Santander Holdings USA, Inc. - Annual Report: 2006 (Form 10-K)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934,

for the fiscal year ended December 31, 2006, or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934,

for the transition period from N/A to ___.

SOVEREIGN BANCORP, INC.

 

(Exact name of Registrant as specified in its charter)

Pennsylvania		23-2453088
(State or other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
1500 Market Street, Philadelphia, Pennsylvania   (Address of Principal Executive Offices)		19102   (Zip Code)

(215) 557-4630

Registrant’s Telephone Number

Title		Name of Exchange on Which Registered
Common stock, no par value		NYSE
Depository Shares for Series C non-cumulative preferred stock		NYSE
7.75% Capital Securities (Sovereign Capital Trust V)		NYSE
8.50% Cumulative Trust Preferred Securities (Seacoast Capital Trust I)		NASDAQ

(Sovereign Capital Trust IV) PIERS Units

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Yes o  No þ 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Act):

Large accelerated filer  þ  Accelerated filer  o  Non-accelerated filer  o 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ 

The aggregate market value of the shares of Common Stock of the Registrant held by nonaffiliates of the Registrant was $9,473,671,601 at June 30, 2006. As of February 16, 2007, the Registrant had 475,141,953 shares of Common Stock outstanding.

 

 

Form 10-K Cross Reference Index

				Page
Forward-Looking Statements				3-4
PART I
Item 1		— Business		5-8
Item 1A		— Risk Factors		9-10
Item 1B		— Unresolved Staff Comments		11
Item 2		— Properties		11
Item 3		— Legal Proceedings		11
Item 4		— Submission of Matters to a Vote of Security Holders		12
Item 4A		— Executive Officers of the Registrant		12
PART II
Item 5		— Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		13
Item 6		— Selected Financial Data		14
Item 7		— Management’s Discussion and Analysis of Financial Condition and Results of Operations		15-49
Item 7A		— Quantitative and Qualitative Disclosures About Market Risk		49
Item 8		— Financial Statements and Supplementary Data		50-106
Item 9		— Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		107
Item 9A		— Controls and Procedures		107
Item 9B		— Other Information		107
PART III
Item 10		— Directors and Executive Officers of the Registrant		107
Item 11		— Executive Compensation		107
Item 12		— Security Ownership of Certain Beneficial Owners and Management		107-111
Item 13		— Certain Relationships and Related Transactions		111
Item 14		— Principal Accountant Fees and Services		111
PART IV
Item 15		— Exhibits and Financial Statement Schedules		112-115
Signatures				116-117
Sovereign Bancorp, Inc. Non-Employee Directors Services Compensation Plan
Sovereign Bancorp, Inc. 1993 Stock Option Plan
Sovereign Bancorp, Inc. 1996 Stock Option Plan
Agreement to Amend dated May 30, 2006, between Sovereign Bancorp, Inc. and Mark R McCollom
Agreement to Amend, dated May 30, 2006, between Sovereign Bancorp, Inc. and James J. Lynch
Change in Control Agreement, dated January 1, 2001, Sovereign Bancorp, Inc. and M. Robert Rose
Sovereign Bancorp, Inc. 2001 Stock Incentive Plan
Sovereign Bancorp, Inc. 2006 Non-Employee Director Compensation Plan
Sovereign Bancorp, Inc. 2004 Broad-Based Stock Incentive Plan
Sovereign Bancorp, Inc. 2007 Deferred Compensation Plan
Subsidiaries of Registrant
Consent of Ernst & Young LLP
Chief Executive Officer certification
Chief Financial Officer certification
Chief Executive Officer certification
Chief Financial Officer certification

Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements made by or on behalf of Sovereign Bancorp, Inc. (“Sovereign”). Sovereign may from time to time make forward-looking statements in Sovereign’s filings with the Securities and Exchange Commission (including this Annual Report on Form 10-K and the Exhibits hereto), in its reports to shareholders (including its 2006 Annual Report) and in other communications by Sovereign, which are made in good faith by Sovereign, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Some of the disclosure communications by Sovereign, including any statements preceded by, followed by or which include the words “may,” “could,” “should,” “pro forma,” “looking forward,” “will,” “would,” “believe,” “expect,” “hope,” anticipate,” “estimate,” “intend,” “plan,” “strive,” “hopefully,” “try,” “assume” or similar expressions constitute forward-looking statements.

These forward-looking statements include statements with respect to Sovereign’s vision, mission, strategies, goals, beliefs, plans, objectives, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business of Sovereign, including statements relating to:

	•		growth in net income, shareholder value and internal tangible equity generation;
	•		growth in earnings per share;
	•		return on equity;
	•		return on assets;
	•		efficiency ratio;
	•		Tier 1 leverage ratio;
	•		annualized net charge-offs and other asset quality measures;
	•		fee income as a percentage of total revenue;
	•		ratio of tangible equity to assets or other capital adequacy measures;
	•		book value and tangible book value per share; and
	•		loan and deposit portfolio compositions, employee retention, deposit retention, asset quality and reserve adequacy.

These forward-looking statements, implicitly and explicitly, include the assumptions underlying the statements. Although Sovereign believes that the expectations reflected in these forward-looking statements are reasonable, these statements involve risks and uncertainties which are subject to change based on various important factors (some of which are beyond Sovereign’s control). The following factors, among others, could cause Sovereign’s financial performance to differ materially from its goals, plans, objectives, intentions, expectations, forecasts and projections (and the underlying assumptions) expressed in the forward-looking statements:

	•		the strength of the United States economy in general and the strength of the regional and local economies in which Sovereign conducts operations;
	•		the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System;
	•		inflation, interest rate, market and monetary fluctuations;
	•		adverse changes that may occur in the securities markets, including those related to the financial condition of significant issuers in our investment portfolio;
	•		Sovereign’s ability to successfully integrate any assets, liabilities, customers, systems and management personnel Sovereign acquires into its operations and its ability to realize related revenue synergies and cost savings within expected time frames;
	•		the possibility that expected merger-related charges are materially greater than forecasted or that final purchase price allocations based on fair value of the acquired assets and liabilities at acquisition date and related adjustments to yield and/or amortization of the acquired assets and liabilities are materially different from those forecasted;
	•		deposit attrition, customer loss, revenue loss and business disruption following Sovereign’s acquisitions, including adverse effects on relationships with employees may be greater than expected;
	•		the implementation of cost savings initiatives may take longer to implement than anticipated or may cost more to implement than anticipated;
	•		the implementation of cost savings initiatives may have unintended impacts on our ability to attract and retain businesses and customers;
	•		revenue enhancement ideas may not be successful in the marketplace or may result in unintended costs;
	•		assumed attrition required to achieve workforce reductions may not come in the right place or at the right times to meet planned goals;
	•		changing market conditions may force us to alter the implementation or continuation of cost savings or revenue enhancement strategies;
	•		Sovereign’s plans to sell loan portfolios may take longer than anticipated, may be sold at prices lower than anticipated or may not occur in their entirety;

	•		Sovereign’s timely development of competitive new products and services in a changing environment and the acceptance of such products and services by customers;
	•		the willingness of customers to substitute competitors’ products and services and vice versa;
	•		the ability of Sovereign and its third party vendors to convert and maintain Sovereign’s data processing and related systems on a timely and acceptable basis and within projected cost estimates;
	•		the impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, capital, liquidity, proper accounting treatment, securities and insurance, and the application thereof by regulatory bodies and the impact of changes in and interpretation of generally accepted accounting principles;
	•		technological changes;
	•		competitors of Sovereign may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than Sovereign;
	•		changes in consumer spending and savings habits;
	•		acts of terrorism or domestic or foreign military conflicts; and acts of God, including natural disasters;
	•		regulatory or judicial proceedings;
	•		changes in asset quality;
	•		if Sovereign acquires companies with weak internal controls, it will take time to get the acquired company up to the same level of operating effectiveness as Sovereign’s internal control structure. The Company’s inability to address these risks could negatively affect the Company’s operating results; and
	•		Sovereign’s success in managing the risks involved in the foregoing.

If one or more of the factors affecting Sovereign’s forward-looking information and statements proves incorrect, then its actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements. Therefore, Sovereign cautions you not to place undue reliance on any forward-looking information and statements. The effect of these factors is difficult to predict. New factors emerge from time to time and we cannot assess the impact of any such factor on our business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward looking statement. Any forward looking statements only speak as of the date of this document.

Sovereign does not intend to update any forward-looking information and statements, whether written or oral, to reflect any change. All forward-looking statements attributable to Sovereign are expressly qualified by these cautionary statements.

PART I

Item 1 — Business

General

Sovereign Bancorp, Inc. (“Sovereign” or “the Company”), is the parent company of Sovereign Bank (“Sovereign Bank” or “the Bank”), and is a $90 billion financial institution as of December 31, 2006, with nearly 800 community banking offices, over 2,000 ATMs and about 12,500 team members with principal markets in the Northeastern United States. Sovereign’s primary business consists of attracting deposits from its network of community banking offices, and originating small business and middle market commercial loans, multi-family loans, residential mortgage loans, home equity lines of credit, and auto and other consumer loans in the communities served by those offices. Sovereign originates auto loans in the Southeastern and Southwestern parts of the United States.

Sovereign Bank was created in 1984 under the name Penn Savings Bank, F.S.B. through the merger of two financial institutions with market areas primarily in Berks and Lancaster counties, Pennsylvania. Sovereign Bank assumed its current name on December 31, 1991. Sovereign was incorporated in 1987. Sovereign has acquired 28 financial institutions, branch networks and/or related businesses since 1990. Eighteen of these acquisitions, with assets totaling approximately $52 billion, have been completed since 1995. Sovereign closed on its acquisition of Independence Community Bank Corp. (“Independence”) effective June 1, 2006 for $42 per share in cash, representing an aggregate transaction value of $3.6 billion. Sovereign funded this acquisition using the proceeds from the $2.4 billion equity offering to Banco Santander Central Hispano (“Santander”), net proceeds from issuances of perpetual and trust preferred securities, and cash on hand. Sovereign issued 88.7 million shares to Santander, in connection with the equity offering which made Santander Sovereign’s largest shareholder. Independence was headquartered in Brooklyn, New York, had assets which totaled $17 billion and deposits of $11 billion and 125 community banking offices in the five boroughs of New York City, Nassau and Suffolk Counties and New Jersey. Sovereign acquired Independence to connect their Mid-Atlantic geographic footprint to New England and create new markets in certain areas of New York.

Sovereign is a Pennsylvania business corporation and its principal executive offices are located at 1500 Market Street, Philadelphia, Pennsylvania. Sovereign Bank is headquartered in Wyomissing, Pennsylvania, a suburb of Reading, Pennsylvania.

Sovereign Bank is a federally chartered savings bank and operates in a heavily regulated environment. Changes in laws and regulations affecting Sovereign and its subsidiaries may have a significant impact on its operations. See “Business — Supervision and Regulation.”

Business Strategy

Sovereign believes that as a result of continuing consolidation in the financial services industry, there is an increasing need for a super-community bank in the Northeastern United States. Sovereign considers a super-community bank to be a bank with the size and range of commercial, business and consumer products to compete with larger institutions, but with the orientation to relationship banking and personalized service usually found at smaller community banks. We believe that our institution has these characteristics.

Subsidiaries

Sovereign had three direct consolidated wholly-owned subsidiaries at December 31, 2006: Sovereign Bank is the only material subsidiary.

Employees

At December 31, 2006, Sovereign had 10,949 full-time and 1,564 part-time employees. None of these employees are represented by a collective bargaining agreement, and Sovereign believes it enjoys good relations with its personnel.

Competition

Sovereign is subject to substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits include the ability to offer attractive rates, the convenience of office locations, and the availability of alternate channels of distribution. Direct competition for deposits comes primarily from national and state banks, thrift institutions, and broker dealers. Competition for deposits also comes from money market mutual funds, corporate and government securities, and credit unions. The primary factors driving commercial and consumer competition for loans are interest rates, loan origination fees, service levels and the range of products and services offered. Competition for origination of loans normally comes from other thrift institutions, national and state banks, mortgage bankers, mortgage brokers, finance companies, and insurance companies.

Environmental Laws

Environmentally related hazards have become a source of high risk and potentially significant liability for financial institutions relative to their loans. Environmentally contaminated properties owned by an institution’s borrowers may result in a drastic reduction in the value of the collateral securing the institution’s loans to such borrowers, high environmental clean up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean up costs, and liability to the institution for clean up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower. To minimize this risk, Sovereign Bank may require an environmental examination of, and report with respect to, the property of any borrower or prospective borrower if circumstances affecting the property indicate a potential for contamination, taking into consideration the potential loss to the institution in relation to the burdens to the borrower. Such examination must be performed by an engineering firm experienced in environmental risk studies and acceptable to the institution, and the costs of such examinations and reports are the responsibility of the borrower. These costs may be substantial and may deter a prospective borrower from entering into a loan transaction with Sovereign Bank. Sovereign is not aware of any borrower who is currently subject to any environmental investigation or clean up proceeding that is likely to have a material adverse effect on the financial condition or results of operations of the Company.

Supervision and Regulation

     General. Sovereign is a “savings and loan holding company” registered with the Office of Thrift Supervision (“OTS”) under the Home Owners’ Loan Act (“HOLA”) and, as such, Sovereign is subject to OTS oversight and reporting with respect to certain matters. Sovereign Bank is chartered as a federal savings bank, and is highly regulated by the OTS as to all its activities, and subject to extensive OTS examination, supervision, and reporting.

Sovereign Bank is required to file reports with the OTS describing its activities and financial condition and is periodically examined to test compliance with various regulatory requirements. The deposits of Sovereign Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”). Sovereign Bank is also subject to examination by the FDIC. Such examinations are conducted for the purpose of protecting depositors and the insurance fund and not for the purpose of protecting holders of equity or debt securities of Sovereign or Sovereign Bank. Sovereign Bank is a member of the Federal Home Loan Bank (“FHLB”) of Pittsburgh, New England and New York, which are part of the twelve regional banks comprising the FHLB system. Sovereign Bank is also subject to regulation by the Board of Governors of the Federal Reserve System with respect to reserves maintained against deposits and certain other matters.

As a result of the investment in Sovereign by Santander in May, 2006 as described below under “Control of Sovereign,” Sovereign is also now considered a subsidiary of a bank holding company for purposes of the Bank Holding Company Act of 1956, as amended. As such, Sovereign is prohibited from engaging in any activity, directly or through a subsidiary, that is not permissible for subsidiaries of bank holding companies. Generally, financial activities are permissible, while commercial and industrial activities are not.

     Holding Company Regulation. The HOLA prohibits a registered savings and loan holding company from directly or indirectly acquiring control, including through an acquisition by merger, consolidation or purchase of assets, of any savings association (as defined in HOLA to include a federal savings bank) or any other savings and loan holding company, without prior OTS approval. Generally, a savings and loan holding company may not acquire more than 5% of the voting shares of any savings association unless by merger, consolidation or purchase of assets.

Federal law empowers the Director of the OTS to take substantive action when the Director determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of any particular activity constitutes a serious risk to the financial safety, soundness or stability of a savings and loan holding company’s subsidiary savings institution. Specifically, the Director of the OTS may, as necessary, (i) limit the payment of dividends by the savings institution; (ii) limit transactions between the savings institution, the holding company and the subsidiaries or affiliates of either; (iii) limit any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution. Any such limits could be issued in the form of a directive having the legal efficacy of a cease and desist order.

Because Sovereign is also considered a subsidiary of Santander for Bank Holding Company Act purposes, Santander may be required to obtain approval from the Federal Reserve if Sovereign were to acquire shares of any depository institution (bank or savings institution) or any holding company of a depository institution. In addition, Santander may have to provide notice to the Federal Reserve if Sovereign acquires any financial entity that is not a depository institution, such as a lending company.

