SecProbe.io

CORRESP
1
filename1.htm

corresp

December 22, 2005

Donald A. Walker, Jr.

Senior Assistant Chief Accountant

Securities and Exchange Commission

Division of Corporate Finance

100 F Street, N.E.

Washington, D.C. 20549

Dear Mr. Walker:

This letter is in response to the comments you raised in your letter dated December 8, 2005 based
on your review of Sovereign Bancorp’s Form 10-K for the Year Ended December 31, 2004 and the Forms
10-Q for the Quarters Ended March 31, 2005, June 30, 2005, and September 30, 2005. Below is each
of your comments and Sovereign’s related responses.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Other Expenses, page 17

    1.

    We note your disclosure that during the second quarter of 2004, you made a $60 million
investment in a synthetic fuel partnership. Please tell us the following

    •

    The dollar amount of tax credits which were used to reduce your income tax expense
during 2004;

    •

    The authoritative literature followed in accounting for the partnership; and

    •

    Why you believe that you will receive tax credits in excess of your recorded
investment over the life of the partnership

Sovereign Response

Sovereign
has an investment in a synthetic fuel limited liability company that
generates IRC Section 29 tax credits
for the production of fuel from a non-conventional source (“the
Synthetic Fuel LLC”). We
account for this investment in accordance with the provisions of APB 18, “The Equity Method of
Accounting for Investments in Common Stock”. As such, our investment increases or declines as
profits or losses are allocated to our share ownership. We classify
this investment with our other equity
method investments within our balance sheet and include our share of
the losses generated by the investment
in the earnings-in-equity-method-investments line within the other expenses section of our income
statement, in accordance with paragraph 19c of APB 18.

Sovereign recorded tax credits of $20.4 million as a reduction of income tax expense in 2004
related to our investment in the Synthetic Fuel LLC. The effect of these tax credits on
our

Donald A. Walker, Jr.

Securities and Exchange Commission

December 22, 2005

Page 2

income tax rate is disclosed in the effective tax rate reconciliation table in footnote 18 to the
consolidated financial statements.

The
Synthetic Fuel LLC will not generate tax credits if it cannot produce
and sell synthetic fuel to third party power plants. However, synthetic fuel is priced lower than the other
sources of power used by the plants which, thus far, has resulted in the power plants purchasing all of the
synthetic fuel that the Synthetic Fuel LLC produces. If this
continues it will ensure that the tax credits
will continue to be realized in the future and that we will receive tax credits in excess of our
recorded to investment over the remaining life of the partnership. For the time period January 1, 2005
through December 31, 2007, we are projecting to receive approximately $90 million of tax
credits, which is based on projected
tonnage of synthetic fuel expected to be produced and sold through
December 31, 2007. The projected tax credits could be 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.

Each quarter, we analyze our investment for impairment and consider the projected tax credits that
will be received based on current and projected average crude oil prices and the projected
remaining fuel production volume. Based on this analysis, we concluded that our investment was not
impaired at December 31, 2004 nor in any of the quarterly reporting periods in 2005. We will
continue to monitor oil price increases in the future and their related impact on our investment
and recognition of alternative energy tax credits.

Other Assets, page 26

    2.

    We note your disclosure that you have $431 million of assets associated with your precious
metals business. Please tell us the following:

    •

    How you account for these assets, citing the authoritative literature used;

    •

    How you value these assets and account for changes in fair value;

    •

    The dollar impact(s) these assets have on your financial statements; and

    •

    In depth, what kind of business you use these assets in.

Sovereign Response

The
precious metals business unit contributed fee income of
$18.9 million or 4% of Sovereign’s consolidated
non-interest income for the year ended December 31, 2004. Sovereign’s precious metals group provides physical
inventory services to commercial customers who utilize precious metals in their business. The
customers are typically jewelry manufacturers, wholesalers or retailers and certain other
businesses that utilize precious metals in their end products. Sovereign consigns this inventory
to our customers. We earn a fee on the consigned inventory, which is recognized over the
consignment period. At the end of the consignment period, the customer has the option of
returning the consigned inventory or paying cash (i.e., buying the metal at the fair market value
at the date of return). Sovereign retains ownership of the metal during the consignment period.

