senior executive officers and allocate total compensation among the various components of compensation in accordance with our executive compensation philosophy;
Administer our equity compensation and other incentive compensation plans;
Make recommendations to the Board regarding equity-based and incentive compensation plans;
Make recommendations regarding succession plans for senior executive officers; and
Recommend to the Board the compensation arrangements with respect to our non-employee directors.
The Role of Management During and Prior to 2008
Management also played an important role in the compensation process during and prior to 2008. The most significant aspects of management’s role in the compensation process were:
Evaluating team member performance (other than his own);
Recommending business performance targets and objectives (other than his own); and
Recommending salary levels, and equity and incentive awards for executive and other employees who report to them.
Our Chief Executive Officer participated in Compensation Committee meetings at the Compensation Committee’s request to provide:
Background information regarding our strategic goals and initiatives;
Evaluation of the performance of senior executive officers (other than himself); and
Compensation recommendations for the senior executive officers (other than himself).
The Role of Outside Independent Compensation Advisors During and Prior to 2008
The Compensation Committee charter granted the Compensation Committee the ability to hire advisors and consultants to assist the Compensation Committee in meeting its obligations under its charter.
In the fall of 2005, the Compensation Committee retained Hewitt Associates (“Hewitt”) to assist the Compensation Committee in identifying specific peer group companies and to provide research with respect to compensation programs and compensation levels among these peer companies. Hewitt also served as the Compensation Committee’s compensation consultant in 2006, 2007 and 2008. The total amount of fees paid to Hewitt for compensation related services in 2008 was $204,922. The Company did not pay any fees to Hewitt for non-compensation related services.
We had a Compensation Consultant Policy that governed the retention of any compensation consultant. The purpose of this policy was to ensure that any compensation consultant that we retained to assist the Compensation Committee in the evaluation of director and/or Chief Executive Officer compensation or with our compensation plans, policies and programs was independent. This policy and the Compensation Committee charter provided that:
The Compensation Committee had the power to hire and fire any compensation consultant, and as a result, (i) the compensation consultant had to report directly to the Compensation Committee chair and (ii) the Compensation Committee could contact the compensation consultant without any interaction from our management.
Should our management have desired to engage the compensation consultant to provide services for Sovereign management, such engagement would have only occurred after the Compensation Committee reviewed such engagement and confirmed that the engagement would not compromise the independence of the compensation consultant.
Our management had the opportunity to review and comment on the advice and recommendations provided by the compensation consultant, but it would not override them or control which materials were sent to the Compensation Committee.
The Compensation Committee regularly evaluated the compensation consultant’s effectiveness, with the consultant either informed of the findings or actively involved in soliciting feedback. The Compensation Committee reviewed the advisability of a compensation consultant rotation not less frequently than every three years.
We were prohibited from employing any individual who worked on Sovereign’s account during the prior year for a period of one year after leaving the employment of the compensation consultant.
The Compensation Committee’s Process During and Prior to 2008
The Compensation Committee’s process typically began with establishing corporate performance objectives for senior executive officers in the first quarter of each fiscal year. The Compensation Committee engaged in an active dialogue with the Chief Executive Officer and other senior executive officers concerning strategic objectives and performance targets. The Compensation Committee reviewed the appropriateness of the financial measures used in our incentive plans and the degree of difficulty in achieving specific performance targets. The Compensation Committee established corporate performance objectives based on pre-established earnings per share and other goals for Sovereign or one or more of our business units.
Together with the performance objectives, the Compensation Committee established targeted total compensation levels for each of the senior executive officers. In making its determination, the Compensation Committee considered a number of factors. While a review of historical compensation levels and competitive pay practices at our peer companies was a critical component, even more important was the Compensation Committee’s review of the relative compensation levels among our senior executive officers as a group, industry conditions, corporate performance compared to peer companies, and the overall effectiveness of our compensation program in achieving desired performance levels.
As targeted total compensation levels were determined, the Compensation Committee also determined the portion of total compensation that would have been contingent, performance-based pay. Performance-based pay generally included cash bonuses for achievement of specific performance objectives and equity-based compensation whose value was dependent upon long-term appreciation in the price of our common stock.
During the period prior to and throughout 2008, the Compensation Committee met as often as necessary to perform its duties and responsibilities. At each of these meetings, the Compensation Committee received and reviewed materials in advance of each such meeting, which included:
Financial reports on year to date performance versus budget and comparison to prior year performance;
Reports on levels of achievement of individual and corporate performance objectives;
Reports on strategic objectives and budget for future periods;
Reports on both then-current and past performance versus a peer group of companies;
Information on the senior executive officers’ stock ownership holdings;
Information with respect to equity compensation awards;
Estimated value of equity awards (using a Black-Scholes evaluation methodology);
Tally sheets setting forth the total compensation of the senior executive officers which included, base salary, cash incentives, equity awards, perquisites, deferred compensation as well as amounts payable to the executives upon voluntary or involuntary termination, retirement, or following a change in control; and
Information regarding compensation programs and compensation levels at peer companies identified by our compensation consultant or by the Compensation Committee.
Finally, with respect to process and in accordance with the provisions of the Compensation Committee’s charter, the Compensation Committee reviewed, on an annual basis, its performance and the effectiveness of our compensation program in obtaining desired results. To this end, during 2006, we undertook an extensive review of our executive compensation programs. This review resulted in recommended program changes approved by our Board for 2007 and beyond that directly supported the philosophy to deliver competitive programs that were easily understood and succinctly aligned to corporate performance goals. Our overall pay philosophy was to pay at the median (50%) level of our peer group (as discussed below under the subsection “Benchmarking”) for each element of executive compensation.
The Rationale Behind Our Executive Compensation During and Prior to 2008
Business Context
Before we became a wholly-owned subsidiary of Santander, we were a publicly traded company with common stock listed on the NYSE. Accordingly, we were committed to maximizing shareholder value by aggressively building our business lines and units through an entrepreneurial, local market strategy. We transformed our historical model of significant expansion through merger and acquisition activity to a balanced organic growth model to achieve ongoing, consistent increases in revenues, earnings per share, and return on equity. The success of this model was dependent on a highly skilled executive team of unquestioned integrity committed to delivering creative solutions for driving increased market share and customer loyalty. As a result, we adopted guiding compensation principles that were intended to directly align the interests of executives with shareholders in accomplishing these objectives.
Benchmarking
When making compensation decisions, we also looked at the compensation of our senior executive officers relative to the compensation paid to similarly-situated executives at companies that we considered to be our peers-this is often referred to as “benchmarking.” We used the same peer group in this benchmarking analysis that we used to assess business performance. The peer group changed over time as needed by adding or replacing major U.S. financial services companies to reflect our asset size and other factors.
We believed that information regarding pay practices at peer companies was useful because we recognized that our compensation practices had to be competitive if we were to attract and retain quality executives. Accordingly, we reviewed compensation levels for our executive officers against compensation levels at the companies in the peer groups identified by our compensation consultant. It should be noted, however, that this benchmarking analysis was but one of the many factors that we considered in assessing the reasonableness of our compensation package.
We based executive compensation opportunities on peer group information to determine competitive levels for base salary, short- and long-term incentives, and executive benefits and perquisites. We based actual compensation on competitive pay levels as well as individual positions in the executive group. We reviewed our executive compensation programs annually, using Hewitt. Hewitt worked with the Compensation Committee from late 2005 through 2006 and with our Human Resources Department in 2007 and 2008. We generally did not use formulas to allocate compensation between long- and short-term compensation or between equity and non-equity awards, rather we targeted all compensation components, including base salary, annual and long-term incentives (including equity awards), benefits, and perquisites, at median market levels compared to our peer group, with the variable components having significant upside potential and downside risk to reinforce pay for performance.
Set forth below was our peer group as of December 31, 2008:
BB&T Corporation
Marshall & Isley Corporation
Fifth Third Bancorp
The PNC Financial Services Group, Inc
Huntington Bancshares Incorporated
UnionBanCal Corporation
KeyCorp
Regions Financial Corporation
M&T Bank Corporation
Zions Bancorporation
Internal Pay Equity
We believed that internal pay equity was an important factor for us to consider in establishing compensation for executive officers. We did not establish a formal policy regarding the ratio of total compensation of the Chief Executive Officer to that of the other executive officers, but we reviewed compensation levels to ensure that an appropriate relationship existed.
Maximization of the Tax Deductibility of Compensation Where Appropriate
We generally sought to maximize deductibility for tax purposes of all elements of compensation. The Compensation Committee reviewed compensation plans in light of applicable tax provisions, including Code Sections 162(m) and 280G and revised compensation plans and arrangements from time to time to maximize deductibility. The Compensation Committee could have, however, approved compensation or compensation arrangements that did not qualify for maximum deductibility when the Compensation Committee deemed it to be in our best interest.
Components of Our Executive Compensation During and Prior to 2008
For 2008, compensation paid to our named executive officers consisted primarily of base salary, short-term incentives, and long-term incentives, as described more fully below. In addition to executive officers being eligible for participation in Company-wide benefits plans, we provided selected executive officers (including the named executive officers) with certain benefits not available to the general team member population but which were at or under competitive levels with peer group programs.
Base Salary During and Prior to 2008
Base salary was a key element of executive compensation because it provided our executive officers with a fixed base level of bi-weekly income. In determining the base salaries of senior executive officers, the Compensation Committee considered the following criteria:
The overall job scope and responsibilities;
The executive’s qualifications, including education and experience level;
The goals and objectives established for the executive;
Individual performance versus objectives;
The executive’s past performance;
Competitive salary practices at peer companies;
Internal pay equity; and
Maximizing the deductibility of compensation for tax purposes.
As a result of our 2006 executive compensation review, we implemented a new executive base salary grade structure in 2007. Beginning in 2007, we classified each executive officer position, other than the Chief Executive Officer, into specific salary grades developed to target base salary at the median of our peer group for similar positions and to differentiate more equitably between executive positions based on job scope and complexity.
We annually reviewed the base salaries for our executive officers to assess the above criteria and determined any necessary adjustments and we generally adjusted, on a prospective basis, the base salaries effective with the first pay period in April. Periodic increases also have occurred if warranted in the event of significant increases in job scope and responsibility or other factors. For example, (i) Mr. Walters received an increase in base salary for 2008 in connection with his appointment as Interim President and Interim Chief Executive Officer, (ii) Mr. Sullivan received an increase in base salary for 2008 in connection with his promotion to Managing Director, Commercial Banking, and (iii) Mr. Rinaldi received an increase in base salary for 2008 for his continued service as Chief of Staff to the Chief Executive Officer. See “Description of Employment and Related Agreements.”
Short-Term Incentive Compensation During and Prior to 2008
Our short-term incentive programs contained two components: a cash bonus component and an equity award component. We discuss our analysis of the mix between cash and equity compensation below and under “Long-Term Incentive Compensation During and Prior to 2008.”
We provided annual short-term incentive opportunities for the named executive officers to reward achievement of Company and individual performance objectives, as well as to reinforce key cultural behaviors used to achieve short-term and long-term success. Each year, we implemented both financial and non-financial measures that we established for each named executive officer including threshold performance expectations for triggering incentive payout eligibility as well as target and maximum performance benchmarks for determining ongoing incentive awards and final incentive payouts. We targeted the variable compensation component at the median level as compared to our peer group for achievement of these benchmarks. Our short-term incentive programs provided significant variance in the amount of potential awards, higher or lower, in order to reinforce our pay for performance philosophy.
The Chief Executive Officers’ annual awards for 2006, 2007 and 2008 (as applicable) were tied 100% to the corporate performance factors described below. Awards to certain other named executive officers we refer to herein as “senior executive officers” (i.e., Mr. McCollom in 2006 and Messrs. McCollom and Rinaldi in 2007 and in 2008) were based 20% on individual performance factors and 80% on meeting the Company performance factors. This mix was intended to reinforce the critical focus of our senior executive officers on certain annual objectives that significantly impacted our long-term performance strategy. Below the senior executive officer level (e.g., Mr. Sullivan in 2007 and Messrs. Sullivan and Lever for 2008), the target award mix for executives was 60% individual performance factors and 40% Company performance factor, reinforcing our Company-wide annual incentive alignment. In determining the individual performance component, the Compensation Committee conducted a detailed assessment of each team member’s accomplishments versus pre-established objectives for the year. The Compensation Committee used this assessment to determine an appropriate incentive payment directly correlated to the level of accomplishment achieved.