     Control of Sovereign. Under the Savings and Loan Holding Company Act and the related Change in Bank Control Act (the “Control Act”), individuals, corporations or other entities acquiring Sovereign common stock may, alone or together with other investors, be deemed to control Sovereign and thereby Sovereign Bank. If deemed to control Sovereign, such person or group will be required to obtain OTS approval to acquire Sovereign’s common stock and could be subject to certain ongoing reporting procedures and restrictions under federal law and regulations. Ownership of more than 10% of the capital stock may be deemed to constitute “control” if certain other control factors are present.

In May 2006, Sovereign and Santander entered into an Investment Agreement, in which, (i) Santander purchased from Sovereign 88.7 million shares of Sovereign’s common stock for $2.4 billion in cash, (ii) Santander can increase its ownership up to 24.99% over the next two years subject to certain standstill restrictions and regulatory limitations, and (iii) Santander can after two years, subject to certain exceptions, acquire 100% of Sovereign in a negotiated transaction subject to shareholder approval. The proceeds of the investment were used to acquire the common stock of Independence. This investment was approved by the OTS. If Santander acquires 25% or more of Sovereign’s stock, Sovereign will no longer be a savings and loan holding company and will no longer be regulated by the OTS, although Sovereign Bank will continue to be regulated by the OTS as long as it remains a federal savings bank.

Santander is one of the largest banks in the world by market capitalization. It has over 10,000 offices and a presence in over 40 countries. It is the largest financial group in Spain and Latin America, and has a significant presence elsewhere in Europe, including the United Kingdom through its Abbey subsidiary and Portugal, where it is the third largest banking group. It also operates a leading consumer finance franchise in Germany, Italy, Spain and nine other European countries.

     Regulatory Capital Requirements. OTS regulations require savings associations to maintain minimum capital ratios. These standards are the same as the capital standards that are applicable to other insured depository institutions, such as banks. OTS regulations do not require savings and loan holding companies to maintain minimum capital ratios.

Under the Federal Deposit Insurance Act (“FDIA”), insured depository institutions must be classified in one of five defined categories (well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized). Under OTS regulations, an institution will be considered “well-capitalized” if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a Tier 1 leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level. A savings institution’s capital category is determined with respect to its most recent thrift financial report filed with the OTS. In the event an institution’s capital deteriorates to the undercapitalized category or below, the FDIA and OTS regulations prescribe an increasing amount of regulatory intervention, including the adoption by the institution of a capital restoration plan, a guarantee of the plan by its parent holding company and the placement of a hold on increases in assets, number of branches and lines of business.

If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver or conservator. Critically undercapitalized institutions generally may not, beginning 60 days after becoming critically undercapitalized, make any payment of principal or interest on their subordinated debt. All but well-capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval. Pursuant to the FDIA and OTS regulations, savings associations which are not categorized as well capitalized or adequately-capitalized are restricted from making capital distributions which include cash dividends, stock redemptions or repurchases, cash-out mergers, interest payments on certain convertible debt and other transactions charged to the capital account of a savings association. At December 31, 2006, Sovereign Bank met the criteria to be classified as “well-capitalized.”

     Standards for Safety and Soundness. The federal banking agencies adopted certain operational and managerial standards for depository institutions, including internal audit system components, loan documentation requirements, asset growth parameters, information technology and data security practices, and compensation standards for officers, directors and employees. The implementation or enforcement of these guidelines has not had a material adverse effect on Sovereign’s results of operations.

     Insurance of Accounts and Regulation by the FDIC. Sovereign Bank is a member of the Deposit Insurance Fund, which is administered by the FDIC. Deposits are insured up to the applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the Insurance Fund. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the Office of Thrift Supervision an opportunity to take such action, and may terminate an institution’s deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

In February 2006, the Federal Deposit Insurance Reform Act was enacted. The new law merged the old BIF and SAIF into the single Deposit Insurance Fund, increased deposit insurance coverage for IRAs to $250,000, provides for the further increase of deposit insurance on all accounts by indexing the coverage to the rate of inflation, authorizes the FDIC to set the reserve ratio of the combined Deposit Insurance Fund at a level between 1.15% and 1.50%, and permits the FDIC to establish assessments to be paid by insured banks to maintain the minimum ratios.

In November 2006, the FDIC adopted final regulations to implement the Reform Act. The final regulations include the annual assessment rates that will take effect at the beginning of 2007. The new assessment rates for nearly all banks will vary between five and seven cents for every $100 of domestic deposits. Applied to Sovereign’s assessment base of approximately $50 billion, this translates to an annual deposit premium estimated to be between $25 million and $33 million. Most banks, including Sovereign, have not been required to pay any deposit insurance premiums since 1995. As part of the Reform Act, Congress provided credits to institutions that paid high premiums in the past to bolster the FDIC’s insurance reserves. As a result, according to the FDIC, the majority of banks will have assessment credits to initially offset all of their premiums in 2007. The preliminary assessment credit for Sovereign was calculated at $29 million. The assessment credit will not be recognized up front, but recognized on a go-forward basis only to the extent the credit is used to reduce future deposit premiums that would otherwise be due. Accordingly, we expect the reinstitution of deposit premiums by the FDIC will not have a material effect on our financial condition, results of operations or cash flows in 2007. The level of annual deposit premiums is dependent on the amount of Sovereign’s deposit assessment base. However assuming our deposit base remains at approximately $50 billion in 2008 our annual deposit premiums will increase by approximately $25 million to $33 million per year which will result in higher general and administrative expenses.

In addition to deposit insurance premiums, all insured institutions are required to pay a Financing Corporation assessment, in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. The annual rate (as of the first quarter of 2007) for all insured institutions is $0.122 for every $1,000 in domestic deposits. These assessments are revised quarterly and will continue until the bonds mature in the year 2017.

     Federal Restrictions on Transactions with Affiliates. All banks and savings institutions are subject to affiliate and insider transaction rules applicable to member banks of the Federal Reserve System set forth in the Federal Reserve Act, as well as such additional limitations as the institutions’ primary federal regulator may adopt. These provisions prohibit or limit a savings institution from extending credit to, or entering into certain transactions with, affiliates, principal stockholders, directors and executive officers of the savings institution and its affiliates. For these purposes, the term “affiliate” generally includes a holding company such as Sovereign and any company under common control with the savings institution. In addition, the federal law governing unitary savings and loan holding companies prohibits Sovereign Bank from making any loan to any affiliate whose activity is not permitted for a subsidiary of a bank holding company. This law also prohibits Sovereign Bank from making any equity investment in any affiliate that is not its subsidiary.

     Restrictions on Subsidiary Savings Institution Capital Distributions. Sovereign’s principal sources of funds are cash dividends paid to it by Sovereign Bank, investment income and borrowings. OTS regulations limit the ability of savings associations such as Sovereign Bank to pay dividends and make other capital distributions. Associations that are subsidiaries of a savings and loan holding company must file a notice with the OTS at least 30 days before the proposed declaration of a dividend or approval of the proposed capital distribution by its board of directors. In addition, a savings association must obtain prior approval from the OTS if it fails to meet certain regulatory conditions, or if, after giving effect to the proposed distribution, the association’s capital distributions in a calendar year would exceed its year-to-date net income plus retained net income for the preceding two years or the association would not be at least adequately capitalized or if the distribution would violate a statute, regulation, regulatory agreement or a regulatory condition to which the association is subject.

     Qualified Thrift Lender. All savings institutions are required to meet a qualified thrift lender test to avoid certain restrictions on their operations. The test under the Home Owners Loan Act (HOLA) requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments. As an alternative, the savings institution under HOLA may maintain 60% of its assets in those assets specified in Section 7701(a) (19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans, certain consumer and small business loans, as defined by the regulations, and mortgage related investments. Sovereign Bank is currently in compliance with the qualified thrift lender regulations.

     Other Loan Limitations. Federal law limits the amount of non-residential mortgage loans a savings institution, such as Sovereign Bank, may make. Separate from the qualified thrift lender test, the law limits a savings institution to a maximum of 10% of its assets in large commercial loans (defined as loans in excess of $2 million), with another 10% of assets permissible in “small business loans.” Commercial loans secured by real estate can be made in an amount up to four times an institution’s capital. An institution can also have commercial leases, in addition to the above items, up to 10% of its assets. Commercial paper, corporate bonds, and consumer loans taken together cannot exceed 35% of an institution’s assets. For this purpose, however, residential mortgage loans and credit card loans are not considered consumer loans, and are both unlimited in amount. The foregoing limitations are established by statute, and cannot be waived by the OTS. Sovereign is currently in compliance with these statutes.

     Federal Reserve Regulation. Under Federal Reserve Board regulations, Sovereign Bank is required to maintain a reserve against its transaction accounts (primarily interest-bearing and non interest-bearing checking accounts). Because reserves must generally be maintained in cash or in non-interest-bearing accounts, the effect of the reserve requirements is to reduce an institution’s asset yields.

Numerous other regulations promulgated by the Federal Reserve Board affect the business operations of Sovereign Bank. These include regulations relating to equal credit opportunity, electronic fund transfers, collection of checks, truth in lending, truth in savings, availability of funds, home mortgage disclosure, and margin credit.

     Federal Home Loan Bank System. The FHLB System was created in 1932 and consists of twelve regional FHLBs. The FHLBs are federally chartered but privately owned institutions created by Congress. The Federal Housing Finance Board (“Finance Board”) is an agency of the federal government and is generally responsible for regulating the FHLB System. Each FHLB is owned by its member institutions. The primary purpose of the FHLBs is to provide funding to their members for making housing loans as well as for affordable housing and community development lending. FHLBs are generally able to make advances to their member institutions at interest rates that are lower than could otherwise be obtained by such institutions. Sovereign is a member of FHLB Pittsburgh, New England, and New York and has advances from these FHLBs of $19.6 billion.

     Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of their delineated communities, including low to moderate-income neighborhoods within those communities, while maintaining safe and sound banking practices. A bank’s performance under the CRA is important in determining whether the bank may obtain approval for, or utilize streamlined procedures in, certain applications for acquisitions or to engage in new activities. Sovereign Bank’s lending activities are in compliance with applicable CRA requirements, and Sovereign Bank’s current CRA rating is “outstanding,” the highest category.

     Other Legislation. The Fair and Accurate Credit Transactions Act (“FACTA”) was signed into law on December 4, 2003. This law extends the previously existing Fair Credit Reporting Act. New provisions added by FACTA address the growing problem of identity theft. Consumers will be able to initiate a fraud alert when they are victims of identity theft, and credit reporting agencies will have additional duties. Consumers will also be entitled to obtain free credit reports, and will be granted certain additional privacy rights. The Check 21 Act was also enacted in late 2003. This Act affects the way checks are processed in the banking system, allowing payments to be processed electronically rather than as traditional paper checks.

On July 30, 2002, the Sarbanes-Oxley Act (“Sarbanes-Oxley”) was enacted. This act is not a banking law, but applies to all public companies, including Sovereign. Sarbanes-Oxley is designed to restore investor confidence by assuring proper corporate governance is applied to all publicly traded companies. Sarbanes-Oxley adopted new standards of corporate governance and imposed new requirements on the board and management of public companies. The chief executive officer and chief financial officer of a public company must now certify the financial statements of the company.

New definitions of “independent directors” have been adopted, and new responsibilities and duties have been established for the audit and other committees of the board of directors. In addition, the reporting requirements for insider stock transactions have been revised, requiring most transactions to be reported within two business days. While complying with Sarbanes-Oxley has resulted in increased costs to Sovereign, the additional costs did not have a material effect on results of operations.

In addition to the legislation discussed above, Congress is often considering some financial industry legislation, and the federal banking agencies routinely propose new regulations. New legislation and regulation may include dramatic changes to the federal deposit insurance system. Sovereign cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.

     Corporate Information. All reports filed electronically by Sovereign Bancorp, Inc. with the United States Securities and Exchange Commission (SEC), including the annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, as well as any amendments to those reports, are accessible at no cost on the Corporation’s Web site at www.sovereignbank.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. These filings are also accessible on the SEC’s Web site at www.sec.gov. Also, copies of the company’s annual report will be made available, free of charge, upon written request.

Item 1A — Risk Factors

The following list describes several risk factors that are applicable to our Company:

•

An Economic Downturn May Lead to a Deterioration in Our Asset Quality and Adversely Affect Our Earnings and Cash Flow.

     Our business faces various material risks, including credit risk and the risk that the demand for our products will decrease. In a recession or other economic downturn, these risks would probably become more acute. In an economic downturn, our credit risk and legal expense will increase. Also, decreases in consumer confidence, real estate values, and interest rates, usually associated with a downturn, could combine to make the types of loans we originate less profitable.

•

The Preparation of Sovereign’s Financial Statements Requires the Use of Estimates That May Vary From Actual Results.

     The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make significant estimates that affect the financial statements. One example of a significant critical estimate is the level of the allowance for credit losses. Due to the inherent nature of this estimate, Sovereign cannot provide absolute assurance that it will not significantly increase the allowance for credit losses and/or sustain credit losses that are significantly higher than the provided allowance.

•

Changing Interest Rates May Adversely Affect Our Profits.

     To be profitable, we must earn more money from interest on loans and investments and fee-based revenues than the interest we pay to our depositors and creditors and the amount necessary to cover the cost of our operations. Rising interest rates may hurt our income because they may reduce the demand for loans and the value of our investment securities and our loans, and increase the amount that we must pay to attract deposits and borrow funds. If interest rates decrease, our net interest income could be negatively affected if interest earned on interest-earning assets, such as loans, mortgage-related securities, and other investment securities, decreases more quickly than interest paid on interest-bearing liabilities, such as deposits and borrowings. This would cause our net interest income to go down. In addition, if interest rates decline, our loans and investments may prepay earlier than expected, which may also lower our income. Interest rates do and will continue to fluctuate, and we cannot predict future Federal Reserve Board actions or other factors that will cause rates to change. If the yield curve steepens or flattens, it could impact our net interest income in ways management may not accurately predict.

•

We Experience Intense Competition for Loans and Deposits.

     Competition among financial institutions in attracting and retaining deposits and making loans is intense. Our most direct competition for deposits has come from commercial banks, savings and loan associations and credit unions doing business in our areas of operation, as well as from nonbanking sources, such as money market mutual funds and corporate and government debt securities. Competition for loans comes primarily from commercial banks, savings and loan associations, consumer finance companies, insurance companies and other institutional lenders. We compete primarily on the basis of products offered, customer service and price. A number of institutions with which we compete have greater assets and capital than we do and, thus, may have a competitive advantage.

•

We Are Subject to Substantial Regulation Which Could Adversely Affect Our Business and Operations.

     As a financial institution, we are subject to extensive regulation, which materially affects our business. Statutes, regulations and policies to which we and Sovereign Bank are subject may be changed at any time, and the interpretation and the application of those laws and regulations by our regulators is also subject to change. There can be no assurance that future changes in regulations or in their interpretation or application will not adversely affect us.

     The regulatory agencies having jurisdiction over banks and thrifts have under consideration a number of possible rulemaking initiatives which impact on bank and thrift and bank and thrift holding company capital requirements. Adoption of one or more of these proposed rules could have an adverse effect on us and Sovereign Bank.

     Existing federal regulations limit our ability to increase our commercial loans. We are required to maintain 65% of our assets in residential mortgage loans and certain other loans, including small business loans. We also cannot have more than 10% of our assets in large commercial loans that are not secured by real estate, more than 10% in small business loans, or more than four times our capital in commercial real estate loans. A small business loan is one with an original loan amount of less than $2 million, and a large commercial loan is a loan with an original loan amount of $2 million or more. Because commercial loans generally yield interest income which is higher than residential mortgage loans, the amount of our interest income could be adversely affected by these provisions. If the growth of our commercial loan portfolio continues at its current rate, we may exceed these regulatory limitations, requiring us to reduce the size of our commercial loan portfolio or take other actions which may adversely affect our net income.

