Summary of SOVEREIGN BANCORP INC

Item 7 - Management's Discussion and Analysis of Financial Condition and Results
of Operations ("MD&A")
EXECUTIVE SUMMARY
Sovereign, is a $77 billion financial institution as of December 31, 2008, 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. On January 30, 2009, Sovereign was acquired by Santander. 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. Furthermore, at September 30, 2008, we contributed $800 million of cash from our holding company in order to enhance our Bank's capital ratios. Our capital position was negatively impacted in the second half of 2008 by the impairment charge on our Fannie Mae and Freddie Mac preferred stock of $575 million, an other than temporary impairment charge of $308 million on certain non-agency mortgage backed securities and the loss on the sale of our entire collateralized debt obligations ("CDO") portfolio of $602 million combined with higher credit losses due to the continuing negative economic environment. The above items resulted in Sovereign recording a pre-tax loss of $1.6 billion in 2008. In 2007, Sovereign had a $1.3 billion pre-tax loss. As a result, Sovereign was in a cumulative loss position for the past three years and we expect that on a stand alone basis, without any consideration given to the merger transaction with Santander in accordance with U.S. accounting principles, 2009 results would continue to be negatively impacted by the difficult economic credit environment thus making it difficult to generate taxable income in the near term. Therefore, it was determined that on a stand alone basis it was more likely than not that deferred tax assets of $1.43 billion were not realizable and as such a valuation allowance was recorded via a charge to income tax expense. Our tangible common equity to tangible assets and tier 1 leverage for the Parent Company was 2.57% and 5.73% at December 31, 2008 compared to 4.04% and 5.89% at December 31, 2007, respectively. The Bank's total risk based capital ratio was 10.20% compared to 10.40% a year ago. Our capital levels and ratios are 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 have increased to 2.10% at December 31, 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 755 community banking offices, was implemented throughout our entire branch network in the first quarter of 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. We experienced improved productivity within retail banking and improved deposit retention during the first half of 2008. In the third quarter of 2008, 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 and the uncertainty of the banking industry. 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 transaction with Santander, helped the Company reclaim deposits as we were able to increase deposit balances at December 31, 2008 by $5.3 billion from September 30, 2008. Although we grew our total deposits, a large percentage of the growth was in higher cost money market and time deposit accounts which has put pressure on our net interest margin.
Market Conditions and Credit
In 2008, conditions in the housing market continued to deteriorate and there was a significant tightening of available credit in the marketplace. Declining real estate values and financial stress on borrowers resulted in higher delinquencies and greater charge-offs in 2008 compared to 2007. Credit spreads significantly widened on various asset classes in the secondary marketplace which has led to a reduction in liquidity for these asset classes.
These changing market conditions impacted our financial results in 2008 in a number of ways. We continued to see higher levels of losses on our remaining correspondent home equity portfolio due to a reduction in housing values and limited availability of credit in the marketplace which reduced refinancing options for these loan customers. Residential charge-offs totaled $26.2 million in 2008 ($14.0 million of which was related to our Alt-A portfolio which totaled $2.7 billion at December 31, 2008) compared to $7.5 million in 2007. In response to the deteriorating economic conditions and higher credit losses experienced in 2008, Sovereign increased its residential loan loss reserve to $105.8 million or 0.93% of total residential loans at December 31, 2008 compared to $38.3 million or 0.29% at December 31, 2007.

