Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)
EXECUTIVE SUMMARY
Sovereign is a financial institution with community banking offices, operations and team members located principally in Pennsylvania, Massachusetts, New Jersey, Connecticut, New Hampshire, New York, Rhode Island, Maryland, and Delaware. 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 residential, home equity, and multi-family loans and investment securities, capital markets products, cash management 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 various factors including the economic environment and its affect on interest rates, consumer and business confidence and spending, as well as competitive conditions within our geographic footprint.
Our customers select Sovereign for banking and other financial services based on our ability to assist customers by understanding and anticipating their individual financial needs and providing customized solutions. Our major strengths include a strong franchise value in terms of market share and demographics and diversified loan portfolio and products. Our weaknesses have included operating returns and capital ratios that are lower than certain of our peers. We have also not achieved our growth targets with respect to low cost core deposits.
We took proactive steps during the second quarter of 2008 to improve our capital position by raising $1.4 billion of common equity and $500 million of subordinated debt at Sovereign Bank. Our capital position was impacted in the third quarter of 2008 by the impairment charge on our Fannie Mae and Freddie Mac preferred stock of $575 million and the loss on the sale of our entire CDO portfolio of $602 million and higher credit losses. The valuations of these investments have been volatile over the past few years and caused significant variations in our capital levels due to large unrealized losses for these two categories. Despite these large losses in the third quarter of 2008, our tangible Common Equity to Tangible Assets and Tier 1 Leverage for the Parent Company increased at September 30, 2008 to 5.01% and 6.60% from 4.04% and 5.89% at December 31, 2007, respectively. The Bank's total risk based capital ratio increased to 10.88% from 10.40%. At September 30, 2008, we contributed $800 million of cash from our holding company in order to enhance our Bank's capital ratios. These capital levels and ratios are well in excess of the levels required to be considered well-capitalized. We continue to strengthen our balance sheet and position the Company for any further weakening in economic conditions by increasing the amount of loan loss reserves on our balance sheet. Reserves for credit losses as a percentage of total loans has increased to 1.79% at September 30, 2008 from 1.28% at December 31, 2007.
In order to further improve our operating returns, we continue to focus on acquiring and retaining customers by demonstrating convenience through our locations, technology and business approach while offering innovative and easy-to-use products and services. We are focused on a number of initiatives to improve the customer experience. During 2007, customer service personnel received refresher service training and we migrated back to having all customer service functions being domestically based. We realigned our consumer and commercial infrastructure by consolidating our commercial and retail banking management structure. We also rationalized and simplified our retail deposit product set by reducing the number of retail checking products we offer.
In the fourth quarter of 2007, we piloted a new retail deposit strategy called "Customer First" in certain markets within our footprint. The goal of Customer First is to increase deposit retention and growth rates and increase the number of products and services our customers maintain and use at Sovereign. Customer First, which is a sales model/methodology that drives consistent team member behavior in each of our 750 community banking offices, was implemented throughout our entire branch network in the first quarter of 2008. We have experienced improved productivity within retail banking and improved deposit retention during 2008. Additionally, in the first quarter of 2008, Sovereign hired a senior level executive who reports to our Chief Executive Officer to lead the Company's Retail Banking Division. In the third quarter, we experienced decreases in deposit levels, primarily in high cost money market and certificate of deposit accounts reflecting intense price competition in the marketplace for deposits. We believe some of the deposit decreases were also due to unprecedented market events such as the failure of Washington Mutual, Inc. which was seized by the FDIC and the accelerated sale of Wachovia Corporation to Wells Fargo & Company. These events as well as other financial institution failures have led to an increase in deposit attrition, particularly for account balances in excess of FDIC insurance limits. We believe that the recent actions by the US government in early October (which included increasing deposit insurance to $250,000 per depositor interest bearing account and unlimited insurance on non-interest bearing accounts) as well as our pending transaction with Santander, will help stabilize our deposit base.