We have historically paid out annual short-term incentive compensation in both cash and restricted stock with a three-year “graded” vesting schedule. In 2006, the cash/restricted stock mix was 67%/33% for the senior executive officers and, in general, 65%/35% for all other executive officers. Based on the 2006 executive compensation study, the Compensation Committee determined that our use of equity as a payment vehicle for short-term incentive compensation was not a competitive practice compared to the majority of our peers. Therefore, the Compensation Committee determined that we would transition to paying short-term incentive compensation to our executive officers 100% in cash by 2009, except for the Chief Executive Officer, whose compensation mix would be governed by the terms of an employment agreement. For 2007, as part of the transition process, we increased the cash/restricted stock mix to 75%/25% for executive officers below the senior executive officer level. The cash/restricted stock mix for senior executive officers remained at 67%/33% for 2007. All named executive officers received their short-term incentive bonus for 2008 in the form of cash.
Payout of short-term incentive awards to the named executive officers for 2007 were tied to our achieving a return on risk-weighted assets target of 1.31%, with our achieving a return on risk-weighted assets, or RORWA, of 1.23% required for any payout. Our actual return on risk-weighted assets in 2007 was 1.21%. Because we did not reach these targets, the named executive officers did not receive a payout of the Company component for 2007 performance under our short-term compensation programs. After consideration, however, the Compensation Committee recognized Messrs. Rinaldi’s and Sullivan’s performances in 2007, and awarded them bonuses of $135,000 and $141,750, respectively. We paid Mr. Rinaldi’s award 67% in cash and 33% in restricted common stock (3,908 shares) and Mr. Sullivan’s award 75% in cash and 25% in restricted stock (3,109 shares). The restricted stock portion of the awards was granted on March 3, 2008, and vests ratably over three years.
For 2008, we set Messrs. Campanelli’s and Rinaldi’s short-term incentive compensation target awards at $1,163,750 (100% based on Company performance), and $285,600 (80% based on Company performance, 20% based on individual performance), respectively. The portion of the target award tied to Company performance was subject to our achieving a 1.05% return on risk-weighted assets in 2008, with a sliding scale of payouts in relation to Company performance against this target as set forth in the table immediately below. However, in May 2008, our Board reduced the return on risk-weighted assets target to .96% due, in part, to dramatic changes in the economic environment compared with the September 2007 budget. Then, in June 2008, based on this revised target and expectations for the remainder of the year, including continued volatility in the financial markets, the Board adjusted the RORWA achievement levels for above or below target performance. As adjusted, the 2008 RORWA achievement levels in relation to the RORWA target of .96% and the percentage payout of the Company performance portion of the target awards are set forth in the following table. A RORWA target of .96% represents 100% achievement of target RORWA in the table below.
In addition, the Compensation Committee could review any excess (above-target) operating earnings achieved at year-end to determine the appropriateness of their inclusion in calculating the return on risk-weighted assets. In accordance with the terms of his employment agreement, Mr. Campanelli’s award was payable one-third in cash and two-thirds in restricted common stock under the 2004 Plan. Pursuant to his Separation Agreement, Mr. Campanelli continued to be eligible to receive a prorated bonus for 2008 based on the same Company performance targets and other business criteria that applied to other executive officers of the Company. Mr. Rinaldi’s award was payable 100% in cash.
For 2008, Mr. Sullivan’s and Mr. Lever’s short-term incentive compensation targets were set at $272,077 and $238,000, respectively; 40% of each of the foregoing targets were based on the same Company performance criteria described above for Messrs. Campanelli and Rinaldi, and 60% of each of the foregoing targets was based on individual performance. Messrs. Sullivan’s and Lever’s bonuses were payable 100% in cash.
Pursuant to the terms of his employment agreement, for 2008, Mr. Walters’ short-term incentive compensation target was set at his annual base salary of $550,000, 100% of which was subject to the same Company performance criteria described above for Messrs. Campanelli and Rinaldi. Under the terms of his employment agreement, Mr. Walters was eligible to receive a short-term incentive bonus of up to 200% of his annual base salary. Mr. Walters’ bonus was payable in cash. See “Description of Employment and Related Agreements.”
Mr. McCollom did not receive a short-term incentive compensation bonus target for 2008.
Ultimately, Sovereign did not achieve the Company goal for return on risk weighted assets in 2008. Nonetheless, in light of: (1) the contributions made by eligible team members with respect to many key initiatives in 2008, including the capital raise in May 2008, the efforts to focus Sovereign Bank on core businesses, and the Santander transaction; (2) our desire to retain valuable team members during a critical transition year; and (3) the fact that our financial performance in 2008 was adversely affected by disruptions that were, to a large extent, outside the control of eligible team members in the short-term incentive plan, the Compensation Committee determined to deem the Company performance component for 2008 satisfied at the target level for all participating team members, including the named executive officers (other than Mr. McCollom). With respect to Mr. Walters, however, in recognition of his overall performance in 2008, the Compensation Committee exercised its discretion to award Mr. Walters a short-term incentive compensation bonus in excess of the target. In taking this action, the Compensation Committee noted, among other things, that Mr. Walters had taken many steps in helping move the Company in a new direction as he worked to resolve outstanding issues and laid a solid foundation to permit the Company to move forward and position itself to make substantial improvements. Upon the Compensation Committee’s recommendation, the Board approved the maximum short-term incentive compensation bonus allowable under Mr. Walters’ employment agreement.
We made cash payments to the named executive officers in the amounts set forth below as short-term incentive awards for 2008. These amounts include payments made with respect to each of the named executive officer’s individual performance (as applicable), the deemed satisfaction of the Company performance at the target level and, in the case of Mr. Walters, the maximum bonus allowable under his employment agreement.
In addition to the short-term incentive compensation described above, on February 13, 2007, the Board approved potential supplemental short-term incentive compensation awards payable in 2008 and 2009 to Messrs. Campanelli and McCollom. In the event that our cash earnings for 2007 and 2008 equaled or exceeded $1.45 and $1.08 per share, respectively, each of Messrs. Campanelli and McCollom would have received a cash payment of $225,500 for each such year, provided that he was a member of the Office of the CEO on December 31, 2007, and December 31, 2008, respectively. In addition, these awards were subject to our Tier 1 capital not being less than 5% as of the end of the applicable year and satisfaction of certain other asset quality criteria as of such date. In the event of a change in control, any potential supplemental short-term compensation awards would have been payable within 30 days after such change in control if such individual were serving as a member of the Office of the CEO immediately before the change in control. Notwithstanding the foregoing, the Compensation Committee could, in its discretion, determine that a participant earned all or a portion of this award for a particular year notwithstanding our failure to achieve the cash earnings or other criteria established for the award. Because we did not reach this target in 2007, and because the Compensation Committee did not exercise its discretion, Messrs. Campanelli and McCollom did not receive the supplemental bonus payment of $225,500 for 2007. As we describe in our discussion of Mr. McCollom’s Separation Agreement in “Description of Employment and Related Agreements,” in connection with Mr. McCollom’s resignation as our Chief Financial Officer effective March 3, 2008, and termination of employment effective May 30, 2008, Mr. McCollom received a cash payment of $225,500 in lieu of his supplemental short-term incentive compensation award for 2008. Mr. Campanelli did not receive a payment with respect to his supplemental short-term incentive compensation for 2008.
Long-Term Incentive Compensation During and Prior to 2008
When we were a public company prior to the consummation of the Santander transaction, we believed in maintaining a strong correlation between management incentives and shareholders’ long-term interests by using equity-based compensation programs that were easily understood and incorporated long-term business growth targets. While our short-term incentive compensation structure rewarded performance over the previous 12 month period, our long-term incentive awards also took into account both past performance as well as projected contributions based on each executive officer’s potential and the level of influence in our organization. We determined, on an annual basis, which executives would receive long-term incentive awards, the size and type of the awards, and the award restrictions (vesting and performance criteria). We generally targeted these awards to the median level compared to our peer group, although actual award size would vary based on individual performance and long-term potential of each executive as determined by the Compensation Committee. We awarded all options and restricted stock under one of our shareholder-approved equity compensation plans. We describe each of the equity compensation plans in the narrative following the Summary Compensation Table, the Grants of Plan-Based Awards Table, and the Outstanding Equity Awards at Fiscal 2008 Year End Table. As discussed in the section entitled “Description of Employment and Related Agreements, “ we granted restricted stock units and stock appreciation rights to Mr. Walters; such grants were not pursuant to our equity compensation plans.
When we were a public company, we used stock options as an incentive vehicle because, among other things:
We believed that stock options aligned the interests of holders, supported the incentive philosophy described above, facilitated executive stock ownership, and focused the executive management team on increasing value for our shareholders;
Stock options were performance-based. All the value received by the recipient from a stock option was based upon the increase in the value of a share of our common stock above the option exercise price;
Stock options helped to provide a balance to the overall compensation program; and
The vesting period and performance criteria encouraged executive retention and, we believed, the preservation of shareholder value.
All stock options included the following features:
The term of grants did not exceed 10 years (in the case of incentive stock options) and 10 years and one month (in the case of non-qualified stock options);
The grant price was not less than the closing price of a share of our common stock on the date of grant;
Grants did not include “re-load provisions”; and
Re-pricing of options was prohibited under the terms of the plans.
We also used restricted stock as an investment vehicle because, among other things:
Restricted stock provided an equally motivating form of incentive compensation as stock options;
In certain circumstances, options could motivate the achievement of short-term gains at the expense of long-term strategic accomplishments; and
Awarding restricted stock permitted us to use fewer shares than options to deliver the same value to the executive, which reduced the potential dilution to our shareholders.
In determining the number of options and shares of restricted stock that we awarded to our executive officers as short-term incentive compensation, the Compensation Committee took into account the individual’s position, scope of responsibility, and the value of the awards in relation to other elements of the executive’s total compensation.
Beginning in 2007, and except in the case of certain 2008 equity grants to Mr. Walters described in “Description of Employment and Related Agreements,” our executive officers received their long-term incentive award in the form of restricted stock. The program provided the following forms of equity compensation:
Our senior executive officers received shares of restricted stock using a performance-vesting grid incorporating return on asset-related performance metrics. The shares had a five-year cliff vesting schedule, which schedule could be reduced to three years if we met certain performance criteria for the three-year cycle.
All other executives received shares of restricted stock that vested ratably over five years.
In order to achieve the median competitive position set forth in our executive compensation philosophy, we increased our target long-term incentive awards for our senior executive officers in 2007, and continued to phase in the increase to our senior executive officers through 2008.
2008 Long-Term Incentive Awards
On March 3, 2008, we awarded Messrs. Campanelli and Rinaldi long-term incentive awards of $2,056,250, and $600,000, respectively, in the form of 180,373 and 52,632 shares of restricted common stock, respectively, under the 2004 Plan (we determined the number of shares based on the $11.40 closing price of our common stock on December 31, 2007). Messrs. Campanelli’s and Rinaldi’s awards were to vest in five years, unless the average of our year-to-year improvement for return on risk-weighted assets for 2008, 2009, and 2010 was greater than the relative performance of at least 50% of the companies in our peer group, in which case the award would have cliff vested in three years. As we describe in our discussion of Mr. Campanelli’s Separation Agreement in “Description of Employment and Related Agreements”, in connection with Mr. Campanelli’s resignation as our Chief Executive Officer effective September 30, 2008, and termination, effective October 30, 2008, Mr. Campanelli received, among other things, a cash payment in respect of each of his shares of restricted stock.
In addition, on March 3, 2008, we awarded Mr. Sullivan a long-term incentive award of $500,000 in the form of 43,860 shares of restricted stock under the 2004 Plan (we determined the number of shares based on the $11.40 closing price of our common stock on December 31,2007). This award was to vest ratably over five years.
On March 3, 2008, we awarded Mr. Lever a long-term incentive award of $500,000 in the form of 43,860 shares of restricted stock under the 2004 Plan (we determined the number of shares based on the $11.40 closing price of our common stock on December 31, 2007). This award was to vest ratably over five years.