•

Changes in Accounting Standards could Impact Reported Earnings.

     The accounting standard setters, including the FASB, SEC and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of Sovereign’s consolidated financial statements. These changes can be hard to predict and can materially impact how it records and reports its financial condition and results of operations. In some cases, Sovereign could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.

•

Difficulties in combining the operations of acquired entities with Sovereign’s own operations may prevent Sovereign from achieving the expected benefits from its acquisitions.

     Sovereign may not be able to achieve fully the strategic and operating efficiencies in an acquisition. Inherent uncertainties exist in the operations of an acquired entity. In addition, the market conditions where Sovereign and its potential acquisition targets operate are highly competitive. Although Sovereign has a strong track record in integrating acquired entities, it is possible that Sovereign may lose customers or the customers of acquired entities as a result of an acquisition. Sovereign may also lose key personnel, either from the acquired entity or from itself, as a result of an acquisition. These factors could contribute to Sovereign not achieving the expected benefits from its acquisitions within desired time frames, if at all.

•

Our cost saving initiatives which began being implemented at the end of 2006 and will continue in 2007 may take longer to implement than anticipated or may lead to unintended consequences.

     Our future results are likely to be affected significantly by the implementation and execution of our cost savings initiative plans. They are expected to reduce Sovereign’s operating expenses by approximately $100 million annually. Approximately $80 million of this savings is anticipated to be realized in 2007. If our plan is not realized timely or if the execution of this plan results in actions that lead to reductions in revenue, the benefits of this initiative may not meet our expectations.

•

Sovereign’s plans to sell the majority of the home equity correspondent loan portfolio and a portion of the multi-family loan portfolio may take longer than anticipated, may be sold at prices lower than anticipated or may not occur in their entirety.

     Our future results are likely to be affected significantly by the execution of our balance sheet restructuring plan, which will allow Sovereign to allocate capital to businesses with the highest risk adjusted returns. In addition, we will diversify the balance sheet to ensure the bank is not overly sensitive to certain interest rate or economic environments. As part of helping to meet these objectives, Sovereign intends to sell approximately $4.3 billion of home equity correspondent loans and $1.5 billion of lower yielding multifamily loans, and reduce our wholesale liabilities in 2007 with the proceeds from these sales. If these sales are not realized timely, if a portion of the sales do not occur, or if the execution of these sales results in pricing significantly lower than anticipated, the full benefits of this initiative may not meet our expectations and/or may require additional material charges to earnings.

Item 1B — Unresolved Staff Comments

None.

Item 2 — Properties

Sovereign Bank utilizes 884 buildings that occupy a total of 6.5 million square feet, including 259 owned properties with 2.0 million square feet and 625 leased properties with 4.5 million square feet. Eight major buildings contain 1.3 million square feet, which serve as the headquarters or house significant operational and administrative functions:

          Columbia Park Operations Center — Dorchester, Massachusetts

          195 Montague Street Regional Headquarters for New York Metro — Brooklyn, New York

          East Providence Call Center and Operations and Loan Processing Center — East Providence, Rhode Island

          75 State Street Regional Headquarters for Sovereign Bank of New England — Boston, Massachusetts

          405 Penn Street Sovereign Plaza Call Center and Operations and Loan Processing Center - Reading, Pennsylvania

          601 Penn Street Loan Processing Center — Reading, Pennsylvania

          1130 Berkshire Boulevard Bank Headquarters and Administrative Offices — Wyomissing, Pennsylvania

          1125 Berkshire Boulevard Operations Center — Wyomissing, Pennsylvania

The majority of the properties of Sovereign outlined above are utilized by our shared services consumer bank segment and those utilized for general corporate purposes by our other segment.

Item 3 — Legal Proceedings

Sovereign is not involved in any pending material legal proceeding other than routine litigation occurring in the ordinary course of business. Sovereign does not expect that any amounts that it may be required to pay in connection with these matters would have a material adverse effect on its financial position.

Item 4 — Submission of Matters to a Vote of Security Holders

None.

Item 4A — Executive Officers of the Registrant

Certain information, including principal occupation during the past five years, relating to the principal executive officers of Sovereign, as of the date of this filing are set forth below:

Joseph P. Campanelli — Age 50. Mr. Campanelli became President and Chief Executive Officer of Sovereign and Sovereign Bank in October 2006. He was appointed Vice Chairman of Sovereign in September 2002. Mr. Campanelli was named President and Chief Executive Officer of SBNE effective January 1, 2005. In May 2002, Mr. Campanelli was appointed President and Chief Operating Officer of Sovereign Bank’s Commercial Markets Group. Prior to becoming President and Chief Operating Officer of Sovereign Bank’s Commercial and Business Banking Division in May 2001, Mr. Campanelli was appointed President and Chief Operating Officer of SBNE in January 2000. Mr. Campanelli joined Sovereign as Executive Vice President in September 1997 through Sovereign’s acquisition of the Fleet Automotive Finance Division and assumed the role of Managing Director of Sovereign’s Automotive Finance Division and the Asset Based Lending Group.

Mark R. McCollom — Age 43. In May 2005, Mr. McCollom was named Chief Financial Officer of Sovereign Bancorp. Mr. McCollom has been with Sovereign since 1996 holding several positions within the company including Managing Director of Corporate Planning, Chief Financial Officer of Sovereign Bank and Chief Accounting Officer.

James Lynch — Age 57. Mr. Lynch was appointed Vice Chairman of Sovereign in February 2006. Mr. Lynch joined Sovereign as Chairman and CEO of Sovereign Bank Mid-Atlantic Division in September 2002. Prior to Sovereign, in 1996, Mr. Lynch was President and CEO of Prime Bancorp, Inc. and Prime Bank. He also became Chairman of Prime Bancorp, Inc. in 1997 until it merged with Summit Bancorp, Inc. in 1999. At Summit, Mr. Lynch served as Senior Executive Vice President of Summit Bancorp and the Chairman and CEO of Summit Bank — Pennsylvania until it merged with FleetBoston Financial in March 2001, where he acted as the President and CEO of Fleet Bank — Pennsylvania until joining Sovereign.

Salvatore J. Rinaldi — Age 52. Mr. Rinaldi was appointed Executive Vice President and Chief of Staff to Sovereign’s Chief Executive Officer in 2007. As Chief of Staff, he oversees Sovereign Bank’s strategic planning and administration activities, including the company’s technology, legal, CRA, and security groups. In addition, he is responsible for overseeing the bank’s conversion and integration management activities. In this role Rinaldi also supervises the operations, documentation, collections, and risk reviews processes for the bank’s middle market, specialty lending and auto finance groups. Prior to joining Sovereign in 1997, Rinaldi served nearly 24 years in a variety of senior positions with Fleet and Shawmut Banks. His responsibilities included dealer floorplan and indirect auto finance operations, collections, underwriting, audit, strategic planning and budgeting.

Robert M. Rose — Age 55. Mr. Rose has served as Credit Risk Management Officer and Executive Vice President of Sovereign since May 2004 and Executive Vice President and Regulation O Officer of Sovereign Bank since May 2004. Previously, Mr. Rose had served as Chief Credit Policy Officer and Executive Vice President of Sovereign from May 2002 until May 2004 and Chief Credit Officer and Senior Vice President of Sovereign from 2000 until May 2002.

PART II

Item 5 — Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Sovereign’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “SOV.” At February 16, 2007, the total number of record holders of Sovereign’s common stock was 22,574.

Market and dividend information for Sovereign’s common stock appear in Item 7 of this Form 10-K.

Sovereign expects to continue its policy of paying regular cash dividends, although there is no assurance as to future dividends because they depend on future earnings, capital requirements, and financial condition. In addition, for certain limitations on the ability of Sovereign Bank to pay dividends to Sovereign, see Part I, Item I, “Business Supervision and Regulation — Regulatory Capital Requirements” and Note 15 at Item 8, “Financial Statements and Supplementary Data.”

The table below summarizes the Company’s repurchases of common equity securities during the quarter ended December 31, 2006:

Average

Total Number of

Maximum Number of

Total

Price

Shares Purchased as

Shares that may be

Number of

Paid

Part of Publicly

Purchased Under

Shares

Per

Announced Plans or

the Plans or

Period

Purchased

Share

Programs (1)

Programs (1)

10/1/06 through 10/31/06

1,147

$

21.03

Not Applicable

19,500,000

11/1/06 through 11/30/06

—

$

—

Not Applicable

19,500,000

12/1/06 through 12/31/06

431

$

23.06

Not Applicable

19,500,000

Sovereign does occasionally repurchase its common securities on the open market to fund equity compensation plans for its employees. Additionally, Sovereign repurchases its shares from employees who surrender a portion of their shares received through the Company’s stock based compensation plans to cover their associated minimum income tax liabilities. Sovereign repurchased 1,578 shares outside of publicly announced repurchase programs during the fourth quarter of 2006.

Item 6 — Selected Financial Data

		SELECTED FINANCIAL DATA
		AT OR FOR THE YEAR ENDED DECEMBER 31,
(Dollars in thousands, except per share data)		2006				2005				2004				2003				2002
Balance Sheet Data
Total assets		$	89,641,849			$	63,678,726			$	54,489,026			$	43,517,433			$	39,601,034
Loans held for investment, net of allowance			54,505,645				43,072,670				36,102,598				25,695,715				22,905,056
Loans held for sale(1)			7,611,921				311,578				137,478				137,154				382,055
Investment securities			14,877,640				12,557,328				11,546,877				12,618,971				11,366,077
Deposits and other customer accounts			52,384,554				37,977,706				32,555,518				27,344,008				26,851,089
Borrowings and other debt obligations			26,849,717				18,720,897				16,140,128				12,197,603				8,829,289
Stockholders’ equity		$	8,644,399			$	5,810,699			$	4,988,372			$	3,260,406			$	2,764,318
Summary Statement of Operations
Total interest income(5)		$	4,326,404			$	2,962,587			$	2,255,917			$	1,951,888			$	2,076,654
Total interest expense(2)			2,504,856				1,330,498				819,327				724,123				899,924
Net interest income(5)			1,821,548				1,632,089				1,436,590				1,227,765				1,176,730
Provision for credit losses(1)			484,461				90,000				127,000				161,957				146,500
Net interest income after provision for credit losses(5)			1,337,087				1,542,089				1,309,590				1,065,808				1,030,230
Total non-interest income(1) (5)			285,574				602,664				450,525				499,439				413,071
General and administrative expenses			1,289,989				1,089,204				942,661				852,364				813,784
Other expenses(1) (2)			313,541				163,429				236,232				157,984				162,962
Income before income taxes			19,131				892,120				581,222				554,899				466,555
Income tax provision (benefit)			(117,780	)			215,960				127,670				153,048				124,570
Net Income(4)		$	136,911			$	676,160			$	453,552			$	401,851			$	341,985
Share Data
Common shares outstanding at end of period (in thousands)(3)			473,755				358,018				345,775				293,111				261,624
Basic earnings per share(3) (4)		$	0.30			$	1.77			$	1.34			$	1.38			$	1.26
Diluted earnings per share(3) (4)		$	0.30			$	1.69			$	1.29			$	1.32			$	1.17
Common share price at end of period		$	25.39			$	20.59			$	21.48			$	22.62			$	13.38
Dividends declared per common share		$	.300			$	.170			$	.115			$	.100			$	.100
Selected Financial Ratios
Book value per common share(6)		$	17.83			$	15.46			$	13.74			$	10.59			$	10.06
Common dividend payout ratio(7)			92.11	%			9.02	%			8.21	%			6.99	%			7.62	%
Return on average assets(8)			0.17	%			1.11	%			.90	%			.97	%			.91	%
Return on average equity(9)			1.82	%			11.92	%			10.74	%			13.41	%			13.50	%
Average equity to average assets(10)			9.46	%			9.34	%			8.36	%			7.24	%			6.71	%

Management’s Discussion and Analysis

Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

EXECUTIVE SUMMARY

Sovereign, is a $90 billion financial institution as of December 31, 2006, with community banking offices, operations and team members located principally in Pennsylvania, Massachusetts, New Jersey, Connecticut, New Hampshire, New York, Rhode Island, and Maryland. Sovereign gathers substantially all of its deposits in these market areas. We use these deposits, as well as other financing sources, to fund our loan and investment portfolios. We earn interest income on our loans and investments. In addition, we generate non-interest income from a number of sources including deposit and loan services, sales of loans and investment securities, capital markets products and bank-owned life insurance. Our principal non-interest expenses include employee compensation and benefits, occupancy and facility-related costs, technology and other administrative expenses. Our volumes, and accordingly our financial results, are affected by the economic environment, including interest rates, consumer and business confidence and spending, as well as the competitive conditions within our geographic footprint.

We are one of the top 20 largest banking institutions in the United States based on asset size. Our customers select Sovereign for banking and other financial services based on our ability to assist customers by understanding and anticipating their individual financial needs and providing customized solutions. Our major strengths include: strong franchise value in terms of market share and demographics; diversified loan portfolio and products; and the ability to internally generate equity through earnings. Our weaknesses have included financial performance metrics and capital ratios that are lower than certain of our peers. Additionally, our operating expense levels are higher than we desire and we have not achieved our growth targets with respect to low cost core deposits.

Management is in the process of implementing strategies to address these weaknesses. Now that Sovereign has successfully merged the operations and processes of Independence into Sovereign, management has completed a comprehensive review of Sovereign’s operating cost structure and established a restructuring plan, which was approved by Sovereign’s Board of Directors in the fourth quarter of 2006. We believe the restructuring plan focuses on a number of strategies which will help to strengthen our capital position and related capital ratios which have decreased following the Independence acquisition and improve our financial performance. Management has developed the following key initiatives to deliver improved quality of earnings, provide greater transparency and understanding of Sovereign’s businesses and strategy, and better position Sovereign for sustainable growth.

The three initiatives are to:

1. Improve productivity and expense management

2. Improve the capital position and quality of earnings

3. Improve the customer experience

In the productivity and expense management initiative we are focused on eliminating functional redundancies and improving operating inefficiencies by deemphasizing products/business lines not meeting profit or strategic goals, leveraging economies of scale with vendor supply and service contracts, optimizing capacity utilization and expenses associated with facilities, consolidating departments and optimizing retail delivery channels while minimizing the impact on customer facing activities and organic revenue generation. Management has identified approximately $100 million of expense reductions involving consolidation of support groups, exit of business lines performing below expectations, contract renegotiations, and a reduction in workforce.

In mid-December, Sovereign notified approximately 360 employees that their positions had been eliminated. Additionally, we expect that approximately 400 positions will be eliminated primarily through attrition by the third quarter of 2007 and the Company does not plan on filling approximately 140 open positions. Finally, certain members of Sovereign’s executive management team resigned in the fourth quarter. Sovereign recorded pre-tax severance charges of $63.9 million due to these events. We will also be closing approximately 40 underperforming branch locations during 2007. We intend to continue to make investments in our retail franchise and are targeting the opening or relocation of 18 new branch offices in 2007 and 22 new branch offices in 2008 in more desirable locations.

In order to improve our capital position, Sovereign intends to sell approximately $10 billion of low margin and/or high credit risk assets and reduce our wholesale fundings significantly in 2007 with the proceeds from these sales. This should enhance the quality of our balance sheet, improve the quality of our earnings, and enhance our capital ratios while repositioning Sovereign for sustainable growth in earnings over the long-term. However, these balance sheet restructuring and expense savings initiatives have and will result in Sovereign recording material charges to our earnings. In the fourth quarter of 2006, Sovereign recorded a total of $412 million of pre-tax charges to its income statement in connection with the balance sheet restructuring and expense savings initiative plans. We anticipate additional pre-tax charges in 2007 of approximately $100 million as we complete our restructuring plan. However, this amount is subject to change based on the execution of our cost savings initiatives.

