UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

Commission File Number 001-16581

SOVEREIGN BANCORP, INC.

(215) 557-4630

Securities registered pursuant to Section 12(B) of the Act:

Securities registered pursuant to Section 12(G) of the Act:

None

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 {X} No {  }

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. {X}

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes {X} No {  }

The aggregate market value of the shares of Common Stock of the Registrant held by nonaffiliates of the Registrant was $4,476,837,761 at June 30, 2003. As of March 1, 2004, the Registrant had 306,494,947 shares of Common Stock outstanding.

Documents incorporated by reference

Responses to Items 10, 11, 12, 13 and 14 of Part III of this Form 10-K are incorporated herein by reference from the Registrant’s definitive Proxy Statement to be used in connection with its 2004 Annual Meeting of Shareholders.

Website Access to Company’s Reports

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 event reports on Form 8-K, as well as any amendments to those reports, are accessible at no cost on the Corporation’s Web site as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC at www.Sovereignbank.com. These filings are also accessible on the SEC’s Web site at www.sec.gov.

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Form 10-K Cross Reference Index

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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 2003 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;
	•		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;
	•		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;

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	•		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;
	•		changes in consumer spending and savings habits;
	•		terrorist attacks in the United States or upon United States interests abroad, or armed conflicts relating to these attacks;
	•		armed conflicts involving the United States military;
	•		regulatory or judicial proceedings;
	•		changes in asset quality; 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.

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”), which after taking into account our recently completed acquisition of First Essex Bancorp on February 6, 2004, is a $45 billion financial institution with 535 community banking offices, approximately 950 ATMs and about 8,300 team members in Pennsylvania, New Jersey, Connecticut, New Hampshire, New York, Rhode Island, Delaware and Massachusetts. Sovereign’s primary business consists of attracting deposits from its network of community banking offices, and originating small business and middle market commercial and loans, residential mortgage loans, home equity lines of credit, and auto and other consumer loans in the communities served by those offices. Sovereign also purchases portfolios of residential mortgage loans and other consumer loans originated throughout 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 24 financial institutions, branch networks and/or related businesses since 1990. Sixteen of these acquisitions, with assets totaling approximately $26 billion, have been completed since 1995.

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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.

In response to this need, in 1996, Sovereign initiated a strategy to transform itself from a traditional mortgage lender into a super-community bank by:

	•		targeting small and medium size businesses through offering a broader array of commercial and business banking products and services;
	•		changing the mix of its deposits and, while endeavoring to preserve its credit quality, changing the mix of its assets to be more characteristic of a commercial bank;
	•		increasing its penetration into larger, more densely populated markets in the northeastern United States;
	•		preserving its orientation toward relationship banking and personalized service, as well as its sales-driven culture; and
	•		increasing its non-interest income as a percentage of net income.

During 2000, Sovereign substantially completed this transformation by acquiring $12.3 billion of deposits, $8.0 billion of loans (exclusive of $1.1 billion of non-relationship mortgage loans sold immediately after the acquisition), and 281 community banking offices located in Massachusetts, Rhode Island, Connecticut and New Hampshire from FleetBoston Financial Corporation (the “FleetBoston Acquisition”). As a result of the FleetBoston Acquisition, Sovereign doubled its deposit base, changed the mix of loans and deposits to be more characteristic of a commercial bank, and increased the breadth and depth of senior and middle management. Since that time, Sovereign has completed two additional acquisitions of community banks. In addition, on January 26, 2004, Sovereign entered into a definitive agreement to purchase Seacoast Financial Services Corporation, a bank holding company headquartered in New Bedford, Massachusetts with, on a pro-forma basis pending its acquisition of Abington Bancorp, Inc., $5.4 billion in assets, $3.6 billion of deposits, and 67 branch offices located in the suburbs of Boston, Cape Cod, Nantucket, and Martha’s Vineyard, Massachusetts. See Management’s Discussion and Analysis of Financial Condition and Results of Operations – Recent and Pending Acquisitions for further discussion.

Subsidiaries

Sovereign had three direct consolidated wholly-owned subsidiaries at December 31, 2003: Sovereign Bank, is the only material subsidiary.

