Sovereign Bankcorp, Inc. Q1 2008 Earnings Call Transcript

Sovereign Bankcorp, Inc. (SOV)

Q1 2008 Earnings Call

April 23, 2008 10:30 am ET

Executives

Kirk W. Walters, CPA - Chief Financial Officer

Joseph P. Campanelli - President and Chief Executive Officer

Robert M. Rose - Executive Vice President and Credit Risk Management Officer

Analysts

Matthew O’Connor - UBS

James Abbott - FBR Capital Markets

Heather Wolf - Merrill Lynch

Collyn Gilbert - Stifel Nicolaus

Matthew Kelley - Sterne Agee

Ken Usdin - Banc of America

Robert [Rowe] - Riversource

Gerard Cassidy - RBC Capital Markets

Salvatore DiMartino - Bear Stearns

Operator

I’d like to welcome everyone to the Sovereign Bank quarter one results conference call. (Operator Instructions) Mr. Walters, you may begin your conference.

Kirk W. Walters, CPA

I would like to thank you for participating in Sovereign’s earnings call for the first quarter of 2008. As a reminder, during this call we will make statements that are forward-looking statements within the meaning of Safe Harbor provision to the United States Private Securities Litigation Reform Act of 1995.

These statements include but are not limited to statements about strategies, plans and objectives, as well as estimates of future operating performance.

These forward-looking statements include matters involve significant known and unknown risks, uncertainties and other factors that may cause actual results, levels of activity, performance or achievements to differ materially from the results expressed or implied in this presentation.

Factors that might result in such differences are outlined in our SEC reports including our annual report on Form 10-K and we refer you to these documents.

These factors include but are not limited to general economic conditions, changes in interest rates, deposit flows and loan demand, changes in accounting principles, changes in the competitive environment, and market factors in the industry and geographic areas in which we operate, and other factors.

You are cautioned not to place undue reliance on these forward-looking statements which speak only as of today. Sovereign undertakes no obligation and does not intend to update these forward-looking statements to reflect events or circumstances occurring after the date of this call.

During today’s call, you will hear remarks from Joe Campanelli, our President and CEO, as well as myself. We will then follow with a question-and-answer period at which time Bob Rose, our Chief Risk Officer; and Tom Cestare, our Chief Accounting Officer will be available for questions as well.

With that, I’d like to turn the call over to Joe.

Joseph P. Campanelli

Sovereign’s results for the first quarter of 2008 demonstrate that we are continuing to make progress in reducing our risk profile and improving the quality of our earnings stream.

Our efforts are far from over, but I’m confident that our new organizational structure, coupled with the finalization of the executive management team, will continue to transform Sovereign into a strong financial institution, while decreasing the risk profile of the company.

We are focused on core commercial and consumer customers in our geographic footprint, and believe there are significant opportunities to continue to grow revenues for our existing customers and increase the rate of acquisition of new clients.

We are positioning the company to address current economic conditions and the impact this may have on our customers and the company’s financial results. Our entire executive team is well seasoned and experienced in managing to major credit cycles, including the challenges experienced in ‘80s and ‘90s.

We are very focused in taking proactive steps to minimize the company’s risk. While we are seeing a higher level of non-performing loans, we are working diligently with our customers to restructure their loans when possible and where appropriate. In addition, we are building both the allowance to loan losses and capital levels to properly reflect the current environment.

Our net interest margin has expanded for the fifth consecutive quarter, while we improved the mix of our funding to decrease reliance on wholesale sources. We are pleased with the initial results of our Customer First program, which has rolled out franchise-wise this quarter.

This program is focused on knowing our customers better than we have ever known them before, and using this knowledge to build deeper and more profitable relationships. Over 85% of our customer deposits are portfolio managed, which we believe will greatly improve customer retention and improve our cross-sell opportunities.

As I mentioned last quarter, we recently recruited Roy Lever to head retail and reinvigorate our retail banking program. Roy brings over 30 years retail banking experience at Sovereign, and he is a proven leader who has been instrumental on executing the Customer First program.

We look forward to discussing this very important initiative providing more details on our progress at the annual meeting in Brooklyn, New York on May 8 and our future earnings call.

Before I turn it over to Kirk, we announced back in February that Mark McCollom will be leaving the company at the end of May. I would like to thank Mark for his commitment and acknowledge his contribution to Sovereign over the past 12 or so years.

At the beginning of March, Kirk Walters joined Sovereign as our new Chief Financial Officer. Many of you may know him from his days at Chittenden, was previous employers. We are pleased to have him in Sovereign, and we look forward to the opportunity for you to meet the entire new executive management team.

I’m proud of the team we put together and I’m confident that we have the right people in the right places to operate the company to the current economic environment as well as focus on unleashing the long-term value of this franchise.

With that, I’d like to now turn things over to Kirk, who will go through the financial details of our first quarter of 2008 earnings.

Kirk W. Walters, CPA

Let me start off by saying that I am excited to be here at Sovereign and looking forward to continuing the transformation process that Joe and the executive management team has started. Sovereign has a solid franchise and relatively stable markets to have excellent density and are deep in small to mid-sized business.

We recognize that our capital ratios have been a concern to the investment community and are committed to improving these ratios to be more inline with our peers. We obviously are facing a difficult operating and economic environment, but are working on reinvesting in our core franchise and evaluating opportunities to further reduce non-core assets in order to use our capital resources more efficiently.

Now, let me get into some of the details on the numbers for this quarter. For the first quarter, our net income was a $100.1 million or $0.20 per share, compared to $48.1 million or $0.09 per share a year ago. Should be noted in the first quarter of 2007 results included charges related to an expense reduction initiative and balance sheet restructuring of $128.7 million after-tax or $0.25 per share.