On March 3, 2008, we awarded Mr. Walters a long-term incentive award of $700,000 in the form of 61,404 shares of restricted stock under the 2004 Plan (we determined the number of shares based on the $11.40 closing price of our common stock on December 31, 2007). This award would have cliff-vested in five years unless the average of our year-to-year improvement for return on risk-weighted assets for 2008, 2009 and 2010 was greater than the relative performance of at least 50% of the companies in our peer group, in which case the award would have cliff-vested in three years. Additionally, on March 7, 2008, we awarded Mr. Walters a long-term incentive award of $200,000 in the form of 19,551 shares of restricted stock under the 2004 Plan (we determined the number of shares based on the $10.23 closing price of our common stock on March 7, 2008). This award was to vest ratably over five years. In addition, in October 2008, we awarded Mr. Walters certain long-term incentive awards as detailed in the section entitled “Description of Employment and Related Agreements” below.
Mr. McCollom did not receive a long-term incentive compensation award for 2008.
As previously discussed, in accordance with the terms and conditions of the Transaction Agreement, all options outstanding immediately prior to the consummation of the transaction were cancelled, and the holders thereof were entitled to receive a cash payment in respect of each option, whether or not vested, equal to the excess, if any, of the fair market value of the stock as of closing over the grant price; all option were underwater as of closing and no employees received any cash payments in respect of the options. Further, in accordance with the terms of the Transaction Agreement, all restricted stock outstanding immediately prior to the consummation of the Santander transaction were effectively cancelled in exchange for the right to receive Santander ADSs.
Additional Commentary on Equity Compensation
The following provides additional general information regarding our equity compensation prior to the Santander transaction:
Delegation of Administration: The Compensation Committee delegated the day-to-day administration of its equity compensation plans to Sovereign’s Human Resources Department (formerly called Team Member Services).
Value of Equity Awards: All equity awards to our team members, including the named executive officers, were awarded and reflected in our consolidated financial statements, based on applicable accounting guidance, at fair market value on the grant date in accordance with SFAS 123(R).
Timing of Stock Option Grants: We did not grant stock options in 2008 except to Mr. Walters, as described in “Description of Employment and Related Agreements.” Subject to certain exceptions, for prior years, we planned the dates of our equity awards, including grants of stock options, well in advance of any actual award. The Compensation Committee approved our annual short- and long-term incentive awards at its regularly scheduled meeting in February or March of each year, which was after we released our annual earnings. Except in unusual circumstances, such as in the case of new hires receiving a grant of less than 50,000 stock options, we did not grant stock options to executive officers at other dates. The grant date of stock options was established when the Compensation Committee approved the grant and all key terms had been determined. Under the terms of each of our equity compensation plans that provided for stock option grants, the exercise price of each option to purchase our stock was the closing price of our common stock on the grant date. If, at the time of any option grant to an executive officer, any member of our Board or senior management was aware of material non-public information, the planned grant was not made.
Employment Agreements
Prior to the consummation of the Santander transaction, we used employment agreements for executive officers to establish key elements of the agreement between us and the executive that differ from the our standard plans and programs. The agreements also facilitated the creation of covenants, such as those prohibiting post-employment competition or hiring by executives. We entered into employment and/or change of control agreements with each of the named executive officers, which are discussed below in detail in the section entitled “Description of Employment And Related Agreements.” However, following the Santander transaction, each of the employment agreements of the named executive officers were terminated in exchange for payments to the subject executives and we entered into new letter agreements with each of the named executive officers. The terms of the new letter agreements are also discussed below in “Description of Employment And Related Agreements.”
Period Following the Santander Transaction
We remain committed to establishing competitive compensation programs for our executives for 2009 and beyond. We anticipate that our short-term incentive compensation program will be substantially similar to our 2008 program (described above) and that the targets will be set at the same levels as in effect for 2008. We continue to work with Santander in establishing a new long-term incentive program that will enable us to continue offering long-term incentives as a tool for retaining and attracting highly qualified executives. Now that we are a wholly-owned subsidiary of Santander, the short and long-term incentive compensation programs will provide awards solely in cash rather than, as done in the past, shares of our common stock.
Matters Relating to the Compensation Committee of the Board
Compensation Committee Report
As a result of the Santander transaction, we currently do not have a Compensation Committee. For purposes of Item 407(e)(5) of Regulation S-K, the Sovereign Board furnishes the following information. The Sovereign Board has reviewed and discussed the Compensation Discussion and Analysis included in Part III - Item 11 of the Form 10-K with management. Based upon the Sovereign Board’s review and discussion with management, the Sovereign Board has recommended that the Compensation Discussion and Analysis be included in the Form 10-K for the fiscal year ended December 31, 2008.
Submitted by:
Gabriel Jaramillo, Chairman
Gonzalo de Las Heras
Marian Heard
Keith Morgan
Alberto Sánchez
Wolfgang Schoellkopf
Anthony Terracciano
Kirk Walters
The foregoing “Compensation Committee Report” shall not be deemed to be “filed” with the SEC or to the liabilities of Section 18 of the Exchange Act, and notwithstanding anything to the contrary set forth in any of Sovereign’s previous filings under the Securities Act or the Exchange Act, that incorporate future filings, including this Form 10-K, in whole or in part, the foregoing “Compensation Committee Report” shall not be incorporated by reference into any such filings.
Compensation Committee Interlocks and Insider Participation
During 2008, the last completed fiscal year, the following directors served as members of the Compensation Committee of the Board: Marian Heard, Chair, Gonzalo de Las Heras, Brian Hard, Andrew C. Hove, Jr., William J. Moran, Maria Fiorini Ramirez, Juan Rodriguez-Inciarte (as an alternative to Mr. de Las Heras), and Ralph V. Whitworth. Mr. Hard had a lending relationship with Sovereign Bank, which was made and remained in compliance with Regulation O. As detailed in Item 13 of this Form 10-K, during the 2008 fiscal year, Messrs. de Las Heras, Rodriguez-Inciarte, and Sánchez served as executive officers of Santander or an affiliated entity, and certain relationships existed between Sovereign and its affiliates, on one hand, and Santander and its affiliates, on the other hand. With these exceptions, no member of the Compensation Committee (i) was, during the 2008 fiscal year, or had previously been, an officer of employee of Sovereign or its subsidiaries nor (ii) had any direct or indirect material interest in a transaction of Sovereign or a business relationship with Sovereign, in each case that would require disclosure under the applicable rules of the SEC. No other interlocking relationship existed between any member of the Compensation Committee or an executive officer of Sovereign, on the one hand, and any member of the compensation committee (or committee performing equivalent functions, or the full board of directors) or an executive officer of any other entity, on the other hand, requiring disclosure pursuant to the applicable rules of the SEC.
Summary Compensation Table - 2008
Footnotes:
In 2006, each of Messrs. Campanelli and McCollom elected to defer 50% of his respective cash bonus to the Deferred Compensation Plan in its former status as the Bonus Deferral Program, which we describe under “Deferred Compensation Plan,” and which are not reflected in this column. Such deferrals are included in the Stock Awards column. No named executive officer elected to defer any salary or bonus into the Deferred Compensation Plan for 2007 or 2008.
(4)
The amounts in this column reflect the dollar amount recognized for financial statement reporting purposes for the applicable fiscal year, in accordance with SFAS 123(R), of awards under our equity compensation plans (each of which is more fully described under the caption “Our Compensation Plans During and Prior to 2008”) and our Bonus Deferral Program for 2008 (which is paid in stock) and thus may include amounts from awards granted in and before the applicable fiscal year. Assumptions used in the calculation of this amount are included in footnotes to our audited financial statements included in this Annual Report on Form 10-K for the fiscal year ended December 31, 2008. For Mr. Walters, the Stock Awards column includes restricted stock units granted to Mr. Walters pursuant to the terms of his employment agreement; such award was not granted under our equity compensation plans.
(5)
Includes the aggregate change in the accumulated pension value of the named executive officer’s benefit under our Enhanced Retirement Plan, which is described following the “Pension Benefits - 2008” table, and the above-market or preferential earnings on compensation deferred under our nonqualified deferred compensation plans, which we describe following the “Nonqualified Deferred Compensation - 2008” table. The separate amounts are as follows:
(6)
Includes the following amounts that we paid to or on behalf of the named executive officers:
Grants Of Plan-Based Awards - 2008
Footnotes:
Outstanding Equity Awards At Fiscal 2008 Year End
Footnotes:
(5)
We awarded these shares of restricted stock on February 15, 2006 as part of our annual short-term equity incentive compensation awards. These restricted shares were to vest ratably over a three-year period from the date of the award.
(6)
We awarded these shares of restricted stock on February 13, 2007 as part of our annual-short-term equity incentive compensation awards. These restricted shares were to vest ratably over a three-year period from the date of the award.
(7)
We awarded these shares of restricted stock on March 3, 2008 as part of our annual-short-term equity incentive compensation awards. These restricted shares were to vest ratably over a three-year period from the date of the award.
(8)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on February 18, 2004. These restricted shares were to vest after five years had elapsed from the date of the award.
(9)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on February 16, 2005. These restricted shares were to vest after five years had elapsed from the date of the award.
(10)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on February 15, 2006. These restricted shares were to vest after five years had elapsed from the date of the award.
(11)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on February 13, 2007. These restricted shares were to vest after five years had elapsed from the date of the award.
(12)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on February 13, 2007. These restricted shares were to vest ratably over a five-year period from the date of the award.
(13)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on March 3, 2008. These restricted shares were to vest ratably over a five-year period from the date of the award.
(14)
We awarded these restricted shares as part of our long-term equity incentive compensation awards on March 3, 2008. These restricted shares were to vest after five years had elapsed from the date of the award, unless the average of Sovereign’s year to year improvement for return on risk-weighted assets for 2008, 2009 and 2010, was greater than the relative performance of at least 50% of the companies in Sovereign’s per group, in which case the award was to vest 100% cliff vest after three years had elapsed from the date of the award.
(15)
We awarded these restricted shares on March 7, 2008 pursuant to the terms of Mr. Walter’s offer letter. These restricted shares were to vest ratably over a five-year period from the date of the award.
(16)
These shares of our common stock represent our 100% matching contribution on the amount of cash bonus deferred under the Bonus Deferral Program. These shares were to vest five years from the date of award as follows:
Option Exercises And Stock Vested - 2008
Our Compensation Plans During And Prior To 2008
Explanatory Note
On January 30, 2009, we became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement, and, in connection with the Santander transaction, many of our compensation plans and programs were terminated. In particular, the 2004 Plan, the 2001 Plan and the Purchase Plan were terminated by the Sovereign Board in connection with, or immediately following, the consummation of the Santander transaction. Moreover, in accordance with the terms and conditions of the Transaction Agreement, all options outstanding immediately prior to the consummation of the transaction were cancelled, and the holders thereof were entitled to receive a cash payment in respect of each option, whether or not vested, equal to the excess, if any, of the fair market value of the stock as of closing over the grant price; all option were underwater as of closing and no employees received any cash payments in respect of the options. Further, in accordance with the terms of the Transaction Agreement, all restricted stock outstanding immediately prior to the consummation of the Santander transaction were effectively cancelled in exchange for the right to receive Santander ADSs. As a result, the discussion below of the compensation disclosure is in regard to periods prior to January 30, 2009 and includes information with respect to various equity incentive compensation plans that are no longer in effect as of the date hereof.
The 2004 Plan
In 2004, our shareholders approved the Sovereign Bancorp, Inc. 2004 Broad-Based Stock Incentive Plan, which we refer to as the “2004 Plan.” The 2004 Plan was broad-based in accordance with management’s strong belief that we would continue to have a performance-oriented culture and would create greater shareholder value if team member stock ownership levels were increased at all levels.
The 2004 Plan authorized us to award team members incentive stock options and nonqualified stock options to purchase shares of our common stock at the fair market value per share as of the date we granted the option. The 2004 Plan also authorized the award of shares of restricted stock to eligible team members.
Under the 2004 Plan, option grants and restricted stock awards must not have fully vested in less than three years. In addition, awards to our senior executive officers must have included a vesting schedule that included the satisfaction of previously established performance goals.
