Sovereign Bancorp, Inc. Q3 FY07 Earnings Call Transcript

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Sovereign Bancorp, Inc. (SOV) Q3 FY07 Earnings Call October 18, 2007 9:00 AM ET

Executives

Mark R. McCollom - CFO

Joseph P. Campanelli - President and CEO

M. Robert Rose - Chief Risk Management Officer

Analysts

James Abbott - Friedman, Billings, Ramsey & Co.

Richard Weiss - Janney Montgomery Scott

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Kenneth Usdin - Banc of America Securities

Bernard R. Horn Jr. - Polaris Capital Management

Gerard Cassidy - RBC Capital Market

Michael Cohen - Sunova Capital

Operator

Good morning. My name is Tracy and I will be your conference operator today. At this time, I would like to welcome everyone to the Sovereign Bank's Q3 2007 Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. McCollom. You may begin your conference.

Mark R. McCollom - Chief Financial Officer

Thank you, Tracy. Good morning everyone. I would like to thank you for participating in Sovereign's earnings call for the third quarter of 2007. As a reminder, during this call you will hear statements about our strategies, plans and objectives, as well as estimates of future operating results that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve significant risks and uncertainties. Actual results may differ materially from the results discussed in these forward-looking statements. Factors that might cause such a difference include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demands, changes in accounting principles, and other factors.

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

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

Joseph P. Campanelli - President and Chief Executive Officer

Thank you, Mark and good morning everyone. I too would like welcome you to our third quarter earnings call. I know, I don't need to tell you all out there that this has been... this last quarter has been a turbulent of period as we have seen in the industry in quite some time. Most financial institutions have been impacted by the weakness in residential housing markets and related liquidity crisis and so our results stand [ph] to this. We disclose the material of facts of this in 8-K on October 5th. Mark McCollom our CFO, will step you through the details of that in a moment.

As you may recall, a year ago we outlined four strategic goals of the company: the first was reduced cost and focus on productivity opportunities. Secondly, was to restructure-induced risk in our balance sheet. Thirdly, improved customer experience; and fourthly improved transparency restoring and results to investors. Mark will speak to the cost side of the company and some of the balance sheet movements that took place during the quarter. I'd like to speak a little bit about the transparency and progress we are making, and improving the customer experience and enhancing the value of our core franchise.

It is unfortunate and frustrating to me that these recent market events have clouded some of the transparency restoring. Because of the changes... because of the charges taken to the deal with this broader sector issue and the Sovereign's specific issues related to strengthening reserves of indirect auto business, our earnings for the quarter are disappointing. But what I hope investors can take away from this call is an understanding that there are many, many things going well within the company, and certain operating trends are heading in the right direction. For example, we saw large expansions during the quarter, 3 basis points, 2.74% up from 2.71% during second quarter. Our previous quarter guidance was at the NIM would be bond range plus or minus 5 basis points in second quarter level; with that key variables being our ability to grow low cost deposits. I am pleased to say that we are establishing traction. With non-wholesale deposits growing over $270 million for the quarter and 3.7 annualized growth rate and over the same period, we pushed out over $1 billion of the wholesale deposits with a blended cost in excess of 5%.

Continued growth in core deposit acquisition is a key component of our strategic transformation. We have recently implemented several deposit retention strategies, such as conversion of over 20 different types of grant Sovereign accounts. Our targeted direct mail campaign and onboard service and outbound calling programs to all new retail customers. The grant Sovereign account conversions represent our highest area of attrition.

In the past quarter, over 400,000 accounts were successfully converted and 205 new everyday checking products. While it takes several more months to fully validate, we've so far have seen an improvement in the attrition rates of this population of account. This past week, we've rolled out or rejuvenated our retail strategy, our initial pilot phases. Once perfected over next 90 days or so, we plan to roll it out throughout the franchise in early 2008. We're also reviewing incentive plans in the retail banking to give our star performance more opportunities to shine, as well as to drive accountability throughout employee base to significantly higher degree than in the past. I'm confident this effort will start to pay off in 2008. The roll out the new pilot program includes new operating metrics, which provide consistent measurement of performance throughout all business lines. I look forward to sharing with you to these performance metrics in the upcoming quarters.

We've made significant, but painful progress over the year in repositioning and refocusing our company on core banking and harnessing the earning power of the franchise. Today our balance sheet is substantially stronger than it was one year ago. We recognized this path for management to execute on the core fundamentals.

I look forward to answer the questions you may have at the end of this call, but first I will turn it back over to Mark to provide you with the financial details for the quarter.

Mark R. McCollom - Chief Financial Officer

Thanks Joe. For the third quarter, our operating earnings for EPS purposes were $96 million or $0.19 a share compared to a $170 million or $0.33 per share in last quarter, and $207 million or $0.41 a share a year ago. Now, we are hopeful that many of the items impacting the quarter which include the low comp adjustments on hold for sale of assets, the capital markets losses stemming from our mortgage warehouse business, and the strengthening of reserves in our consumer auto business would not recur in future periods.

However in our continuing effort to provide a more transparent cleaner financials, we elected to keep all these items in or operating EPS number. The only two items that we excluded from operating earnings was the last of our restructuring charges and some additional reserves on our corresponding home equity business, as previous charges related to these two items were treated in the similar fashion.

Going forward, you should expect us to report one number, GAAP earnings; and then around that GAAP earnings, we expect to provide you with enough detail on the unusual items up and down that would occur within the quarter, so that each of you can then make your individual assessment as to the core nature of each of these items. So for this quarter on a GAAP basis including all charges, our net income was $58.2 million or $0.11 per share. Over the past few months, I have been indicating at several financial conferences that we were concerned about a few areas and we may have to take some losses to address recent market events. The common question that I receive from a lot of you during these calls is will this be the end of all the special charges. I mean that's a fair question and my answer is I certainly hope so. We have a duty under GAAP to reflect all known embedded losses in our books on the balance sheet today and we believe that we've done that.