In order to improve the customer experience, Sovereign’s strategy is to acquire and retain customers by demonstrating convenience through our locations, technology and business approach while offering innovative and easy-to-use products and service. Customer service personnel will receive refresher service training and we have migrated back to all customer service functions being domestically based. We will realign consumer and commercial infrastructure by consolidating our commercial and retail on-line banking management structure. The plan also includes rationalizing and simplifying our retail deposit product set. During 2006, Sovereign completed the branding of approximately 1,050 ATM machines in CVS Pharmacy locations in the Northeast. This more than doubled the number of branded ATM locations and provides greater convenience for our customers. We also announced an agreement with OPEN from American Express, the company’s small business unit, to offer co-branded American Express Cards to Sovereign’s small business customers. This relationship will generate an additional source of fee revenue for Sovereign and will enable us to leverage the American Express brand to help Sovereign generate core deposits and build and retain small-business relationships. We also entered into an alliance with ADP, the country’s leading payroll services provider. With this partnership, ADP provides approximately 200 dedicated representatives throughout our footprint to assist our commercial relationship managers in providing payroll solutions for our business customers.

We experienced a challenging year in 2006 as the Company generated net income of $136.9 million compared with $676.2 million in 2005. Current year earnings were reduced (in addition to the restructuring charges already discussed) in part because of merger-related charges of $42.8 million associated with the Independence acquisition. Additionally, following the Independence acquisition, Sovereign sold $3.5 billion of investment securities for asset/liability purposes, to maintain compliance with its existing interest rate policies and guidelines and to offset, in part, the negative effect of the current yield curve on net interest margin for future periods. In connection with the sale, Sovereign incurred a $238.3 million pretax loss ($154.9 million after tax). Additionally, during the second quarter of 2006, Sovereign recorded an other-than-temporary impairment charge of $67.5 million on FNMA and FHLMC preferred stock. See Note 6 for additional details.

In connection with management’s plan to improve the financial prospects of the Company mentioned earlier, several significant charges to earnings were recorded in the fourth quarter of 2006. We decided to sell the majority of our remaining correspondent home equity loan portfolio a business that we had exited in early 2006.

Although these loans represented 11% of our average loan portfolio over the first nine months of 2006, they accounted for 50% of the Company’s total net charge-offs during this time period. In the prior year, these loans represented 15% of our average loan portfolio in 2005 and represented 26% of our 2005 charge-offs. The portfolio historically also experienced a high level of prepayments which caused us to write off the associated purchase premium on these loans. This negatively impacted our net interest margin and caused a higher level of volatility in our earnings stream. The loans were also held by customers outside of Sovereign’s branch footprint and as a result, it was difficult to cross-sell any other products to these customers. Due to these factors, we decided to sell these loans prior to year end and are negotiating the sale of the loans which we anticipate will occur in 2007. For accounting purposes, we were required to classify these loans as held for sale and as such needed to write them down to their estimated fair market value (based on the preliminary pricing negotiated with the potential buyers of the loans) as of December 31, 2006. Sovereign recorded a pretax charge of $296 million ($192 million after tax) in the fourth quarter of 2006 which was recorded as additional provision for credit losses due to the determination that this reduction in fair value was primarily associated with credit factors and not interest rates.

Additionally as a result of the recent restructuring plan, management decided to sell approximately $2.9 billion of purchased residential real estate loans and $1.5 billion of low yielding available for sale investment securities. These actions resulted in pretax charges to earnings of $28.2 million and $43 million, respectively. The purchased residential real estate loan sale will settle in the first quarter, however Sovereign entered into this trade right before December 31, 2006 and as a result classified these loans as held for sale and recorded a charge to write them down to their estimated fair value. Management also sold $0.5 billion of lower yielding multifamily loans in the fourth quarter. This sale did not have a significant impact on the results of our operations in 2006. The proceeds from the asset sales mentioned above will be used to pay down FHLB short-term borrowings and high cost brokered money markets whose funding costs are approximately 5.25%.

Our net interest margin decreased in 2006 as a result of an unfavorable shift into higher cost deposit products and the interest rate environment. In 2006, our net interest margin declined to 2.75% from 3.17% in 2005 due largely to the impact of slower than anticipated core deposit growth rates and an increasing asset mix of lower yielding fixed rate loans. Additionally, the average interest rate spread between the 3-month Treasury bill and the 10-year Treasury note compressed from 108 basis points in 2005 to a negative 5 basis points in 2006 illustrating the relative pressure between shorter term and longer term funding costs and loan and investment security reinvestment opportunities. Sovereign’s net interest income did increase $189.5 million to $1.8 billion in 2006 as a result of the increase in interest earning assets from the Independence acquisition. See “Results of Operations for December 31, 2006 and 2005” in this MD&A for more details as to the factors, which affect year-over-year performance.

RECENT INDUSTRY CONSOLIDATION IN OUR GEOGRAPHIC FOOTPRINT

The Banking industry has experienced significant consolidation in recent years, which is likely to continue in future periods. Consolidation may affect the markets in which Sovereign operates as new or restructured competitors integrate acquired businesses, adopt new business practices or change product pricing as they attempt to maintain or grow market share. Recent merger activity involving national, regional and community banks and specialty finance companies in the Northeastern United States, including acquisitions by Sovereign, have affected the competitive landscape in the markets we serve. Sovereign acquired Independence on June 1, 2006 which we believe strengthens our franchise and extends our operations to New York, a major market in the Northeast where we did not have significant operations previously. Management continually monitors the environment in which it operates to assess the impact of the industry consolidation on Sovereign, as well as the practices and strategies of our competition, including loan and deposit pricing, customer expectations and the capital markets.

CURRENT INTEREST RATE ENVIRONMENT

Net interest income represents a significant portion of the Company’s revenues. Accordingly, the interest rate environment has a substantial impact on Sovereign’s earnings. Sovereign currently has a liability sensitive interest rate risk position. The impact of the flattening to inverted yield curve that has been experienced in 2006 has negatively impacted our margin since the spread between our longer-term assets and our shorter-term liabilities has contracted. The flat to inverted yield curve, coupled with low-cost core deposit increases not meeting our targets, has resulted in net interest margin compression to 2.75% for the year ended December 31, 2006 compared to 3.17% in the prior year. We anticipate that when the balance sheet restructuring occurs our net interest margin will increase by approximately 20 to 25 basis points in 2007. Our 2007 net interest margin will also be impacted by our ability to grow and retain core deposits and the future interest rate environment. We would expect to benefit from any substantial sustained expansion between long-term and short-term interest rates, and if we are able to grow low-cost core deposits. See our discussion of Asset and Liability Management practices in a later section of this MD&A, including the estimated impact of changes in interest rates on Sovereign’s net interest income.

CREDIT RISK ENVIRONMENT

The credit quality of our loan portfolio has a significant impact on our operating results. With the exception of our correspondent home equity loan portfolio which the company decided to sell in December 2006, we have experienced stable trends in certain key credit quality performance indicators over the past few years. In addition to our credit risk mitigation programs, the improvement is due, in part, to the economic conditions in our geographic footprint. We believe the credit risk with respect to our investment portfolio is low. Any significant change in the credit quality of our loan portfolio would have a significant effect on our financial position and results of operations. While credit quality metrics have remained stable throughout the majority of 2006, we did experience a mild weakening in the fourth quarter of 2006. However, our credit quality metrics are by historical standards very favorable. We do not expect this very favorable credit performance to continue in future periods indefinitely and would expect to see an increase in losses in future periods.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005

		YEAR ENDED DECEMBER 31,
(Dollars in thousands, except per share data)		2006				2005
Net interest income		$	1,821,548			$	1,632,089
Provision for credit losses			484,461				90,000
Total non-interest income			285,574				602,664
General and administrative expenses			1,289,989				1,089,204
Other expenses			313,541				163,429
Net income		$	136,911			$	676,160
Basic earnings per share		$	0.30			$	1.77
Diluted earnings per share		$	0.30			$	1.69

The major factors affecting comparison of earnings and diluted earnings per share between 2006 and 2005 were:

	•		The growth in net interest income was driven by the increase in the balance of earning assets, as a result of the Independence acquisition as well as organic balance sheet growth, partially offset by a decline in net interest margin to 2.75% in 2006 from 3.17% in 2005. The decline in margin was due to the flattening yield curve, which has contracted the spread between our longer-term assets and shorter—term liabilities and a lack of low cost core deposit growth which has forced the Company to fund asset growth with higher cost borrowings and wholesale deposit obligations.
	•		Included in non-interest income:

	(1)		Net losses on investment securities of $238.3 million on the sale of investment securities and an other-than-temporary impairment charge of $67.5 million on FNMA and FHLMC Preferred Stock in the second quarter of 2006 and a $43.0 million loss on the sale of $1.5 billion of available for sale investments as part of the balance sheet restructuring in the fourth quarter of 2006. See Note 6 for additional details.
	(2)		An increase in consumer and commercial fee income in 2006 of $49.1 million. The continued growth in fee income in consumer and commercial banking is due to loan and deposit growth as a result of Independence acquisition as well as strong growth in commercial loans.
	(3)		A decrease in mortgage banking revenues in 2006 of $63.9 million is due to a $28.2 million lower of cost or market adjustment related to the previously mentioned $2.9 billion residential real estate portfolio that is classified as held for sale. In 2005, Sovereign also sold $1.4 billion of home equity loans and recognized a gain of $32.1 million. Sovereign did not recognize any gains associated with sales of home equity loans in 2006.

•

Other expenses have increased due primarily to employee severance and restructuring charges of $78.7 million in 2006 compared to only $4.0 million in 2005. Additionally, merger-related charges of $42.4 million were incurred in 2006, compared to charges of $12.7 million in 2005.

•

The increase in provision for credit losses in 2006 is primarily related to the previously mentioned lower of cost or market adjustment for the correspondent home equity portfolio in the fourth quarter. Since the loss was determined to be solely related to credit deterioration, Sovereign recorded an additional provision of $296 million.

•

Sovereign recorded an income tax (benefit) of $117.8 million in 2006, compared to an income tax provision of $216.0 million in 2005. The reason for the variance was due to the low level of pre-tax earnings in 2006 due to the aforementioned restructuring and other significant charges in 2006, which have magnified the impact of our favorable permanent tax-free items. See a later section of the MD&A for further discussion.

•

Increases in general and administrative expenses were due primarily to the Independence acquisition.

     Net Interest Income. Net interest income for 2006 was $1.82 billion compared to $1.63 billion for 2005, or an increase of 11.6%. The increase in net interest income in 2006 was due to an increase in average interest-earning assets of $16.0 billion, which was related to the 2006 Independence acquisition and organic loan growth primarily in the commercial and residential mortgage portfolios. The increase in our assets was funded principally by time deposits and other borrowings. Net interest margin (net interest income divided by average interest-earning assets) was 2.75% for 2006 compared to 3.17% for 2005. The decline in margin was driven by the flattening yield curve experienced in 2006 and 2005, which has contracted the spread between our longer-term assets and shorter-term liabilities and a shift to higher-cost wholesale deposits and borrowing obligations.

Interest on investment securities and interest-earning deposits was $775 million for 2006 compared to $576 million for 2005. The increase in interest income was due to an increase in the average balance of investment securities from $12.2 billion in 2005 to $14.6 billion in 2006, as well as higher yields in 2006 which averaged 5.82% compared to 5.12% in 2005.

Interest on loans was $3.55 billion and $2.39 billion for 2006 and 2005, respectively. The average balance of loans was $55.2 billion with an average yield of 6.45% for 2006 compared to an average balance of $41.5 billion with an average yield of 5.76% for 2005. The increase in average yields year to year is due to the increase of market rates experienced during 2006. The overall growth in total loans resulted from the Independence acquisition and from origination activity in commercial loans. At December 31, 2006, approximately 30% of our loan portfolio reprices monthly or more frequently.

Interest on total deposits was $1.37 billion for 2006 compared to $625 million for 2005. The average balance of deposits was $41.2 billion with an average cost of 3.33% for 2006 compared to an average balance of $31.2 billion with an average cost of 2.00% for 2005. Additionally, the average balance of non-interest bearing deposits increased to $6.0 billion in 2006 from $5.3 billion in 2005. The increase in the average balance of deposits was due to the acquisition of Independence.

Interest on borrowings and other debt obligations was $1.13 billion for 2006 compared to $706 million for 2005. The average balance of total borrowings and other debt obligations was $23.4 billion with an average cost of 4.85% for 2006 compared to an average balance of $17.7 billion with an average cost of 3.99% for 2005. The increase in the cost of funds on borrowings and other debt obligations resulted principally from the higher rates on short-term sources of funding including repurchase agreements and overnight FHLB advances due to an increase in short-term interest rates.

Table 1 presents a summary on a tax equivalent basis of Sovereign’s average balances, the yields earned on average assets and the cost of average liabilities for the years indicated (in thousands):

Table 1: Net Interest Margin

		YEAR ENDED DECEMBER 31,
		2006												2005												2004
		Average								Yield/				Average								Yield/				Average								Yield/
		Balance				Interest				Rate				Balance				Interest				Rate				Balance				Interest				Rate
Interest-earning assets:
Interest-earning deposits		$	285,382			$	13,897				4.87	%		$	155,672			$	5,717				3.67	%		$	135,338			$	2,153				1.59	%
Investment securities(1)
Available for sale			11,217,296				658,966				5.87				7,404,848				385,158				5.20				10,320,377				521,084				5.05
Held to maturity			2,248,565				125,886				5.60				4,062,700				217,889				5.36				3,309,530				167,455				5.06
Other			849,040				51,414				6.06				623,005				18,058				2.90				477,010				8,789				1.84
Total investments			14,600,283				850,163				5.82				12,246,225				626,822				5.12				14,242,255				699,481				4.91
Loans:
Commercial loans(3)			20,833,022				1,489,484				7.15				15,904,425				983,461				6.18				12,530,293				624,984				4.99
Multifamily			3,612,737				224,290				6.21				—				—				—				—				—				—
Consumer:
Residential mortgages(3)			15,770,676				888,546				5.63				10,588,935				568,831				5.37				6,215,557				329,546				5.30
Home equity loans and lines of credit(3)			10,119,375				654,760				6.47				10,157,824				567,548				5.59				7,828,671				405,670				5.18
Total consumer loans secured by real estate(3)			25,890,051				1,543,306				5.96				20,746,759				1,136,379				5.48				14,044,228				735,216				5.24
Auto loans			4,457,932				266,806				5.98				4,356,121				233,283				5.36				3,891,325				209,660				5.39
Other			452,029				37,201				8.23				535,616				40,468				7.56				465,908				34,107				7.32
Total Consumer			30,800,012				1,847,313				6.00				25,638,496				1,410,130				5.50				18,401,461				978,983				5.32
Total loans			55,245,771				3,561,087				6.45				41,542,921				2,393,591				5.76				30,931,754				1,603,967				5.19
Allowance for loan losses			(489,775	)			—				—				(420,879	)			—				—				(359,920	)			—				—
Net loans(1)(2)			54,755,996				3,561,087				6.50				41,122,042				2,393,591				5.82				30,571,834				1,603,967				5.25
Total interest-earning assets			69,356,279				4,411,250				6.36				53,368,267				3,020,413				5.66				44,814,089				2,303,448				5.14
Non-interest-earning assets			10,139,116				—				—				7,363,707				—				—				5,744,518				—				—
Total assets		$	79,495,395			$	4,411,250				5.55	%		$	60,731,974			$	3,020,413				4.97	%		$	50,558,607			$	2,303,448				4.56	%
Interest-bearing liabilities:
Deposits:
NOW accounts		$	5,990,180			$	70,303				1.17	%		$	5,296,828			$	33,232				0.63	%		$	4,632,908			$	19,012				0.41	%
NOW accounts — government and wholesale			4,293,111				215,557				5.02				3,435,963				120,045				3.49				2,111,905				37,491				1.78
Customer repurchase agreements			1,229,845				55,158				4.48				887,614				24,230				2.73				834,636				7,462				0.89
Savings accounts			4,286,355				29,660				0.69				3,779,333				25,347				0.67				3,498,539				19,417				0.56
Money market accounts			10,904,581				362,969				3.33				8,244,406				131,354				1.59				7,633,932				81,992				1.07
Certificates of deposits			9,870,674				405,215				4.10				6,662,657				176,136				2.64				5,678,604				118,320				2.08
Certificates of deposits — wholesale			4,590,767				233,335				5.08				2,918,679				114,246				3.91				920,619				19,351				2.10
Total deposits			41,165,513				1,372,197				3.33				31,225,480				624,590				2.00				25,311,143				303,045				1.20
Total borrowings and other debt obligations			23,377,692				1,132,659				4.85				17,707,167				705,908				3.99				15,591,901				516,282				3.31
Total interest-bearing liabilities			64,543,205				2,504,856				3.88				48,932,647				1,330,498				2.72				40,903,044				819,327				2.00
Non-interest-bearing DDA			6,020,184				—				—				5,294,135				—				—				4,698,584				—				—
Non-interest-bearing liabilities			1,412,368				—				—				831,296				—				—				733,856				—				—
Total liabilities			71,975,757				2,504,856				3.48				55,058,078				1,330,498				2.42				46,335,484				819,327				1.77
Stockholders’ equity			7,519,638				—				—				5,673,896				—				—				4,223,123				—				—
Total liabilities and stockholders’ equity		$	79,495,395			$	2,504,856				3.15	%		$	60,731,974			$	1,330,498				2.19	%		$	50,558,607			$	819,327				1.62	%
Net interest spread(4)											2.48	%											2.94	%											3.14	%
Taxable equivalent interest income/net interest margin							1,906,394				2.75	%							1,689,915				3.17	%							1,484,121				3.31	%
Tax equivalent basis adjustment							(84,846	)											(57,826	)											(47,531	)
Net interest income						$	1,821,548											$	1,632,089											$	1,436,590
Ratio of interest-earning assets to interest-bearing liabilities											1.07	x											1.09	x											1.10	x