The 2004 Plan provided for acceleration of vesting in certain circumstances, including a “change in control” of Sovereign. In addition, the 2004 Plan provided that, upon a participant’s termination of employment, the Compensation Committee could, in circumstances in which it deemed it appropriate, exercise its discretion to accelerate vesting of outstanding stock option grants and restricted stock awards and extend the exercise period for vested options.
As of December 31, 2008, there were 51,978 vested and 444,774 unvested options outstanding under the 2004 Plan.
The 2001 Plan
In 2001, our shareholders approved the Sovereign Bancorp, Inc. 2001 Stock Incentive Plan, which we refer to as the “2001 Plan.” The 2001 Plan authorized us to award team members incentive stock options and nonqualified stock options to purchase shares of our common stock at the fair market value per share as of the date we granted the option. The 2001 Plan also authorized the award of shares of restricted stock to eligible team members.
Under the 2001 Plan, option grants and restricted stock awards must not have fully vested in less than one year and three years, respectively.
The 2001 Plan provided for acceleration of vesting in certain circumstances, including a “change in control” of Sovereign. In addition, the 2001 Plan provided that, upon a participant’s termination of employment, the Compensation Committee could, in circumstances in which it deemed it appropriate, exercise its discretion to accelerated vesting of outstanding stock option grants and restricted stock awards and extend the exercise period for vested options.
As of December 31, 2008, there were 1,925,709 vested and 1,920,605 unvested options outstanding under the 2001 Plan.
The 1996 Plan
In 1996, our shareholders approved the Sovereign Bancorp, Inc. 1996 Stock Option Plan, which we refer to as the “1996 Plan.” The 1996 Plan expired by its terms on February 28, 2006. The 1996 Plan permitted us to grant officers and team members a right to purchase shares of stock at the fair market value per share as of the date of grant. The 1996 Plan permitted the grant of both incentive and nonqualified stock options to our team members. Non-employee directors were not eligible to receive options under the 1996 Plan. Awards under the 1996 Plan generally provided for a minimum vesting period of one year following the date of grant but did provide for acceleration of vesting and extension of the exercise period of options in certain circumstances, including a change in control of Sovereign.
As of December 31, 2008, there were 2,996,602 vested and 146,475 unvested options outstanding under the 1996 Plan.
The 1993 Plan
In 1993, our shareholders approved the Sovereign Bancorp, Inc. 1993 Stock Option Plan, which we refer to as the “1993 Plan.” The 1993 Plan expired by its terms in 2003. The 1993 Plan permitted us to grant team members a right to purchase shares of stock at the fair market value per share as of the date of grant. The 1993 Plan permitted the grant of both incentive and nonqualified stock options to team members. In addition, our non-employee directors were eligible to receive a one-time grant of nonqualified stock options when the 1993 Plan was effective. The 1993 Plan provided for a minimum vesting period of five years following the date of grant but did provide for acceleration of vesting in certain circumstances, including a “change in control” of Sovereign.
As of December 31, 2008, there were 81,813 vested and 0 unvested options outstanding under the 1993 Plan.
Equity Compensation Plan Information During and Prior to 2008- Shares Outstanding and Available for Grant or Award
The following table provides information about the securities authorized for issuance under our equity compensation plans as of December 31, 2008:
Footnotes:
The table does not include information for options outstanding under equity compensation plans that we assumed in connection with our acquisitions of the companies that originally established those plans. As of December 31, 2008, a total of 1,210,927 shares of our common stock were issuable upon exercise of outstanding options under those assumed plans. The weighted average exercise price of those outstanding options is $10.34 per share.
Description Of Employment And Related Agreements
As noted elsewhere in this Form 10-K, on January 30, 2009, we became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement. It is important to understand that several actions were taken immediately following the consummation of the Santander transaction that affect a fair understanding of our executive officers and their employment and related agreements. In particular, following the consummation of the Santander transaction, each of the employment agreements of the named executive officers was terminated in exchange for payments to the subject executives, following which we entered into new letter agreements with each of the named executive officers. Despite these employment agreements no longer being in effect, because this Item 11 requires us to discuss the terms of such employment agreements for periods ending on or prior to December 31, 2008, we have disclosed such information below. Additionally, below is disclosure with respect to the new letter agreements entered into between the certain named executive officers and us.
Employments Agreement During and Prior to 2008; New Letter Agreements
Kirk Walters
On September 30, 2008, Sovereign and Kirk Walters entered into (i) the First Amendment to an employment agreement, dated March 3, 2008 (as so amended, the “Prior Employment Agreement”), which appointed Mr. Walters as the Interim Chief Executive Officer, Interim President and Chief Financial Officer effective as of September 30, 2008, and (ii) an employment agreement (the “Initial Walters Employment Agreement”) to employ Mr. Walters as its Senior Executive Vice President, Chief Administrative Officer and Chief Financial Officer effective on January 3, 2009 (the “Initial Walters Effective Date”). Sovereign and Mr. Walters entered into an employment agreement, dated October 2, 2008 (the “Walters Employment Agreement”), which superseded the terms of the Prior Employment Agreement and the Initial Walters Employment Agreement (the “Walters Effective Date”).
The Walters Employment Agreement provided that Mr. Walters would continue to serve as the Interim Chief Executive Officer, Interim President, and Chief Financial Officer until the earlier of January 3, 2009 and the commencement of the employment of Paul Perrault, the successor Chief Executive Officer. At such time, Mr. Walters would then serve as the Senior Executive Vice President, Chief Administrative Officer and Chief Financial Officer. The Walters Employment Agreement had an initial term of three years and, unless terminated as set forth therein, was to automatically extend annually to provide a new term of three years.
The Walters Employment Agreement provided for an annual base salary of at least $700,000. Contingent upon Sovereign achieving annual bonus objectives for itself established by our Board in consultation with Mr. Walters, Mr. Walters would have been eligible to receive an annual bonus determined in accordance with guidelines of our bonus plans for senior bank executives with a target bonus for each calendar year of at least 100% of his salary. For the 2008 calendar year, Mr. Walters received a base salary of $550,000.
Pursuant to the Walters Employment Agreement, we granted the following equity grants (many of which as detailed elsewhere in this Form 10-K were effectively exchanged for the right to receive Santander ADSs following consummation of the Santander transaction and pursuant to the terms and conditions of the Transaction Agreement):
•
19,045 shares of our restricted common stock under the 2001 Plan, which was granted on October 2, 2008 at the closing trading price on such date. The shares were to vest in three equal annual installments, subject to Mr. Walters’ continued employment as of each vesting date.
•
180,955 restricted stock units, which was granted on October 6, 2008 at the closing trading price on such date. The units were to vest in three equal annual installments, subject to Mr. Walters’ continued employment as of each vesting date.
•
Stock options to purchase 300,000 shares of our common stock, which was granted on October 2, 2008 at the closing trading price on such date. The options were divided into two equal tranches, the first tranche (granted under the 2001 Plan) of which vested in three equal annual installments, subject to Mr. Walters’ continued employment as of each vesting date. The second tranche (granted under the 2004 Plan) was subject to the three-year graded vesting schedule, as well as to conditions regarding the performance or our stock price. Amounts of the second tranche that did not vest during the applicable three-year period, could have also vested on the fifth anniversary of the grant date, subject to continued employment and conditions related to the performance of our common stock as of such date.
•
Stock appreciation rights with respect to 700,000 shares of our common stock, which was granted on October 6, 2008 at the closing trading price on such date. The stock appreciation rights would have conditionally vested, subject to the same vesting conditions applicable to the second tranche of options discussed above.
The Walters Employment Agreement provided for full vesting of each of the foregoing equity awards upon a change in control of Sovereign.
In addition, the Walters Employment Agreement provided, among other things, a right to participate in all employee benefit plans and programs available to senior management, automobile and parking allowances, temporary housing and relocation costs and club dues and business-related expenses.
In the event the employment of Mr. Walters was terminated without “cause” or for “good reason,” Mr. Walters was entitled to receive his accrued but unpaid base salary, his earned but unpaid annual bonus, any unreimbursed business expenses and all payments, rights and benefits under the employee benefit plans. Mr. Walters was also entitled to receive severance benefits, which were calculated differently based on a “change in control” of Sovereign. If the termination of employment took place in the absence of a “change in control”, he would have received (1) a lump sum payment equal to two times his current base salary payable on the 30th day after the termination date, (2) a lump sum payment equal to two times the greater of the prior year’s bonus amount or the average of the prior three year’s annual bonus amounts payable on the 30th day after the termination date (or if not applicable, the target bonus), (3) a pro-rata annual bonus based on the number of days during the calendar year and our actual performance payable in cash, and (4) a continuation of all his health and medical benefits for a three year period following the termination date. If the termination of employment took place following a “change in control,” he would receive (1) a lump sum payment in monthly installments equal to three times his current base salary payable on the 30th day after the termination date, (2) a lump sum payment equal to three times the greater of the prior year’s annual bonus amount or the average of the prior three years’ annual bonus amounts (or if not applicable, the target bonus), (3) a pro-data annual bonus based on the number of days during the calendar year and our actual performance payable in cash, and (4) a continuation of all his health and medical benefits for a three year period following the termination date.
The Walters Employment Agreement also contained restrictive covenants imposing non-competition obligations, restricting the solicitation of our employees, protecting confidential information and requiring cooperation in litigation, as well as other covenants, during his employment and for specified periods after the termination of employment.
In the event that the amounts and benefits payable under his employment agreement, when added to other amounts and benefits which may become payable, were such that he became subject to the excise tax provisions of Section 4999 of the Internal Revenue Code, Mr. Walters was entitled to receive such additional amounts as would have resulted in his retention of a net amount equal to the net amount he would have retained had the initially calculated payments and benefits been subject only to income and employment taxation.
On February 12, 2009, the Walters Employment Agreement was terminated in exchange for a payment of $8,137,695 and a letter agreement governing the terms of his employment going forward. The payment represented an amount approximately equal to the termination benefits set forth in his terminated employment agreements with us (less applicable deductions and withholdings). The letter agreement does not provide a fixed term of employment. Under the terms of the letter agreement, if we terminate Mr. Walters’ employment other than for cause prior to the date we make our regular payment of 2009 bonuses, Mr. Walters will receive a pro-rated portion of his discretionary target bonus amount of $650,000, based on the number of full months that he worked for us in 2009. In addition, if we terminate Mr. Walters’ employment other than for cause at any time or if Mr. Walters resigns, he will receive continued coverage under our group health insurance plan, at no charge, for three years following the date of his termination.
The letter agreement also provides, among other things, a right to participate in all employee benefit plans and programs available to senior management, automobile and parking allowances, temporary housing and relocation costs and club dues and business-related expenses. Mr. Walters is also subject to a covenant not to solicit our employees for 12 months following termination of his employment.
Salvatore J. Rinaldi
We entered into an employment agreement with Mr. Rinaldi, dated as of August 7, 2007, which was amended in September 2007. Mr. Rinaldi’s agreement had an initial term of three years and, unless terminated as set forth therein, was automatically extended annually to provide a new term of three years.
The agreement provided for a base salary of $375,000, which the Board could have increased in its discretion.
In addition, the agreement provided, among other things, that Mr. Rinaldi had the right to:
Participate in the bonus programs that we maintained for our executive officers of similar rank;
Participate in our insurance, vacation, pension, and other fringe benefit programs; and
Participate in our executive benefit programs at benefit levels comparable to his peer executive officers.
If we terminated Mr. Rinaldi’s employment without “cause” and no change in control occurred at the date of such termination, he would have become entitled to the greater of:
Continued payments of current base salary through the end of the employment term or a period of 36 months, whichever is longer; or
A lump sum severance payment, within 30 days following Mr. Rinaldi’s termination, equal to the severance provided under our severance pay plan at the time of termination.
In the event that Mr. Rinaldi resigned for good reason or we terminated his employment without cause, on or after the public announcement of a change in control, he would have become entitled to the following severance benefits under his employment agreement:
Payment of a lump sum cash payment, within 30 days following Mr. Rinaldi’s termination, equal to three times the sum of:
The highest annualized base salary paid to Mr. Rinaldi during the year of termination or the immediately preceding two calendar years, and
The greater of:
Mr. Rinaldi’s target bonus in the year of termination; or
The highest bonus paid to Mr. Rinaldi with respect to one of the three calendar years immediately preceding the year of termination.