We managed risks and one scenario is that you always look at and managing risk is the low probability but high severity potential outcome and then unfortunately that's why this quarter fell, with that normal credit spread widening and rapid liquidity tightening. So, well I don't perceive future periods to be like this past quarter, we have taken steps from a risk management perspective to reduce the magnitude of losses, should a similar environment arise in future. I'll speak to that near the end of my comments.

Before we step through the core trends, I will take a minute to itemize the five areas that are highlighted throughout the quarter, as areas of concern for us and what the third quarter impact for each of these areas was. First with the correspondent home equity business; we ultimately decided to increase reserves by $47 million in reaction to projected declines in housing values, increase the delinquency in charge off rates in both the second lien portion of this portfolio and reference for the public deals along with updated knowledge now that we've serviced the portfolio for six months. Because of these remaining loans will move back into the loan portfolio in March, this additional reserve is reflected as additional allowance for loan loss reserves.

With this additional reserve that we took this quarter, we now hold around 5% in reserves on the first lien portfolio and around 40% in reserves on second lien portfolio. When you add up both the previous reserves that are at a lower cost or market adjustment as well as the additional loan loss reserves, we now have total of about $77 million in reserves of which $26 million of this is embedded in the loan balance, as this low comp adjustment and the remainder is in the allowance for loan losses. So in future periods once this low comp reserve is fully utilized, you will begin to see Sovereign's consolidated net charge offs increase from charge offs related to this portfolio. This will most likely happen late in the fourth quarter of 2007 or in early 2008.

The second item we talked about that was a concern for us, mortgage warehouse lending. We'd told you that we had a portfolio of around $625 million outstanding as of June, and that some of these companies were under going credit squeeze. The balance of that has come down at September to now about $468 million. Our decision in looking at these companies in many cases was whether or not to support the borrower by either extending or taking collateral or liquidating the underlying collateral. Ultimately, we incurred losses of $19.4 million related to this business. The losses are categorized as capital markets revenues because the losses were taken when market value swaps then in essence provided back stop protection to the broker in the event of a broker to fall. We only have one remaining market value swap on the books as of September 30th, it's collateralized by agency always of collateral and we don't believe there's any exposure related to that position.

Number three, our loans held for sale. We originate and resell loans in two areas of our company. We have a small loan syndicated trading desk that operates the portfolio between $100 million and $200 million and our commercial real estate group originates commercial real estate loans that are then repackaged into CMBS and securitized. During the quarter, the CMBS pipeline that we were building for our next transaction was approximately $200 million. In both of these portfolios, the dramatic widening the credit spreads triggered accounting losses, as these loans must be marked to a lower cost of market. There are no credit issues with these or these portfolios. This is solely an accounting issue caused by widening of spreads in the credit markets.

As a result we booked a low comp adjustment of $6.2 million in the loan trading portfolio, which you will see reflected in commercial banking fees and we recorded a low comp and related servicing asset write-downs of $8.3 million which is reflected in mortgage banking revenues. We have moved a portion of these loans back into the held-for-investment portfolio at the lower cost of market during the quarter, as we do not believe the current market pricing is reflective of the inherent value of these loan portfolios.

Number four; our indirect auto business. We had noted in recent speeches that our auto business was the one area where credit losses have gone up meaningfully from the prior year. I also noted that we are receiving a higher spread on this business in 2007. New volumes for the third quarter were a blended spread of 330 basis points over our two-year cost to funds target versus our targeted spread of 285, and the yield on the portfolio has increased 111 basis points from a year ago to 6.95%. That said, given the weakness in the credit consumer markets generally, growth in the portfolio, higher credit losses and recent weakening credit trends, we came to the conclusion to increase loan loss reserves for this business adding approximately $37 million to the portfolio. Our auto charge offs increased less than this total that we added this quarter, but they did increase to $19.4 million during the quarter versus $12.3 million last quarter, and for the reasons I just mentioned, we believe the additional reserves are necessary.

Number five, CDO's; Sovereign does hold a $750 million of CDOs in its investment portfolio and the recent widening of credit spreads impacted this portfolio as well. Our unrealized securities losses which are reflected in other comprehensive income as a component of capital decreased $97 million during the quarter. I should say that the OCI decreased $97 million or the losses increased. There are no economic losses here. We own 15 separate pools. We have approximately 6% of subordination ahead of us and also we have the intent and ability to hold these securities to maturity. But this movement in the credit spreads did impact our capital on September 30th. The way the accounting works, there is not income statement impact, but we do have unrealized losses in the investment portfolio that must be reflected in equity. Our strategy in this portfolio is always to maintain the AAA rating and if there would be any down grades on any of the tranches, we do have the ability to restructure the pools so that we would always maintain AAA rating. Now all of this noise is very frustrating as Joe mentioned earlier because behind these noise are some improvements in our core trends that are encouraging.

First our net interest margin as Joe mentioned, expanded 3 basis points, 2.74% from 2.71% last quarter. Commercial loan balances on an average balance basis including multi-family are down $702 million from the second quarter, principally resorted the CMBS securitization that we closed in late June and as a reminder, that was approximately $1 billion which included a mix of multi-family and commercial real estate assets. Period and balances quarter-to-quarter increased $365 million in commercial with majority of that growth in C&I category. C&I loans grew $247 million, which is an annualized growth rate of about 7%. Accrued [ph] loans grew nominally about $80 million during the quarter and multi-family loans by design, were kept relatively flat to second quarter levels at $4 billion.