Table 2 presents, on a tax equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):

Table 2: Volume/Rate Analysis

		YEAR ENDED DECEMBER 31,
		2006 VS. 2005												2005 VS. 2004
		INCREASE/(DECREASE)												INCREASE/(DECREASE)
		Volume				Rate				Total				Volume				Rate				Total
Interest-earning assets:
Interest-earning deposits		$	5,879			$	2,301			$	8,180			$	368			$	3,196			$	3,564
Investment securities available for sale			218,809				54,999				273,808				(151,220	)			15,294				(135,926	)
Investment securities held to maturity			(101,182	)			9,179				(92,003	)			39,918				10,516				50,434
Investment securities other			8,335				25,021				33,356				3,227				6,042				9,269
Net loans(1)			862,362				305,134				1,167,496				599,161				190,463				789,624
Total interest-earning assets											1,390,837												716,965
Interest-bearing liabilities:
Deposits			241,660				505,948				747,608				83,082				238,463				321,545
Borrowings			255,166				171,584				426,750				75,747				113,879				189,626
Total interest-bearing liabilities											1,174,358												511,171
Net change in net interest income		$	497,377			$	(280,898	)		$	216,479			$	332,625			$	(126,831	)		$	205,794

     Provision for Credit Losses. The provision for credit losses is based upon actual credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimation of losses inherent in the current loan portfolio. The provision for credit losses for 2006 was $484.5 million compared to $90.0 million for 2005. The higher provision in 2006 was driven by the previously mentioned $296.0 million lower of cost or market adjustment in our correspondent home equity loan portfolio in the fourth quarter, loan portfolio growth and higher net loan charge-offs. The provision increased from $90.0 million, or 0.22% of average loan outstandings in 2005, to $484.5 million, or 0.88% of average loan outstandings in 2006. The overall allowance for credit losses as a percentage of loans held for investment outstanding has declined from 1.01% in 2005 to 0.88% in 2006. This is reflective of the addition of $5.6 billion of multi-family loans from the Independence acquisition which has historically had very low loss experience and therefore have lower reserve requirements, as well as the reclassification of our correspondent home equity loan portfolio to loans held for sale as these loans carried higher reserve requirements than our blended loan portfolio. Management regularly evaluates the risk inherent in its loan portfolio and adjusts its allowance for loan losses as deemed necessary. Additionally, since the addition of multifamily loans was largely a new asset class for Sovereign, the Company engaged an outside consultant to conduct an analysis of Independence’s multifamily loan portfolio. As a result of the analysis, Sovereign increased the loss percentage that Independence had historically maintained on pass-rated multifamily loans which caused Sovereign to record an additional $12.5 million of provision for credit losses to cover the inherent losses in that portfolio in the second quarter of 2006.

Sovereign’s net charge-offs for 2006 were $529.1 million and consisted of charge-offs of $594.8 million and recoveries of $65.7 million. This compares to 2005 net charge-offs of $81.7 million consisting of charge-offs of $137.0 million and recoveries of $55.3 million. The increase in charge-offs was driven by our correspondent home equity loan portfolio where net charge-offs increased from $17.0 million in 2005 to $454.0 million in 2006. The majority of this increase was related to a $382.5 million charge-off we recorded when we reclassified $4.3 billion of loans to held for sale.

The ratio of net loan charge-offs to average loans, including loans held for sale, was .96% for 2006, compared to .20% for 2005. Commercial loan net charge-offs as a percentage of average commercial loans were .21% for 2006, compared to .18% for 2005. The consumer loans secured by real estate net charge-off rate was 1.75% for 2006, compared to .08% for 2005. The consumer loans not secured by real estate net charge-off rate was .66% for 2006 and .75% for 2005. Excluding $389.6 million of charge-offs associated with the correspondent home equity loans ($382.5 million) and purchased residential mortgage loans ($7.1 million) classified as held for sale at December 31, 2006, our net loan charge-offs to average loans would have been .25% and our consumer loans secured by real estate net charge-off rate would have been .25% in 2006. The deterioration in these ratios in 2006 is principally due to the correspondent home equity loan portfolio which we are selling in 2007.

Table 3 presents the activity in the allowance for credit losses for the years indicated (in thousands):

Table 3: Reconciliation of the Allowance for Credit Losses

		2006				2005				2004				2003				2002
Allowance for loan losses, beginning of period		$	419,599			$	391,003			$	315,790			$	288,018			$	255,153
Allowance acquired in acquisitions			97,824				28,778				64,105				—				14,877
Provision for loan losses (2)			487,418				89,501				121,391				160,585				145,282
Allowance released in connection with loan sales or securitizations			(4,728	)			(8,010	)			—				—				—
Charge-offs:
Commercial			56,916				40,935				77,499				101,597				85,931
Consumer secured by real estate			463,902				24,125				12,219				16,685				21,205
Consumer not secured by real estate			73,958				71,906				63,530				47,106				55,509
Total charge-offs (1)			594,776				136,966				153,248				165,388				162,645
Recoveries:
Commercial			14,097				13,100				12,825				7,531				6,082
Consumer secured by real estate			9,933				7,085				5,395				6,405				4,826
Consumer not secured by real estate			41,663				35,108				24,745				18,639				24,443
Total recoveries			65,693				55,293				42,965				32,575				35,351
Charge-offs, net of recoveries			529,083				81,673				110,283				132,813				127,294
Allowance for loan losses, end of period		$	471,030			$	419,599			$	391,003			$	315,790			$	288,018
Reserve for unfunded lending commitments, beginning of period			18,212				17,713				12,104				10,732				9,514
Provision for unfunded lending commitments (2)			(2,957	)			499				5,609				1,372				1,218
Reserve for unfunded lending commitments, end of period (3)			15,255				18,212				17,713				12,104				10,732
Total Allowance for credit losses		$	486,285			$	437,811			$	408,716			$	327,894			$	298,750
Net charge-offs to average loans (1)			.96	%			.20	%			.36	%			.55	%			.58	%

(1)		The 2006 consumer secured by real estate charge-offs included $389.6 million of charge-offs or 71 basis points related to the lower of cost or market valuation adjustment recorded for the correspondent home equity loan ($382.5 million) and purchased residential mortgage loans ($7.1 million) that were classified as held for sale at December 31, 2006. The 2002 consumer secured by real estate charge-offs include $4.6 million of charge-offs incurred as part of accelerated dispositions of non-performing residential loans sold during the first and fourth quarters of 2002.
(2)		The provision for credit losses on the consolidated statement of operations consists of the sum of the provision for loan losses and the provision for unfunded lending commitments.
(3)		The reserve for unfunded commitments is classified on other liabilities on the consolidated balance sheet.

See Note 1 for Sovereign’s charge-off policy with respect to its various loan types.

     Non-interest Income. Total non-interest income was $285.6 million for 2006 compared to $602.7 million for 2005. Several factors contributed to this change as discussed below.

Consumer banking fees were $276.0 million for 2006 compared to $256.6 million in 2005. This increase was primarily due to increased deposit fees which increased 6.3%, resulting from growth in average core deposit balances which increased 23% primarily as a result of the Independence acquisition. The Company continues to aggressively promote demand deposit products, which, in exchange for favorable minimum balance requirements and convenience for the customer, generally produce higher fee revenues than time deposit products.

Commercial banking fees were $179.1 million for 2006 compared to $149.3 million in 2005. This increase of 20% was due to growth in average commercial loans which increased 31% in 2006 and expanded cash management capabilities and product offerings.

Mortgage banking revenues were $24.2 million for 2006 compared to $88.1 million for 2005. The principal components of mortgage banking revenues are: gains or losses from the sale or securitization of mortgage, home equity and multifamily loans or mortgage-backed securities that were related to loans originated or purchased and held by Sovereign; gains or losses on mortgage banking derivative and hedging transactions; servicing fees; amortization of mortgage servicing rights; and changes in the valuation allowance for recoveries or impairments related to mortgage servicing rights. The table below summarizes the components of net mortgage banking revenues (in thousands):

		Twelve-months ended December 31,
		2006				2005
Recoveries / (impairments) to mortgage servicing rights		$	(7,123	)		$	5,944
Mortgage servicing fees			30,799				20,376
Amortization of mortgage servicing rights			(19,987	)			(17,578	)
Net (losses) gains under SFAS 133			825				645
Sales of mortgage, home equity and multifamily loans and mortgage backed securities			19,725				78,730
Total		$	24,239			$	88,117

There were a number of transactions in 2006 that caused the decrease of $63.9 million in mortgage banking revenues from the 2005 levels. Included in 2006 results is $2.9 billion of residential mortgage loans transferred to held for sale in the fourth quarter where Sovereign recorded a loss of $28.2 million. Included in 2005 results is $2.9 billion of mortgage loans that were sold in the three-month period ended June 30, 2005 where Sovereign recorded gains of $28.4 million. Additionally, in September 2005 and December 2005, Sovereign sold $503 million and $898 million of home equity loans and recorded net gains of $13.1 million and $19.0 million, respectively. Sovereign did not record any gains associated with home equity loans in 2006. In 2006, Sovereign sold multi-family loans totaling $1.6 billion and recorded gains related to these sales of approximately $14.8 million. Additionally due primarily to changes in prepayment speeds a $7.1 million impairment charge was recorded in 2006 compared to a recovery of $5.9 million in 2005. The most important assumptions in the valuation of mortgage servicing rights are anticipated loan prepayment rates (CPR speed) and the positive spread we receive on holding escrow related balances. Increases in prepayment speeds (which are generally driven by lower long term interest rates) result in lower valuations of mortgage servicing rights, while lower prepayment speeds result in higher valuations. The escrow related credit spread is the estimated reinvestment yield earned on the serviced loan escrow deposits. Increases in escrow related credit spreads result in higher valuations of mortgage servicing rights while lower spreads result in lower valuations. For each of these items, Sovereign must make assumptions based on future expectations. All of the assumptions are based on standards that we believe would be utilized by market participants in valuing mortgage servicing rights and are consistently derived and/or benchmarked against independent public sources. Additionally, an independent appraisal of the fair value of our mortgage servicing rights is obtained at least annually and is used by management to evaluate the reasonableness of our discounted cash flow model.

Income related to bank owned life insurance increased to $67.0 million for 2006 compared to $47.3 million in 2005. This $19.7 million, or 42% increase, was due to the acquisition of Independence which increased bank owned life insurance assets by $343 million as well as purchases of additional bank owned life insurance by Sovereign of approximately $300 million during 2006.

Net gains/ (losses) on sales of investment securities were $(312.0) million for 2006, compared to $11.7 million for 2005. Included in 2006 was an investment restructuring charge of $238.3 million and an other-than-temporary impairment charge of $67.5 million on FNMA and FHLMC preferred stock in the second quarter and a $43.0 million loss on the sale of $1.5 billion of available for sale investments as part of the balance sheet restructuring in the fourth quarter of 2006. See Note 6 for further discussion and analysis of our determination that the unrealized losses in the investment portfolio at December 31, 2006 were considered temporary.

     General and Administrative Expenses. Total general and administrative expenses were $1.3 billion for 2006 compared to $1.1 billion in 2005, or an increase of 18.4%. The increase in 2006 is primarily related to the Independence acquisition and the full year effect of the Waypoint acquisition, as well as increased compensation and benefit costs associated with the hiring of additional team members. At December 31, 2006, Sovereign had total employees of 12,513 compared to 10,174 in 2005, a 23% increase. In addition, marketing and other administrative expenses have increased to support the growth in our franchise. Sovereign’s efficiency ratio, (all general and administrative expenses as a percentage of net interest income and total fees and other income) for 2006 was 53.3% compared to 49.0% for 2005. The increase is primarily due to net interest margin compression as well as the impact of the number of large adjustments recorded in 2006 discussed previously.

     Other Expenses. Total other expenses were $313.5 million for 2006 compared to $163.4 million for 2005. Other expenses included amortization expense of core deposit intangibles of $109.8 million for 2006 compared to $73.8 million for 2005. This increase is due to the additional intangible amortization expense associated with core deposit and other intangible assets of $394.2 million recorded in connection with the Independence acquisition. In 2006, net merger-related expenses were $42.4 million primarily associated with the Independence acquisition, compared to $12.7 million in 2005. In 2006, Sovereign recorded charges of $78.7 million associated with executive and other employee severance arrangements and other restructuring charges activities, as discussed previously.

     Other expense related to equity method investments includes an investment that Sovereign has in a synthetic fuel partnership that generates Section 29 tax credits for the production of fuel from a non-conventional source (“the Synthetic Fuel Partnership”). Our investment for the Synthetic Fuel Partnership totaled $16.0 million at December 31, 2006. Sovereign is amortizing this investment through December 31, 2007, which is the period through which we expect to receive alternative energy tax credits. Reductions in the investment value and our allocation of the partnership’s earnings or losses totaled $26.3 million and $28.2 million for 2006 and 2005, respectively and are included as expense in the line “Other minority interest expense and equity method investment expense” in our consolidated statement of operations, while the alternative energy tax credits we receive are included as a reduction of income tax expense. We anticipate receiving tax credits in excess of our recorded investment over the remaining life of the partnership. Based on current oil prices, we would not anticipate any phase out of our 2007 tax credits to occur, however, oil prices have been volatile and as a result we may not fully realize our anticipated 2007 tax credits. The alternative energy tax credit is reduced and ultimately eliminated based on a formula tied to the annual average wellhead price per barrel of domestic crude oil which is not subject to regulation by the United States. To the extent that the average price of crude oil exceeds certain levels resulting in a phase out and/or an elimination of the alternative energy tax credits, Sovereign’s investment in the synthetic fuel partnership could become impaired. Sovereign will continue to monitor oil price increases in the future and their related impact on our investment and recognition of alternative energy tax credits.