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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)
RECENT INDUSTRY CONSOLIDATION IN OUR GEOGRAPHIC FOOTPRINT
The Banking industry has experienced significant consolidation in recent years. Consolidation may affect the markets in which Sovereign operates as new or restructured competitors integrate acquired businesses, adopt new business practices or change product pricing as they attempt to maintain or grow market share. Recent merger activity involving national, regional and community banks and specialty finance companies in the northeastern United States, have affected the competitive landscape in the markets we serve. Management continually monitors the environment in which it operates to assess the impact of the industry consolidation on Sovereign, as well as the practices and strategies of our competition, including loan and deposit pricing, customer expectations and the capital markets.
On October 13, 2008, the Company and Santander entered into a transaction agreement which is anticipated to close in the first quarter of 2009. We believe that the transaction will further strengthen our financial position and enable us to continue to execute our strategy of focusing on our core retail and commercial customers in our geographic footprint.
CURRENT INTEREST RATE ENVIRONMENT
Net interest income represents a substantial portion of the Company's revenues. Accordingly, the interest rate environment has a substantial impact on Sovereign's earnings. Sovereign currently has a mildly liability sensitive interest rate risk position. During the third quarter of 2008, we shortened the duration of our investment portfolio in order to mitigate the impact of interest rate changes on the market value of our balance sheet. Sovereign sold $4.2 billion of longer duration mortgage backed securities and $0.5 billion of longer duration municipal securities for a gain of $29.5 million. We reinvested $3.5 billion of these securities in shorter duration agency securities. Although this transaction reduces the risk of adverse market value changes in our available for sale investment portfolio due to changes in interest rates, this action, along with the elimination of the dividends received on our Fannie Mae and Freddie Mac preferred shares will reduce our net interest income in the fourth quarter and in future periods. Net interest margin in future periods will also be impacted by several factors such as but not limited to, our ability to grow and retain core deposits, the future interest rate environment, and loan and investment prepayment rates. 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. We have experienced a deterioration in certain key credit quality performance indicators during 2008 which has resulted in higher levels of charge-offs and provision for credit losses. For the third quarter of 2008, the provision for credit losses and charge-offs were $304.0 million and $129.1 million, respectively, compared to $162.5 million and $33.6 million in the third quarter of 2007, respectively. Our provision for credit losses and charge-offs for the nine-month period ended September 30, 2008 were $571.0 million and $290.4 million compared to $259.5 million and $83.3 million, respectively, for the corresponding period in the prior year. The increases were driven by deterioration in our consumer and commercial portfolios. As of September 30, 2008, total non-performing loans were $638.5 million or 1.12% of total loans compared to $282.4 million or 0.49% at September 30, 2007. The increase in non-performing loans was primarily driven by our residential Alt-A, commercial real estate, multi-family and commercial and industrial loan portfolios.
During 2007, Sovereign expanded its indirect auto loan portfolio into the Southeastern and Southwestern United States ("out-of-market loans"). Sovereign originated $2.8 billion of out-of-market loans in 2007 at a weighted average yield of 8.04%. Effective January 31, 2008, Sovereign ceased originating new auto loans from these markets. We also strengthened our underwriting standards in the second half of 2007 on our entire auto loan portfolio. We believe these two decisions will lower loss rates in future periods; however, losses remained elevated thus far in 2008 as the newly originated loans continue to season. For the nine-month period ended September 30, 2008, net losses on our auto loan portfolio were $121.4 million compared to $41.9 million for the nine months ending September 30, 2007. Deterioration in the economy of the regions where we extended these loans could have a significant adverse impact on the amount of credit losses we experience in future periods. The remaining balance of our auto out-of-market loan portfolio at September 30, 2008 was $2.0 billion with reserves for credit losses of $93.4 million.

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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
As discussed previously, conditions in the housing market significantly impacted areas of our business. Certain segments of our consumer and commercial loan portfolios have exposure to the housing market. Sovereign has residential real estate loans totaling $11.5 billion at September 30, 2008 of which $2.7 billion is comprised of Alt-A residential loans. Although losses have been increasing since the prior year, actual credit losses on these loans have been modest and totaled $5.4 million and $14.9 million during the three-month period and nine-month period ended September 30, 2008 compared to $1.7 million and $3.8 million for the corresponding periods in the prior year. However non-performing assets and past due loans have been increasing particularly for the Alt-A portion of the residential portfolio. The increased loss experience and asset quality trends led us to increase our reserves for our residential portfolio over the past three quarters. Future losses in our residential loan portfolio will continue to be significantly influenced by home prices in the residential real estate market, unemployment and general economic conditions.