On the consumer side our consumer loans that increased $592 million during the quarter on an average basis, and on a spot balance basis consumer loans increased $256 million within this consumer loan category, resi-mortgages continue to run down average balances are down $72 million and period end balance is down $377 million up from second quarter levels. Home equities increased normally about $41 million during the quarter which is a 3% annualize and on a spot-balance basis grew about a $100 million. The retained correspondent home equity balance was about $415 million, net of both a discount of about $25 million and the reserve I mentioned earlier as of September 30th.

Our auto loan growth was slower this quarter than in more recent quarters although was still significant. Average balances grew $690 million to $6.6 billion and the yield expanded 13 bps to 7.09%. During the quarter our originations in the auto business were $1.3 billion at a weighted average yield of 8.10. the average FICO on this new business was 7.13 and the split was a little bit more weighted to new than we seen in prior our periods we were typically closer to 50-50 and we were 56% new 44% used by design in the third quarter. Let me give you few more perspective on this business when I give you some credit quality and risk management comments in a few minutes.

Moving now along the balance sheet to the investment portfolio, the investment portfolio decreased about a $190 million on an average balanced basis but increased $1.2 billion on a spot balances during the quarter. As you may recall last quarter we needed to hold higher investment balances for a few days over quarter end to maintain compliances with the regulatory guideline, while we are continuing to work with our regulators to put a more permanent structure in place. This quarter end we did need to hold $4.5 billion of additional cash and investments over this quarter-end, for just in quarter-end fell over weekend so we had to hold that for three days, which did inflate our investment balance and because its on of spot basis, it did negatively impact our capital ratios as well; but did not have any meaningful impact to average balances.

Average deposits declined $1 billion during the quarter to $50 billion. Of this decline, more than a 100%, $1.4 billion was planned run off in a higher cost government and wholesale deposits at a blended cost of 5.26%, as we continued to reduce our reliance on wholesale deposit sources. As Joe mentioned, stripping out those deposits, we grew our other deposits to $372 million, which is about a 3.7% annualized growth rate. We saw a very strong growth during the quarter and retail money market accounts and in retail CDs. Unfortunately this was offset somewhat by declines in our interest bearing DDA accounts.

Moving on to borrowings, our wholesale borrowings increased $2.3 billion during the quarter, on an average balance basis, about our total borrowings increased only $767 million. As we mentioned last quarter, we had to unwound a $1.2 billion financing, was in international bank, and we refinanced this was from wholesale borrowings. We also called a few smaller trust preferred securities over the past several quarters. Actually during this year, we've actually called 5 separate issues of trust preferred totally $310 million, which had a blended cost of 9.09%. So, over the last few quarters, getting rid of those had a positive impact on our other borrowing costs, but also had a little bit of negative impact on our capital ratios... regulatory ratios.

Moving on to fee income, our fee income was adversely impacted this quarter as a result of some of the charges I mentioned earlier, and where... where appropriate I will provide you some color on the trends excluding these charges. In total fee income before securities gains was a $141 million for the quarter, compared to a $190 million a quarter ago and $172 million a year ago. Consumer banking fees were down $4 million on a linked-quarter basis to $73 million. Two items going on there; last quarter we had $2.7 million gain on a student loan sale which occurs as we have packaged those loans, originating and package them up for sale. We did have a student loan sale this quarter as well. However it was smaller, the gain was about $800,000. So net you see about $2 million swing quarter-to-quarter there. Also during the quarter, we had discussed that we converted over 400,000 grandfather checking accounts and the fees related to that grandfathering impacted the quarter by about $1.5 million. But despite the drop off in fees, our analysis shows that within six to nine months this move will pay off for us and then some through reduced deposit attrition.

Our commercial banking fees were negatively impacted by the low comp adjustment I spoke to you earlier of $6 million, related to our syndicated loan trading portfolio as well as a smaller lower cost or market adjustment in our precious metals business of about $1.5 million. Excluding those two items, the rest of our commercial banking fees were in line with the prior quarter. Our mortgage banking revenues were $3.8 million this quarter as compared to $26.5 million last quarter. Included in our mortgage banking revenues for the quarter were market value adjustments totaling $8.3 million and excluding these adjustments, mortgage banking revenues were $12 million. And then also comparing then that $12 million to last quarter, last quarter also contained a gain of $13.8 million related to the CMBS securitization we successfully completed last quarter. Capital markets revenues for the quarter, I already spoke to contained a loss of $12.6 million as a result of $19.4 million of losses in our mortgage warehouse business. Excluding these losses, capital market revenues were $6.8 million compared to $5.9 million a quarter ago.

Moving on to expenses, our G&A expenses were up little bit during the quarter about $4 million to $341 million, which is when you get inside that, it is principally two items. Our legal fees increased about $3 million bucks and that was a result of strengthening our reserves, and legal about $2 million as well just slight elevation workout expenses. And then in OREO, we had an increase, we had $3.2 million charge related to a repossessed asset that we had to write-down during the quarter. So if you strip out those two items, expenses basically remained flat to down to second quarter levels across the board.

Moving on to the other expense category; other expenses for the third quarter were $44 million. In addition to the normal expenses that you see in there, which is CDI amortization as the largest component of that, we did have $5 million of restructuring charges related to our cost cutting initiatives and $1 million dollars of a debt extinguishment charges related to the trust preferred securities, I mentioned earlier. And these charges, I believe are in line with guidance we had provided you last quarter.