Employees

At December 31, 2003, Sovereign had 7,046 full-time and 1,060 part-time employees. None of these employees are represented by a collective bargaining agreement, and Sovereign believes it enjoys good relations with its personnel.

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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 and the range of products and services offered.

Environmental Laws

Environmentally related hazards have become a source of high risk and potentially unlimited 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 charted 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, which is one 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.

     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

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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.

     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. As of December 31, 2003, no individual corporation or other entity owned more than 10% of Sovereign’s capital stock.

     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, 2003, 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 Savings Association 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.

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The FDIC’s deposit insurance premiums are assessed through a risk-based system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Under the system, institutions classified as well-capitalized and considered healthy pay no premium or reduced premiums while institutions that are less than adequately capitalized and considered of substantial supervisory concern pay higher premiums. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.

The FDIC is authorized to increase assessment rates, on a semi-annual basis, if it determines that the reserve ratio of the Savings Association Insurance Fund will be less than the designated reserve ratio of 1.25% of Savings Association Insurance Fund insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. The FDIC may also impose special assessments on Savings Association Insurance Fund members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC.

The current premium schedule for Savings Association Insurance Fund insured institutions ranges from 0 to 27 basis points per $100 of deposits. Sovereign Bank’s premium assessment for 2003 was 0 basis points. Sovereign Bank is in the category of institutions who pay zero in FDIC premiums. In addition, 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 current rate for all insured institutions is 1.54 basis points for each $100 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

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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 increase an institution’s cost of funds.

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.

     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.

     Recent Legislation. The Fair and Accurate Credit Transactions Act (“FACT”) was signed into law on December 4, 2003. This law extends the previously existing Fair Credit Reporting Act. New provisions added by FACT 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. Regulators will be issuing rules to implement FACT over the next year, and some of these rules will likely impose additional duties on Sovereign Bank.

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 adopts new standards of corporate governance and imposes 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 will result in increased costs to Sovereign, the additional costs are not expected to 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.

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Item 2 - Properties

Sovereign Bank utilizes 606 buildings that occupy a total of 5.1 million square feet, including 139 owned properties with 1.1 million square feet and 467 leased properties with 4.0 million square feet. Seven 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

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

525 Lancaster Avenue Operations Center - Reading, Pennsylvania

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

1125 Berkshire Boulevard Operations Center - Wyomissing, Pennsylvania

601 Penn Street Loan Processing Center - Reading, Pennsylvania

The majority of the properties of Sovereign outlined above are utilized by the retail banking operations and for general corporate purposes.

Item 3 - Legal Proceedings

     Sovereign is not involved in any pending legal proceedings other than non-material legal proceedings occurring in the ordinary course of business. Sovereign does not expect that any sums it may have to pay in connection with these matters would have a materially adverse effect on its financial position.

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

None.

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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 February 28, 2004, is set forth below:

Jay S. Sidhu – Age 52. Mr. Sidhu became Chairman of Sovereign and Sovereign Bank in April 2002. He has been a director of Sovereign since September 1988 and a director of Sovereign Bank since 1987. In addition, Mr. Sidhu has served as President and Chief Executive Officer of Sovereign since November 1989. Prior thereto, Mr. Sidhu served as Treasurer and Chief Financial Officer of Sovereign. Mr. Sidhu is also President and Chief Executive Officer of Sovereign Bank. Prior to becoming President and Chief Executive Officer of Sovereign Bank on March 28, 1989, Mr. Sidhu served as Vice Chairman and Chief Operating Officer of Sovereign Bank.

Lawrence M. Thompson, Jr. – Age 51. Mr. Thompson serves as Vice Chairman and Chief Administrative Officer of Sovereign. Mr. Thompson was appointed Vice Chairman in September 2002. Also, Mr. Thompson was appointed President and Chief Operating Officer of Sovereign Bank’s Consumer Banking Division in November 2000. Mr. Thompson was hired as Sovereign Bank’s General Counsel and Secretary in 1984. He was promoted to Vice President in 1985. In April 1986, he became Sovereign Bank’s Senior Vice President for legal affairs and administration. In January 1990, he became Group Executive Officer — Lending and in June 1995, he became Chief Administrative Officer of Sovereign and Sovereign Bank. Mr. Thompson became Chief Operating Officer of Sovereign Bank in November 1996.