For the current quarter, our net interest margin expanded 11 basis points to 2.88% from 2.77% last quarter, and 2.70% in the first quarter of last year. The current steepening of the yield curve and overall reduction in short-term rates has benefited our margin. In addition, the growth of our commercial loans, coupled with the runoff of indirect auto loans, and the improvement of the retail wholesale mix of our deposits have been important contributors to the margin increase.

Average deposits decreased $1.4 billion on a linked-quarter basis to $48.8 billion. The decline was entirely attributable to a runoff in higher cost wholesale deposits. Average deposits, excluding wholesale, increased to $163 million.

Breaking it down a bit further, we had a strong retail deposit growth of $459 million on an annualized growth rate of 5.8%, which is partially offset by seasonal declines in commercial deposits of $160 million and government deposits of $136 million.

As Joe mentioned earlier, we believe this retail deposit growth is a result of our increased focus on improving the retail deposit franchise, and the early impact of the Customer First initiative. Based on the first quarter average cost of deposits, we have lowered our total deposit costs 54 basis points during the quarter passing along some under short-term market rate cuts, while still seeing growth in almost all of our retail deposit categories.

We anticipate further reductions in our average cost of deposits, as the impact of the recent multiple Federal Reserve interest rate reductions are priced into our deposit base. Average commercial loan balances increased $935 million from the fourth quarter as a result of higher originations of both commercial real estate and C&I loans within our core markets.

C&I loans and other commercial loans grew $481 million to $14.5 billion on a linked-quarter basis. In addition, CRE loans grew $455 million to $12.6 billion, and multifamily loans grew $162 million to $4.3 billion. Yields on the commercial portfolio decreased 74 basis points in the first quarter, primarily due to the aforementioned multiple actions by the Federal Reserve to lower interest rates.

The majority of our C&I loans are variable rate and the portfolio yield reflected these decreases in market interest rates. The company continues to carefully monitor its commercial customers, and considering the current environment expects that it will remain prudent and disciplined in future commercial loan growth throughout 2008.

Average consumer loans decreased $398 million during the quarter to $26.8 billion. On a spot balance basis, consumer loans decreased to $177 million from the fourth quarter of 2007.

Within the consumer loan category, residential mortgages continued to decrease as we executed our strategy of selling the majority of our production in the secondary markets. Average balances are down $472 million and period-end balances are down $63 million from the fourth quarter levels.

The company’s average direct home equity loan portfolio increased to $136 million during the quarter, or about 9.7% annualized and spot balances grew about a $106 million to $5.8 billion. Yields in this portfolio decreased 31 basis points to 6.21% as a result of lower short-term market interest rates.

Direct home loans are generated through our branch network and have led to numerous cross-sell opportunities. The bank’s direct home equity loans are of high credit quality and the current level of non-performing loans within the direct home equity category are 30 basis points and they have been relatively flat for the past four quarters.

Current quarter originations were $920 million with a weighted average combined LTV of 63% and a weighted average FICO of 791. Past due levels and losses for this portfolio continue to be stable with past due loans equal to 51 basis points on March 31, 2008, compared to 60 basis points at December 31,2007 and losses of $5.3 million for the first quarter compared to $3.8 million in the fourth quarter of 2007.

Auto loan average balances declined $29 million to $7.0 billion. On a spot basis, auto loans declined $213 million to $6.8 billion as a result of the decision to stop originating auto loans in out-of-footprint markets. The yield on this portfolio declined 14 basis points to 7%, as we are focusing on originating higher quality credits within our footprint.

Current quarter originations totaled $503 million, compared to $549 million last quarter, with average FICO score improving to 749 from 708 a year ago. As you will recall we ceased originations in the Southeast and Southwest markets effective January 31, 2008.

While we saw 11 basis points of margin expansion this quarter, our outlook on the margin is relatively stable, plus or minus five basis points, as both our variable rate loans and deposits fully repriced given the recent reductions in market interest rates.

Fee income before investment gains was $158 million for the first quarter of 2008, as compared to $153 million in the fourth quarter of ‘07 and $46 million in the similar period a year ago. Year-over-year consumer banking fees grew $5.2 million or 8%, primarily as a result of increased deposit fees and investment services revenues.

Consumer banking fees were down $4.2 million on a linked-quarter basis to $73.2 million, as a result of normal seasonality in deposit fees in the first quarter of each year. Commercial banking fees were $54.4 million in the first quarter of ‘08, compared to $56.7 million in the fourth quarter of ‘07. Included in the first quarter of ‘08 was the $2.7 million securitization loss. Year-over-year commercial banking fees grew 10% to $54.4 million, due to increased deposit fees.

Mortgage banking revenues experienced a loss of $5.1 million for the first quarter, as compared to revenues of $9.2 million on a linked-quarter basis and a loss of $107.2 million in the similar quarter a year ago.

The primary driver of this quarter’s loss was servicing rights, impairment charges on our residential and multi-family servicing portfolios of $23.6 million, which resulted from changes in interest rates and higher market prepayment speed assumptions during this quarter.

Excluding this impairment charge, mortgage banking revenues were relatively robust at $18.4 million due to increased refinance activity and stronger margins on multi-family and residential loan sales.

Capital markets revenues for the quarter were $10.4 million as compared a loss of $18.3 million last quarter and revenues of $5.7 million a year ago. The fourth quarter of 2007 included $27.4 million of losses on repurchase agreements to mortgage companies. The current quarter results were benefited by the recent interest rate environment, which has allowed us to sell more interest rate derivative products to our customers.

During the quarter, we had investment gains on the partial redemption of our VISA IPO shares of $14.1 million. We still have 415,000 restricted shares in VISA that are valued at zero on our books for the SEC guidance and accounting for this asset.

G&A expenses for the quarter were $359 million, compared to $338 million on a linked-quarter basis and $330 million for the similar quarter in 2007. The fourth quarter of 2007 included an $18.7 million reversal of incentive compensation accruals as a result of corporate objectives not being achieved.