During the fourth quarter of 2005, Sovereign terminated $211.3 million of receive fixed-pay variable interest rate swaps that were hedging the fair value of $211.3 million of junior subordinated debentures due to capital trust entities. The fair value adjustment to the basis of the debt was $11.6 million at the date of termination. Sovereign had utilized the short-cut method of assessing hedge effectiveness under SFAS No. 133 when this hedge was in place. On July 21, 2006, in connection with the SEC’s review of the Company’s filings, it was determined that this hedge did not qualify for the short-cut method due to the fact that the junior subordinated debentures contained an interest deferral feature. As a result, Sovereign recorded a pretax charge of $11.4 million in the second quarter of 2006 to write-off the remaining fair value adjustment.

Also impacting other expenses were proxy and related professional fees of $14.3 million recorded in the three-month period ended March 31, 2006. Due to the settlement with Relational Investors LLC, we do not anticipate any additional significant costs related to this matter.

     Income Tax Provision/ (Benefit). The income tax provision/ (benefit) was $(117.8) million for 2006 compared to a provision of $216.0 million for 2005. The effective tax rate for 2006 was (615.8)% compared to 24.2% for 2005. The current year tax rate differs from the statutory rate of 35% due to the significant charges recorded in 2006 which has magnified the impact of our favorable permanent tax-free items which are principally due to income from tax- exempt investments, non-taxable income related to bank-owned life insurance and tax credits received on low income housing partnerships and the Synthetic Fuel Partnership.

Sovereign is subject to the income tax laws of the U.S., its states and municipalities and certain foreign countries. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant Governmental taxing authorities. In establishing a provision for income tax expense, the Company must make judgments and interpretations about the application of these inherently complex tax laws.

Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. Sovereign reviews its tax balances quarterly and as new information becomes available, the balances are adjusted, as appropriate. The Company is subject to ongoing tax examinations and assessments in various jurisdictions. The Internal Revenue Service (the “IRS”) is currently examining the Company’s federal income tax returns for the years 2002 through 2005. We anticipate that the IRS will complete this review in 2007. Included in this examination cycle are the two separate financing transactions with an international bank, totaling $1.2 billion which are discussed in Note 12. As a result of these transactions, Sovereign was subject to foreign taxes of $154.0 million dollars during the years 2003 through 2005 and claimed a corresponding foreign tax credit for foreign taxes paid during those years. In 2006, Sovereign paid an additional $87.6 million of foreign taxes from this financing transaction and claimed a corresponding foreign tax credit. It is possible that the IRS may challenge the Company’s ability to claim these foreign tax credits. Sovereign believes that it is entitled to claim these foreign tax credits and also believes that its recorded tax liabilities adequately provide for any liabilities to the IRS related to foreign tax credits and other tax assessments. However, the completion of the IRS review and their conclusion on Sovereign’s tax positions included in the tax returns for 2002 — 2005 could result in an adjustment to the tax balances and reserves that have been recorded and may materially affect our income tax provision in future periods.

     Line of Business Results. Beginning in the third quarter of 2006, the business unit profitability reporting system was reorganized to include a Metro New York segment. This new segment is primarily comprised of the net assets of Independence and substantially all of Sovereign’s New Jersey banking offices, which were moved from the Mid-Atlantic segment. The Company’s segments are focused principally around the customers Sovereign serves and the geographies in which those customers are located. The Mid-Atlantic Banking Division is comprised of our branch locations in, Pennsylvania, and Maryland. The New England Banking Division is comprised of our branch locations in Massachusetts, Rhode Island, Connecticut and New Hampshire. The Metro New York Banking Division is comprised of our branch locations in New York and New Jersey. All areas offer a wide range of products and services to customers and each attracts deposits by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposits and retirement savings plans. The Shared Services Consumer segment is primarily comprised of our mortgage banking group, our correspondent home equity business, and our indirect automobile group. The Shared Services Commercial segment provides cash management and capital markets services to Sovereign customers, as well as asset-backed lending products, commercial real estate loans, automobile dealer floor plan loans, leases to commercial customers, and small business loans. Other includes earnings from the investment portfolio, interest expense on Sovereign’s borrowings and other debt obligations, minority interest expense, amortization of intangible assets, merger-related and integration charges and certain unallocated corporate income and expenses. For additional discussion of these business lines and the Company’s related accounting policies, see Note 26 to the Notes to the Consolidated Financial Statements.

     Segment results are derived from the Company’s business unit profitability reporting system by specifically attributing managed balance sheet assets, deposits and other liabilities and their related interest income or expense. Funds transfer pricing methodologies are utilized to allocate a cost for funds used or a credit for funds provided to business line deposits, loans and selected other assets using a matched funding concept. The provision for credit losses recorded by each segment is based on the net charge-offs of each line of business. Effective in the first quarter of 2006, the difference between the provision for credit losses recognized by the Company on a consolidated basis and the provision recorded by the business lines at the time of charge-off is allocated to each business line based on a risk profile of their loan portfolio. Previously, this amount was recorded in the Other segment. Prior periods have been reclassified to conform to the current period presentation. Other income and expenses directly managed by each business line, including fees, service charges, salaries and benefits, and other direct expenses as well as certain allocated corporate expenses are accounted for within each segment’s financial results. Where practical, the results are adjusted to present consistent methodologies for the segments. Accounting policies for the lines of business are the same as those used in preparation of the consolidated financial statements with respect to activities specifically attributable to each business line. However, the preparation of business line results requires management to establish methodologies to allocate funding costs and benefits, expenses and other financial elements to each line of business.

The Mid-Atlantic Banking Division’s net interest income decreased $11.4 million to $318.6 million in 2006. The decrease in net interest income was principally due to margin compression on a matched funded basis. The net spread on a match funded basis for this segment was 2.53% in 2006 compared to 2.59% in 2005. The average balance of Mid-Atlantic Banking Division’s loans was $4.6 billion and $4.5 billion during 2006 and 2005, respectively. The average balance of deposits was $8.3 billion in 2006 compared to $8.4 billion in 2005. General and administrative expenses (including allocated corporate and direct support costs) increased from $261.8 million for 2005 to $284.8 million for 2006. As previously discussed, Sovereign’s management team is currently working on a cost saving initiative to eliminate or reduce certain redundant expenses.

The New England Banking Division’s net interest income decreased $7.9 million to $656.5 million in 2006. The decrease in net interest income was principally due to margin compression on a matched fund basis. The net spread on a match funded basis for this segment was 2.88% in 2006 compared to 2.92% in 2005. The average balance of New England Banking Division’s loans was $5.6 billion and $5.4 billion during 2006 and 2005, respectively. The average balance of deposits was $17.7 billion in 2006 compared to $17.6 billion in 2005. The increase in fees and other income of $7.3 million to $168.1 million for 2006 was generated by deposit fees and loan fees, which grew with the increased level of deposits and loans. The provision for credit losses increased in 2006 to $12.7 million from $8.4 million in 2005 due to increased net loan charge-offs in 2006. General and administrative expenses (including allocated corporate and direct support costs) increased from $467.8 million for 2005 to $490.9 million for 2006. As previously discussed, Sovereign’s management team is currently working on a cost saving initiative to eliminate or reduce certain redundant expenses.

The Metro New York Banking Division’s net interest income increased $201.5 million to $454.1 million in 2006. The increase in net interest income was principally due to the acquisition of Independence on June 1, 2006. The average balance of loans was $8.9 billion versus $1.7 billion during 2006 and 2005, respectively. The average balance of deposits was $13.1 billion in 2006, compared to $6.7 billion in 2005. The increase in fees and other income of $57.7 million to $107.9 million was due primarily due to the acquisition of Independence on June 1, 2006. The provision for credit losses increased $17.4 million to $22.1 million in 2006. Included in the 2006 provision is the $12.5 million charge recorded at June 30, 2006 to increase reserves on Independence’s multifamily loan portfolio. General and administrative expenses (including allocated corporate and direct support costs) increased from $144.6 million for 2005 to $314.2 million for 2006. The increase in general and administrative expenses is principally due to the acquisition of Independence on June 1, 2006, however, Sovereign’s management team is currently working on a cost saving initiative to eliminate or reduce certain redundant expenses. In addition cost savings from the Independence acquisition were not fully realized until the end of 2006.

Shared services consumer segment net interest income decreased $13.3 million to $323.8 million in 2006. The decrease in net interest income was principally due to spread compression on a matched funded basis. The net spread on a match funded basis for this segment was 1.34% in 2006 compared to 1.55% in 2005. The average balance of Shared services consumer loans was $25.5 billion and $21.1 billion during 2006 and 2005, respectively. The average balance of deposits was $140.0 million in 2006 compared to $150.1 million in 2005. The decrease in fees and other income of $86.3 million to $16.8 million for 2006 was primarily generated by decreased mortgage banking revenues from the sale of mortgage and home equity loans. These gains decreased to $1.5 million in 2006 from $78.7 million in 2005 due to the previously discussed reduction in mortgage banking revenues in 2006 compared to 2005. Mortgage banking revenue is contingent upon loan growth and market conditions. The provision for credit losses increased in 2006 to $411.9 million from $52.7 million in 2005 due primarily to the $296.0 million additional provision for our correspondent home equity portfolio. Additionally, our correspondent home equity loan charge-offs were $60.4 million in 2006 (excluding the year-end held for sale charge-off) compared to $21.4 million in 2005. General and administrative expenses (including allocated corporate and direct support costs) decreased from $129.9 million for 2005 to $119.8 million for 2006. As previously discussed, Sovereign’s management team is currently working on a cost saving initiative to eliminate or reduce certain redundant expenses.

Shared services commercial segment net interest income increased $1.3 million to $237.4 million for 2006 compared to 2005 due to increases in average commercial assets. The average balance of Shared services commercial loans was $10.6 billion in 2006 versus $8.9 billion during 2005. The net spread on a match funded basis for this segment was 2.36% in 2006 compared to 2.63% in 2005. Fees and other income have increased by $10.4 million to $148.9 million principally from increases in income related to our precious metals business. The provision for credit losses increased by $20.1 million in 2006 to $26.7 million compared to 2005 due to higher levels of commercial charge-offs in 2006 which was due in part to one large commercial charge-off of $14 million recorded in December 2006. General and administrative expenses (including allocated corporate and direct support costs) increased slightly from $135.9 million for 2005 to $138.7 million in 2006. However, Sovereign’s management team is currently working on a cost saving initiative to eliminate or reduce certain redundant expenses.

The net loss before income taxes for the Other segment increased from $209.1 million in 2005 to $620.9 million in 2006. Net interest expense decreased from $188.1 million in 2005 to $168.8 million for 2006. The Other segment includes net losses on securities of $312 million in 2006, as compared to a net gain of $11.7 million recorded in 2005. This resulted from the previously discussed $67.5 million other-than-temporary impairment charge on the FNMA and FHLMC preferred stock in our investment portfolio as well as the $238.3 million and $43.0 million of securities losses recorded in the second and fourth quarters of 2006. The 2006 results included $78.7 million of charges associated with executive and other employee severance arrangements and certain other restructuring activities. The 2006 and 2005 results also included net charges of $42.4 million and $12.7 million for merger and integration charges. Finally, the Other segment included $26.3 million and $28.2 million of expense associated with the Synthetic Fuel Partnership, as well as amortization of intangibles of $109.8 million and $73.8 million in 2006 and 2005, respectively.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004

		YEAR ENDED DECEMBER 31,
		2005				2004
(Dollars in thousands, except per share data)
Net interest income		$	1,632,089			$	1,436,590
Provision for credit losses			90,000				127,000
Total non-interest income			602,664				450,525
General and administrative expenses			1,089,204				942,661
Other expenses			163,429				236,232
Net income		$	676,160			$	453,552
Basic earnings per share		$	1.77			$	1.34
Diluted earnings per share		$	1.69			$	1.29

The major factors affecting comparison of earnings and diluted earnings per share between 2005 and 2004 were:

	•		The growth in net interest income was driven by the increase in the balance of earning assets, which were primarily related to business acquisitions and organic balance sheet growth, offset by a decline in net interest margin to 3.17% in 2005 from 3.31% in 2004. The decline in margin was due to the flattening yield curve, which has contracted the spread between our longer-term assets and shorter—term liabilities.
	•		The debt extinguishment charges of $63.8 million in 2004. We felt it was prudent to redeem these high cost borrowings, even in light of the significant charges we incurred, since the redemption improved net interest margin and net income in subsequent periods.
	•		Included in net gains on investment securities for 2004 is an other-than-temporary impairment charge of $32.1 million on FNMA and FHLMC Preferred Stock.
	•		The merger-related charges of $46.4 million incurred in 2004 related to the First Essex and Seacoast acquisitions, compared to net after tax merger related charges of $12.7 million incurred in 2005.
	•		The decrease in provision for credit losses in 2005 of $37 million resulting from the improving credit quality of our loan portfolio in 2005 compared to 2004, as average charge-off rates declined to 0.20% in 2005 compared with 0.36% in 2004.
	•		The continued growth in fee income in consumer and commercial banking due to loan and deposit growth.
	•		The increase in mortgage banking revenues in 2005 of $66.7 million due primarily to increased sales of residential and home equity loans.
	•		Increases in general and administrative expenses to supporting the growth in Sovereign’s franchise and continued investment in human resources and systems and increases related to business acquisitions.

     Net Interest Income. Net interest income for 2005 was $1.63 billion compared to $1.44 billion for 2004, or an increase of 13.6%. The increase in net interest income in 2005 was due to an increase in average interest-earning assets of $8.6 billion, which was related to the full year impact of our Seacoast acquisition and to a lesser extent, the First Essex acquisition, the 2005 Waypoint acquisition and organic loan growth primarily in the commercial and consumer secured by real estate portfolios. The increase in our assets was funded principally by the increase in core deposits, repurchase agreements and other borrowings. Net interest margin (net interest income divided by average interest-earning assets) was 3.17% for 2005 compared to 3.31% for 2004. The decline in margin was driven by the flattening yield curve experienced in 2005 and 2004, which has contracted the spread between our longer-term assets and shorter-term liabilities.

Interest on investment securities and interest-earning deposits was $576 million for 2005 compared to $659 million for 2004. The decrease in interest income was due to a decrease in the average balance of investment securities from $14.1 billion in 2004 to $12.1 billion in 2005, partially offset by higher yields in 2005 which averaged 5.12% compared to 4.91%.

Interest on loans was $2.39 billion and $1.60 billion for 2005 and 2004, respectively. The average balance of loans was $41.5 billion with an average yield of 5.76% for 2005 compared to an average balance of $30.9 billion with an average yield of 5.19% for 2004. The increase in average yields year to year is due to the increase of market rates experienced during 2005 due to increases in interest rates by the Federal Reserve Bank. The overall growth in total loans from $36.6 billion at December 31, 2004 to $43.8 billion at December 31, 2005 resulted from the Waypoint acquisition and from origination activity in commercial loans and purchases of bulk and correspondent loans, principally in the consumer and mortgage loan portfolios. At December 31, 2005, approximately 17% of our loan portfolio repriced monthly or more frequently.

Interest on total deposits was $625 million for 2005 compared to $303 million for 2004. The average balance of deposits was $31.2 billion with an average cost of 2.00% for 2005 compared to an average balance of $25.3 billion with an average cost of 1.20% for 2004. Additionally, the average balance of non-interest bearing deposits increased to $5.3 billion in 2005 from $4.7 billion in 2004. The increase in the average balance was due to the full year impact of our Seacoast acquisition and to a lesser extent, the First Essex acquisition, the 2005 Waypoint acquisition and an increase in time deposit funding which has recently become a more favorable funding alternative to shorter-term borrowings due to rising market rates. The increase in the average cost of deposits in 2005 is the result of increases in short-term interest rates which were partially passed on to our customers.