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In addition to our residential and Alt-A residential loan portfolios, we saw elevated levels of losses in our auto loan portfolio in 2008. During 2007, Sovereign expanded its indirect auto loan business in the Southeastern and Southwestern United States ("the Southeast and Southwest production offices"). When we decided to expand our auto loan business into the Southeast and Southwest, we expected to see higher levels of losses than what we had historically experienced for our auto loan business in our geographic footprint given that it was a new market and economic conditions were different in these markets as compared to the Northeast. However, we had believed that our pricing was adjusted to consider this expected difference in risk. The Southeast and Southwest production offices experienced significant growth in auto loan balances in 2007. However, credit losses were significantly higher than our expectations and were the primary reasons for additional provisions for credit losses that were recorded in the second half of 2007. Charge-offs on our auto portfolio totaled $175.7 million during 2008 compared to $76.2 million in 2007. Additionally, $115.6 million of these losses were related to the Southeast and Southwest production offices. At December 31, 2008, our total auto loan portfolio was $5.3 billion of which $1.8 billion consisted of loans originated in the Southeast and Southwest production offices. At December 31, 2008 our total allowance for loan losses for the auto portfolio was $140.0 million. Effective January 31, 2008, Sovereign ceased originating new auto loans from the Southeast and Southwest production offices. In January 2009, Sovereign ceased originating indirect auto loans within its geographic footprint as well. Sovereign has increased its reserves on its auto lending portfolios significantly over the past two years. We believe the additional provisions responds to the increased risk in our auto loan portfolio. However, deterioration in the economy of the regions where we extended these loans could have a significant continued adverse impact on the amount of credit losses we experience in 2009.
In addition to increasing the provision for credit losses for the auto loan and residential mortgage portfolios, Sovereign also increased the provision for credit losses to cover exposures in its commercial portfolio, as well as increased charge-offs. Our commercial reserves as a percentage of commercial loans increased to 2.37% at December 31, 2008, from 1.40% at December 31, 2007. This was due to an increase in the level of criticized and non-performing loans from the prior year and weakening market conditions. Additionally, we recorded additional provisions in 2008 due to growth of $0.6 billion on our commercial real estate and commercial and industrial loan portfolios.
Our total allowance for credit losses as a percentage of total loans increased to 2.10% at December 31, 2008 compared to 1.28% at December 31, 2007. We believe the reserves we have established are adequate to provide for inherent losses in our portfolio at this time. Although the credit quality of our loan portfolio will most likely have the most significant impact on our financial performance in 2009, we believe the recent steps we have taken with regards to our auto loan portfolio will reduce the credit risk in our consumer portfolio. Additionally, in 2008, we curtailed certain commercial lending related to the homebuilding industry which we believe will reduce the risk in our commercial loan portfolio. The disruption in the residential real estate market also had a significant impact on Fannie Mae (FNMA) and Freddie Mac (FHLMC). On September 7, 2008 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 which resulted in an other than temporary impairment charge we recorded in the third quarter of 2008 of $575 million.
The deteriorating economic conditions also have significantly impacted the fair value of certain non-agency mortgage backed securities. The collateral for these securities consists of residential loans originated by a diverse group of private label issuers. For the period ended December 31, 2008, it was concluded that the Company would not recover all of its outstanding principal on five bonds in our non-agency mortgage backed portfolio with a book value of $654.3 million whose fair value was $346.4 million. This resulted in a $307.9 million other than temporary impairment charge.
Sovereign also has an equity method investment in a multi-family loan broker that was determined to be impaired at December 31, 2008. This broker refers borrowers seeking financing of their multi-family and/or commercial real estate loans to Sovereign as well as other financial institutions. Substantially all of Sovereign's multi-family loan originations are obtained through this relationship. Although this broker remained profitable in 2008, their earnings have declined from recent periods due to the current economic slowdown. Additionally, we believe earnings in future periods will remain under pressure due to the current recessionary environment. As a result, it was concluded that the fair value of this equity method investment was significantly below its carrying value and as a result recorded an impairment charge of $95 million which was recorded in "Minority interest expense and equity method investments" on the Consolidated Statement of Operations.
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, 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 competitors, including loan and deposit pricing, customer expectations and the capital markets.
On January 30, 2009, the Company was acquired by Santander. We believe that the acquisition of the Company by Santander 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.