Continuation, for three years, of certain welfare benefits in effect during the immediately preceding two calendar years (or a lump sum tax-effected payment in lieu thereof, if continued participation in such benefits is not permitted because Mr. Rinaldi is no longer an employee)-less such amount as he was paying for such benefits at the time of his termination.
In the event that the amounts and benefits payable under his employment agreement, when added to other amounts and benefits which may become payable, were such that he became subject to the excise tax provisions of Code Section 4999, Mr. Rinaldi was entitled to receive such additional amounts as will result in his retention of a net amount equal to the net amount he would have retained had the initially calculated payments and benefits been subject only to income and employment taxation. In addition, Mr. Rinaldi’s employment agreement was revised in September 2007 to ensure that such agreement complies with the final regulations issued under Code Section 409A.
In all events, Mr. Rinaldi was subject to a covenant not to compete and an agreement not to solicit our customers or employees for 12 months following termination of the employment agreement.
On February 27, 2009, Mr. Rinaldi resigned for good reason pursuant the terms of his employment agreement and, as a result, his employment agreement was terminated on such date. Under the terms of his employment agreement, Mr. Rinaldi was entitled to receive a lump sum cash payment of approximately $2.2 million, and continued coverage under our group health insurance plan, at no charge, for three years. In addition, because Mr. Rinaldi was subject to the excise tax provisions of Code Section 4999, he was entitled to receive an additional payment of approximately $854,000 in order for him to retain a net amount equal to the net amount he would have retained had the above payments and benefits been subject only to income and employment taxation.
Roy J. Lever
We entered into an employment agreement with Mr. Lever, dated as of February 11, 2008.
Mr. Lever’s agreement had an initial term of two years and, unless terminated as set forth therein, was automatically extended annually to provide a new term of two years.
The agreement provided for a base salary of $350,000, which the Board could have increased in its discretion.
In addition, the agreement provided, among other things, that Mr. Lever had the right to:
•
Participate in the bonus programs that we maintained for our executive officers of similar rank;
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Participate in our insurance, vacation, pension, and other fringe benefit programs; and
•
Participate in our tax qualified employee benefit plans.
If we terminated Mr. Lever’s employment without “cause” and no change in control occurred at the date of such termination, he would have become entitled to:
•
Payment of a lump sum cash payment, within 30 days following Mr. Lever’s termination, equal to the greater of:
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Continued payments of current base salary through the end of the employment term or a period of 24 months, whichever is longer; or
•
A lump sum severance payment equal to the severance provided under our severance pay plan at the time of termination.
In the event that Mr. Lever resigned for good reason or we terminated his employment without cause, on or after the public announcement of a change in control, he will become entitled to the following severance benefits under his employment agreement:
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Payment of a lump sum cash payment, within 30 days following Mr. Lever’s termination, equal to two times the sum of:
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The highest annualized base salary paid to Mr. Lever during the year of termination or the immediately preceding two calendar years, and
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The greater of:
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Mr. Lever’s target bonus in the year of termination; or
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The highest bonus paid to Mr. Lever with respect to one of the three calendar years immediately preceding the year of termination.
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Continuation, for two years, of certain welfare benefits in effect during the immediately preceding two calendar years (or a lump sum tax-effected payment in lieu thereof, if continued participation in such benefits is not permitted because Mr. Lever is no longer an employee)-less such amount as he was paying for such benefits at the time of his termination.
In the event that the amounts and benefits payable under Mr. Lever’s employment agreement, when added to other amounts and benefits which may become payable, were such that he became subject to the excise tax provisions of Code Section 4999, the amounts and benefits payable under his employment agreement would be reduced to such an extent as may be necessary to avoid the payment of any excise tax. In this case, Mr. Lever could have elected to be bound by a 12-month non-competition restriction, in exchange for a reasonable additional payment in an amount to be determined by us (which in no circumstance will exceed the amount of the reduction of payments under this agreement that was made in order to avoid the excise tax provisions described above).
In the event that Mr. Lever voluntarily terminated his employment during the term of his agreement, but before the announcement of a change in control, or if we terminated his employment without cause and no change in control occurred at the date of such termination, Mr. Lever would have been subject to a covenant not to compete and an agreement not to solicit our customers or employees for 12 months following termination of the employment agreement. In the event that Mr. Lever resigned for good reason or we terminated his employment without cause, on or after the public announcement of a change in control, Mr. Lever would have been subject to a covenant not to solicit our customers or employees, the violation of which would have caused his right to payments and benefits to immediately terminate (and would have entitled us to recover payments made to him following commencement of the prohibited conduct, but before the discovery of such conduct).
In 2008, Mr. Lever also received a $300,000 signing bonus pursuant to the terms of his offer letter, dated December 11, 2007.
On February 3, 2009, Mr. Lever’s employment agreement was terminated in exchange for a payment of $1,305,948 and a letter agreement governing the terms of his employment going forward. The payment represented an amount approximately equal to the termination benefits set forth in his terminated employment agreement with Sovereign (less applicable deductions and withholdings). The letter agreement does not provide a fixed term of employment. Under the terms of the letter agreement, if we terminate Mr. Lever’s employment other than for cause prior to the date we make our regular payment of 2009 bonuses, Mr. Lever will receive: (1) a pro-rated portion of his discretionary target bonus amount of $300,000, based on the number of full months that he worked for us in 2009; and (2) continued coverage under our group health insurance plan, at no charge, for two years following the date of his termination.
The letter agreement also provides, among other things, a right to participate in all employee benefit plans and programs available to senior management, automobile and parking allowances, and club dues and business-related expenses.
Mr. Lever is subject to a covenant not to solicit our employees for 12 months following his resignation or involuntary termination and a covenant not to compete with us or solicit our customers for six months following his resignation or involuntary termination for cause.
Patrick J. Sullivan
We entered into an employment agreement with Mr. Sullivan, dated as of February 11, 2008. The terms of Mr. Sullivan’s employment agreement were substantially similar to the terms of Mr. Lever’s employment agreement, described above.
On February 3, 2009, Mr. Sullivan’s employment agreement was terminated in exchange for a payment of $1,268,152 and a letter agreement governing the terms of his employment going forward. The payment represented an amount approximately equal to the termination benefits set forth in his terminated employment agreement with us (less applicable deductions and withholdings). The letter agreement does not provide a fixed term of employment. Under the terms of the letter agreement, if we terminate Mr. Sullivan’s employment other than for cause prior to the date we make our regular payment of 2009 bonuses, Mr. Sullivan will receive: (1) a pro-rated portion of his discretionary target bonus amount of $272,077, based on the number of full months that he worked for us in 2009; and (2) continued coverage under our group health insurance plan, at no charge, for two years following the date of his termination.
In addition, Mr. Sullivan will receive a retention payment of approximately $132,244 as follows: (i) 50% will be paid on July 31, 2009, if Mr. Sullivan is in active service with us as of such date; and (ii) 50% will be paid on January 29, 2010, if Mr. Sullivan is in active service with us as of such date. If Mr. Sullivan is terminated other than for cause or resigns prior to January 29, 2010, we will pay him any portion of the above amount that has not yet been paid, provided that Mr. Sullivan signs a non-competition agreement.
The letter agreement also provides, among other things, a right to participate in all employee benefit plans and programs available to senior management, automobile and parking allowances, and club dues and business-related expenses.
Mr. Sullivan is subject to a covenant not to solicit our employees for 12 months following his resignation or involuntary termination and a covenant not to solicit our customers for six months following his resignation or involuntary termination for cause.
Separation Agreements
Joseph P. Campanelli
On September 30, 2008, we entered into a Separation and Consulting Agreement with Mr. Campanelli setting forth the terms of his termination of employment.
In accordance with the terms of Mr. Campanelli’s employment agreement, dated January 16, 2007 (which is described in detail below), the Separation Agreement reflects that Mr. Campanelli would receive (a) a severance payment of $3,253,624, (b) continued eligibility for a target bonus for the 2008 calendar year, but prorated to reflect the period of his employment during 2008 (which bonus amount, if any, would be based on the same Sovereign performance targets and other business criteria as would apply to such bonuses for executive officers of Sovereign generally), (c) his total accrued benefit under the Enhanced Executive Retirement Plan in the amount of $4,328,076, (d) full vesting and distribution of his entire account (29,125 shares) under the Sovereign Bancorp, Inc. Bonus Recognition and Retention Plan, (e) full vesting of his nonqualified stock options under the 2001 Stock Incentive Plan, (f) a cash payment, in respect of each of his 341,495 shares of restricted stock, equal to the fair value per share of our common stock, and (g) continued participation in Sovereign’s welfare benefit plans for a limited time. Under the Separation Agreement, Mr. Campanelli’s stock options would remain exercisable for two years following his termination of employment.
In addition to the foregoing, under the terms of the Separation Agreement, Mr. Campanelli is to provide one year of consulting services to us for $300,000, payable in two equal installments. Mr. Campanelli is subject to restrictive covenants under the Separation Agreement, which prohibit him from competing with, and soliciting employees from, us for one year following his termination of employment.
Mr. Campanelli’s employment agreement was entered into on March 14, 2007, in connection with his appointment on January 16, 2007, as President and Chief Executive Officer of Sovereign and of Sovereign Bank. The initial term of the agreement was for three years and the agreement annually renewed for a term ending three years from each annual anniversary date, unless a party had given the other party written notice at least 60 days prior to such anniversary date that such party did not agree to renew the employment agreement. Mr. Campanelli’s base annual salary under his employment agreement was $850,000, which we could have increased from time to time during the term of the agreement. Mr. Campanelli was eligible to receive an annual target bonus of 133% of base salary, contingent upon the achievement of annual performance objectives established by our Board in consultation with Mr. Campanelli. To the extent that Mr. Campanelli’s employment was terminated after September 30 of a calendar year but prior to the end of such calendar year and we determined in good faith that we would achieve the annual performance objectives for payment of the annual bonus for such year, Mr. Campanelli would have received the target bonus for such year prorated to the date of termination. The annual bonus would have been payable one-third in cash and two-thirds in our common stock. We could have also paid such other bonuses as our Board, in its sole discretion, deemed appropriate. Mr. Campanelli could voluntarily terminate his employment for “constructive discharge” whether before or following a “change in control.”
In the event that Mr. Campanelli terminated his employment for constructive discharge prior to a change in control, he would have generally received a lump-sum payment, within 30 days following his termination, equal to two times the sum of:
His annual base salary as of the date of termination (or for either of the two prior years, if higher); plus
One-half the sum of his actual bonus for the year prior to termination and the target bonus (calculated at 133% of base salary) for the year of termination; and
In the event we terminated Mr. Campanelli’s employment other than for cause or disability prior to a change in control, he would also have received a lump-sum payment, within 30 days following his termination, equal to the base salary and bonus amounts set forth in the preceding sentence multiplied by the greater of (a) 2 or (b) the number of years then remaining in the term of his employment agreement.
In the event Mr. Campanelli terminated his employment for constructive discharge, or we terminated his employment other than for cause or disability prior to a change in control, he would have also received for a period of two years (in the case of constructive discharge) or the longer of two years and the remaining term of the employment agreement (in the event of involuntary termination) continuation of all normal welfare benefits in effect for him during the two years prior to termination (or a lump sum tax-effected payment in lieu thereof if plan participation is not permitted) and would have generally vested in all of our benefit plans in which he was a participant.
Mr. Campanelli was also entitled to certain payments and benefits in the event he terminated employment for constructive discharge or we terminated his employment other than for cause or for disability following a change in a control.
In the event that the amounts and benefits payable under his employment agreement, when added to other amounts and benefits which may become payable, were such that he became subject to the excise tax provisions of Section 4999 of the Internal Revenue Code, Mr. Campanelli was entitled to receive such additional amounts as would have resulted in his retention of a net amount equal to the net amount he would have retained had the initially calculated payments and benefits been subject only to income and employment taxation.
Mark R. McCollom
We entered into an employment agreement with Mr. McCollom, dated as of May 20, 2005, which was amended on May 30, 2006, and further amended on November 9, 2007.
Mr. McCollom’s agreement had an initial term of three years and, unless terminated as set forth therein, was automatically extended annually to provide a new term of three years.