Moving on to asset quality, our net charge offs increased during the quarter. They were $33.6 million or 24 basis points to average loans compared to $26 million or 18 bps last quarter. Taking a closer look by loan category, our residential charge offs were relatively unchanged to 5 bps versus 4 basis points a quarter ago. Home equity charge offs decreased to 6 basis points from 13 basis points, a quarter ago. We have already talked about the auto business, saw a significant increase there. It increased to a 118 basis points for the quarter from 83 bps the quarter ago, which prompted the additional reserves we spoke about.

Our C&I net charge offs increased a little bit from a 20 basis points to 24 on an annualized basis and lastly our commercial real estate decreased 1 basis point to six basis points. Our provision was $162.5 million which was $129 million higher than the $33 million of net charge offs. Just very quickly because we gone through a lot of this. We did increase our reserves by $47 million related to the corresponding home equity portfolio and $37 million related to indirect auto lending. We also increased reserves to cover exposures in our commercial portfolio, particularly in construction lending and commercial real estate. What we have done an extensive review of the commercial loan portfolio and we have identified a number of loans that we believe have been impacted by the recent market conditions and we recorded an additional provision of $10 million for these loans, which we believe more accurately reflects the embedded risk in the credits and should provide for more orderly progression of these credits through the rating cycle.

As a result of these additional reserves, our allowance to loan losses as a percent of total loans increased to 114 basis points from in the 90s, a quarter ago. And our allowance to non-performing loans increased to 230%. Our total non-performing loans increased $42.5 million from second quarter levels to $282 million. However, when you look inside that, all but a $1 million of it, $41.5 million is related to or retained corresponding home equity portfolio. A quarter ago, these non-performing loans were excluded from our non-performing balance and were just footnoted, because we continue to separate reserves on that portfolio and at that time, we believe that separate lower cost or market adjustment was efficient to cover all expected credit losses.

Now that we have taken additional allowance on that portfolio, and those loans were moved back into the portfolio on March 31, we believe it's appropriate to reflect those non-performers in that total balance. So, excluding that accounting phenomenon our non-performing loans increased about $1.1 million over last quarter. We saw an improvement in our commercial non-performers of $9.6 million, but this was offset by increases of $10.5 million in our residential non-performers.

I would like to add a few comments with regard to risk management. Given the market dislocation that happened this quarter, Sovereign has reacted in several ways to minimize our exposure going forward. In our Capital Markets Group, as I mentioned earlier there's only one remaining market value swap and this is... we feel this is well collateralized by agency collateral. We do not believe there's any exposure related to that position. In our indirect auto business we have implemented several changes that should begin to impact that business quickly, due to the shorter duration of the asset class. Just a sample of the... there's probably 10 to 12 meaningful changes that we've made in that business in the last month or so. But just to give you example, we did analyze our dealer base in the Southeast because we were seeing a higher percentage of first payment defaults in that region and we have terminated relationships with approximately 90 auto dealers that represented a disproportionate percentage of those defaults.

We've shifted the tiering of our originations, so that now we are closer to 70% of our new volumes of what we call Tier I which would be in excess of 700 FICO scores, versus about 60% of our originations for Tier 1 at the beginning of 2007. I mentioned earlier, we've increased our spreads on this business over the past year. As of the end of third quarter, I mentioned earlier, the average for the quarter was 330... as to the end of the quarter our spread on that business is 360 basis points. So despite an increase in net charge off-set, we have been able to absorb these increased loss levels with the increased spreads that we are getting. And I would note that going forward though, we might see the spreads on new business contract a little bit in the fourth quarter, because we continue to shift into these higher credit tiers. So as we go up in FICO, the spread will reduce, but obviously we think that will result in less forecasted than actual losses as well.

Another thing we have done on our commercial business, we have been in a very deliberate way calling through our loan portfolio and we are not renewing lines with commercial borrowers where our spreads are too thin for the credit risks that we are taking on. We believe this profitability could churn somewhere between $500 million and $1 billion of low profit relationships off our books over the next 12 months and this would be replaced with higher margin business.

And then lastly five quarters ago as a reminder, we started to become concerned that consumer credit may be weakening and so as you might recall we entered into a credit default swap transaction in June of 2006 which caps credit losses on a portion of our residential loans at 10 basis points over the life of that reference pool and when we did that transaction, it was $6 billion. We did sell some of those loans with our restructuring, so with combination of sales and just normal rundown there is now about $3.4 billion left on that reference pool. But at the time we are questioned why we were doing this when credit was so pristine, but our view was that the best time to buy insurance is when you don't need it. So as we analyzed the credit quality of our... particularly our residential book, you need to keep that transaction in mind.

Lastly moving on to capital; as I mentioned earlier we didn't need to hoard an additional $4.5 billion of cash and investments at quarter end in order to maintain compliance with a regulatory guideline. This did have a negative impact on our period-end capital and depending on which ratio you look at, it impacts our capital ratios anywhere between 22 and 35 basis points. Also, impacting capital during the quarter was the mark-to-market on our available for sale investment portfolio. Our OCI declined by about $97 million and that also had an impact on capital by about 12 basis points.

And so, when you look at our capital ratio you should consider those two items. With cleaner quarters on the horizon, we believe that our capital ratios will build up from here in coming quarters. And with that, I'll now to turn things back over to Joe for some final comments and then I will open up for Q&A.

Joseph P. Campanelli - President and Chief Executive Officer

Thank you Mark. Obviously, there has been lot going on in course of 2007, we all are anxious to get to... get these issues behind as we focus on the core fundamentals of the Bank and the progress we are making are enhancing the franchise throughout from Philadelphia to Boston and to New York. I think its best just to answer some questions that's within minds. So Tracy can you start to queue.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from James Abbott with FBR Capital Markets.

James Abbott - Friedman, Billings, Ramsey & Co.