Dennis S. Marlo – Age 61. Mr. Marlo was appointed Chief Risk Management Officer and Executive Vice President of Sovereign in April 2001. Mr. Marlo joined Sovereign in February 1998 as the President of the Pennsylvania Division of Sovereign Bank. He was appointed Chief Financial Officer and Treasurer of Sovereign in May 1998 and served in that capacity through April 2001. Prior thereto, Mr. Marlo served as President and Chief Executive Officer of ML Bancorp, a predecessor company of Sovereign. Mr. Marlo will retire effective April 30, 2004.

John P. Hamill – Age 63. Mr. Hamill was named Chairman and Chief Executive Officer of the Sovereign Bank New England Division of Sovereign Bank (“SBNE”) in January 2000. Prior thereto, Mr. Hamill served as President of Fleet National Bank – Massachusetts for eight years and President of Shawmut Corporation.

Joseph P. Campanelli – Age 47. Mr. Campanelli serves as a Vice Chairman of Sovereign. He became a Vice Chairman in September 2002. 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.

James D. Hogan – Age 59. Mr. Hogan joined Sovereign as Chief Financial Officer in April 2001 and has served as Chief Financial Officer and Executive Vice President since April 2002. Prior to that Mr. Hogan served as Executive Vice President and Controller at Firstar Corporation, formerly Star Bancorp, from May 1993 until April 2001, and as Controller of Star Bank from 1987 until 1993.

James Lynch Age 54. 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.

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PART II

Item 5 - Market for the Registrant’s Common Equity and Related Stockholder Matters

Sovereign’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “SOV.” Sovereign’s common stock was listed and commenced trading on the NYSE on July 10, 2001. Previously, Sovereign’s common stock was traded in the over-the-counter market and was quoted on the Nasdaq National Market under the symbol “SVRN.” At March 1, 2004, the total number of record holders of Sovereign’s common stock was 18,359.

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

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 16 at Item 8, “Financial Statements and Supplementary Data.”

12 Sovereign Bancorp

Item 6 - Selected Financial Data

(1)		Effective July 1, 2003, management elected to change its accounting policy to treat its Trust Preferred Security obligations as liabilities and the associated dividends on the trust preferred securities as interest expense. Previously, this cost was included in Other Expenses since the obligations were classified on the consolidated balance sheet as Company - Obligated Mandatorily Redeemable Preferred Securities. Periods prior to July 1, 2003 have not been reclassified to conform to the new presentation (see Note 12 to the Consolidated Financial Statements for further discussion).
(2)		Net income includes after-tax merger-related, integration and other charges of $19 million ($0.07 per diluted share) in 2003, $14 million ($0.05 per diluted share) in 2002, $170 million ($0.66 per diluted share) in 2001, $270 million ($1.20 per diluted share) in 2000 and $23 million ($0.13 per diluted share) in 1999.
(3)		Effective January 1, 2002, Sovereign adopted the fair value expense provisions of Statements of Financial Accounting Standards (SFAS) Nos. 123, “Accounting for Stock Based Compensation,” and 142, “Goodwill and Other Intangible Assets.” See Notes to the Consolidated Financial Statements for further discussion regarding the impact to 2002 reported results of the change in accounting related to these pronouncements.
(4)		All per share data have been adjusted to reflect all stock dividends and stock splits.
(5)		Book value per share is calculated using stockholders’ equity divided by common shares outstanding at end of period.
(6)		Dividend payout ratio is calculated by dividing total dividends declared by net income for the period.
(7)		Return on average assets is calculated by dividing net income by the average balance of total assets for the year.
(8)		Return on average equity is calculated by dividing net income by the average balance of stockholders’ equity for the year.
(9)		Average equity to average assets is calculated by dividing the average balance of stockholders’ equity for the year by the average balance of total assets for the year.
(10)		These ratios are not applicable due to the net loss recognized for the year ended December 31, 2000.
(11)		In 2001, Sovereign recorded a loss of $6.5 million, net of a tax benefit of $3.5 million, associated with a debt restructuring. In 2000, Sovereign recorded a gain of $10.8 million, net of a tax provision of $5.2 million, also in connection with a debt restructuring. In prior year financial statements, these transactions had been treated as Extraordinary Items. Pursuant to the requirements of SFAS No. 145, Sovereign reclassified the effect of these debt restructurings to Other Expense with the associated tax effect included in the Income Tax Expense (Benefit) line.