Included in the first quarter of 2008 were the normal seasonally higher payroll taxes of $6.5 million, higher deposit insurance premiums of $4.7 million, and increased marketing expense of $2.4 million which was offset by $6.4 million reversal in legal cost and the accrual related to the VISA IPO. Adjusting for these items, G&A expense as well as the company’s headcount was relatively flat to the fourth quarter of 2007.

The increase in general, administrative expenses from the first quarter of 2007 of $29 million was primarily due to the increased compensation expense of $13.7 million, which included $5 million of reversals of incentive accruals in the first quarter of 2007, higher deposit insurance premiums of $7.6 million, and increased marketing expense of $7.4 offset by the aforementioned reduction and legal expense of $6.4 million in the first quarter of ‘08.

In terms of our asset quality, the company added a new table which is Table G to the press release financials last quarter which highlights by type trended loan composition, net charge-offs both in dollars and as a percentage of average loans, and total past due loans excluding non-performers.

This quarter we broken down the CRE category between commercial real estate and multi-family, and also segregated the out-of-market auto and correspondent home equity loans for your analysis.

Our provision this quarter was a $135 million, compared to $148 million last quarter and $46 million a year ago. We increased our allowance for credit losses by $60.7 million to $798 million.

On March 31, the allowance for total loans was 1.36%, up from 1.28% at year-end and 0.90% a year ago. The increase in reserves is due primarily to growth in commercial loans and deterioration in our commercial construction portfolio. We increased reserves for these portfolios by $57.7 million during the quarter, due to the current environment and the resulting impact on residential construction activity.

Net charge-offs were $74.3 million or 51 basis points of average loans, compared to $60.5 million or 42 basis points of average loans in the fourth quarter of 2007. Sovereign ceased originating correspondent home equity loans early in the first quarter of 2006 and in January of this year ceased originating indirect auto loans out of the company’s footprint.

Approximately 43% of the net charge-offs this quarter related to the out-of-footprint indirect auto portfolio of $28.3 million, and losses on correspondent home equity loans of $4 million. Of the $13.8 million increase in net charge-offs $8.9 million related to auto loans originated out of the footprint. The remaining balance in this out-of-footprint portfolio is $2.4 billion with reserves of $91.4 million at March 31, 2008.

In addition, $4 million of net charge-offs were related to the correspondent home equity portfolio, as a remaining low comp reserve was exhausted. Therefore, net charge-offs started to be recorded and deducted against our allowance for loan losses this quarter.

The remaining balance of the correspondent home equity portfolio is $439 million which consisted $321.5 million of first lien loans and a $117.6 million of second lien loans with reserves of $11.6 million and $47.8 million respectively at March 31, 2008.

Total non-performing loans increased to $113.5 million from the fourth quarter to $417.8 million. The increase was driven by higher non-performing commercial loans, a significant portion of which related to the housing market.

As I mentioned earlier, we have added to our reserves for these portfolios during this quarter and in prior quarters to cover the risks associated with these loans. That being said continued deterioration in these asset classes in future period could require additional reserves considering the current environment.

Tangible equity to tangible assets excluding other comprehensive income was 4.97% at March 31, 2008, compared to 4.67% last quarter and 4.59% a year ago. Tangible common equity to tangible assets excluding OCI was 4.72% compared to 4.43% last quarter and 4.34% a year ago. Including OCI, tangible equity to tangible assets was 4.06% and tangible common equity to tangible assets was 3.81% at March 31, 2008.

Sovereign’s Tier 1 leverage ratio was 6.21% at March 31, 2008 as compared to 5.89% at December 31, 2007. The company’s other comprehensive income losses increased $423 million after-tax from December 31, 2007, primarily due to the impact the reduction in interest rates had on our derivatives portfolio of $122 million after-tax as well as certain categories on the investment portfolio.

In addition, the continued widening of credit spreads also impacted the investment portfolio. Unrealized losses related to the investment portfolio increased $301.5 million after-tax from year-end. I’d like to spend a minute explaining each of these investment categories to you.

Our non-agency mortgage-backed securities are AAA rated. They are not backed for any sub-prime mortgage-related loans. The increase in unrealized losses on this portfolio of $111.2 million after-tax since year-end is due solely to the widening of credit spreads. The average remaining maturity in this portfolio is 3.22 years.

Our municipal bond securities portfolio consists of a 100% general obligation bonds, states, cities, counties and school districts. The portfolio has a weighted average underlying credit risk rating of AA minus. The majority of the bonds are insured to AAA as extra credit protection.

The unrealized losses on the portfolio increased $67.4 million after-tax, due to a widening of credit spreads in the marketplace and concerns with respect to third-party insurers. However, even if we were to assume that the insurers could not honor their obligations, our underlying portfolio is still investment grade, and we expect that all schedule principal and interest will be realized. The estimated remaining life of these securities is approximately 10 years.

The increased unrealized loss of a $127.5 million in our CDO portfolio is due primarily to the continued widening of credit spreads. Our CDO portfolio is backed entirely by corporate names. We do not have any exposure to sub-prime or residential mortgages in our CDO portfolio. Our CDOs have not experienced any losses to-date and maintain AAA credit ratings. All of our CDO investments have subordinated investor classes with first loss responsibility.

Based on the current subordination within the CDOs, Sovereign will not have any loss exposure and took cumulative losses on the corporate names in the CDOs exceeded 5.15%, which is three times the historical average loss rate. The average remaining maturity in this portfolio is 8.61 years.

As you may recall at December 31, 2007, we had to temporarily increase the amount of asset to year-end to maintain compliance with certain OTS regulatory requirement. We are able to significantly reduce the amount of leverage at March 31, 2008 to $850 million, down from $4 billion at year-end.