The auto portfolio; could you tell us, where the reserve to loan ratio stands on that particular piece of the portfolio? And then where it was last quarter, trying to understand through the directional magnitude of how much the increase was there?

M. Robert Rose - Chief Risk Management Officer

Yes James, this Bob Rose. The reserve at the end of September on that portfolio was approximately 135 basis points and that is increased from approximately 88 basis points, at the end of June.

James Abbott - Friedman, Billings, Ramsey & Co.

Okay, Thank you. And then as you look through that portfolio, what was the main driving factor behind increasing reserve, was it the early payment defaults that caused a substantial increase and then maybe if you could put some color around that, and then also if you could look down through the FICO spectrum, where are you seeing... are you seeing the falls at the 700 FICO core level or above? Or is it all occurring down in the low 600 or what can you tell us on that?

M. Robert Rose - Chief Risk Management Officer

Well, I think you have several questions there. What we did was, we went through this portfolio and examined in the usual ways delinquency roll rates, FICO analysis, where the losses were coming from, even down on a dealer-specific basis. And the losses are as Mark has indicated, had been skewed more to our expansion market where we are undertaking new business, and as you expand into a new business, you do experience slightly higher losses. Going back through the FICO band, overall the FICO... pardon me, profile of this portfolio is about 62% of it would be over 700 and that varies according to the sector that we're in. In the Northeast it's somewhere around 64%. But in some of the expansion markets, it's a little lower as we were working, some of the second tier and third tier credits there. The defaults are coming from a fairly broad range of the FICO scores James, not concentrated in any one sector in the FICO range.

James Abbott - Friedman, Billings, Ramsey & Co.

Okay

M. Robert Rose - Chief Risk Management Officer

Does that answer all of your questions?

James Abbott - Friedman, Billings, Ramsey & Co.

I think so and maybe one last one and then I'll get jump back into the queue; but on severity as you are repossessing cars and selling them into the secondary market. I don't know if you have statistics on what the third quarter's severity was, loss given the fall compared to second quarter, that is really what I am interested in but if you don't have the exact number may be if you can give us a sense as to whether you are experiencing any changes there were relative to historical trends.

M. Robert Rose - Chief Risk Management Officer

Well I think that I do not have those specific numbers, but there is an increase in severity of default across the auto business. I think that higher gasoline prices have caused SUVs to bring less money today than they did in the first quarter. I think also that there's just a general sort of malaise in the consumer business, where people are not wanting to buy new cars as much as they were and if you have a slight decline in demand for vehicles, it affects prices across the board.

Joseph P. Campanelli - President and Chief Executive Officer

Jim it's Joe Campanelli, we did adjust that issue in anticipation of continued weakness in used car prices. We just do try to underwrite terms, lower advanced rates, shifting more towards new vehicle financing instead of used and shifting on the higher FICO scores as Mark mentioned.

James Abbott - Friedman, Billings, Ramsey & Co.

Okay. Thank you very much. I'll step back. Thank you.

Joseph P. Campanelli - President and Chief Executive Officer

Thanks Jim.

Operator

Your next question comes from Rich Weiss with Janney Montgomery.

Richard Weiss - Janney Montgomery Scott

Can you hear me?

Joseph P. Campanelli - President and Chief Executive Officer

Yes we can Rich.

Richard Weiss - Janney Montgomery Scott

Okay. I was just wondering... phone problems today I think. I just want to go back to the indirect auto lending, just kind of ask why are you increasing them so rapidly it's a charge offs are ramping up and also what kind of limit do you have in portfolio or in the indirect portfolio as a percentage of the total portfolio?

Joseph P. Campanelli - President and Chief Executive Officer

Yes, you could anticipate slower growth now as when you answered your Mark and basis Joe [ph] obviously it has more proportionate impact on our growth rates. But through a combination of things the growth is moderating to more normalized basis that are looking that as more like mature markets. So we anticipated by the single-digit growth based n where we are today and where we see the economy going both in total car sales within the country and the concerns of the consumer credit being much more conservative.

Richard Weiss - Janney Montgomery Scott

Okay, when you are saying single-digit growth rate that's on an annual basis?

Joseph P. Campanelli - President and Chief Executive Officer

Yes.

Richard Weiss - Janney Montgomery Scott

Okay. And also on the correspondent home equity low, how do you value the sub-prime loans today since, it's just a pretty difficult for everybody and Fed reserves against that?

Joseph P. Campanelli - President and Chief Executive Officer

Yes, I think it was very difficult from a year ago, where I think we are one of the first to decide that that's the business that we don't want on our balance sheet. It had been at discontinued business it starting from I guess the late '05 to early '06 periods but was just in run off mode. We went to market very early on and received the variety of goods. Spread at that time is that more recognize the market start to deteriorate. I think a lot of people still having great deal of difficulty in establishing with the range who would be based on our payment history and this is your portfolio. Some of the stats flows we've looked at the positive of the fall was variable above growth in this team came up with a methodology that we felt was appropriate to apply the portfolio to corresponding write-down. Bob do you want to add.

M. Robert Rose - Chief Risk Management Officer

Well the benefit unfortunately in parts of this portfolio. We have lost a fair percentage of the principle balance so if 1 goes back and adds back in, in the second mean portion in particular add back in the charge offs that have been taken since we brought it back on our books and add that to reserves that have been placed on that second mean portfolio we've in access of a 46% reserve and you know unfortunately in this business for losses of binary you need to lose it all in the case of second lien loans in this quality range or you lose a little there's not a lot of middle ground. But we think the second past through this portfolio through our analysis of the previous of falls we stressed the property value quite a bit off of their current values and we think that the amount of money that we have here is adequate to see it through to its conclusion.