Sovereign Bancorp 13

Management’s Discussion and Analysis

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

EXECUTIVE SUMMARY

Sovereign, which after taking into account our recently completed acquisition of First Essex Bancorp on February 6, 2004, is a $45 billion financial institution with community banking offices, operations and team members located principally in Pennsylvania, Massachusetts, New Jersey, Connecticut, New Hampshire, New York, Rhode Island, 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 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 franchise.

We are one of the top 20 largest banking institutions in the United States. 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 in terms of market share and demographics; a stable, low cost core deposit base; diversified loan portfolio and products; strong service culture and the ability to cross sell multiple product lines to our customers resulting in higher fee based revenues; and the ability to internally generate equity through earnings. Our weaknesses have included lower than average capital ratios when compared against our peers and higher cost Holding Company debt that has depressed our earnings. In addition, asset quality is not as strong as we desire and we do not possess desired market share in some of our geographic micro-markets. Management has implemented strategies to address these weaknesses. With respect to our capital position, we have strengthened our ratios significantly over the last two years through the generation of earnings. Our net earnings in 2003 exceeded $400 million. In addition, we have strategically accessed the financial markets to strengthen our capital position including the issuance of $800 million of bank subordinated debt (which qualifies as Tier 2 capital), increased tangible equity by $188 million in connection with warrants exercises and restructuring a portion of the high cost financing that was incurred in the FleetBank Boston acquisition. In addition in February 2004, Sovereign completed an offering of $700 million of Contingent Convertible Trust Preferred Income Equity Redeemable Securities (“PIERS”). In March 2004, Sovereign issued an additional $100 million of PIERS under this offering. (See additional discussion with respect to this transaction in the “MD&A-Financial Condition” section of this document). Selected asset quality statistics have improved toward the end of 2003; however, we continue to execute programs to improve our asset quality position. To address the weakness in our position in certain micro-markets, we continue to investigate strategic acquisitions. In February 2004, we completed the acquisition of First Essex Bancorp, Inc. (“First Essex”). We have also executed a definitive agreement to acquire Seacoast Financial Services Corporation (“Seacoast”) which is expected to close in the third quarter of 2004. See additional discussion of these transactions in a later section of this MD&A. Sovereign also may develop and construct new community banking offices to strengthen our market position. The ability to growth through acquisition or otherwise is significantly dependent upon our capital levels, stock price and the merger and acquisition market for banking institutions.

Our critical success factors include management of interest rate risk and credit risk, superior service delivery, and productivity and expense control.

We experienced a successful year in 2003 as the Company generated net income of $401.9 million, or $1.38 per diluted share, compared with $342.0 million, or $1.23 per diluted share, in 2002. Our net interest margin was under continued pressure in 2003 as a result of the asset sensitive position of our balance sheet and the low interest rate environment. The increase in net interest income was driven by the increase in earning assets that were funded, in part, with low cost core deposits. Fee income reached record levels in 2003 as a result of the growth of our franchise, as well as expanded product offerings. Our provision for loan losses increased due primarily to the increase in our loan portfolio. Our operating expense levels remained within management’s target levels in 2003. We experienced an improvement in our efficiency ratio from 53.23% in 2002 to 52.02% in 2003. See “Results of Operations for December 31, 2003 and 2002” in this MD&A for more details as to the factors, which affect year-over-year performance.

