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The Negative Basis of Sovereign Bancorp
October 17, 2006

The Negative Basis of Sovereign Bancorp

At the start of 2006, we stopped issuing conventional buy-sell stock ratings on US companies in favor of focusing on producing Basel II benchmarks for banks and financial performance benchmarks for non-bank subjects. This decision was partly driven by business issues, namely that getting paid for research�is very tough, and partly a matter of preference, namely that we prefer working with risk professionals, auditors, and regulators -- people who care about financial performance and business models as opposed to quarterly earnings�and momentum.�

Like the character played by Mel Gibson in the film Tequila Sunrise, however, we keep hearing from our old clients, fund managers and traders, all our buddies who wish we'd stayed in the stock picking game.� And the name they almost always ask us about: Sovereign Bancorp (NYSE:SOV).� We don't know how the Q3 earnings for SOV will look when released later today, but we can tell you that the bank's historical financial performance does not square with recent moves in the stock price.

Last time we issued a stock rating on SOV it was not a buy. In the almost two years we followed the stock, we were concerned about the mediocre financial performance of this acquisitive thrift and the inflated estimates of the group's valuation coming from management.� Plainly stated, in terms of financial results, SOV is one of the weakest performers in the regional bank peer group.� And the call report financial statement�data provided by the Office of Thrift Supervision to the Federal Deposit Insurance Corp tells the story.�

When we heard in 2005 that Banco Santander (NYSE:STD) was acquiring a stake in SOV, our question at the time was why now? Wait a year and you could get it cheaper. Sadly, STD�did not take our advice. With the exception of people like Jim Cramer, though,�the Sell Side has been singing the�bull hymn on SOV.

In early October, following changes in senior management, the market valuation of SOV jumped double digits to current levels. Investors seemingly believe the changes in the C-Suite are going to be positive for the franchise going forward. Maybe so.� But the changes which caught our eye and confirm our view that SOV is a chronic under performer are contained in the most recent data from the FDIC, as interpreted by the IRA Bank Monitor ratings model.

Holders of SOV might be interested to know that the bank's ROA fell to 0.38% for the six months�ended�June 30,�2006, and that the ROE for that period�was just 3.7%, perhaps explaining why the stock is still trading at just 1.4x book -- even with the "Goodbye Jay" pop in the stock price in recent days.�

OK, so it's�tough for everybody out there in bank land, right?��No.� Both the ROA and ROE for SOV are more than 1.5 standard deviations below the regional bank peer group defined by the FDIC.��In fact, SOV has been in the bottom quartile of the peer�group with respect to such financial performance measures�for years.�

It that weren't bad enough, the lead unit of SOV's�latest acquisition,�Independence Community Bancorp (NASDAQ:ICBC), reported a loss in its 2Q 2006 call report to the FDIC, this after showing weakness in its Q1 2006 results.�

Strangely, performance metrics for both SOV and ICBC started to slide in 2006 in the way that you usually see in acquired institutions.� The operational and human disruption of an acquisition almost always causes a target to display deterioration in performance after a transaction is announced.� But of course, STD has not yet pulled the trigger on the $90 billion asset SOV+ICBC combo.�

And as we've said,�the sub-par financial performance of both SOV and ICBC is nothing new -- unless you are among those brave souls who believe the M&A; story apparently driving this bank's equity market valuation.

If you�subscribed to the IRA Bank Monitor and�were following the�financial performance of SOV during 2006, you would know (or at least suspect) that STD probably is the only institution out there with even a remote interest in buying�SOV�-- at least the chunk it does not already own.� But�maybe those astute folks at STD finally have taken a look at SOV's financial statements and have�figured out that if they wait a little while, the stock�price may go down.

In our view, the only reasonable excuse to hold SOV today is because you believe that the folks at STD are going to pull the trigger sooner rather than later�at around or even at a�premium to current levels.� But even this rationale fails to explain why this pooch of a financial institution is still trading�in this neighborhood in the first place.� The Sell Side may like retail financial exposure, but we see a bottom looming before valuations in the banking sector again�make sense.

For us, the real reason for the current lofty equity multiple for SOV and so�many other bank names is a phenomenon that also affects the broader markets. It's not just that the M&A; arbs have pushed SOV to its recent high of $25 last week, but also the general crush of speculative cash and credit that is more broadly buying all widely traded US equities and "hedging" this exposure into the market for�credit derivative swaps or CDS.

As equity valuations surge and the large cap indices reach new heights, the spreads on CDS get tighter and tighter, this�along with bond spreads, from which the former are "derived."� That is, the equity market tail is wagging the credit market dog, as we wrote some weeks ago (The IRA: "Wag the Swap: Auto CDS Spreads Rally as Fundamentals Slip").

Indeed, so much institutional money is chasing so few real opportunities that some CDS contracts are trading through the bonds of many issuers, what's called negative basis.� When the basis is negative in CDS, it means that�the credit default swap spread is less than the bond spread -- and that�a trader can�own a bond�without taking default risk.

Being one of the few BBB rated large�bank names, SOV does not trade regularly in�the OTC market for�CDS, but its�5.125s of 13 trade around 87 bp�over the curve. We hear that there are some brave souls out there quoting CDS on SOV, but we have not�located them yet.� One trader said�a good indication for SOV�in�five-year CDS on the 5.125s would be 100bp.� Compare that to the 23bp CDS�spread quoted for Washington Mutual (NYSE:WM) yesterday in New York.� Got your attention now?�

Think of SOV's current valuation as a more general comment on the state of the US banking sector in particular and the equity markets generally, albeit an outlier in terms of the disparity between historical�financial performance and equity market valuation.��And remember the term "negative basis."� More on this in our next comment.

Questions? Comments? [email protected]

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