Richard Weiss - Janney Montgomery Scott

Okay and one final question I guess Mark this for you. What sort of tax rate would be appropriate to use going forward from modeling purposes?

Mark R. McCollom - Chief Financial Officer

Yeah, going forward, I think you should expect us to be some where just out of 20% into the fourth quarter going into next year, then if you go back and look at our K, where we do a reconciliation to your statutory rate there is about 3% impact from our Section 29 credits, which were the synthetic fuel credits. That part of the other tax law actually goes away as a 1231. So we won't have investment on our books next year. So when you think the next year all other things been equal you would expect our tax rate in a sort of low to mid-twenties range.

Richard Weiss - Janney Montgomery Scott

Okay. Thank you.

Operator

Your next question comes from Collyn Gilbert with Stifel Nicolaus.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

A couple of questions, starting with capital. Mark you had said assuming cleaner quarters ahead that your capital levels should rebound, I mean can you give a little bit more color as to what the goals are there and I mean obviously given the constraints that are happening there, I wouldn't anticipate much in the way buybacks for you guys? Is that true?

Mark R. McCollom - Chief Financial Officer

I think that's fair Collyn for at least in next several quarters. I mean we have... we had always put out some interim capital targets to achieve that we wanted to get back to where we were... sort of free the acquisition of Independence, so go back and look at our numbers in September of '05, which back then one of the numbers with tangible capital was 4.54. We have always said that we wanted to get back there by the end of this year. We were on track to do that until the charges that we had to take this quarter. I think that interim target might be delayed a quarter or so, but then once we even get back to that level, I know I have also said that we need to then evaluate once you get back to that interim stage, how your balance sheet has shifted and with the moves that we have made over the past year, we have come decidedly more commercial and as that commercial exposure increases, so should your capital, particularly in the light of what I think everyone views as a weakening credit environment. So, I think you can anticipate for Sovereign that we are going to be building capital for several quarters to come.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Okay. And then on the C&I side, what is driving and if you said this in your opening comments, I apologize, but what's driving a lot of that growth and is it sustainable?

Joseph P. Campanelli - President and Chief Executive Officer

Yes. I think it's and there is two things going on. One is we will take much more disciplined approach in risk adjusted returns, so in certain areas where we don't feel we are getting adequately compensated, we are not renewing credits and the other side we are adding resources in market to better service commercial clients through our Pennsylvania, New Jersey and in to New York market. You may recall that Independence several years ago was primary a thrift under Brendan Dugan and his team, he has able to add experience commercial lenders into that marketplace to complement the branch network and small business. So I think its better servicing the needs of small businesses and middle market companies residing in our franchise.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Okay and then would you characterize it's still more as small business focus, are you moving upscale in terms of credit?

Joseph P. Campanelli - President and Chief Executive Officer

There is some opportunities for end market companies to provide better services but I think the focus is really going from the small business all way up to the mid-tier middle market company, where we can add some value.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Okay, okay and then, Mark can you just give a little bit more detail again for us on that credit default swap and exactly how that... how you covered on that?

Mark R. McCollom - Chief Financial Officer

Yes, it was a deal that we did in the second quarter of '06, there was a reference pool at that time of about $6 billion of residential mortgage loans which what it does is that it caps the life losses that can incur under that portfolio to 10 basis points. So in other words then if losses in that reference pool would go above 10 basis points, we would then get paid on the credit default swap because some of the loans that were, that we were pointing that against in the reference pool were loans that we sold as our restructuring in the fourth quarter, a combination of that plus just normal amortization, there is now the remaining reference pool of $3.6 billion. And so the point is that on our $14 billion or so of residential mortgages, a little more than a quarter of them, we have protection against for life to date loss... life losses of only 10 bps.

Collyn Gilbert - Stifel Nicolaus & Company, Inc.

Okay. Great, okay that was it. Thank you.

Operator

[Operator Instructions]. Your next question comes from Ken Usdin with Banc of America Securities.

Kenneth Usdin - Banc of America Securities

Mark, you made the point... we know that there are these one time charges extra provisions that you had in the... on the credit side. So if you back them out, you are kind provided in the kind of mid 70s or so and I'm just wondering if you can kind of help box for us either how much ahead of future provisioning you got this quarter or if this is more of that kind of normal run rate of provisioning, if not higher; going forward to your points about your credit continuing to deteriorate going forward.

Mark R. McCollom - Chief Financial Officer

Right. I assume that was a trick question, Ken because we never get ahead of ourselves in provision, you provide what's required under GAAP. But when you strip those two items, the other components that I did mention is what we have seen is an increase in criticized and classified assets, which takes... if you have a commercial loan, that typically you're reserving a 100 basis points against; as you see that it goes through the credit cycle, you may now need to reserve 2.5% or 5% if that becomes either criticized or classified. And then ultimately if it becomes a doubtful asset then you are required to reserve 50% against the asset. So as we have seen in some of those migrations through our credit portfolio that's requiring some of that additional amount. And I would anticipate for the next several quarters that you could see increased or higher levels of provisioning relative to charge offs, until that sort of front-end credit process stabilizes itself. I mean is it going to be in the $77 million range, I not prepared to forecast to that level of detail today, but I would anticipate you to expect to see continued weakening in terms of charge offs in the portfolio for the next couple of quarters certainly.

Kenneth Usdin - Banc of America Securities

Right and then on that basis I mean can you talk about where you are in your expectation of charge-off normalization or moving towards peak even and what inning are we in of that deterioration of credit as far as you see it?