Sovereign also has $6.3 billion of home equity loans and lines of credit (excluding our correspondent home equity loans). Net charge-offs on these loans for the three-month and nine-month periods ended September 30, 2008 were $4.7 million and $14.4 million, respectively, compared with $0.9 million and $4.3 million for the corresponding periods in the prior year. This portfolio consists of loans with an average FICO at origination of 775 and an average loan to value of 58%. We have total reserves of $36.5 million for this loan portfolio at September 30, 2008.
During 2008, we have continued to experience increases in non-performing assets in our commercial lending and commercial real estate portfolios. Non-performing assets for these portfolios increased to $155.5 million and $201.6 million at September 30, 2008 from $85.4 million and $61.8 million at December 31, 2007. Given these changes, we increased our allowance for loan losses for these portfolios by approximately $107.9 million and $201.6 million during the three-month and nine-month periods ended September 30, 2008. This increase was a significant component of our provision for credit losses of $304.0 million and $571.0 million for the three-month and nine-month periods ended September 30, 2008. A large portion of these increases is tied to companies that are in housing related industries. We have decreased the amount of loan originations to these borrower types in 2008; however, we expect that the difficult housing environment as well as deteriorating economic conditions will continue to impact our commercial lending and commercial real estate portfolios which may result in elevated levels of provisions for credit losses in future periods.
RESULTS OF OPERATIONS
General
Net (loss)/income was $(981.6) million, or $(1.48) per diluted share, and $(754.0) million, or $(1.33) per diluted share, for the three-month and nine-month periods ended September 30, 2008 as compared to $58.2 million, or $0.11 per diluted share, and $253.7 million, or $0.51 per diluted share for the three-month and nine-month periods ended September 30, 2007. Current year results include a higher provision for credit losses compared with the corresponding periods in the prior year due to the slowing economic conditions and the deterioration in most categories of our loan portfolios as discussed above. The provision for credit losses has increased to $304.0 million and $571.0 million in the three-month and nine-month periods ended September 30, 2008 compared to $162.5 million and $259.5 million for the three-month and nine-month periods ended September 30, 2007 due to the impact of the slowing economy and the deterioration of credit quality in our loan portfolios.
During the third quarter of 2008, Sovereign recorded a $575 million after-tax other-than-temporary impairment charge on our FNMA and FHLMC preferred stock portfolio. On September 7, the U.S. Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) announced that the FHFA was putting Fannie Mae and Freddie Mac under conservatorship and giving management control to their regulator, the FHFA. In connection with this action, the dividends on our preferred shares were eliminated thereby significantly reducing the value of this investment. The remaining value of our shares was $47 million at September 30, 2008. Beginning in the fourth quarter of 2008, Sovereign will no longer receive dividends on these preferred shares which will reduce interest income by approximately $13 million each quarter. As discussed in Note 18, the US Government passed the Emergency Economic Stabilization Act of 2008 in early October. This legislation changes the tax treatment on losses on the preferred stock of Fannie Mae and Freddie Mac to allow financial institutions to account for them as operating losses rather than capital losses. Due to this change in tax law, Sovereign anticipates recording a $269.2 million tax benefit related to charges associated with these investments in the fourth quarter of 2008.
In order to reduce risk in the investment portfolio, Sovereign sold its entire portfolio of collateralized debt obligations ("CDOs") during the third quarter incurring a pretax loss of $602.3 million. The CDO portfolio has experienced significant volatility over the past year as a result of conditions in the credit markets. The Company decided to sell these securities due to the unprecedented uncertainty in the credit markets and to reduce the risk profile of its balance sheet.
Net income in 2007 included charges of $222.0 million ($144.3 million after-tax or $0.30 per diluted share) related to our 2007 balance sheet restructuring and an expense saving initiative.