At December 31, 2004, we had net assets of $431 million related to our precious metals business.
Our inventory asset positions are carried at fair market value within other assets on our balance
sheet, with changes recorded in earnings based on Accounting Research Bulletin No. 43, Chapter
4, Statement 9 which indicates the following:

Donald A. Walker, Jr.

Securities and Exchange Commission

December 22, 2005

Page 3

“Only in exceptional cases may inventories properly be stated above cost. For example,
precious metals having a fixed monetary value with no substantial cost of marketing may be
stated at such monetary value”.

We hedge our inventory positions through a combination of forward purchase and sale agreements and
futures contracts to protect against movements in precious metal prices. Sovereign’s forward
purchase and sale agreements and future positions are accounted for as derivatives under FASB
Statement 133 and as such are recorded on the balance sheet at fair value with market value changes
recorded in the income statement. The fair value of these derivative instruments at December 31,
2004, was a net unrealized gain of $11.3 million and this balance is included in the net assets
related to the precious metals business of $431 million at December 31, 2004.

Financial Statements

Note 1 – Summary of Significant Accounting Policies, page 51

    3.

    Please confirm that you follow the guidance in FASB 114 and FASB 118 in determining your
specific allowance. If you do not, please tell us how you applied FASB 114 and FASB 118 in
determining the amount of your specific and your overall allowance for loan losses.

Sovereign Response

Sovereign
applies the guidance in FASB Statements No. 114 and 118 in determining its specific
allowance for loan losses. We have disclosed in footnote 1 of our financial statements that we
define impaired loans in accordance with Statement No. 114 and 118. For loans that are subject to
Statement No. 114 and 118, the specific allowance element of the allowance for loan losses includes amounts
related to shortfalls in collateral coverage as determined under
Statement No. 114 and 118, and an estimate
of other probable losses based on analysis of historical and
projected losses on impaired loans.

We will revise the disclosure in future filings in our discussion of “Critical Accounting Policies”
in our MD&A, as well as our “Summary of Significant Accounting Policies” in footnote 1 to
specifically state that we apply Statements No. 114 and 118 in determining the specific allowance
for loan losses.

Note 6 — Investment Securities, Page 58

    4.

    We note your disclosure regarding the fair value and the
unrealized losses of non agency
securities that have been in a continuous unrealized loss position for less than twelve months and for
twelve months or more that are not considered to be other than temporarily impaired. Please
tell us what types of investments make up your non-agency securities and explain your basis
for concluding that these investments were not other than temporarily
impaired as of December 31, 20004, March 31, 2005, June 30, 2005, and September 30, 2005. Please provide us with your
comprehensive analysis based on the factors described in SAB Topic 5.M.

Donald A. Walker, Jr.

Securities and Exchange Commission

December 22, 2005

Page 4

Sovereign Response

Sovereign’s non–agency debt securities consist of mortgage-backed securities and collateralized
mortgage obligations issued by private institutions. These investments are all highly rated
(investment grade – Aaa rated) and have contractual maturity
dates which require payment of the principal amount of the
securities. The fair values and unrealized
losses on the non-agency securities as of December 31, 2004 and
each quarter-end in 2005 were as
follows:

    Less than 12 months

    12 months or Longer

    Unrealized

    Unrealized

    Fair Value

    Losses

    %

    Fair Value

    Losses

    %

    Non-agencies - 12/31/04

    $
    2,078,281

    $
    18,837

    0.91
    %

    $
    68,554

    $
    1,800

    2.63
    %

    Non-agencies - 3/31/05

    2,925,841

    55,169

    1.89
    %

    65,528

    417

    0.64
    %

    Non-agencies - 6/30/05

    1,705,037

    13,475

    0.79
    %

    724,645

    11,571

    1.60
    %

    Non-agencies - 9/30/05

    2,125,760

    38,247

    1.80
    %

    719,658

    19,467

    2.71
    %

Each quarter, Sovereign evaluates the amount of unrealized losses in its investment portfolio and
considers whether any of the unrealized losses are other than temporary. In making this
evaluation, Sovereign considered the guidance in SAB Topic 5.M. We evaluated the length of time
and the extent to which the market value for the securities had been less than cost and noted no
securities had losses significantly below cost. We also took into account that the principal and
interest on these securities are from issuers that are investment grade (Aaa rated). We therefore
focused on the financial condition of the issuers and noted that no negative changes in investment
ratings occurred during any of the above time periods which could be
an indicator that the issuers would not have the ability to make the scheduled interest and principal payments on these securities that would lead
to Sovereign not realizing its cost basis in these investments. At each of the above time periods,
the change in the unrealized losses on the non agency mortgage-backed securities were caused by
changes in interest rates. Because the decline in market value is attributable to changes in
interest rates and not credit quality, and because the Company has the ability and intent to hold
those investments until a recovery of fair value, which may be maturity, the Company does not
consider those investments to be other-than-temporarily impaired at any of the above time periods.