Effective April 1, 2006, we increased Mr. McCollom’s base salary to the same level as our other senior executive officers (other than our Chief Executive Officer) as required by the terms of Mr. McCollom’s employment agreement.
Under his agreement, if we terminated Mr. McCollom’s employment without cause and no change in control occurred at the date of such termination, he was entitled to a lump sum cash payment, within 30 days of his termination, equal to the greater of one or the number of years remaining in the employment term times the sum of his highest base salary as of the date of termination and the average of his bonuses for the three immediately preceding calendar years, payable monthly. He was entitled to also continue to receive, for the greater of one year or the then-remaining term of the agreement, all welfare benefits in effect during the immediately preceding two calendar years (or a lump sum tax-effected payment in lieu thereof, if plan participation was not permitted because he was not an employee).
In connection with the mutually agreed resignation of Mr. McCollom as our Chief Financial Officer, effective March 3, 2008, and his termination of employment without cause, effective May 30, 2008, we entered into a separation agreement with Mr. McCollom, dated February 20, 2008.
As of the date of the separation agreement, the total payments due to Mr. McCollom in connection with his termination of employment equaled approximately $3,008,407. These payments include:
The separation agreement also provides that Mr. McCollom would receive a payment, as compensation for, among other things, his past contributions to us, equal to the value of 35,055 shares of our common stock, which amount we would pay on May 28, 2010, or if earlier, the date on which a change in control occurs. The value of such payment was to be determined by multiplying 35,055 by the closing price of a share of our common stock on the business day immediately preceding such payment. In addition, to the extent any vested stock option expires after the maximum allowable exercise period under the applicable equity plan, with an exercise price (i) greater than $11 and (ii) greater than the fair market value of the underlying stock on the last day of such maximum allowable exercise period, Mr. McCollom would receive a lump sum cash payment, equal to the difference, if any, of (a) the fair market value of the underlying stock on the earlier of: (i) the original expiration date of such stock option, (ii) the closing date of a change in control, or (iii) May 30, 2010, and (b) the exercise price of such stock option.
Under the Separation Agreement, we agreed to waive the otherwise applicable lapse provisions of Mr. McCollom’s outstanding and vested stock options (subject to the terms of the applicable plan under which such options were granted) and permit their exercise until a date which is the earlier of the expiration of the term of such stock options or the latest date permitted under the applicable plan.
Pension Benefits - 2008
Footnotes:
Enhanced Executive Retirement Plan
The only plan we maintained in 2008 that provided defined benefit pension-type benefits was the Sovereign Bancorp, Inc. Enhanced Executive Retirement Plan, which we refer to as the “Enhanced Retirement Plan.” We adopted the Enhanced Retirement Plan, effective as of June 1, 1997.
Under the Enhanced Retirement Plan, a participant was entitled to an enhanced retirement benefit to the extent the retirement benefits payable from the qualified retirement plans and certain other sources is less than a targeted level. Such targeted level is an annual benefit equal to a stated percentage (generally ranging from 35% to 45%) of his or her average compensation (which includes salary, bonus, and deferred compensation but excludes income from the exercise of stock options). The actual supplemental retirement benefit to which an eligible executive was entitled to receive under the Enhanced Retirement Plan was reduced, but not below zero, by the sum of the executive’s:
Pension under the terminated qualified defined benefit retirement plan (determined as of March 31, 1999, the date benefit accruals ceased under such plan); and
Calculated Social Security benefit.
In order to vest in the enhanced retirement benefit, an eligible executive had to remain employed by us until age 55 and attain five years of service under our qualified retirement plan. Provision was made for a reduction in the plan benefit for a participant who terminated before age 60 and who had completed less than 15 years of service, but in no event would the targeted level have been reduced below 30% of average compensation.
The Enhanced Retirement Plan also provided benefits in the event of involuntary termination without “cause,” as well as under other circumstances, such as death, disability and upon a “change in control.”
Mr. Campanelli was the only remaining participant in the Enhanced Retirement Plan in 2008. Pursuant to the terms of his Separation Agreement, Mr. Campanelli will receive, among other things, his total accrued benefit under the Enhanced Executive Retirement Plan in the amount of $4,328,076 in 2009 (described above under “Separation Agreements”).
Nonqualified Deferred Compensation - 2008
In addition to the qualified retirement plan that we maintain for the benefit of all our eligible team members and the nonqualified defined benefit plans described above, certain of our executive officers participate in the nonqualified deferred compensation plans and arrangements described below:
Deferred Compensation Plan
Effective November 1, 1997, our Board adopted the Sovereign Bancorp, Inc. Bonus Recognition and Retention Program, which we refer to as the “Bonus Deferral Program.” On December 20, 2006, the Board amended the Bonus Deferral Program to make the Bonus Deferral Program similar to a traditional nonqualified deferred compensation plan. Beginning with amounts earned in 2007, the revised Bonus Deferral Program, which we renamed the Sovereign Bancorp, Inc. 2007 Nonqualified Deferred Compensation Plan, and which we refer to here as the “Deferred Compensation Plan” has the following features:
The Deferred Compensation Plan permits participants to defer up to 100% of their cash bonus and choose among various investment options upon which the rate of return of amounts deferred will be based. We adjust participant’s accounts periodically to reflect the deemed gains and losses attributable to the deferred amounts. The specific investment options mirror the investment options in our qualified retirement plan with some additional alternative investments available.
We distribute all account balances in cash.
We no longer make matching contributions on the deferred amounts.
Distribution events will be only as permitted under Code Section 409A.
Participants are always 100% vested in the amounts deferred.
We now permit directors of Sovereign and Sovereign Bank to defer receipt of cash fees received for service as a director.
The terms of the Bonus Deferral Program in effect prior to the amendment govern all deferrals made with respect to fiscal years before 2007. These terms included:
We permitted selected executive team member to defer annually receipt of 25% to 50% of his or her cash bonus for a given year.
We placed the deferred amount in a grantor trust and invested it in our common stock (which is now invested in Santander ADSs), which the trust’s independent trustee purchased on the open market. We made a 100% matching contribution to the trust on behalf of the participant and invested it in our common stock.
A participant became 100% vested in the aggregate of each year’s deferral, match, and earnings five years after the initial funding of such year’s contributions to the trust.
A participant also vested in his or her account balance in the event of termination of employment due to death, disability, retirement, involuntary termination, or the occurrence of a change in control.
Termination for cause or voluntary termination of employment prior to the expiration of the five-year vesting period generally resulted in the forfeiture of the entire account balance, including the amounts deferred by the participant.
We paid the vested account balances in stock, in accordance with a participant’s prior election.
No named executive officer deferred any salary or bonus earned in 2008 into the Deferred Compensation Plan. Amounts set forth in the Summary Compensation Table reflect amounts deferred for 2006 and prior years and that appear on our financial statements for the applicable year as compensation expense as required by Statement of Financial Accounting Standards No. 123(R).
Prior Deferred Compensation Plan
Through December 31, 1999, we maintained the Sovereign Bancorp, Inc. Nonqualified Deferred Compensation Plan, which we refer to as the “Prior Deferred Compensation Plan.” Payment of benefits under the Prior Deferred Compensation Plan are generally made following termination of employment under the option (which may include a lump sum) selected by the participant at the time a deferral election was made. Deferrals under the Prior Deferred Compensation Plan ceased effective December 31, 1999. We will distribute account balances under this plan in accordance with the terms of the plan and a participant’s prior distribution election when an event giving rise to distribution occurs. Distribution events include retirement, death, disability, termination of employment, certain unforeseen emergencies, and a short-term payout option. In addition, upon proper notice, a participant may elect at any time to withdraw all of the participant’s balance, less a 10% penalty. The Prior Deferred Compensation Plan is considered “grandfathered” for purposes of Code Section 409A.
As of December 31, 2008, Mr. Campanelli was the only named executive officer who participated in the Prior Deferred Compensation Plan before its discontinuance.
Other Arrangements
Under Messrs. Campanelli’s and Rinaldi’s original employment agreements with us, dated July 1, 1997 and June 30, 1997, respectively, each is entitled to receive a payment of $23,417 and $16,783 (as of December 31, 2008), respectively, plus investment earnings, if any, in cash, payable when they receive a distribution of the balance in his employee stock ownership plan accounts in our qualified retirement plan. The payments are intended to equal the cash value of the contribution allocations that Messrs. Campanelli and Rinaldi would have received for 1998 had they been eligible to participate in our employee stock ownership plan during that year.
Potential Payments Upon Termination Or Change In Control
On December 31, 2008, each of the named executive officers (other than Messrs. Campanelli and McCollom, who each entered into Separation Agreements with us and were no longer employed with us on December 31, 2008; see “Separation Agreements”) were entitled to certain benefits upon a change in control or upon the executive’s termination of employment. These benefits were payable in accordance with their employment agreements. We describe these agreements, including the material conditions or obligations applicable to the receipt of these benefits, under the caption “Description of Employment Agreements and Related Agreements.” In addition, the named executive officers were entitled to benefits upon a change in control under certain plans and arrangements, which we described above under the caption “Our Compensation Plans During and Prior to 2008.” As previously discussed, following the Santander transaction, each of the employment agreements of the named executive officers was terminated in exchange for payments to the subject executives, following which Sovereign entered into new letter agreements with each of the named executive officers who continued in the employ of Sovereign following the termination of their employment agreements. Such payments and letter agreements are described in “Description of Employment Agreements and Related Agreements.”
Director Compensation In Fiscal Year 2008
We believed that the amount, form, and methods used to determine compensation of our non-employee directors were important factors in: (i) attracting and retaining directors who were independent, interested, diligent, and actively involved in our affairs, (ii) substantially aligning the interests of our directors with the interests of our shareholders and (iii) providing a simple straight-forward package that compensates our directors for the responsibilities and demands of the role of director.
The following table sets forth a summary of the compensation that we paid to our non-employee directors in 2008:
Footnotes:
Director Plan
As noted elsewhere in this Form 10-K, on January 30, 2009, Sovereign became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement. It is important to understand that several actions were taken immediately following the consummation of the Santander transaction affecting compensation, including the termination of the “Director Plan” and in its place approving the following compensation for non-employees directors for service on the Board and the Bank Board: (a) $140,000 in cash annually; plus (b) $50,000 in cash annually for each non-executive director who serves on the Executive Committee; plus (c) $35,000 in cash annually for the non-executive director who serves as the chairman of the Audit Committee; plus (d) $5,000 in cash annually for each other Board committee for which such non-executive director serves as chairman.
Notwithstanding the foregoing, because compensation disclosure regarding directors’ fees for 2008 is required under the SEC’s rules and regulations, we have disclosed information with respect to the Director Plan below. Please consider all this information accordingly.
At the 2006 annual meeting of shareholders, our shareholders approved the Sovereign Bancorp, Inc. 2006 Non-Employee Director Compensation Plan, which we refer to as the “Director Plan.” The Director Plan provided compensation to non-employee directors of Sovereign and certain of its subsidiaries in the form of cash and shares of common stock. We generally made payments on a quarterly basis in arrears. Under the Director Plan, we annually established the dollar amount of compensation. For 2008, the compensation of our directors was:
$50,000 in cash; plus
$50,000 in shares of Sovereign common stock; plus
$35,000 in cash if such director served as Lead Director or as chairperson of the Audit Committee; plus
$25,000 in cash for each Board committee (other than the Audit Committee) for which the director serves as chairperson; plus
$125,000 half in cash and half in shares of our common stock if such director served as the non-executive Chairman of the Board; plus
An additional $25,000 in cash to Mr. Moran for his service during the fiscal year of 2008 as the Audit Committee’s “audit committee financial expert” (as such term is defined by SEC rules and regulations).
An individual who served as both a director of Sovereign and Sovereign Bank was eligible to receive compensation under the Director Plan in both capacities. All of the directors of Sovereign Bank were also directors of Sovereign. For 2008, the compensation of our directors for service on the Board of Sovereign Bank was:
$21,000 in cash; plus
$21,000 in shares of Sovereign common stock.
Effective January 1, 2008, members of the Board who were also employees of Santander (i.e., Messrs. de La Heras, Jaramillo, Rodriguez-Inciarte and Sánchez) began receiving the same fees as the other non-employee members of the Board, except that, due to restrictions in the Investment Agreement, they received their fees 100% in cash. In addition, due to certain restrictions in the Transaction Agreement, our directors received their fourth quarter compensation entirely in cash.