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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) CONSOLIDATED AVERAGE BALANCE SHEET / TAX EQUIVALENT NET INTEREST MARGIN ANALYSIS NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2008 AND 2007 (in thousands) 2008 2007 Tax Tax Average Equivalent Yield/ Average Equivalent Yield/ Balance Interest Rate Balance Interest Rate EARNING ASSETS INVESTMENTS $ 12,120,843 $ 542,710 5.97 % $ 14,359,545 $ 662,500 6.15 % LOANS: Commercial loans 27,504,751 1,192,542 5.79 % 25,169,599 1,361,906 7.23 % Multi-Family 4,536,897 203,626 5.99 % 4,827,663 232,677 6.43 % Consumer loans Residential mortgages 12,501,718 529,885 5.65 % 14,788,758 630,279 5.68 % Home equity loans and lines of credit 6,402,562 276,327 5.76 % 7,122,383 369,186 6.93 % Total consumer loans secured by real estate 18,904,280 806,212 5.69 % 21,911,141 999,465 6.09 % Auto loans 6,535,905 341,495 6.98 % 5,915,010 307,332 6.95 % Other 306,435 17,831 7.77 % 376,740 24,156 8.57 % Total consumer 25,746,620 1,165,538 6.04 % 28,202,891 1,330,953 6.30 % Total loans 57,788,268 2,561,706 5.92 % 58,200,153 2,925,536 6.71 % Allowance for loan losses (780,182 ) - - (496,921 ) - - NET LOANS 57,008,086 2,561,706 6.00 % 57,703,232 2,925,536 6.77 % TOTAL EARNING ASSETS 69,128,929 3,104,416 5.99 % 72,062,777 3,588,036 6.65 % Other assets 10,321,919 - - 11,632,426 - - TOTAL ASSETS $ 79,450,848 $ 3,104,416 5.22 % $ 83,695,203 $ 3,588,036 5.72 %

FUNDING LIABILITIES Deposits and other customer related accounts: Retail and commercial deposits $ 31,422,080 $ 571,506 2.43 % $ 31,078,240 $ 711,076 3.06 % Wholesale deposits 3,395,117 67,968 2.67 % 7,248,712 293,528 5.41 % Government deposits 3,360,712 68,151 2.71 % 3,783,505 145,585 5.14 % Customer repurchase agreements 2,579,235 32,911 1.70 % 2,433,331 81,358 4.47 % TOTAL DEPOSITS 40,757,144 740,536 2.43 % 44,543,788 1,231,547 3.70 % BORROWED FUNDS: FHLB advances 18,089,980 623,925 4.60 % 16,280,973 614,962 5.04 % Fed funds and repurchase agreements 1,116,988 21,875 2.62 % 1,342,104 53,546 5.33 % Other borrowings 3,790,370 172,011 6.05 % 4,785,627 218,863 6.10 % TOTAL BORROWED FUNDS 22,997,338 817,811 4.75 % 22,408,704 887,371 5.29 % TOTAL FUNDING LIABILITIES 63,754,482 1,558,347 3.26 % 66,952,492 2,118,918 4.23 % Demand deposit accounts 6,580,094 - - 6,381,978 - - Other liabilities 1,575,189 - - 1,585,747 - - TOTAL LIABILITIES 71,909,765 1,558,347 2.89 % 74,920,217 2,118,918 3.78 % STOCKHOLDERS' EQUITY 7,541,083 - - 8,774,986 - - TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 79,450,848 1,558,347 2.62 % $ 83,695,203 2,118,918 3.38 % NET INTEREST INCOME $ 1,546,069 $ 1,469,118 NET INTEREST SPREAD (1) 2.73 % 2.42 % NET INTEREST MARGIN (2) 2.98 % 2.72 %

(1) Represents the difference between the yield on total earning assets and the cost of total funding liabilities.

(2) Represents annualized, taxable equivalent net interest income divided by average interest-earning assets.