This decrease in leverage of approximately $3.1 billion increased our holding company Tier 1 ratio by 25 basis points and our tangible ratios by 15 basis points. We are striving to fully resolve this issue in future period.

Effective January 1, we modified our tangible equity ratios to include deferred tax liabilities related to intangibles. This is consistent with industry practice and the inclusion of the deferred tax liabilities in this calculation increased the tangible capital ratios by approximately 35 basis points. Prior periods have been restated to reflect this modification.

The bank’s Tier 1 leverage of 6.84% and total risk-based capital of 10.22% continued to exceed the levels defined as well-capitalized by our regulators. Total risk-based capital was negatively impacted during the quarter by 15 basis points due to qualifying sub-debt being phased out. In addition, changes in loan mix negatively impacted total risk-based capital by approximately 23 basis points, partially offset by 18 basis points of growth from retained earnings.

As I indicated earlier, we understand that our capital ratios have been a concern to the investment community and that one of the primary responsibilities of the Board of Directors and management are to be good stewards of the existing shareholders’ capital. The company regularly evaluates its capital position in relation to the current environment as well as a variety of other internal and external factors.

We are committed to focusing on the core franchise, reducing wholesale and non-core businesses. This process of aligning the balance sheet with our core franchise is expected to result in a smaller institution that is very focused on our most profitable customers. This strategy should improve our capital position in future periods.

In addition to disciplined management, the balance sheet, the company expects to continue to build its capital ratios through increasing retained earnings and reducing its risk profile. As I previously discussed, in the first quarter of ‘08 the company increased its tangible equity to tangible asset ratios by 30 basis points to 4.97%, and its Tier 1 leverage ratio by 32 basis points to 6.21% on a linked-quarter basis.

The underlying drivers of these increases were net income of a $100.1 million, which was added to retained earnings, the suspension of the common stock dividend and the reduction in total assets of $2.8 billion.

Although, we believe that we do not have an immediate need for capital, dependent on our success and reducing the bank’s risk profile, internally generating additional capital, and the severity of the current economic downturn, we could decide we will need to augment our capital base in future periods.

I’ll now turn the call over to Joe for some closing comments, before we open it up for Q&A.

Joseph P. Campanelli

Looking ahead into the balance of 2008, we will continue to execute strategies to reduce risks throughout the company, including credit, interest rate, liquidity and operational risks. In addition, we have committed to continue to improve the quality and transparency of our financial results.

I’d to open up the lines for questions-and-answers on our 2008 first quarter results.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from Matthew O’Connor - UBS.

Matthew O’Connor - UBS

I can appreciate the capital getting boosted over time from shrinking the balance sheet a little bit and generating positive earnings. So, I’m just wondering thoughts on raising the capital a little quicker. If you look at the tangible comment including the OCI, which I think is one way to look at it, does show up as quite low and declined this quarter, and with stability in the franchise, it seems like it could be a lot easier to raise capital now than say a quarter ago from your perspective?

Kirk W. Walters, CPA

I think as we look at the variety of capital ratios that one can look at and in managing the business, clearly one of the items is that the OCI that does flow through our GAAP stockholders’ equity is added back for both the regulatory capital and by the rating agencies in looking at our capital ratios. So, as we look at our overall tangible equity capital, we think at this point the levels are sufficient.

As we indicated in our commentary, we certainly are looking at a variety of factors, not only within the company, but also within the environment to make sure that we are acting prudently on a go forward basis.

Matthew O’Connor - UBS

The deposit trend did stabilize and actually increase despite, I think, lower seasonality typically in 1Q. Maybe just give a little more color on what’s driving from that stabilization in the core deposit franchise?

Joseph P. Campanelli

We believe this is directly tied to our new retail strategy on the Customer First initiative, which we talked a little bit about in the past, and it’s a real consistent focus on customer acquisitions. We are seeing much higher levels of new account openings and much lower attrition rates to the combination of the whole Customer First strategy focusing on being a much better retail experience for our clients in the northeast.

Operator

Your next question comes from James Abbott - FBR Capital Markets.

James Abbott - FBR Capital Markets

Was there any prepayment penalty income that was affecting margin positively? One of your competitors had that issue this quarter, and I am just trying to see if that is case for you?

Kirk W. Walters, CPA

We did have some level of prepayment income that was flowing through. I think if you look at it on a quarter-over-quarter basis fourth to first, the difference was only about a $100,000 and that prepayment fees have flowed through. The biggest piece of that is on the multi-family business that occurs in predominantly in New York.

James Abbott - FBR Capital Markets

So, no material change linked quarter to the margin.

Kirk W. Walters, CPA

Linked-quarter absolutely.

James Abbott - FBR Capital Markets

On legal expense, the press release talks about it being a reduction in legal expense. Was that a contrast expense as in a credit or is it just a lowering from the fourth quarter level?

Kirk W. Walters, CPA

Well, in the fourth quarter we booked the total reserve of little over $8 million for the VISA IPO, the situation that was occurring there. And what we have done at this point is we have reversed $6.4 million of that. So, we still are sitting with some reserves on the books. And on the other side, we are still sitting of course with the restricted stock that we ended up with.

James Abbott - FBR Capital Markets

So it was a credit then in the first quarter.

Kirk W. Walters, CPA

That’s correct.

James Abbott - FBR Capital Markets

The CDO portfolio, it looks like the write-down is about $316 million. I could be off by a million or two there, but about $316 million on the $750 million portfolio. And at what point, I understand that conceptionally you can actually hold this to maturity I suppose. There has been no impairment in the underlying collateral at this point. But at what point do you say this really is an impaired asset, we really need to take it in other than temporary impairment.