Interest on borrowings and other debt obligations was $706 million for 2005 compared to $516 million for 2004. The average balance of total borrowings and other debt obligations was $17.7 billion with an average cost of 3.99% for 2005 compared to an average balance of $15.6 billion with an average cost of 3.31% for 2004. The increase in the cost of funds on borrowings and other debt obligations resulted principally from the higher rates on short-term sources of funding including repurchase agreements and overnight FHLB advances due to an increase in short-term interest rates.

     Provision for Credit Losses. The provision for credit losses is based upon actual credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimation of losses inherent in the current loan portfolio. The provision for credit losses for 2005 was $90 million compared to $127 million for 2004. Included in 2004 results was a $6 million provision recorded in connection with the acquisition of First Essex to conform to Sovereign’s reserving methodology. The lower provision in 2005 was driven by continued favorable credit quality statistics in our loan portfolio, combined with a reduction in net loan charge-offs, which declined from $110.3 million, or 0.36% of average loan outstandings in 2004, to $81.7 million, or 0.20% of average loan outstandings in 2005. The overall allowance for credit losses as a percentage of loans held for investment outstanding has declined from 1.12% in 2004 to 1.01% in 2005. This is reflective of the quality of the loan portfolios, improved credit risk identification, analysis, and loss estimation, as well as residential loan growth where reserve requirements are generally lower than in commercial loan portfolios. As a result of continued improved credit risk identification, analysis and loss estimation, certain class allowance factors, primarily commercial, were adjusted during 2005 to more accurately project loss rates resulting in a reduction of the allowance for loan losses. Management regularly evaluates the risk inherent in its loan portfolio and adjusts its allowance for loan losses as deemed necessary.

Sovereign’s net charge-offs for 2005 were $81.7 million and consisted of charge-offs of $137.0 million and recoveries of $55.3 million. This compares to 2004 net charge-offs of $110.3 million consisting of charge-offs of $153.2 million and recoveries of $42.9 million. The decrease in charge-offs was driven by the performance of our commercial loan portfolios where net charge-offs decreased from $64.7 million in 2004 to $27.8 million in 2005.

The ratio of net loan charge-offs to average loans, including loans held for sale, was .20% for 2005, compared to .36% for 2004. Commercial loan net charge-offs as a percentage of average commercial loans were .18% for 2005, compared to .52% for 2004. The consumer loans secured by real estate net charge-off rate was .08% for 2005, compared to .05% for 2004. The consumer loans not secured by real estate net charge-off rate was .75% for 2005 and .89% for 2004.

     Non-interest Income. Total non-interest income was $602.7 million for 2005 compared to $450.5 million for 2004. Several factors contributed to the increase as discussed below.

Consumer banking fees were $256.6 million for 2005 compared to $223.2 million in 2004. This increase was primarily due to increased loan and deposit fees which increased 50% and 10%, respectively, resulting from growth in average loan and deposit balances which increased 34% and 23%, respectively. The Company continued to aggressively promote demand deposit products, which, in exchange for favorable minimum balance requirements and convenience for the customer, generally produced higher fee revenues than time deposit products.

Commercial banking fees were $149.3 million for 2005 compared to $112.4 million in 2004. This increase was due to growth in both commercial loans and expanded cash management capabilities and product offerings. Commercial banking loan fees increased by $26.5 million to $70.0 million while commercial deposit fees decreased slightly by $1.0 million to $46.7 million, in 2005. Included in commercial banking fees were gains of $9.4 million related to the 2005-1 dealer floor plan securitizations executed in the third and fourth quarter of 2005. See Note 2 for further details.

Mortgage banking revenues were $88.1 million for 2005 compared to $21.6 million for 2004. The principal components of mortgage banking revenues are: gains or losses from the sale or securitization of mortgage and home equity loans or mortgage-backed securities that were related to loans originated or purchased and held by Sovereign; gains or losses on mortgage banking derivative and hedging transactions; servicing fees; amortization of mortgage servicing rights; and changes in the valuation allowance for recoveries or impairments related to mortgage servicing rights. The primary factor contributing to the increase in mortgage banking revenues was increased loan sales resulting from high levels of origination and loan purchase activity. The table below summarizes the components of net mortgage banking revenues (in thousands):

		Twelve-months ended December 31,
		2005				2004
Impairments to mortgage servicing rights		$	5,944			$	(1,792	)
Mortgage servicing fees			20,376				18,489
Amortization of mortgage servicing rights			(17,578	)			(18,895	)
Net (losses) gains under SFAS 133			645				(2,020	)
Sales of mortgage loans and mortgage backed securities			78,730				25,805
Total		$	88,117			$	21,587

There were a number of transactions in 2005 that caused the increase of $52.9 million in gains on sales of mortgage loans, mortgage backed securities and home equity loans from the 2004 levels. Included in 2005 results were $2.9 billion of mortgage loans that were sold in the three-month period ended June 30, 2005 where Sovereign recorded gains of $28.4 million. Additionally, in September 2005 and December 2005, Sovereign sold $503 million and $898 million of home equity loans and recorded net gains of $13.1 million and $19.0 million, respectively. Included in mortgage banking revenue for 2005 was a $5.9 million mortgage servicing rights impairment reversal primarily because of slower prepayment speed assumptions compared to a $1.8 million impairment charge in 2004.

Capital Markets revenues were $17.8 million in 2005 and $19.9 million in 2004. Capital markets revenues declined in 2005 compared to 2004 because of challenging market conditions in 2005 related to the low interest rate environment which reduced demand for our broker dealer products and services.

Net gains on sales of investment securities were $11.7 million for 2005, compared to $14.2 million for 2004. Included in 2005 and 2004 results were impairment charges of $2.7 million and $0.9 million, respectively, related to our retained interests in securitizations. See Note 22 in the consolidated financial statements for a discussion of our retained interests in securitized assets.

In the fourth quarter of 2004, Sovereign determined that certain unrealized losses on perpetual preferred stock of FNMA and FHLMC was other-than-temporary in accordance with SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities” and the SEC’s Staff Accounting Bulletin No. 59 “Accounting for Non-current Marketable Equity Securities”. The Company’s assessment considered the duration and severity of the unrealized loss, the financial condition and near term prospects of the issuers, and the likelihood of the market value of these instruments increasing to our initial cost basis within a reasonable period of time. Based on the anticipated interest rate environment expected in the near term at the time and certain negative developments at these issuers, we concluded that the unrealized losses were other-than-temporary and recorded an impairment charge of $32.1 million ($20.9 million after-tax or $0.06 per diluted share) to writedown these investments to their fair values. No other than temporary impairment changes were recorded in 2005 related to these investments securities. See Note 6 for further discussion and analysis of our determination that the unrealized losses in the investment portfolio at December 31, 2005 were considered temporary.

The reduction in gross gains on sales of investment securities in 2005 was a result of the increasing interest rate environment in 2005 which reduced the amount of unrealized gains in our investment portfolio.

Miscellaneous income was $31.8 million in 2005 compared with $19.9 million in 2004. The 2005 results included $4.0 million of premium income recognized on written call options related to mortgage-backed securities and $3.7 million of revenues from a benefit consulting practice that was acquired in 2005. Also included in the 2005 results was a $1.9 million gain on the sale of a marketing trademark to a third party.

     General and Administrative Expenses. Total general and administrative expenses were $1.1 billion for 2005 compared to $943 million in 2004, or an increase of 15.5%. The increase in 2005 is primarily related to the Waypoint acquisition and the full year effect of the Seacoast acquisition, as well as increased compensation and benefit costs associated with the hiring of additional team members. At December 31, 2005, Sovereign had total employees of 10,174 compared to 9,330 in 2004, a 9.0% increase. In addition, marketing and other administrative expenses have increased to support the growth in our franchise. Although general and administrative expenses have increased, Sovereign’s efficiency ratio, (all general and administrative expenses as a percentage of net interest income and total fees and other income) for 2005 was 49.0% compared to 50.3% for 2004, as net interest income and fees and other income have risen at a faster rate than general and administrative expenses.

     Other Expenses. Total other expenses were $163.4 million for 2005 compared to $236.2 million for 2004. Other expenses included amortization expense of core deposit intangibles of $73.8 million for 2005 compared to $72.6 million for 2004. As previously discussed, in 2004 Sovereign incurred debt extinguishment losses of $63.8 million and net merger related expenses of $46.4 million. In 2005, net merger related expenses were $12.7 million.

     Other expense related to equity method investments included an investment that Sovereign has in a synthetic fuel partnership that generates Section 29 tax credits for the production of fuel from a non-conventional source (“the Synthetic Fuel Partnership”). Our investment balance totaled $32.4 million at December 31, 2005. Sovereign is amortizing this investment through December 31, 2007, which is the period through which we expect to receive alternative energy tax credits. Reductions in the investment value and our allocation of the partnership’s earnings or losses totaled $28.2 million and $20.9 million for 2005 and 2004, respectively and are included as expense in the line “Other minority interest expense and equity method investment expense” in our consolidated statement of operations, while the alternative energy tax credits we receive are included as a reduction of income tax expense. We anticipate receiving tax credits in excess of our recorded investment over the remaining life of the partnership. The alternative energy tax credit is reduced and ultimately eliminated based on a formula tied to the annual average wellhead price per barrel of domestic crude oil which is not subject to regulation by the United States.

     Income Tax Provision. The income tax provision was $216 million for 2005 compared to a provision of $128 million for 2004. The effective tax rate for 2005 was 24.2% compared to 22.0% for 2004. The tax rates differ from the statutory rate of 35% due principally to income from tax-exempt investments, non-taxable income related to bank-owned life insurance and tax credits received on low income housing partnerships and the Synthetic Fuel Partnership. The increase in the effective tax rate in 2005 was due to a reduction in the proportion of permanent favorable tax differences to pre-tax book income in 2005 compared to 2004.

     Line of Business Results. Beginning in the third quarter of 2006, the business unit profitability reporting unit system was reorganized to include a Metro New York segment. This new segment is primarily comprised of the net assets of Independence and substantially all of Sovereign’s New Jersey banking offices, which were moved from the Mid-Atlantic segment. The Company’s reportable segments have changed to the Mid-Atlantic Banking Division, the New England Banking Division, the Metro New York Banking Division, Shared Services Consumer, Shared Services Commercial, and Other. The 2005 and 2004 results have been restated to reflect Sovereign’s new segments. For additional discussion of these business lines and the Company’s related accounting policies, see Note 26 to the Notes to the Consolidated Financial Statements.

The Mid-Atlantic Banking Division’s net interest income increased $103.3 million to $330.0 million in 2005. The increase in net interest income was principally due to the impact of the Waypoint acquisition. The net spread on a match funded basis for this segment was 2.59% in 2005 compared to 2.54% in 2004. The average balance of Mid-Atlantic Banking Division’s loans was $4.5 billion versus $3.0 billion during 2005 and 2004, respectively. The average balance of deposits was $8.4 billion in 2005 compared to $6.0 billion in 2004. These average balance increases reflect the impact of the Waypoint acquisition. The increase in fees and other income of $6.7 million to $72.1 million for 2005 was generated by deposit fees and loan fees, which grew with the increased level of deposits and loans. The provision for credit losses decreased in 2005 to $17.8 million from $21.7 million in 2004 due to decreased net loan charge-offs in 2005 due to the improving credit quality of our loan portfolio. General and administrative expenses (including allocated corporate and direct support costs) increased from $194.6 million for 2004 to $261.8 million for 2005. The increase in general and administrative expenses is due principally to Sovereign’s continued investment in people and processes to support its expanding franchise, which included the acquisition of Waypoint.

The New England Banking Division’s net interest income increased $155.9 million to $664.4 million in 2005. The increase in net interest income was principally due to loan growth, because of the full year impact of the Seacoast and First Essex acquisitions. The net spread on a match funded basis for this segment was 2.92% in 2005 compared to 2.51% in 2004. The average balance of New England Banking Division’s loans was $5.4 billion versus $4.4 billion during 2005 and 2004, respectively. The average balance of deposits was $17.6 billion in 2005 compared to $16.0 billion in 2004. The increase in fees and other income of $10.8 million to $160.8 million for 2005 was generated by deposit fees and loan fees, which grew with the increased level of deposits and loans. The provision for credit losses decreased in 2005 to $8.4 million from $16.7 million in 2004 due to decreased net loan charge-offs in 2005 and the improving credit quality of our loan portfolio. General and administrative expenses (including allocated corporate and direct support costs) increased from $424.5 million for 2004 to $467.8 million for 2005. The increase in general and administrative expenses was due principally to Sovereign’s continued investment in people and processes to support its expanding franchise, which included the full year impact of the 2004 acquisitions of First Essex and Seacoast.

The Metro New York Banking Division’s net interest income increased $33.9 million to $252.6 million in 2005. The increase in net interest income was principally due to loan growth. The net spread on a match funded basis for this segment was 3.06% in 2005 compared to 2.64% in 2004. The average balance of Metro New York Banking Division’s loans was $1.7 billion and $1.4 billion during 2005 and 2004, respectively. The average balance of deposits was $6.7 billion in 2005 compared to $6.9 billion in 2004. The increase in fees and other income of $4.0 million to $50.2 million for 2005 was generated by deposit fees and loan fees, which grew with the increased level of deposits and loans. The provision for credit losses decreased in 2005 to $4.7 million from $10.9 million in 2004 due to decreased net loan charge-offs in 2005 and the improving credit quality of our loan portfolio. General and administrative expenses (including allocated corporate and direct support costs) were $146.2 million for 2004 and $144.6 million for 2005.

Shared services consumer segment net interest income increased $35.3 million to $337.1 million in 2005. The increase in net interest income was principally due to loan growth. The net spread on a match funded basis for this segment was 1.55% in 2005 compared to 1.96% in 2004. The average balance of Shared services consumer loans was $21.1 billion versus $15.1 billion during 2005 and 2004, respectively. The average balance of deposits was $150.1 million in 2005 compared to $143.0 million in 2004. The increase in fees and other income of $70.0 million to $103.1 million for 2005 was primarily generated by increased mortgage banking revenues from the sale of mortgage and home equity loans. These gains increased to $78.7 million in 2005 from $25.8 million in 2004. Mortgage banking revenue is contingent upon loan growth and market conditions. Due to strong loan originations, increased loan purchases, and favorable market conditions, Sovereign experienced a higher level of gains from the sale of loans in 2005 compared to 2004. The provision for credit losses increased in 2005 to $52.7 million from $46.6 million in 2004 due to loan growth and increased charge-offs on our correspondent home equity loan portfolio. General and administrative expenses (including allocated corporate and direct support costs) increased from $97.5 million for 2004 to $129.9 million for 2005. The increase in general and administrative expenses was due principally to Sovereign’s continued investment in people and processes to support its expanding franchise.

Shared services commercial segment net interest income increased $48.7 million to $236.1 million for 2005 compared to $187.4 million in 2004. The increase in net interest income was principally due to loan growth. The net spread on a match funded basis for this segment was 2.63% in 2005 compared to 2.50% in 2004. The average balance of Shared services commercial loans was $8.9 billion in 2005 versus $7.0 billion during 2004. Fees and other income have increased by $49.8 million to $138.5 million principally from an increase in loan fees of $26.9 million. Included in 2005 results were $9.4 million of gains related to the 2005-1 dealer floor plan securitization. The provision for credit losses decreased by $24.5 million in 2005 to $6.6 million compared to 2004 due to a lower level of net charge-offs in 2005. General and administrative expenses (including allocated corporate and direct support costs) increased slightly from $129.4 million for 2004 to $135.9 million in 2005.