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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. 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 and FHLB stock reduced our net interest income in the fourth quarter and will continue to do so 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, loan and investment prepayment rates and levels of non-accrual loans. 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 had a significant impact on our operating results for 2008. We have experienced deterioration in certain key credit quality performance indicators in 2008. We had charge-offs of $477.1 million in 2008 compared to $143.8 million in 2007. Our provision for credit losses was $911.0 million in 2008 compared to $407.7 million in 2007. The increases were driven by deterioration in our consumer and commercial 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. However, losses remained elevated on these portfolios in 2008 as the newly originated loans continue to season and the US economy entered into a recession. Sovereign decided to exit its in footprint indirect auto portfolio and ceased originating these loans in January 2009. For the twelve-month period ended December 31, 2008, net losses on our auto loan portfolio were $175.7 million compared to $76.2 million for the twelve months ending December 31, 2007. Continued 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. At December 31, 2008, our total auto loan portfolio was $5.3 billion of which $1.8 billion consisted of loans originated in the Southeast and Southwest production offices. At December 31, 2008 our total allowance for loan losses for the auto portfolio was $140.0 million. As discussed previously, conditions in the housing market significantly impacted various 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 $11.4 billion at December 31, 2008 of which $2.7 billion is comprised of Alt-A residential loans. Residential loan losses have been increasing since the prior year and actual credit losses on these loans totaled $26.2 million in 2008 compared to $7.5 million in the prior year. 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. 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.
The homebuilder industry also has been impacted by a decline in new home sales and a reduction in the value of residential real estate which has decreased the profitability and liquidity of these companies. Declines in real estate prices in 2008 and 2007 have been the most pronounced in certain states where previous increases were the largest, such as California, Florida and Nevada. Additionally, foreclosures have increased sharply in various other areas due to increasing levels of unemployment. Sovereign provided financing to various homebuilder companies which is included in our commercial loan portfolio. The Company has been working on de-emphasizing this loan portfolio during 2008 which has resulted in it declining to $0.8 billion at December 31, 2008 compared to $1.1 billion a year ago. Approximately eighty five percent of these loans at December 31, 2008 are to builders in our geographic footprint which generally have had more stable economic conditions on a relative basis compared to the national economy. We continue to monitor this portfolio in future periods given recent market conditions and determine the impact, if any, on the allowance for loan losses related to these homebuilder loans.
Sovereign also has $6.5 billion of home equity loans and lines of credit (excluding our correspondent home equity loans). Net charge-offs on these loans for the twelve-month period ended December 31, 2008 was $21.1 million compared with $8.1 million for the corresponding period in the prior year. This portfolio consists of loans with an average FICO at origination of 777 and an average loan to value of 58%. We have total reserves of $39.1 million for this loan portfolio at December 31, 2008.
During 2008, we have continued to experience increases in non-performing assets in our commercial lending and commercial real estate portfolios as a result of worsening credit and economic conditions. Non-performing assets for these portfolios increased to $244.8 million and $319.6 million at December 31, 2008 from $85.4 million and $61.8 million at December 31, 2007. Charge-offs on these portfolios were $169.0 million and $32.8 million in 2008 compared to $34.9 million and $15.5 million in 2007. Given these changes, we increased our allowance for loan losses for these portfolios by approximately $222.8 million and $80.9 million during 2008. This increase was a significant component of our provision for credit losses of $911 million for the twelve-month period ended December 31, 2008. 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.

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RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007

                                                        YEAR ENDED DECEMBER 31,
    (Dollars in thousands, except per share data)        2008             2007
    Net interest income                             $  1,903,311     $  1,864,022
    Provision for credit losses                          911,000          407,692
    Total non-interest income                           (818,743 )        354,396
    General and administrative expenses                1,541,409        1,345,838
    Other expenses                                       265,793        1,874,600
    Net (loss)/income                               $ (2,357,210 )   $ (1,349,262 )
    Basic (loss)/earnings per share                 $      (3.98 )   $      (2.85 )
    Diluted (loss)/earnings per share               $      (3.98 )   $      (2.85 )

The major factors affecting comparison of earnings and diluted earnings per share between 2008 and 2007 were:
� Net interest income increased 2.1% during 2008 due to an expansion in net interest margin to 2.91% from 2.73% a year ago, partially offset by a $3.3 billion decline in earning assets.