14 Sovereign Bancorp

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. Mergers and acquisitions continued at an increased level in the fourth quarter of 2003 and in early 2004. Recent merger activity involving national, regional and community banks in the northeastern United States, including acquisitions by Sovereign, have affected the landscape in the markets we serve. As noted above, Sovereign recently completed the acquisition of First Essex and announced a definitive agreement to acquire Seacoast. We believe these acquisitions will strengthen our franchise by further enabling Sovereign to capitalize on anticipated market disruption resulting from recent merger activity. These acquisitions, however, also present conversion and systems integration risk; however, as a result of management’s extensive conversion and systems integration experience and the size of the acquisitions in relation to Sovereign, we believe the risk associated with these transactions is limited. 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 approximately 70% of the Company’s revenues. Accordingly, the interest rate environment has a substantial impact on Sovereign’s earnings. Sovereign currently has an asset sensitive balance sheet. An institution that maintains an asset sensitive balance sheet generally experiences reduced net interest income in a low or declining rate environment, while earnings are enhanced in an increasing rate cycle. The impact of a low and declining rate environment in 2003 and 2002 on Sovereign has been mitigated in part by our large core deposit base. We would expect to benefit from any substantial increase in interest rates if they occur, in 2004. 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 stable to positive trends in certain key credit quality performance indicators over the past several quarters. 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.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2003 AND 2002

Sovereign Bancorp 15

Management’s Discussion and Analysis

The major factors affecting comparison of earnings between 2003 and 2002 were:

	•		Decrease in net interest margin from 3.61% in 2002 to 3.42% in 2003 due primarily to a declining interest rate environment which has led to high levels of prepayments on assets which are being replaced with lower yielding assets. The growth in net interest income was driven by the increase in the balance of earning assets.
	•		Charges related to merger and integration costs and other restructuring charges (including debt extinguishment costs). The 2003 results include charges of $29.8 million ($19.4 million after-tax) related to the extinguishment of borrowings and other debt obligations. The 2002 results include charges related to the Main Street Bancorp acquisition of $21.9 million consisting of additional loan loss provision of $6 million ($ 3.9 million after-tax) and merger related and integration expenses of $15.9 million ($10.3 million after-tax). These items reduced diluted earnings per share by $0.07 and $0.05, respectively, for the years ended December 31, 2003 and 2002, respectively.
	•		Increase in provision for loan losses in 2003 of $15.5 million.
	•		Continued growth in fee income across all business units.
	•		Increases in mortgage banking and capital markets revenues in 2003 of $33.5 million.
	•		Increase in net realized gains on sales of investment securities.
	•		Increases in general and administrative expenses to supporting the growth in Sovereign’s franchise and continued investment in human resources and systems.

     Net Interest Income. Net interest income for 2003 was $1.21 billion compared to $1.16 billion for 2002, or an increase of 4%. The increase in net interest income in 2003 was due to an increase in interest-earning assets. The increase in our assets was funded principally by the increase in low cost core deposits, repurchase agreements and other borrowings. Net interest margin (net interest income divided by average interest-earning assets) was 3.42% for 2003 compared to 3.61% for 2002. The decline in margin was driven by the declining interest rate environment experienced in 2003 which has resulted in reinvestment yields being lower than the yields on maturing assets, and to a lesser extent the reclassification of trust preferred securities expense to net interest margin. This margin compression was partially offset by lower funding costs from downward re-pricing of deposits and a reduced cost of borrowings.

Interest on investment securities available for sale was $585 million for 2003 compared to $615 million for 2002. The decrease in interest income was due to the lower yield on these securities due to declining market interest rates, offset in part by the increase in the average balance of investment securities available for sale from $10.1 billion in 2002 to $11.4 billion in 2003.

Interest on loans were $1.32 billion and $1.39 billion for 2003 and 2002, respectively. The average balance of net loans was $24.0 billion with an average yield of 5.50% for 2003 compared to an average balance of $21.7 billion with an average yield of 6.45% for 2002. The decline in average yields year to year is due to the decrease of market rates experienced during 2003. In addition, the decrease in market interest rates also resulted in higher prepayment experience on fixed rate loans with proceeds being reinvested by Sovereign in lower yielding assets. The overall growth in loans from $23.2 billion at December 31, 2002 to $26.1 billion at December 31, 2003 resulted from origination activity and purchases of bulk loans, principally in the consumer and mortgage loan portfolios. At December 31, 2003, approximately 38% of our loan portfolio reprices monthly or more frequently.