Directors Retirement Plan
Effective October 1, 2005, we amended the Sovereign Bancorp, Inc. Non-Employee Directors Services Compensation Plan, which we refer to as the “Services Compensation Plan,” to “freeze” eligibility, participation, and benefit amounts. The Services Compensation Plan provides that individuals who were directors at or prior to September 30, 2005 and who are non-employee directors on the date their service as a director ends are eligible to receive a cash payment in an amount equal to three times the highest annual retainer paid to such director during his or her term of service. The base for the payment amount does not include any other incentive compensation or other awards that we may have paid to a non-employee director during the course of any year. To be eligible, a non-employee director must have 10 or more years of service as a director with Sovereign, Sovereign Bank, or an affiliate and attain age 65 during service with Sovereign or Sovereign Bank.
Non-employee directors who completed 10 years of Board service (including service as a non-employee director on the board of directors of any merged or acquired holding company, bank, or other affiliate) as of October 1, 2005, and attained age 65 as of October 1, 2005, are eligible to receive the retirement benefit described above.
We also amended the Services Compensation Plan, effective as of October 1, 2005, to provide that a director serving at that time, who did not complete 10 years of service as of October 1, 2005, or attain age 65 as of October 1, 2005, is eligible to receive a retirement benefit determined by reference to service and highest annual retainer as of September 30, 2005, provided such director completes 10 years of service and attains age 65 prior to termination of service. In addition, the amended Services Compensation Plan provides that upon a change in control, each director serving before October 1, 2005, and who has completed five or more years of service, will be entitled to receive a retirement benefit. On February 13, 2007, we further amended the Services Compensation Plan to comply with Section 409A of the Internal Revenue Code by requiring all payments to be made in a lump sum as soon as administratively practicable following the director’s termination of service.
The following table sets forth the amounts that each eligible non-employee director would have received under the Services Compensation Plan had such director ceased to be a director or we had a change in control on December 31, 2008:
Mr. Botin was not entitled to and did not receive a benefit under the Services Compensation Plan upon his termination of service as a director.
Directors Participation in Deferred Compensation Plan
On December 20, 2006, our Board amended the Deferred Compensation Plan (the significant features of which we describe following the table entitled “Nonqualified Deferred Compensation-2008”) to permit non-employee directors of Sovereign and of Sovereign Bank to elect defer cash fees earned beginning in 2007 into the Deferred Compensation Plan. The relevant terms of the revised Deferred Compensation Plan, as described above, apply in the same manner to participants who are directors as they do to participants who are executive officers.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
As noted elsewhere in this Form 10-K, on January 30, 2009, Sovereign became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement. As a result, following January 30, 2009, all of Sovereign’s voting securities are owned by Santander.
Also as noted elsewhere in this Form 10-K, as a result of the Santander transaction, there are no longer any outstanding equity awards under Sovereign’s equity incentive compensation plans. Pursuant to the Transaction Agreement, (i) all stock options outstanding immediately prior to the Transaction were cancelled and any positive difference between the exercise price of any given stock option and the closing price of Sovereign’s common stock on January 29, 2009 was paid in cash to option holders, and (ii) all shares of restricted stock outstanding immediately prior to the Transaction vested and were treated the same way as all other shares of Sovereign common stock in the Transaction.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Explanatory Note
As noted elsewhere in this Form 10-K, on January 30, 2009, Sovereign became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement. It is important to understand that several actions were taken immediately following the consummation of the Santander transaction. In particular, many of the directors that served on Sovereign’s Board during the 2008 fiscal year through January 30, 2009 resigned effective immediately upon the effective time of the Santander transaction. Moreover, as a wholly-owned subsidiary of Santander without common equity listed on the NYSE, Sovereign is no longer subject to various corporate governance standards codified by the NYSE in Section 303A of the NYSE’s Listed Company Manual, including the requirement that the Sovereign Board must have a majority of “independent” directors. Nevertheless, because this Item 13 requires disclosure with respect to matters that occurred during the 2008 fiscal year, we have disclosed such information. Please consider this disclosure accordingly.
Certain Relationships and Related Transactions
Since the beginning of 2008, Sovereign was a participant in the transactions described below in which a “related person” (as defined in Item 404(a) of Regulation S-K, which includes directors who served during the 2008 fiscal year) had a direct or indirect material interest and the amount involved in such transaction exceeded $120,000.
Santander Relationship: During the 2008 fiscal year, Messrs. Gonzalo de Las Heras, Gabriel Jaramillo, Juan Rodriguez-Inciarte, and Alberto Sánchez served as Sovereign directors, while also serving as executive officers of Santander or its affiliates during such time. Since the consummation of the Santander transaction, Kirk Walters, as an executive officer of Sovereign, is also deemed to be an executive officer of a Santander affiliate. The following relationships existed during the 2008 fiscal year or are currently proposed between Sovereign and its affiliates, on the one hand, and Santander or its affiliates, on the other hand:
•
In January 2006, Santander extended a total of $425 million in an unsecured line of credit to Sovereign Bank for federal funds and Eurodollar borrowings and for the confirmation of standby letters of credit issued by Sovereign Bank. This line of credit is at market rates, in the ordinary course of business and can be cancelled by either Sovereign Bank or Santander at any time and can be replaced by Sovereign at any time. As of December 31, 2008, the average balance outstanding was $412,158,735, all of which was for confirmation of standby letters of credit. Sovereign Bank paid approximately $2,354,871 in fees to Santander in 2008 in connection with this line of credit, which, for the fiscal year ended December 31, 2008.
•
ISBAN UK Limited, a Santander affiliate, is under contract with Sovereign Bank to provide technology consulting services focusing on improvements to current systems and analyzing and recommending new systems with fees paid of $1,551,289.
•
Ingenieria de Software Bancario, S.L., Branch US, an affiliate of Santander, is under contract with Sovereign to provide advice with respect to implementing a single technological platform for Sovereign with fees paid of $1,355,749.
•
In November 2007, Santander Universidades, the major corporate social responsibility program for Santander, and Babson College (of which Mr. Campanelli is a trustee) entered into an educational partnership pursuant to which the parties will support a variety of projects in regions where Santander has a significant presence. The first four projects included scholarships for students from Latin American countries to spend time at Babson. Santander has invested approximately $500,000 annually in this partnership.
•
Sovereign Bank provides U.S. deposit (free and investable balances) and other cash management services to Santander’s Latin American and European commercial clients. Customer vetting procedures are the same as those that apply to other Sovereign customers. Under a revenue sharing agreement, Santander receives 50% of the “net” margin on any deposits, which resulted in a fee to Santander for 2008 of $347,795. There were 113 accounts and 58 customers with approximately $90,057,631 in deposits outstanding at December 31, 2008 under this agreement.
•
Keith Morgan, a Santander consultant, provided advice with respect to the restructuring of Sovereign Bank’s retail banking strategy for a fee of $60,000 per month plus expenses.
Cameron C. Troilo, Sr. The relationships below existed during the 2008 fiscal year between Sovereign and its affiliates, on the one hand, and Mr. Troilo and his affiliates, on the other hand. Mr. Troilo was elected to the Sovereign Board in 1997 and served until his tendered resignation became effective on January 30, 2009.
Loans to Directors and Executive Officers
Sovereign is in the business of gathering deposits and making loans. Like substantially all financial institutions with which we are familiar, Sovereign actively encourages its directors and the companies which they control and/or are otherwise affiliated with to maintain their banking business with Sovereign Bank, rather than with a competitor. All banking transactions with Sovereign directors and such entities and affiliates are with Sovereign Bank, and are subject to regulation by the Office of Thrift Supervision.
All lending relationships between Sovereign Bank and its directors and the entities which they control are subject to Regulation O and are in compliance with Regulation O1. In addition, in management’s opinion, all loans to directors and entities affiliated with them (whether or not controlled by them and therefore, subject to Regulation O) were made in the ordinary course of business and on substantially the same terms, including interest rates, collateral and repayment terms, as those prevailing at the time for comparable transactions with similar customers and do not involve more than normal collection risk or present other unfavorable features. Sovereign believes that the aggregate dollar amount of Sovereign Bank’s loans to directors and the entities they control or are otherwise affiliated with represent insignificant percentages of Sovereign Bank’s total loans and equity and ranks it somewhere near the middle of the 125 largest financial services companies with U.S. operations. Because of the foregoing, we do not believe that public disclosure of director by director and affiliate by affiliate information is material, absent unusual facts and circumstances. Sovereign believes this position is consistent with the disclosure positions of other large financial institutions.
In addition, Sovereign Bank provides other banking services to its directors and entities which they control or with which they are affiliated. In each case, these services are provided in the ordinary course of Sovereign Bank’s business and on substantially the same terms as those prevailing at the time for comparable transactions with others.
Sovereign Bank, as part of its banking business, also extends loans to officers and employees of Sovereign and Sovereign Bank. Such loans are provided in the ordinary course of Sovereign Bank’s business and on substantially the same terms as those prevailing at the time for comparable transactions with others.
Certain mortgage loans held by executive officers, like similar loans made to other Sovereign employees, are priced at a 1% discount to market but contain no other terms which are different than terms available in comparable transactions with non-employees. The 1% discount is discontinued when an employee terminates his or her employment with Sovereign. In each case, all loans to executive officers (i) were made in the ordinary course of business, (ii) were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, including other employees of Sovereign or Sovereign Bank, and (iii) did not involve more than the normal risk of collectability or present other unfavorable features. Such loans also comply with Regulation O and were never non-accrual, past due, restructured or potential problem loans.
Approval of Related Transactions
Prior to and following January 30, 2009, the date on which the Santander transaction was consummated, Sovereign has had policies to approve all proposed transactions between Sovereign and its subsidiaries, on the one hand, and “related persons” (as defined therein), on the other hand. Sovereign’s policies require that all related person transactions be reviewed for compliance and applicable banking and securities laws and be approved by, or approved pursuant to procedures approved by, Sovereign’s “Transactions with Affiliates Committee” (except for loans to directors and officers that were subject to Federal Reserve Regulation O, which were handled under a different process). Moreover, Sovereign’s policies require that all material transactions be approved by Sovereign’s Board or Sovereign Bank’s Board.
Director Independence
As noted elsewhere in this Form 10-K, on January 30, 2009, Sovereign became a wholly-owned subsidiary of Santander as a result of the consummation of the transactions contemplated by the Transaction Agreement. As a result, all of Sovereign’s voting common equity securities are owned by Santander and are no longer listed on the NYSE. However, each of the (i) depositary shares for Sovereign’s Series C non-cumulative preferred stock and (ii) 7.75% Capital Securities (Sovereign Capital Trust V), continue to be listed on the NYSE. In accordance with the NYSE rules, because Sovereign does not have common equity securities but rather only preferred and debt securities listed on the NYSE, the Sovereign Board is not required to have a majority of “independent” directors. Nevertheless, this Item 13 requires Sovereign to identify each director that is “independent” using a definition of independence of a national securities exchange, such as the NYSE’s listing standards (which Sovereign is not currently subject to). Based on the foregoing, although the Sovereign Board has not made a formal determination on the matter, under current NYSE listing standards (which Sovereign is not currently subject to), Sovereign believes that Directors Heard, Schoellkopf and Terracciano would be independent under such standards.
Item 14.
Item 14. Principal Accounting Fees and Services.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Fees of the Independent Auditor
The following tables set forth the aggregate fees billed to Sovereign for the fiscal years ended December 31, 2008 and December 31, 2007, by our principal accounting firm Ernst & Young LLP.
Fiscal Year Ended December 31, 2008
Audit fees in 2008 included fees associated with the annual audit of the financial statements and the audit of internal control over financial reporting of Sovereign, subsidiary audits required for certain subsidiaries that are registered with the SEC, the reviews of our Quarterly Reports on Form 10-Q, certain accounting consultations, consent to use its report in connection with various documents filed with the SEC, and comfort letters issued to underwriters for securities offerings.
Audit-related fees in 2008 principally included accounting consultations, audits of employee benefit plans, audits of separate subsidiary financial statements required by their formation agreements, and attestation reports required under services agreements.
Tax fees in 2008 included tax compliance, tax advice and tax planning.