Mark R. McCollom - Chief Financial Officer

Sure, I mean as far what inning I guess I will leave the folks from the baseball town in Boston to answer that question. Bob Rose can comment on that, but from my perspective I do believe that for significantly into 2008 I expect there to be continued credit weakness I think exactly how weak it gets is exactly what we as well as the folks who cover us I think all trying to get our arms around. Bob.

M. Robert Rose - Chief Risk Management Officer

Well, the areas that we are paying attention to are those same ones that you are reading about in the newspaper and that we are seeing some downgrade activity take place in, in anticipation of and in recognition of actual deterioration and those are in the for sale housing sectors of the portfolio and in some building related areas and so the inning there it varies according to the individual developer and the situation. Some are very well capitalized and are able to put additional capital into situations, and some are not so well capitalized and are more collateral reliant. So we are going through all of those assets in our portfolio in making those determinations.

Kenneth Usdin - Banc of America Securities

Okay and --

Joseph P. Campanelli - President and Chief Executive Officer

And we are fortunate, Ken to be in the highly concentrated Northeast where we have haven't experienced a great boom over the last five years, especially in some of the housing growth in the Southeast and in other areas, so we are not anticipating a big bust either.

Kenneth Usdin - Banc of America Securities

Okay and Mark one further question, just on the margins side. You did have a little bit of... little increase this quarter, but then you are talking about you maybe moving upscale in the Auto bucket and your talking about some of the other loan growth areas being okay. But slowing in some areas and deposits kind of being tough out there I mean, can you just give us some color on what you think directionally the margin should head from hear and also what impact if anything the Fed cuts have on you guys.

Mark R. McCollom - Chief Financial Officer

Yes, the Fed cuts benefit us a little bit, but not enough to move the needle over the kind of credit weakness that we are seeing on the credit side of things. But in terms of margin, I only anticipate for the fourth quarter it to be more flattish, I say plus or minus 5, I mean it could be plus or minus 5 again this quarter, although I only anticipate it to probably be fairly range beyond to the 274 we reported this quarter. And you are right, Ken, that I mean some of the things we are doing to clamp down from a credit perspective, are going to have a little bit of an adverse impact on loan yields, but again we think that's going to be more than made up for in terms of credit cost.

Kenneth Usdin - Banc of America Securities

Okay, thanks a lot.

Operator

Your next question comes from Bernard Horn with Polaris Capital.

Bernard R. Horn Jr. - Polaris Capital Management

Just like to ask another question on kind of corresponding home equity and indirect auto loan business. I'm wondering if you have any contractual obligations to continue to accept loans that are originated by others in that area and that doesn't necessarily... the contractual obligation question doesn't really apply just to those two loan categories. I am wondering if you have obligations to do that from distribution systems elsewhere and other parts of your loan portfolio.

Second question I had is I know that Independence had quite a lot of competition on at least on multi-family housing business from other kinds of non-bank lenders like hedge funds, indirect insurance conduits and so forth, and I am wondering if that has subsided or if they have noticed any difference in there, both the competition and the spreads that they are seeing in the market?

Mark R. McCollom - Chief Financial Officer

I am sure. The first question on the contractual obligation, Bernard, corresponding home equity business we had... we had shut that business down in the early 2006. So we have not been taking any corresponding home equity paper for several quarters. On the indirect auto side, while that business is still open and running and growing, we underwrite every credit that comes in to us. So we always have the ability for credit reasons or otherwise to reject any application that will come in to us.

Then with respect to I think you said on Independence and specifically I think you are asking about the multi-family business. Independence had a strategy of putting more of those loans on the balance sheet. Historically, Sovereign in the time that we have owned the business, we liked the business and we want to grow that business and continue to partner with Meridian Capital on that business, however with this kind of interest rate environment it made more sense for us to focus on the originate and sell portion of that business as opposed to the portfolio piece of the business. So we have been running the portfolio side of that business down from about $6 billion to $4 billion, but our goal and intent is still to grow the originate and sell side of that business, whether it's through direct sales to Fannie Mae or whether it's through a CMBS conduit, as robustly as we can.

Bernard R. Horn Jr. - Polaris Capital Management

So it sounds like on the multi-family business is because Fannie or Freddie you are getting very aggressive in trying to enter that market, I know that was a threat due to lot of the multi-family vendors have seen that would likely reduce margins in the business, is that... is that the reason that you are not bringing it on to the portfolio, those are generally speaking pretty good loans with decent yields and so forth but of course the yields were beaten down by this kind of extra competition?

Mark R. McCollom - Chief Financial Officer

Yes, yes that is right and I would say that if you look to where we source a lot of our loans in multi family through our relationship with Meridian and as do some other banks who have, who are... who take Meridian's production and in recent quarters I would say that some of those other banks have been more aggressive on the portfolio side than we have and you are right, the credit quality is really strong but for us it is always a balance of profitability versus just a balance sheet in earnings growth and for us right now, we think the right thing to do is to selectively put loans in portfolio for certain relationships but to instead focus on the for sale portion of that business.

Bernard R. Horn Jr. - Polaris Capital Management

Okay and just getting back to my other question on the contractual obligations. I wasn't quite sure if you were saying that you have no contractual obligations or you do, but you are able to kind of moderate the inflow. Is... do you have like obligations to take or not take certain loans from the various distributions systems that you are in?

Joseph P. Campanelli - President and Chief Executive Officer

Yes, just to be clear, Bernard, this is Joe Campanelli. We have no contractual obligations to purchase loans. Every loan we have put on our books is our sole underwriting discretion and underwriting standards and pricing on every business line.

Bernard R. Horn Jr. - Polaris Capital Management

Okay, Thanks. That's all from me.

Operator

Your next question comes from Gerard Cassidy with RBC Capital Market.

