The Short Case on Sovereign Bancorp

Yesterday morning I decided to take a small short position in Sovereign Bancorp (SOV). I spent some time scouting potential bank shorts over the weekend, and in comparison with the rest of the sector, SOV looks very vulnerable right now. The stock has been selling off recently, but received a nice bounce yesterday in line with the general markets. I used this bounce to short the stock ahead of today’s CPI and Sovereign’s earnings release on Thursday.

My short is essentially a play on the fact that all of the regional banks have been experiencing increasing defaults, and are having to set aside money to write down their book. Sovereign’s price to book of 1.3 represents a fairly significant premium as compared with the rest of the sector, representing a substantial premium over the rest of the sector due to the potential for a buyout from Banco Santander, which already owns 25 percent of SOV. However, Santander cannot take over SOV at present due to legal restrictions, which require shareholders to waive the right to prevent a takeover. This is not going to happen until the annual meeting in May, so there is little worry of an outright takeover of Sovereign in the very near term.

Although Sovereign is less leveraged to the mortgage market than they were six months ago (thanks to the very wise decision to divest themselves of $10 billion in mortgage assets), I believe the hyper-growth in assets that the company has experienced in recent years through M&A has created a bloated bank that is trying to restructure itself right into the teeth of a degrading mortgage market. Restructuring a bank that has grown the way Sovereign has is difficult to do under normal conditions, but with the mortgage market really slipping, I think it will prove especially difficult. Although SOV was not active in the subprime market, they have been fairly active in the non-prime mortgage space such as Alt A and non-documented loans.

Based on the anecdotal evidence, these markets are rapidly deteriorating, and this means that Sovereign’s book is probably overvalued to its true worth at the moment. We will find out on Thursday how much SOV has been affected by the mortgage meltdown, but it appears likely that the bank is going to take a hit for delinquent mortgages.

As for the potential buyout from Santander that continues to prop up the stock, I believe that investors are hanging on for a bailout buyout from the Spanish bank which is not likely to happen in the immediate future. Santander’s three way bid for ABN Amro (ABN) makes the buyout of SOV less likely over the near term, because Santander is not going to binge on acquisitions back to back. I believe that the buyout will eventually happen, but given that Santander already owns 25 percent of SOV, there appears to be no rush to get the deal done.

I refuse to believe that Santander’s management would be willing to take on SOV’s large debt at a time when the mortgage market is beginning to show some serious signs of weakening. They are negotiating from a position of strength, and they have to anticipate the fact that SOV’s book is probably not reflecting the true value of the company. Therefore, I would be highly surprised to see Santander jump in and make a reckless bid before the full picture of the mortgage market is known. Based on past recent deals, they will probably pay 2 to 2.5 times the book value for SOV, but the key variable here is just what is the actual book value of SOV. Based on what we’ve seen from some of the other mortgage lenders, SOV’s current book value might just be in jeopardy.

As with most shorts, this trade is thesis dependent, which means that if SOV’s quarter on Thursday does not show some deterioration, I will cover and cut my risk. I don’t intend for this trade to linger, given the potential for a buyout. My basis is 24.08.

SOV 1-yr chart

Disclosure: Author has a short position in SOV