Fiscal Year Ended December 31, 2007
Audit fees in 2007 included fees associated with the annual audit of the financial statements and the audit of internal control over financial reporting of Sovereign, subsidiary audits required for certain subsidiaries that are registered with the SEC, the reviews of our Quarterly Reports on Form 10-Q, certain accounting consultations, consent to use its report in connection with various documents filed with the SEC, and comfort letters issued to underwriters for securities offerings.
Audit-related fees in 2007 principally included accounting consultations, audits of employee benefit plans, audits of separate subsidiary financial statements required by their formation agreements, and attestation reports required under services agreements.
Tax fees in 2007 included tax compliance, tax advice and tax planning.
The Audit Committee considered whether the provision of non-audit services by our principal auditor during 2008 was compatible with maintaining auditor independence.
The Audit Committee began considering whether the non-audit services proposed to be performed by Ernst & Young LLP in advance of such performance for compatibility with their independence beginning in September 2002.
Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services by Independent Auditor
During 2008, the Audit Committee pre-approved all audit and non-prohibited, non-audit services provided by the independent auditor. These services may have included audit services, audit-related services, tax services and other services. The Audit Committee adopted a policy for the pre-approval of services provided by the independent auditor. Under the policy, pre-approval was generally provided for up to one year and any pre-approval was detailed as to the particular service or category of services and was subject to a specific budget. In addition, the Audit Committee may also have pre-approved particular services on a case-by-case basis. For each proposed service, the Audit Committee received detailed information sufficient to enable the Audit Committee to pre-approve and evaluate such service. The Audit Committee may have delegated pre-approval authority to one or more of its members. Any pre-approval decisions made under delegated authority must have been communicated to the Audit Committee at or before its then next scheduled meeting. There were no waivers by the Audit Committee of the pre-approval requirement for permissible on-audit services in 2008.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(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.
(2.1)
Transaction Agreement, dated as of October 13, 2008, between Sovereign Bancorp, Inc. and Banco Santander, S.A. (Incorporated by reference to Exhibit 2.1 to Sovereign’s Current Report on Form 8-K filed October 16, 2008)
(3.1)
Amended and Restated Articles of Incorporation of Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Sovereign’s Current Report on Form 8-K filed January 30, 2009)
(3.2)
Amended and Restated Bylaws of Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit 3.2 to Sovereign’s Current Report on Form 8-K filed January 30, 2009)
(4.1)
Sovereign Bancorp, Inc. has certain debt obligations 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 to the SEC on request.
(4.2)
Fiscal Agency Agreement dated December 22, 2008 between Sovereign Bank and The Bank of New York Mellon Trust Company, N.A., as fiscal agent (Incorporated by reference to Exhibit 4.1 to Sovereign’s Current Report on Form 8-K filed December 22, 2008)
(4.3)
Fiscal Agency Agreement dated December 22, 2008 between Sovereign Bancorp, Inc. and The Bank of New York Mellon Trust Company, N.A., as fiscal agent (Incorporated by reference to Exhibit 4.2 to Sovereign’s Current Report on Form 8-K filed December 22, 2008)
(10.1)
Employment Agreement, dated as of January 30, 2003, between Sovereign Bancorp, Inc. and Joseph P. Campanelli (Incorporated by reference to Exhibit 10.14 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002)
(10.2)
Agreement to Amend, dated May 30, 2006, between Sovereign Bancorp, Inc. and Joseph P. Campanelli (Incorporated by reference to Exhibit 10.2 to Sovereign’s Current Report on Form 8-K filed November 14, 2006)
(10.3)
Amendment #2 to Employment Agreement, dated as of October 10, 2006, between Sovereign Bancorp, Inc. and Joseph P. Campanelli (Incorporated by reference to Exhibit 10.3 to Sovereign’s Current Report on Form 8-K filed November 14, 2006)
(10.4)
Employment Agreement, dated as of January 16, 2007, between Sovereign Bancorp, Inc. and Joseph P. Campanelli (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed March 20, 2007)
(10.5)
Separation and Consulting Agreement, dated September 30, 2008, between Sovereign Bancorp, Inc. and Joseph P. Campanelli (Incorporated by reference to Exhibit 10.4 to Sovereign’s Current Report on Form 8-K filed on September 30, 2008)
(10.6)
Employment Agreement dated as of May 20, 2005, between Sovereign Bancorp, Inc. and Mark R. McCollom (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K/A filed on May 20, 2005)
(10.7)
Agreement to Amend dated May 30, 2006, between Sovereign Bancorp, Inc. and Mark R. McCollom (Incorporated by reference to Exhibit 10.17 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.8)
Amendment #2 to Employment Agreement, dated November 9, 2007, between Sovereign Bancorp, Inc. and Mark R. McCollom (Incorporated by reference to Exhibit 10.4 to Sovereign’s Current Report on Form 8-K filed November 15, 2007)
(10.9)
Separation Agreement, dated February 20, 2008, between Sovereign Bancorp, Inc. and Mark R. McCollom (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed February 21, 2008)
(10.10)
Employment Agreement, effective March 3, 2008, between Sovereign Bancorp, Inc. and Kirk W. Walters (Incorporated by reference to Exhibit 10.2 to Sovereign’s Current Report on Form 8-K filed February 21, 2008)
(10.11)
First Amendment to Employment Agreement, dated September 30, 2008, between Sovereign Bancorp, Inc. and Kirk W. Walters (Incorporated by reference to Exhibit 10.2 to Sovereign’s Current Report on Form 8-K filed on September 30, 2008)
(10.12)
Employment Agreement, dated September 30, 2008, between Sovereign Bancorp, Inc. and Kirk W. Walters (Incorporated by reference to Exhibit 10.3 to Sovereign’s Current Report on Form 8-K filed on September 30, 2008)
(10.13)
Employment Agreement, dated October 2, 2008, between Sovereign Bancorp, Inc. and Kirk W. Walters (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed on October 7, 2008)
(10.14)
Employment Agreement, dated September 30, 2008, between Sovereign Bancorp, Inc. and Paul A. Perrault (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed on September 30, 2008)
(10.15)
Sovereign Bancorp, Inc. Employee Stock Purchase Plan (Incorporated by reference to Exhibit “C” to Sovereign’s definitive proxy statement, dated March 22, 2004)
(10.16)
Form of Incentive Stock Option Agreement under the Sovereign Bancorp, Inc. 1986 Stock Option Plan (Incorporated by reference to Exhibit 10.13 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.17)
Sovereign Bancorp, Inc. Non-Employee Directors Services Compensation Plan (Incorporated by reference to Exhibit 10.9 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.18)
Sovereign Bancorp, Inc. 1993 Stock Option Plan (the “1993 Plan”) (Incorporated by reference to Exhibit 10.10 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.19)
Form of Incentive Stock Option Agreement under the 1993 Plan (Incorporated by reference to Exhibit 10.11 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.20)
Form of Nonqualified Stock Option Agreement under the 1993 Plan (Incorporated by reference to Exhibit 10.12 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.21)
Sovereign Bancorp, Inc. 1996 Stock Option Plan (the “1996 Plan”) (Incorporated by reference to Exhibit 10.12 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.22)
Form of Incentive Stock Option Agreement under the 1996 Plan (Incorporated by reference to Exhibit 10.9 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.23)
Form of Nonqualified Stock Option Agreement under the 1996 Plan (Incorporated by reference to Exhibit 10.10 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.24)
Sovereign Bancorp, Inc. 1997 Non-Employee Directors’ Stock Option Plan (the “1997 Directors’ Plan”) (Incorporated by reference to Exhibit “A” to Sovereign’s definitive proxy statement dated March 16, 1998)
(10.25)
Form of Nonqualified Stock Option Agreement under the 1997 Directors’ Plan (Incorporated by reference to Exhibit 10.8 to Sovereign’s Current Report on Form 8-K filed February 18, 2005.)
(10.26)
Sovereign Bancorp, Inc. 2001 Stock Incentive Plan (the “2001 Plan”) (Incorporated by reference to Exhibit 10.21 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.27)
Form of Incentive Stock Option Agreement under the 2001 Plan (Incorporated by reference to Exhibit 10.5 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.28)
Form of Nonqualified Stock Option Agreement under the 2001 Plan (Incorporated by reference to Exhibit 10.6 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.29)
Form of Restricted Stock Agreement under the 2001 Plan (Incorporated by reference to Exhibit 10.7 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.30)
Sovereign Bancorp, Inc. 2004 Broad-Based Stock Incentive Plan (the “2004 Plan”) (Incorporated by reference to Exhibit 10.23 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.31)
Form of Incentive Stock Option Agreement under the 2004 Plan (Incorporated by reference to Exhibit 10.2 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.32)
Form of Nonqualified Stock Option Agreement under the 2004 Plan (Incorporated by reference to Exhibit 10.3 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.33)
Form of Restricted Stock Agreement under the 2004 Plan (Incorporated by reference to Exhibit 10.4 to Sovereign’s Current Report on Form 8-K filed February 18, 2005)
(10.34)
Sovereign Bancorp, Inc. 2006 Non-Employee Director Compensation Plan (Incorporated by reference to Exhibit 10.22 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.35)
Sovereign Bancorp, Inc. 2006 Leaders Incentive Plan (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed February 22, 2006)
(10.36)
Sovereign Bancorp, Inc. 2007 Deferred Compensation Plan (Incorporated by reference to Exhibit 10.36 to Sovereign’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006)
(10.37)
Investment Agreement, dated as of October 24, 2005 between Sovereign Bancorp, Inc. and Banco Santander, S.A. (Incorporated by reference to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed October 27, 2005)
(10.38)
Amendment to Investment Agreement, made as of November 22, 2005, between Sovereign Bancorp, Inc. and Banco Santander, S.A. (Incorporated by reference to Exhibit 10.2 to Sovereign’s Current Report on Form 8-K filed November 23, 2005)
(10.39)
Second Amendment to Investment Agreement, dated as of May 31, 2006, between Sovereign Bancorp, Inc. and Banco Santander, S.A. (Incorporated by reference to Exhibit 10.3 to Sovereign’s Current Report on Form 8-K filed June 6, 2006)
(10.40)
Third Amendment to Investment Agreement, dated as of October 13, 2008, between Sovereign Bancorp, Inc. and Banco Santander, S.A. (Incorporated by reference to Exhibit 4.2 to Sovereign’s Current Report on Form 8-K filed October 16, 2008)
(10.41)
Form of Letter Agreement, dated May 9, 2008, by and between Sovereign Bancorp, Inc. and Banco Santander, S.A. (incorporated by referenced to Exhibit 10.1 to Sovereign’s Current Report on Form 8-K filed May 12, 2008)
(10.42)
Form of Shareholder Agreement, dated October 13, 2008, between Banco Santander, S.A. and the shareholder signatory thereto (Incorporated by reference to Exhibit 4.1 to Sovereign’s Current Report on Form 8-K filed October 16, 2008)
(10.43)
Agreement and General Release, dated February 12, 2009, between Sovereign Bancorp, Inc. and Kirk W. Walters.
(10.44)
Agreement and General Release, dated February 12, 2009, between Sovereign Bancorp, Inc. and Patrick J. Sullivan.
(10.45)
Agreement and General Release, dated February 16, 2009, between Sovereign Bancorp, Inc. and Roy J. Lever.
(10.46)
Employment Agreement, dated February 9, 2008, between Sovereign Bancorp, Inc. and Roy J. Lever.
(10.47)
Offer Letter, dated December 11, 2007, between Sovereign Bancorp, Inc. and Roy J. Lever.
(10.48)
Employment Agreement, dated August 7, 2007 between Sovereign Bancorp, Inc. and Salvatore J. Rinaldi.
(10.49)
Amendment to Employment Agreement, dated September 18, 2007, between Sovereign Bancorp, Inc. and Salvatore J. Rinaldi.
(10.50)
Employment Agreement, dated February 11, 2008, between Sovereign Bancorp, Inc. and Patrick J. Sullivan
(21)
Subsidiaries of Registrant
(23.1)
Consent of Ernst & Young LLP
(31.1)
Chief Executive Officer certification pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act
(31.2)
Chief Financial Officer certification pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act
(32.1)
Chief Executive Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(32.2)
Chief Financial Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
March 17, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.