Kirk W. Walters, CPA

Well, every quarter we obviously go through a detailed analysis, particularly considering the new size of it within our own staff here at the company, but obviously our outside auditors and others look through it. And the real test, of course, is your ability to intend to hold and ability to hold until you can recover the losses.

Certainly, one of the factors that underlies it in our analysis is that the underlying bonds or corporate bonds, investment grade corporate bonds, we’ve had no defaults on those. Certainly, the credit spreads have widened significantly in the corporate market. And that is one of the benchmarks that we will continue to look at is the health of the corporate credit market. And I think that will probably drive the ultimate question, whether there is any permanent impairment within those bonds.

James Abbott - FBR Capital Markets

And in your own portfolio, this quarter you mentioned in the press release that there was some deterioration in the commercial, and I assume that to be commercial and industrial loan category. Are they at some point related cousins, I know they are not the exact same credits.

Kirk W. Walters, CPA

No, no, they are not related cousins. But certainly, as you come to the asset quality questions, I can have Bob Rose address what deterioration we saw in the C&I portfolio and what categories that fell into.

James Abbott - FBR Capital Markets

With the CDO portfolio, the subordination levels fell to $515. That’s I assume, because you were replacing assets, corporate bonds.

Kirk W. Walters, CPA

That’s right. We have an ability under the structure to continue to restructure, depending on downgrades, concentrations, etc., to retain the AAA rating.

James Abbott - FBR Capital Markets

So there are downgrades occurring, but you’ve been able to maintain. And the yield on the portfolio, it was $661 in the December quarter?

Kirk W. Walters, CPA

You’re looking at the face yield or are you looking at the yield with the markdown?

James Abbott - FBR Capital Markets

I guess it would be the face yield. There was a slide in the PowerPoint presentation in the fourth quarter that gave the yield. And as I understand, when you replace these assets, as they are downgraded by the rating agencies, the underlying collateral, you can take a reduction in subordination or you can take a reduction in yield. And I’m not an expert or a guru in structured finance, so I would imagine maybe the yield has moved down. I would assume is the face is a coupon yield?

Kirk W. Walters, CPA

I think the overall, if you’re looking into the similar slides that we would have had in the investor presentation which will be filed at the end of the week. overall the yield at 3/31 would be LIBOR plus a 169 basis points.

Operator

Your next question comes from Heather Wolf - Merrill Lynch.

Heather Wolf - Merrill Lynch

I’ll go ahead and ask the C&I question. Can you give us a little bit more color in terms of what types of credits drove the increase in non-performing?

Robert M. Rose

We actually had a $92 million increase in the NPAs, of which about $55 million came out of C&I. If we were to just scale down, the largest C&I name was actually a mortgage company which has been an old problem for us. It was approximately $18 million, and the way that workout is progressing it was just prudent for us to add it to non-accrual. So, it is related to housing in that sense.

The second largest was a precious metals customer that had been in our workout group for seven or eight months, and it has been in bankruptcy and not been going favorably late. And despite collateral coverage that’s been ample, we placed it on non-accruals.

And looking down some of the other names here, there were two borrowers for $5 million each that went on non-accrual in the C&I book that have since paid. One of them was taken out by another financial institution, and the other one was able to restructure his arrangement in very favorable way with us.

So I would clearly characterize the two larger names that I mentioned as old historical problems in the vicinity of around $30 million and $10 million of that has since exited building.

Heather Wolf - Merrill Lynch

Can you give us more color on the increase in the past dues in the multifamily category?

Kirk W. Walters, CPA

One credit Heather, one single name, 12 two-story buildings, debt operator and we are coming down very hard on that borrower to replace the management and we don’t expect any loss on that.

Heather Wolf - Merrill Lynch

I assume it was New York, was it Manhattan or Brooklyn?

Kirk W. Walters, CPA

It was not New York. The multifamily group has a portfolio out of area often they follow their New York customers to other places and it was in Florida. It is in Florida. But it is not in Miami.

Operator

Your next question comes from Collyn Gilbert - Stifel Nicolaus.

Collyn Gilbert - Stifel Nicolaus

My question has to do with the reserve strategy behind the out-of-market auto loans. Can you just talk about that I think, Kirk, you said $91.4 million in reserves, but yet assuming losses escalate from here that’s already eating into a third of the reserve level. So you just give some guidance as to where that reserve is going and how you are going to build it?

Robert M. Rose

Yes. We actually what we are seeing in the auto book in the auto area, auto loans has been a rising level of delinquencies and a rising level of charge-offs and we are starting to see that turn in the other direction to our favor.

You may recall back July, August of last year, the bank put in place some very concrete strengthening procedures for better credit, more equity in the cars and things like that and we’ve gone over those with you in past calls. But, we are now seeing delinquencies falling and delinquencies fell in the total auto book by a very large number. I think it was over 23%, more than you would expect in a seasonal drop.

And, we have every expectation that the charge-offs are going to begin to plateau and begin to slowly taper down during the rest of the year. So they have been front loaded in 2008 and we expect to see them slowdown.

Collyn Gilbert - Stifel Nicolaus

Mark had given as a run rate on charge-offs in the portfolio of about $10 to $12 million. I think was is it a quarter or a month?

Joseph P. Campanelli

That would have been a month and then I believe we gave guidance last call of somewhere between $140 and $150 for the year more front loaded to the first half is what our models are telling us and the performance is operating within those models.

Collyn Gilbert - Stifel Nicolaus

So before you are looking at $140 to $150 in net charge-offs for the year in this business, then that $91 million in reserves, you think that had come close to covering that so, should we assume?

Kirk W. Walters, CPA

The $140 to $150 million is for the indirect as a whole.

Robert M. Rose

The entire reserve against this at March 31 is $135 million.

Collyn Gilbert - Stifel Nicolaus

So $91 of that is to the out-of-market so the remainder is to the in-market?

Robert M. Rose

Correct.