Note 12 – Borrowings and Other Debt Obligations, Page 66

    5.

    We note your disclosure that you issued contingent convertible trust preferred equity income
redeemable securities (“PIERS”). The debt is convertible into common stock if certain
conditions are met. Please tell us how you account for the conversion feature associated with
the debt. Refer to FASB Statement 133 and EITF 00-19.

Sovereign Response

In 2004, Sovereign issued $800 million of Contingent Convertible Trust Preferred Equity Income
Redeemable Securities (“PIERS”). The offering was completed through Sovereign Capital Trust IV
(the “Trust”), a special purpose entity established to
issue the PIERS. Each PIERS had an

Donald A. Walker, Jr.

Securities and Exchange Commission

December 22, 2005

Page 5

issue price of $50 and represents an undivided beneficial ownership interest in the assets of the
Trust, which consist of:

    •

    Junior subordinated debentures issued by Sovereign with a distribution rate of 4.375%
per annum on the $50.00 issue price, and each of which will have a principal amount at
maturity of $50 and a stated maturity of March 1, 2034; and

    •

    Warrants to purchase shares of Sovereign common stock from Sovereign at any time prior
to the close of business on March 1, 2034, by delivering junior subordinated debentures
(or, in the case of warrant exercises before March 5, 2007, cash equal to the accreted
principal amount of a junior subordinated debenture).

We concluded that the debt and the warrant components of the PIERS should be accounted for
separately, because prior to March 5, 2007, the holder has the ability to exercise the warrant
with cash without surrendering the debenture if certain conditions are met. Paragraph 7 of APB 14
states that accounting for the components as a single instrument is required if “the holder can not
exercise the option to convert unless he foregoes the right to
redemption, and vice-versa.” As noted above, the holder of the PIERS unit has the right to tender the warrant for cash without redeeming the
debenture. Sovereign allocated the proceeds of the PIERS offering between the debenture and the
warrant based on the relative fair value method as provided in paragraph 15 of APB 14. The
debentures are included in borrowings and other debt obligations on our consolidated balance sheet.
The value assigned to the warrant is recorded as a separate component of our
stockholders’ equity. Assigning a portion of the proceeds to the value of the warrant results in
the debentures being recorded at a discount, which is being accreted into earnings over the life of
the debentures using the effective interest rate method. Accordingly, although the coupon on the
PIERS debenture is 4.375%, the effective rate reflected in our
consolidated income statement is 7.55%.

We considered FASB Statement 133 and EITF 00-19 in accounting for the warrants and determined that
the warrants had all of the characteristics of a derivative instrument as defined in paragraph 6 of
Statement 133. However, although the warrants had the characteristics of a derivative
instrument, we noted the warrants met the exception criteria in paragraph 11 of FASB Statement 133 as
follows:

“Notwithstanding the conditions of paragraphs 6–10, the reporting entity shall not consider the
following contracts to be derivative instruments for purposes of this Statement:

a. Contracts issued or held by that reporting entity that are both (1) indexed to its own
stock and (2) classified in stockholders’ equity in its statement of financial position”

We also considered the guidance in EITF 00-19, “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock,” to determine whether there were
specific features in the warrant or structure which would require the warrant to be treated as a
liability. EITF 00-19 provides that a contract that requires net-cash settlement or a contract
that gives the counterparty a choice of net-cash settlement or settlement in shares is classified
as a liability. The warrants provide only for issuance of shares upon exercise and do not require
net cash settlement or provide for settlement alternatives at the option of the holder. EITF 00-19
further provides that contracts that include any
provision that could require net-cash

Donald A. Walker, Jr.

Securities and Exchange Commission

December 22, 2005

Page 6

settlement be considered an asset or liability. Accordingly, contracts must meet all of the
following additional conditions to be accounted for as equity:

    1.

    The contract permits the company to settle in unregistered shares.

    2.

    The company has sufficient authorized and unissued sh