� The increase in provision for credit losses in 2008 is related to the previously mentioned deterioration in our loan portfolios due to the current economic environment.

� Included in non-interest income:

(1) Net losses on investment securities of $1.5 billion and $176.4 million in 2008 and 2007, respectively. Our 2008 and 2007 results included other-than-temporary impairment charges of $575.3 million and $180.5 million, respectively, on FNMA and FHLMC preferred stock. Net losses on investment securities in 2008 also included a $602.3 million loss on the sale of our CDO portfolio and a $308 million other-than-temporary impairment charge on non-agency mortgage backed securities. See Note 6 for additional details.

(2) An increase in capital markets revenues of $43.1 million due to charges of $46.9 million related to customers who defaulted on repurchase agreements and other financing obligations during 2007.

(3) An increase in mortgage banking revenues in 2008 of $54.6 million due to a $119.9 million lower of cost or market adjustment related to the previously mentioned correspondent home equity loan transactions in the first quarter of 2007. Mortgage banking revenues included a $47.3 million residential MSR impairment in 2008 due to increased prepayment speed assumptions due to lower market interest rates.

� Increases in general and administrative expenses in 2008 were due primarily to increased cash based compensation of $87.9 million, which included severance charges of $11.1 million and a reduction in workforce severance charges of $15.8 million. REO and loan expenses also increased $17.6 million as a result of deteriorating credit conditions. Marketing expense increased $22.9 million due to the Customer First initiative during 2008 as well as advertising campaigns incurred in the fourth quarter of 2008 to reclaim deposits lost at the end of the third quarter and related to the Santander transaction. Additionally, deposit insurance premiums increased $28.5 million due to FDIC regulations to implement the Reform Act.

� Other expenses have decreased due primarily to non-deductible goodwill impairment charges of $943 million in our Metro New York reporting unit and $634 million in our Shared Services Consumer reporting unit in 2007. See Note 4 for additional details on this charge. Sovereign also recorded restructuring and ESOP termination charges of $102.1 million in 2007. 2008 results included an impairment charge of $95 million on our equity method investments. See Note 1 for details.

� Sovereign recorded an income tax expense of $723.6 million in 2008 compared to a benefit of $60.5 million in 2007. As previously discussed 2008 results included a valuation allowance of $1.43 billion due to the conclusion that it was more likely than not that our deferred tax assets were not realizable on a stand alone basis. 2007 tax results were significantly impacted by the aforementioned significant charges which magnified the impact of our favorable permanent tax-free items. See a later section of the MD&A for further discussion.

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Net Interest Income. Net interest income for 2008 was $1.90 billion compared to $1.86 billion for 2007, or an increase of 2.1%. The increase in net interest income in 2008 was due to the reduction in market rates which reduced our deposit and borrowing costs in excess of reductions in yields on earning assets since we are liability sensitive.
Interest on investment securities and interest-earning deposits was $584 million for 2008 compared to $792 million for 2007. In connection with management's plan that was announced at the end of 2006, Sovereign has been focused on reducing the size of its investment portfolio as a percentage of total assets. Our average investment portfolio declined by $2.5 billion during 2008 to 14.9% of our total average assets in 2008 compared to 17% in 2007. Additionally, the Company has been working on reducing the duration of its investment portfolio to reduce interest rate risk. The average life of our investment portfolio has declined to 4.62 years at December 31, 2008 compared to 5.24 years at December 31, 2007. Reducing the average life of our investment portfolio has negatively impacted the overall yield on this asset class; however, it reduces the impact that changes in interest rates have on the market value of our balance sheet.
Interest on loans was $3.34 billion and $3.86 billion for 2008 and 2007, respectively. The average balance of loans was $57.5 billion with an average yield of 5.84% for 2008 compared to an average balance of $58.0 billion with an average yield of 6.69% for 2007. The decrease in average yields year to year is due primarily to decreased yields on our commercial loan portfolios which is due . . .