Collyn Gilbert - Stifel Nicolaus

Are you seeing similar trends to your in-market auto business, so you are in the auto market?

Robert M. Rose

It stabilized, the step-up in charge-offs we saw in as they stabilized, delinquencies are down and we expect the same trend.

Operator

Your next question comes from Matthew Kelley - Sterne Agee.

Matthew Kelley - Sterne Agee

Along the lines of capital, it sounds like the preferred method here is just to give it a go of shrinking the balance sheet and seems some of these credit cost stabilizing, but I was wondering, if you can give us a little bit better sense on how much we should expect to see the asset levels come down, the risk based asset levels come down, maybe break it down a little bit, by bucket there in terms of hitting some of your goals and what are those goals for capital over the next 6, 12, 24 months?

Kirk W. Walters, CPA

We haven’t, Matt, as you go through that really we haven’t put anything out public, in terms of the specific goals, I think what we’re certainly trying to put the message across as we know that our primary responsibility is to be good stewards of the existing shareholders capital, and accordingly under that scenario of continuing to work our balance sheet down in a careful and thoughtful fashion, not only on the wholesale activities, but also on anything that we look at and deem to be non-core businesses as we saw through it.

And make sure that our balance sheet is right size, as we look at the capital needs, while at the same time, obviously adding to it in retained earnings and doing what we can to move the risk structure for regulatory standpoint to maximize that capital.

As we indicated in our comments that being said, we certainly are going to remain to be diligent and thoughtful about what all is going on in the macro environment as well in terms of the overall credit environment as well as the other factors that play into it.

Matthew Kelley - Sterne Agee

In the current quarter total assets were down 3%, in the fourth quarter they are down 2%. would it be fair to extrapolate those type of percentage drops over the next couple of quarters in terms of the model and its size?

Kirk W. Walters, CPA

I think at this point we are really not in a position or really not intending to give any specific guidance on that.

Operator

Your next question comes from Ken Usdin - Banc of America.

Ken Usdin - Banc of America

Just on asset quality broadly speaking, it’s the third straight quarter of a really sizable provision and understanding the risks still lie out there as far as the direction and magnitude of where the economic deterioration goes. But I’m just wondering, if you can just give us a little bit more color on your overall comfort with the reserve and/or how much we might expect you need to over provide as we still go forward through this cycle?

Kirk W. Walters, CPA

I think in terms of the overall reserve and what we are seeing in terms of the environment we are obviously continuing to build that reserve now it is set to 1.36% of loans and provide, that’s well in excess of charge-offs for this quarter. We obviously need to really continue to evaluate the economic environment, how that’s going to play out against our portfolios and such as to the further needs to increase absolute level.

And then ultimately how you would expect to see the charge-offs come through. But, it is one that I think, as we see the continuing deterioration in the economy that it was certainly prudent to continue to build those reserves as we did this quarter.

Robert M. Rose

I would say that we’ve taken consorted effort to returning the dials on the factors that we use for our past loans and recognition that, the economy is not improving, at best its stable but, its clearly not going to get much better fast. And it has been skewed heavily towards commercial real estate construction with the flavor towards homebuilders. And, so increasing those past factors, it is anticipatory of what could be happening in those portfolios.

Secondly, we recognized deterioration in those portfolios and that’s been driving, more money into the reserve in excess of charge-offs. And, we continue to take and we are taking a deep look and a hard look at certain segments of the portfolio given what’s going on around us. And, being as conservative as we can in our acknowledgment of the given customer status. So, those are really the three primary reasons behind the excess provisioning.

Ken Usdin - Banc of America

But do you think that though that, does the magnitude of over provisioning here, because to take all those things considered, you have taken already conservative over provisioning, yet it seems like also your view is a little, less optimistic. So, I’m just wondering if you think that’s actually the magnitude of over provisioning. I think we can all anticipate that the over provisioning will continue, but I’m wondering if you believe that the magnitude of over provisioning might have to widen out also?

Kirk W. Walters, CPA

Yes, I think that’s one that we are obviously will be evaluating quarter-to-quarter. If you look, we would probably not expect certainly during this year to see charge-offs appreciably drop on a quarterly basis.

And so as we look on a quarter-to-quarter basis, what’s going on in terms of specific portfolios in such the need as Bob, would say to adjust the dials or reflect that in the portfolio or what’s going to drive the underlying amount. So, I think what’s important is that we’re going to be careful and thoughtful and make sure that we are adequately reserved to deal with those factors.

Ken Usdin - Banc of America

I know there is a lot of moving factors now with the shrinking the balance sheet, and the liability sensitivity playing out little bit, but I’m just wondering what would prevent, the margin from being bias towards the upside, you gave a broad, plus or minus five basis points. What are the factors that are really still weighing on the margin and preventing it from continuing to move directionally higher?

Kirk W. Walters, CPA

I think as we see the numbers continue to play out from the current Fed increase, we’re going to see the yields drop as all the repricing goes through on the commercial side, I think on the consumer side with our focus at the higher end of the quality spectrum and the end market and the auto on a variety of things, and continued adjustments coming from home equities. You will see that drop in there as well.

On the deposit side, we will certainly continue to push down as we are able to deposit rates; one of the realities that you have to face though is looking at the absolute level of rates. You will start running into some of those situations like we did back in ‘03 that you are limited in terms of how much you can continue to push down the rates and the customers and still I didn’t feel like that there is a fair deal for all of this strength on the overall deposits.

So, there are pieces going both ways some of that’s obviously, but ultimately the Fed does a lot of it’s what our competitors do etc. that will balance against. But I think that’s the plus or minus five right now, it’s a pretty good indication for what we currently see and certainly as we go forward in the future quarters we can update that.

Operator

Your next question comes from Robert [Rowe] - Riversource.