The net loss before income taxes for the Other segment increased from $152.5 million in 2004 to $209.1 million in 2005. Net interest expense increased from $6.4 million in 2004 to $188.1 million for 2005 due to tightening margins between our investment and borrowing obligations in 2005 due to the flattening yield curve. The Other segment includes net gains on securities of $14.3 million in 2005, as compared to $15.1 million recorded in 2004. The previously discussed impairment charges related to our retained interests in consumer loan securitizations are recorded in the Consumer Bank segment; however, the other-than-temporary impairment charge on the FNMA and FHLMC preferred stock in our investment portfolio was recorded in the Other segment. The 2005 results included proxy and related professional expenses and other restructuring charges of $5.8 million and $4.0 million, respectively. See Note 29 for additional details. The 2004 results also include pre-tax losses of $63.8 million on the extinguishment of debt. The 2005 and 2004 results also included net charges of $12.7 million and $46.4 million for merger and integration charges. Finally, the Other segment included $28.2 million and $20.9 million of expense associated with the Synthetic Fuel Partnership, as well as amortization of intangibles of $73.8 million and $72.6 million in 2005 and 2004, respectively.

Critical Accounting Policies

MD&A is based on the consolidated financial statements and accompanying notes that have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). Our significant accounting policies are described in Note 1 to the consolidated financial statements. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments, and, as such, have a greater possibility of producing results that could be materially different than originally reported. However, the Company is not currently aware of any reasonably likely events or circumstances that would result in materially different results. We have identified accounting for the allowance for loan losses, securitizations, goodwill and derivatives and hedging activities as our most critical accounting policies and estimates in that they are important to the portrayal of our financial condition and results, and they require management’s most difficult, subjective or complex judgments as a result of the need to make estimates about the effects of matters that are inherently uncertain.

The Company’s senior management has reviewed these critical accounting policies and estimates with its Audit Committee. Information concerning the Company’s implementation and impact of new accounting standards issued by the Financial Accounting Standards Board (FASB) is discussed in Note 2.

     Allowance for Loan Losses and Reserve for Unfunded Lending Commitments. The allowance for loan losses and reserve for unfunded lending commitments represent management’s best estimate of probable losses inherent in the loan portfolio. The adequacy of Sovereign’s allowance for loan losses and reserve for unfunded lending commitments are regularly evaluated. This evaluation process is subject to numerous estimates and applications of judgment. Management’s evaluation of the adequacy of the allowance to absorb loan losses takes into consideration the risks inherent in the loan portfolio, past loan loss experience, specific loans which have loss potential, geographic and industry concentrations, delinquency trends, economic conditions, the level of originations and other relevant factors. Management also considers loan quality, changes in the size and character of the loan portfolio, amount of non-performing loans, and industry trends. Changes in these estimates could have a direct impact on the provision for credit losses recorded in the income statement and could result in a change in the recorded allowance and reserve for unfunded lending commitments. The loan portfolio also represents the largest asset on our consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan losses and reserve for unfunded lending commitments and a discussion of the factors driving changes in the amount of the allowance for loan losses and reserve for unfunded lending commitments is included in the Credit Risk Management section of this MD&A.

     Securitizations. Securitization is a process by which a legal entity issues certain securities to investors, which pay a return based on the cash flows from a pool of loans or other financial assets. Sovereign has securitized mortgage loans, home equity loans, and other consumer loans, as well as automotive floor plan loans that it originated and/or purchased from certain other financial institutions. After receivables or loans are securitized, the Company continues to maintain account relationships with its customers. As a result, the Company continues to consider these securitized assets to be part of the business it manages. Sovereign may provide administrative, liquidity facilities and/or other services to the resulting securitization entities, and may continue to service the financial assets sold to the securitization entity.

In the case where Sovereign transferred financial assets to a special purpose entity, a decision must be made as to whether that transfer should be considered a sale and whether the assets transferred to the special purpose entity should be consolidated into the Company’s financial statements or whether the non-consolidation criteria have been met according to generally accepted accounting principles. The accounting guidance governing sale and consolidation of securitized financial assets is included in SFAS No. 140.

Accounting for the valuation of retained interests in securitizations requires management judgment since these assets are established and accounted for based on discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, credit loss experience, and servicing costs, as well as discount rates that consider the risk involved.

Because the values of these assets are sensitive to changes to assumptions, the valuation of retained interests is considered a critical accounting estimate. Note 1 and Note 22 to the consolidated financial statements include further discussion on the accounting for these assets and provide sensitivity analysis showing how the fair value of these assets would respond to adverse changes in the key assumptions utilized to value these assets.

     Goodwill. The purchase method of accounting for business combinations requires the Company to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the assets acquired and liabilities assumed. The excess of the purchase price of an acquired business over the fair value of the identifiable assets and liabilities represents goodwill. Goodwill totaled $5.0 billion at December 31, 2006.

The Company follows SFAS No. 142, “Goodwill and Other Intangible Assets,” to account for its goodwill. This statement provides that goodwill and other indefinite lived intangible assets will not be amortized on a recurring basis, but rather will be subject to periodic impairment testing. Other than goodwill, Sovereign has no indefinite lived intangible assets.

The impairment test for goodwill requires the Company to compare the fair value of business reporting units to their carrying value including assigned goodwill. SFAS No. 142 required an annual impairment test. In addition, goodwill is tested more frequently if changes in circumstances or the occurrence of events indicate impairment potentially exists. No charge for impairment of goodwill has been required under the provisions of SFAS No. 142 in 2006, 2005 or 2004.

Determining the fair value of its reporting units requires management to allocate assets and liabilities to such units and make certain judgments and assumptions related to various items, including discount rates, future estimates of operating results, etc. If alternative assumptions or estimates had been used, the fair value of each reporting unit determined by the Company may have been different. However, management believes that the estimates or assumptions used in the goodwill impairment analysis for its business units were reasonable.

The previously discussed restructurings of our balance sheet as well as our cost savings initiatives will have a significant impact on our future financial results. Additionally, we are increasing our investment and focus on our commercial lending portfolios as well as certain consumer segment portfolios including indirect auto lending. We believe that these steps will enhance future profitability. However, to the extent that these changes do not impact our operations as anticipated, they could affect the realizability of our goodwill in future periods.

     Derivatives and Hedging Activities. Sovereign uses various derivative financial instruments to assist in managing interest rate risk. Sovereign accounts for these derivative instruments in accordance with the provisions of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended (SFAS No. 133). Under SFAS No. 133, derivative financial instruments are recorded at fair value as either assets or liabilities on the balance sheet. The accounting for changes in the fair value of a derivative instrument is determined by whether it has been designated and qualifies as part of a hedging relationship and on the type of hedging relationship. Transactions hedging changes in the fair value of a recognized asset, liability, or firm commitment are classified as fair value hedges. Derivative instruments hedging exposure to variable cash flows of recognized assets, liabilities or forecasted transactions are classified as cash flow hedges.

Fair value hedges result in the immediate recognition in earnings of gains or losses on the derivative instrument, as well as corresponding losses or gains on the hedged item, to the extent they are attributable to the hedged risk. The effective portion of the gain or loss on a derivative instrument designated as a cash flow hedge is reported in accumulated other comprehensive income, and reclassified to earnings in the same period that the hedged transaction affects earnings. The ineffective portion of the gain or loss, if any, is recognized in current earnings for both fair value and cash flow hedges. Derivative instruments not qualifying for hedge accounting treatment are recorded at fair value and classified as trading assets or liabilities with the resultant changes in fair value recognized in current earnings during the period of change.

During 2006 and 2005, Sovereign had both fair value hedges and cash flow hedges recorded in the consolidated balance sheet as “other assets” or “other liabilities” as applicable. For both fair value and cash flow hedges, certain assumptions and forecasts related to the impact of changes in interest rates on the fair value of the derivative and the item being hedged must be documented at the inception of the hedging relationship to demonstrate that the derivative instrument will be effective in hedging the designated risk. If these assumptions or forecasts do not accurately reflect subsequent changes in the fair value of the derivative instrument or the designated item being hedged, Sovereign might be required to discontinue the use of hedge accounting for that derivative instrument. Once hedge accounting is terminated, all subsequent changes in the fair market value of the derivative instrument must be recorded in earnings, possibly resulting in greater volatility in Sovereign’s earnings. If Sovereign’s outstanding derivative positions that qualified as hedges at December 31, 2006 were no longer considered effective, and thus did not qualify as hedges, the impact in 2006 would have been to lower pre-tax earnings by approximately $49.6 million.

Recent Acquisitions

On June 1, 2006, Sovereign acquired Independence for $42 per share in cash, representing an aggregate transaction value of $3.6 billion and the results of their operations are included in the accompanying financial statements subsequent to the acquisition date. Sovereign funded this acquisition using the proceeds from the $2.4 billion equity offering to Santander, net proceeds from issuances of perpetual and trust preferred securities and cash on hand. Sovereign issued 88.7 million shares to Santander, which made Santander its largest shareholder. Independence was headquartered in Brooklyn, New York, with 125 community banking offices in the five boroughs of New York City, Nassau and Suffolk Counties and New Jersey and had total assets and deposits of $17.1 billion and $11.0 billion, respectively. Sovereign acquired Independence to connect their Mid-Atlantic geographic footprint to New England and create new markets in certain areas of New York. Sovereign recorded merger-related and integration charges of $42.8 million pre-tax ($27.8 million after-tax), or $0.06 per diluted share, in 2006.

On January 21, 2005, Sovereign acquired Waypoint for approximately $953 million and the results of Waypoint are included in the accompanying financial statements subsequent to the acquisition date. A cash payment of $269.9 million was made in connection with the transaction with the remaining consideration consisting of the issuance of 29.8 million shares of common stock and stock options (to convert outstanding Waypoint stock options into Sovereign stock options). The value of the common stock for accounting purposes was determined based on the average price of Sovereign’s shares over the three day period preceding and subsequent to the announcement date of the acquisition. Waypoint was a bank holding company headquartered in Harrisburg, Pennsylvania, with assets of approximately $4.3 billion and deposits of $2.9 billion. Waypoint operated 66 community banking offices in ten counties in south-central Pennsylvania and northern Maryland. This acquisition has increased Sovereign’s market presence in many counties in Pennsylvania and has created new markets in certain counties in Maryland. Sovereign recorded merger related and integration charges of $16.7 million pre-tax ($10.9 million after-tax), or $0.03 per diluted share in 2005.

On February 6, 2004, Sovereign closed the acquisition of First Essex for approximately $418 million and the results of First Essex are included in the accompanying financial statements subsequent to the acquisition date. A cash payment of $208 million was made in connection with the transaction with the remaining consideration consisting of the issuance of 12.7 million shares of Sovereign’s common stock and the exchange of Sovereign stock options for existing First Essex options. The value of the common stock for accounting purposes was based on the average price of Sovereign’s shares over the three day period preceding and subsequent to the announcement date of the acquisition. First Essex had approximately $1.7 billion in assets and $1.3 billion in deposits and was headquartered in Andover, Massachusetts, with 20 community banking offices throughout 2 counties in Massachusetts and 3 counties in New Hampshire. This acquisition fortified our presence in both of these states and gave us greater leverage in commercial and retail banking in these markets. Sovereign recorded merger-related and integration charges of $22.7 million pre-tax ($14.8 million after-tax), or $.04 per diluted share, in 2004. The majority of these charges related to closing Sovereign branch and office locations which will be serviced by acquired First Essex properties.

On July 23, 2004, Sovereign completed the acquisition of Seacoast, a commercial bank holding company, with $5.7 billion in assets and $3.7 billion in deposits, headquartered in New Bedford, Massachusetts, and the results of Seacoast’s operations are included in the accompanying financial statements subsequent to the acquisition date. Sovereign issued 36.2 million shares of common stock and exchanged Sovereign stock options for existing Seacoast options, with a combined value of $817.5 million and made cash payments of $256.2 million, to acquire and convert all outstanding Seacoast shares and employee stock options and pay associated fees. The value of the common stock was determined based on the average price of Sovereign’s shares over the three-day period preceding and subsequent to the closing date of the acquisition since the final consideration was subject to change based upon the value of Sovereign’s stock price immediately preceding the closing date of the transaction. The Seacoast acquisition added 67 banking offices throughout Southeastern Massachusetts. This acquisition has increased Sovereign’s market presence in the New England market place. Sovereign recorded merger related and integration charges of $23.7 million pre-tax ($15.4 million after-tax) or $.05 per diluted share in 2004. See Note 27 for additional details on the merger-related charges recorded by Sovereign on the acquisitions noted above.

Financial Condition

     Loan Portfolio. Sovereign’s loan portfolio at December 31, 2006 was $62.6 billion (including $7.6 billion of loans held for sale), compared to $43.8 billion (including $0.3 billion of loans held for sale) at December 31, 2005, and was comprised of $30.5 billion of commercial loans, $26.8 billion of consumer loans secured by real estate and $5.3 billion of consumer loans not secured by real estate. This compares to $16.6 billion of commercial loans, $22.3 billion of consumer loans secured by real estate, and $4.9 billion of consumer loans not secured by real estate at December 31, 2005.

Commercial loans grew by 83% during 2006 to $30.5 billion principally due to the Independence acquisition and loan origination activity. Consumer loans secured by real estate grew by 22% in 2006 to $26.8 billion as a result of business acquisitions, loan origination activity and loan purchases.

Table 4 presents the composition of Sovereign’s loan portfolio by type of loan and by fixed and variable rates at the dates indicated (in thousands):

Table 4: Composition of Loan Portfolio

		AT DECEMBER 31,
		2006								2005								2004								2003								2002
		BALANCE				PERCENT				BALANCE				PERCENT				BALANCE				PERCENT				BALANCE				PERCENT				BALANCE				PERCENT
Commercial real estate loans		$	11,514,983				18.4	%		$	7,209,180				16.5	%		$	5,824,133				15.9	%		$	4,702,046				18.0	%		$	4,386,522				18.9	%
Commercial and industrial loans			13,188,909				21.1				9,426,466				21.5				8,040,107				21.9				6,361,640				24.3				5,940,234				25.6
Multifamily (1)			5,768,451				9.2				—				—				—				—				—				—				—				—
Total Commercial Loans			30,472,343				48.7				16,635,646				38.0				13,864,240				37.8				11,063,686				42.3				10,326,756				44.5
Residential mortgages			17,404,730				27.8				12,462,802				28.4				8,497,496				23.2				5,074,684				19.4				4,347,512				18.7
Home equity loans and lines of credit			9,443,560				15.1				9,793,124				22.4				9,577,656				26.2				6,457,682				24.7				5,165,834				22.3
Total Consumer Loans secured by real estate			26,848,290				42.9				22,255,926				50.8				18,075,152				49.4				11,532,366				44.1				9,513,346				41.0
Auto loans			4,848,204				7.7				4,434,021				10.1				4,205,547				11.5				3,240,383				12.4				3,038,976				13.1
Other			419,759				0.7				478,254				1.1				486,140				1.3				312,224				1.2				314,356				1.4
Total Consumer Loans			32,116,253				51.3				27,168,201				62.0				22,766,839				62.2				15,084,973				57.7				12,866,678				55.5
Total Loans		$	62,588,596				100.0	%		$	43,803,847				100.0	%		$	36,631,079				100.0	%		$	26,148,659				100.0	%		$	23,193,434				100.0	%
Total Loans with:
Fixed rates		$	39,716,958				63.5	%		$	26,141,411				59.7	%		$	21,145,915				57.7	%		$	15,171,129				58.0	%		$	13,599,898				58.6	%
Variable rates			22,871,638				36.5				17,662,436				40.3				15,485,164				42.3				10,977,530				42.0				9,593,536				41.4
Total Loans		$	62,588,596				100.0	%		$	43,803,847				100.0	%		$	36,631,079				100.0	%		$	26,148,659				100.0	%		$	23,193,434				100.0	%