M. Robert Rose - Chief Risk Management Officer

Hello, Gerard, are you there?

Operator

Please hold sir.

M. Robert Rose - Chief Risk Management Officer

Yes, thank you Tracy.

Gerard Cassidy - RBC Capital Market

Hello?

Operator

Mr. Cassidy, you may proceed with your question.

Gerard Cassidy - RBC Capital Market

Yes. Can you hear me now guys?

Mark R. McCollom - Chief Financial Officer

Yes, we can, Gerard.

Gerard Cassidy - RBC Capital Market

I apologize. I have been jumping on and off the call. And I apologize if you have addressed this, but in your commercial --

Mark R. McCollom - Chief Financial Officer

Gerard, we just lost you midstream on your question. Don't know if you hit a mute button or if your phone was disconnected. Tracy, can we try to get him back or if not we will go to our next question please.

Operator

Yes. Hold one moment.

Mark R. McCollom - Chief Financial Officer

Thank you.

Operator

Mr. Cassidy, you may proceed.

Gerard Cassidy - RBC Capital Market

Will try one more time and if I get lost I will just call you on the outside. In regards to your commercial real estate portfolio can you guys give us some color of the trend you are seeing there and second what percentage of the commercial real-estate numbers are in construction loans and once you give us that number, can you give us some color of what's in residential real estate market versus the non-residential real estate market. Thank you.

M. Robert Rose - Chief Risk Management Officer

Sure this Bob again. The commercial real estate portfolio is about $11.8 billion... $12 billion and of that $2 billion is construction and $10 billion is permanent. Within the construction portfolio, the home builders would be approximately $472 million, the conduit [ph] builders would be about $457 million. The balance of the portfolio is split the largest next sector would be retail, then office, then warehouse space multi-family hospitality and other so that gives you the spectrum of that. The parts of it that we believe retail and it is performing fine, office is performing well, the warehouse multi-family hospitality etcetera all the other sectors are performing fine. The sectors that have our attention again are for sale housing and we are approaching that with a very careful management approach and we escalated all of our reporting and all of our discovery and all of our action steps to manage through any imbalance in supply/demand that makes it.

Gerard Cassidy - RBC Capital Market

Thank you.

Joseph P. Campanelli - President and Chief Executive Officer

To see the conservative underwriting over the past three to five years is maintained is resulting in some ability in the portfolio?

Gerard Cassidy - RBC Capital Market

Great. Thank you.

Operator

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

James Abbott - Friedman, Billings, Ramsey & Co.

Just another question but just a follow up on construction loans the home building and the condo, what's the typical loan-to-value for the firm and are you seeing a lot of deterioration in the markets that you are in. I don't know how much exposure do you have to various different markets there and maybe just to get the opportunity to ask that question as well?

M. Robert Rose - Chief Risk Management Officer

I'm sorry, you were coming through a little weak; could you repeat those again please James.

James Abbott - Friedman, Billings, Ramsey & Co.

Sure, just looking at the construction, the residential construction, just a piggyback offer to earlier question. The homebuilder, loans and the condo loans; what the loan-to-value ratios are on those projects in general and then also geographic dispersion on that?

M. Robert Rose - Chief Risk Management Officer

Yes, the loan-to-value in those two sectors range at some of them as low as 35% and 40% and some is high as 80%. Again that would be of cost of the structure not the retail price. So that can stand some marking down in the process. As to sector, the majority of these are in our area, I would say there is approximately $250 million out of area in these sectors; and our footprint would include the Northeast and when we do leave the area, we are often times following a developer who is headquartered in one of our main markets here and we have a relationship with them and we're helping them out in some out of area projects.

James Abbott - Friedman, Billings, Ramsey & Co.

That's helpful. And when you say out of area, can we isolate, do we know how much is in for to California, Nevada, Arizona areas?

M. Robert Rose - Chief Risk Management Officer

Yes, there is no Nevada exposure, there is one Arizona project that we've done, that's... its such a low loan-to-value we did for a very deep and large relationships that represents little opening in terms of total exposure that customer. Florida I don't have an exact number with me but Florida would represent I mean to say in the 150 a range little less than that. We actually exited the credit two days ago with $21 million credit that had a fair out of area exposure and I need to include that in the outstanding because they were just reduced by in excess of $20 million.

James Abbott - Friedman, Billings, Ramsey & Co.

Okay, well that's helpful. Then my main question that I was asking and so I switched back to the auto portfolio just as a follow up, of the charge offs of the roughly $20 million of charges offs in auto loan this quarter, how much of that came from loans that were less than a year old and how much of it was from loans that were loans that were more than a year old. Trying to get a sense of seasoning on these?

Mark R. McCollom - Chief Financial Officer

Well James, I think as I had mentioned before I mean particular in the South East are the one of the disproportionate amount of first payment of falls was to triggered a lot of changes that we're making. If you look to the end-market portion of our portfolio, you'd expect to see that these losses attract what a normal season curve would show.

James Abbott - Friedman, Billings, Ramsey & Co.

Okay. Alright, thanks again.

Operator

[Operator Instructions]. Your next question comes from Michael Cohen with Sunova Capital.

Michael Cohen - Sunova Capital

My questions have been asked and answered. I apologize.

Mark R. McCollom - Chief Financial Officer

Okay thank you. I believe we are at the end of our allocated time. So I thank everybody for listening in on our call this morning. If you have any follow up questions please feel free to call myself Mark McCollom, Stacey Weikel, Head of Investor Relations or certainly, you can call Joe Campanelli, our CEO at any time. Thank you very much. Bye-bye.

Joseph P. Campanelli - President and Chief Executive Officer

Thank you a lot.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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