Robert [Rowe] - Riversource

My credit question is fundamentally, I have a hard time reconciling an acceleration in NPAs in the quarter with the decline in reserve coverage of those NPAs. So, the question why is now the time to have our reserve coverage ratio of our NPAs go down, when in fact NPAs are accelerating?

Kirk W. Walters, CPA

Because it really is a factor of how you are valuating and what you have reserved against the NPAs going in there.

Robert M. Rose

The fact that a loan is on non-accrual or in non-performing status, Robert doesn’t necessarily mean that it has a high loss and in some cases there are no losses or right on the cusp.

And so, I think that in times like this you can see that ratio a little bit, you’ll see it move around, as names come in and out, but I don’t think there is any magic that says the reserve has to be always 200% of NPAs or 175% of NPAs. If we went down there name-by-name, I think, some of them are current on their payments to us it’s just the way we call them in the workouts.

Robert [Rowe] - Riversource

So, effectively you think have visibility and to what that ultimate charge-offs would be from the current NPAs and that’s what gives you the conviction that you don’t need to maintain the previous levels of coverage is that correct?

Robert M. Rose

In the case of commercial real estate non-performing assets, our non-accrual loans, there all in the managed assets group, they’re all managed very intently. We review them on a name-by-name basis. We take charge-offs where appropriate, when the time is correct, when it would appear that we’re in a permanently impaired situation.

And, so that review gives us very strong visibility on them, to the extent that an NPA is something in OREO, they are written down to a carrying value before they are placed, into OREO, so that they reflect a realizable value dollar-for-dollar. So, there is good knowledge of them on a one-by-one basis.

Robert [Rowe] - Riversource

And, then just regarding the forward look, obviously the economy is not accelerating here. Doesn’t prudence want that you keep the reserve at maybe higher just, given that the uncertain direction, I think?

Kirk W. Walters, CPA

Well, I would go back once again, that I don’t think we manage or look to manage our credit quality by that ratio, there is a lot of factors to go into the numbers in terms of, how we look at our allowance and the adequacy of our allowance etc., and that just one of many ratios that happen to fall out.

Robert [Rowe] - Riversource

Regarding capital, obviously tangible capital of the company is very low relative on an absolute basis and relative to most banking institutions in this country. We’ve seen a lot of other banks interest with much higher capital levels got raised, billion of dollars of capital. And I guess in some ways some of this is forced by regulators, and why do you think you can escape that that capital rising, and when is your next deep examination by the OTS?

Kirk W. Walters, CPA

I think we’ve already went through that, we described how we look at capital, what we are going to do, etc., and how we’re going to continuously evaluate it on a go forward basis. I think that’s already been addressed in a number of questions. Secondly, our examining on an annual basis by the regulators, on a variety of fronts obviously safety and soundness as well as CRA trust, etc.

Robert [Rowe] - Riversource

When is the next examination?

Kirk W. Walters, CPA

That is not something that is out there as public information, but all I can say at this point is that we are examined annually as most large institutions are. And as most large institutions are, there is almost continuous discussion and following and dialogue with the regulators on a regular basis.

Robert [Rowe] - Riversource

Have you received any in-bound calls on our capital ratios or is it something you would be worried about at this point?

Kirk W. Walters, CPA

We really have covered the capital discussion, how we’re going about it. And, I don’t think there’s any other commentary that would be appropriate at this point.

Operator

Your next question comes from Gerard Cassidy - RBC Capital Markets.

Gerard Cassidy - RBC Capital Markets

On the home equity correspondent portfolio which I think totaled about $500 million at the end of ‘07. But, where does that stand today and then within that portfolio what losses are you seeing when the consolidated loan to value number is over 90% for that portion of the correspondent portfolio?

Kirk W. Walters, CPA

In the terms of the correspondent portfolio itself, just looking back here to my notes. We have a total, the remaining total in that portfolio is $439 million of which of course $321 million is first lien loans, which we have reserves of about $11.6 against and $117.6 million is the second lien loan, which are pretty heavily reserved at $47.8 million

Robert M. Rose

Well, we’ve seen some fairly heavy losses on this particular portfolio. The second liens in particular, the second liens because of the nature of this portfolio it had a very high loan to value profile and a FICO profile was skewed to the subprime areas and we see in some cases you’re at 100% losses on these second mortgages.

Gerard Cassidy - RBC Capital Markets

Which is what we are hearing from others as well?

Robert M. Rose

Exactly, it is a well reserved portfolio the way we have it set up today. We have, as of March 31 the reserves on the second liens are almost 40% on the principal balances. And so we look at this over its remaining lifetime and we make adjustments up or down to the reserve, as we see the life of it playing out.

Gerard Cassidy - RBC Capital Markets

What’s going on in Washington with some of the legislation that Barney Frank from your state as well as Dodd from Connecticut is pushing regarding relief for people whose houses are upside down. The value of their home was less than the first mortgage.

Does that worry you about the moral hazard of people that have big home equity portfolios that maybe more people rush if this legislation ever is passed that, the unintended consequences more people come rushing into participate in this program and, therefore, home equity portfolios may have greater risk in them, if some type of legislation similar to what is being talked about is actually passed.

Joseph P. Campanelli

Yes. I think it’s hard to predict anything that’s going to come out of Washington, especially during an election year; you probably have a good insight as I do, Gerard. But we believe that we will not be affected significantly when you look at the nature of our home equity portfolios.

It’s really the tale of two cities, you have this residual portfolio from the legacy correspondent business that we exited back in ‘06 early and we sold the majority of that that both first and second mortgages some $3.5 billion between now and the end of ‘06 and early ‘07. So this is really a run-off that is very troubled as Bob talked about. We put up significant reserves and continue to track in.