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SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income
Net interest income for the three-month and nine-month periods ended September 30, 2008 was $491.2 million and $1.5 billion compared to $456.8 million and $1.4 billion for the same periods in 2007. The increase in net interest income was due to an increase in net interest margin for the three-month and nine-month periods ended September 30, 2008 to 3.02% and 2.98%, compared to the corresponding periods in the prior year of 2.74% and 2.72%. The reason for the increase has been due to the recent steepening of the yield curve, the balance sheet restructuring we executed in the first quarter of 2007 and reductions in short-term interest rates which has benefited us given our mildly liability sensitive interest rate position. Partially offsetting this positive impact in net interest income was a decrease in average interest earning assets to $67.4 billion and $69.1 billion for the three-month and nine-month periods ending September 30, 2008 compared to $70.0 billion and $72.1 billion for the three-month and nine-month periods ending September 30, 2007 as a result of the sale of $3.4 billion, $2.9 billion and $1.2 billion of correspondent home equity, residential mortgage loans and multi-family loans, respectively, in connection with our balance sheet restructuring in the first quarter of 2007. Even though we have reduced our exposure to these loan categories, Sovereign has generated commercial loan growth within its geographic footprint which has led to an increase of approximately $2.3 billion of average commercial loans. However, most of that growth occurred in late 2007 and early 2008. Since June 30, 2008, Sovereign's average commercial loans have decreased $224 million. Sovereign is focused on limiting its balance sheet growth given the difficult economic and credit conditions.
Interest on investment securities and interest earning deposits was $143.1 million and $487.8 million for the three-month and nine-month periods ended September 30, 2008, compared to $196.1 million and $602.1 million for the same periods in 2007. The average balance of investment securities was $12.1 billion with an average tax equivalent yield of 5.97% for the nine-month period ended September 30, 2008 compared to an average balance of $14.4 billion with an average yield of 6.15% for the same period in 2007. The decrease in average balances is due to our efforts to reduce our reliance on certain wholesale investment security asset categories. The Company continues to anticipate that investment securities as a percentage of our total assets will decline in future periods. Interest on investment securities will decrease in the fourth quarter as a result of the CDO sale and the elimination of dividends by the FHFA on our Fannie Mae and Freddie Mac perpetual preferred stock. Additionally, during the third quarter of 2008, we shortened the duration of our investment portfolio in order to mitigate the impact of interest rate changes on the market value of our balance sheet. Sovereign sold $4.2 billion of longer duration mortgage backed securities and $0.5 billion of longer duration municipal securities for a gain of $29.5 million. We reinvested $3.5 billion of these securities in shorter duration agency securities. We expect the impact of the above items to reduce the yield on our investment portfolio which will result in a decrease in investment income.
Interest on loans was $816.7 million and $2.6 billion for the three-month and nine-month periods ended September 30, 2008, compared to $954.0 million and $2.9 billion for the three-month and nine-month periods in 2007. The average balance of loans was $57.8 billion with an average yield of 5.92% for the nine-month period ended September 30, 2008 compared to an average balance of $58.2 billion with an average yield of 6.71% for the same period in 2007. Average balances of commercial loans in 2008 increased $2.3 billion as compared to 2007, primarily due to strong organic growth in our commercial loan portfolio. Commercial loan yields have decreased 144 basis points due to the decline in short-term interest rates which has decreased the yields on our variable rate loan products. Average residential mortgages decreased $2.3 billion due to the sale of $2.9 billion of residential loans in the first quarter of 2007. Average home equity loans and lines of credit decreased $0.7 billion from the prior year due to the sale of $3.4 billion of correspondent home equity loans in connection with the previously mentioned balance sheet restructuring at the end of the first quarter of 2007. Average balances of auto loans increased to $6.5 billion from $5.9 billion due to organic in-market growth and a decision towards the middle of 2006 to expand out-of-market loans. However, as previously discussed, losses on these loans have been higher than our expectations and effective January 31, 2008, management ceased originating loans from these channels. This has led to a reduction of average auto loans in the third quarter of 2008 as this portfolio declined to $6.1 billion for the three-month period ended September 30, 2008 compared to $6.6 billion for the three-month period ended June 30, 2008. . . .