The balance of our home equity is really a high quality FICO scores, relatively stable communities in the Northeast. So, we’ve good diversity of employment and people need their homes to live in and what not. So, it’s really at the higher end of market in an area where there is a much better balance between supply and demand levels.

So, we really have not seen any actual results, I think which has come down first quarter and our charge-offs inline with the last four quarters historical levels, which really speaks to the underwriting going in. I think, I don’t know if you want to call earlier, but the average originations last quarter were about 791 zero score, about 63% combined loan of value versus second mortgage all within footprint. So, that is an industry wide affect, we believe we will be less impacted in other regions and other types of customer segments.

Gerard Cassidy - RBC Capital Markets

I think Bob mentioned something about a non-performing asset that was down in Florida multifamily type of property. And I thought I heard one of the reasons that you have it as you followed one of your in footprint borrowers down to Florida. What percentage of your commercial real estate or multifamily portfolio is that in that category was in-footprint developer that has chosen to go to Florida or some other part outside of your footprint?

Robert M. Rose

Well, it can be common in certain types of operators in that. The multifamily family book has about $200 million in multi in exposure in the state of Florida and practically all of that are customers that operate in both places.

Gerard Cassidy - RBC Capital Markets

And how about just other out-of-footprint not just Florida, but is that or is that the extent of it, is it just in Florida?

Robert M. Rose

Well, we have commercial real estate business. It’s heavily concentrated in our footprint, but we do have it in other states, but let’s see that Florida would be the largest piece of it that would be the biggest number.

Kirk W. Walters, CPA

Gerard, in our investor slides which will be filed next Monday, we do have a graph that gives the out-of-footprint by portfolio and to your question in multifamily about 14% in the multifamily is out-of-footprint.

Gerard Cassidy - RBC Capital Markets

Coming back to the capital commentary you have had. We’re seeing company is raising capital with either private equity or straight common offerings. With your ownership with the Spanish Bank is there any special or different restrictions or opportunities that you have in terms of, should you ever decide to raise capital, in whatever form, any preferred or a common offering at some point in the future.

Could you share with us, if there is any color that is different than what other banks are doing because of that ownership position by the Spanish?

Joseph P. Campanelli

No, Gerry it’s a public document, so I’m sure, you’ve seen it. There is nothing that precludes us from taking the appropriate steps that we feel to be necessary if the time ever came.

Kirk W. Walters, CPA

And then in terms of, obviously what our responsibilities here are, and I think we’re pretty clear on the commentary to all the shareholders in terms of making sure we’re good stewards of capital and there and, there is nothing particular one way or the other that would be driven by one shareholder or the other.

Operator

Your next question comes from Salvatore DiMartino - Bear Stearns.

Salvatore DiMartino - Bear Stearns

Can you give us the besides of your homebuilder portfolio at the end of the quarter? Could you provide us with an update on your retail banking strategy. I think had a pilot program with Santander in the Phili market. Where does that stand and when will that be rolled out to the rest of the franchise?

Robert M. Rose

The homebuilder portfolio outstandings are up about $982 million at the end of March.

Salvatore DiMartino - Bear Stearns

And geographically is this still mostly in the Mid-Atlantic?

Robert M. Rose

Yes it is. It is, $600 million is in Mid-Atlantic and about $250 million is in New England.

Joseph P. Campanelli

Sal, on your second question you may recall from prior earnings calls you talked about our Customer First initiative. During the course of 2007, we took a whole hard look our whole organizational structure and strategy. We recognized we had significant opportunities on the retail front to really stimulate the retail customer acquisition and really grow it at least market rates if not faster with these franchise that we’ve put together.

We had a group internally that was supplemented with some consultants that we engaged from Santander and looked at some of the activities that they have found successful in Europe and other areas in Latin America. And put together a team build to formulate what’s the best strategy for us to execute. We implemented a test program in the fourth quarter of ‘07 to really fine tune the structure and the strategy.

We’ve rolled out that entire strategy bank wide to 750 branches. You may recall that test program constituted about 25 branches, where we saw significant improvements in productivity. With the rollout in January we also supplemented it with the new organizational structure headed-up by Roy Lever which I talked about earlier.

During the course of the first quarter, we’ve seen strong results. They showed up in our retail deposit numbers 5.8% quarter linked quarter retail deposit growth, really a combination of higher levels of customer acquisitions and lower levels of customer attrition. We are looking at a set of metrics that we can share with the Street on a regular basis to track what progress we make there.

But at the end of the day it’s really predicated by knowing our customers better than ever before and taking that knowledge and using it to really drive further cross-selling and faster acquisition of new clients. So it’s probably one of the most significant initiatives we have given the opportunity we have in our deposit franchise in the Northeast.

Kirk W. Walters, CPA

And Sal, Roy will be one of the featured speakers at our annual meeting in Brooklyn on May 8th as well. So, there will be more discussion and information will be put out at that time..

Since we have gone well over the time, certainly appreciate everybody listening in and the interest in Sovereign and I’m sure we’ll be talking to folks as we go forward here. Thanks a bunch.

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Comments

[deaverb:]

Sovereign is the perfect consumer and business bank. They have a no fee policy for both. So we leave our balances in as a small business, which sometimes are quite high. They kept after us for a mortgage loan and we did it through the branch. No lawyers; just forms; no downtown closing. If they stay on course, watch out. We have recommended Sovereign to many. They beat their local competitors, Bank America and Citizens, as well as staying up with the other small ones (so they are the big-small bank). Great positioning. As a customer, we hope they won't change.

BOA is suffering from "fee-itis" and the word is out on them. Several small companies we are associated with have left them for Sovereign and others. Ken Lewis better focus, as Sam Walton always did, on "one branch" at a time--to get his people to realize that banks are retailers--"You can only get somewhere one store at a time," Sam Walton, Made in America.

Sovereign is doing it right.

2008 Apr 26 09:23 AM