Interest on total deposits was $321 million for 2003 compared to $458 million for 2002. The average balance of deposits was $27.0 billion with an average cost of 1.19% for 2003 compared to an average balance of $25.4 billion with an average cost of 1.81% for 2002. The increase in the average balance was due primarily to the success of marketing initiatives to increase the amount of core deposits, particularly municipal deposits. The decrease in average cost of deposits in 2003 is the result of Sovereign’s ability to reduce deposit rates in the declining interest rate environment.

16 Sovereign Bancorp

Interest on borrowings and other debt obligations was $403 million for 2003 compared to $442 million for 2002. The average balance of total borrowings and other debt obligations was $10.3 billion with an average cost of 3.92% for 2003 compared to an average balance of $8.6 billion with an average cost of 5.11% for 2002. The reduction in the cost of funds on borrowings and other debt obligations resulted principally from the lower rates on short-term sources of funding including repurchase agreements and overnight FHLB advances. In addition, Sovereign retired certain high cost term funding in 2003. See Note 12 in the Notes to the Consolidated Financial Statements for additional discussion.

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

(1)		Tax equivalent adjustments to interest on investment securities available for sale for the years ended December 31, 2003, 2002 and 2001 were $24.0 million, $15.4 million and $10.2 million, respectively. Tax equivalent adjustments to loans for the years ended December 31, 2003, 2002 and 2001, were $3.7 million, $4.9 million and $5.0 million, respectively. Tax equivalent interest income is based upon an effective tax rate of 35%.
(2)		Amortization of net fees of $25.6 million, $29.2 million and $29.7 million for the years ended December 31, 2003, 2002 and 2001, respectively, are included in interest income. Average loan balances include non-accrual loans and loans held for sale.
(3)		Effective July 1, 2003, management elected to change its accounting policy to treat its Trust Preferred Security obligations as liabilities and the associated dividends on the trust preferred securities as interest expense. Previously, this cost was recorded in other expenses since the obligation was classified on the consolidated balance sheet as Company – Obligated Mandatorily Redeemable Preferred Securities. See Note 12 to the Consolidated Financial Statements for further discussion. Periods prior to July 1, 2003, have not been reclassified to conform with the new presentation.
(4)		Represents the difference between the yield on total assets and the cost of total liabilities and stockholders’ equity.

Sovereign Bancorp 17

Management’s Discussion and Analysis

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

(1)

Includes non-accrual loans and loans held for sale.

     Provision for Loan Losses. The provision for loan 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 loan losses for 2003 was $162.0 million compared to $146.5 million for 2002. The higher provision was driven by loan portfolio growth of $3.0 billion, higher net charge-offs in 2003 than in 2002, and recognition of continued slow economic growth. The overall allowance as a percentage of loans outstanding has declined from 1.29% in 2002 to 1.25% in 2003. This is reflective of improvement in credit quality, primarily in portions of the commercial portfolios, and loan growth that slightly favored consumer and residential loans portfolios where reserve requirements are generally lower than in commercial loan portfolios. 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 2003 were $132.8 million and consisted of charge-offs of $165.4 million and recoveries of $32.6 million. This compares to 2002 net charge-offs of $127.3 million consisting of charge-offs of $162.6 million and recoveries of $35.3 million. The increase in charge-offs was driven by the performance of our commercial loan portfolios where net charge-offs increased from $79.8 million in 2002 to $94.1 million in 2003.

The ratio of net loan charge-offs to average loans, including loans held for sale, was .55% for 2003, compared to .58% for 2002. Commercial loan net charge-offs as a percentage of average commercial loans were .89% for 2003, compared to .84% for 2002. Consumer loan net charge-offs as a percentage of average consumer loans were .39% for 2003, compared to .51% for 2002. Residential real estate mortgage loan net charge-offs as a percentage of average residential mortgage loans, including loans held for sale, were .06% for 2003 and .16% for 2002.

     Other Income. Total other income was $522 million for 2003 compared to $433 million for 2002. Several factors contributed to the increase in other income as discussed below.

18 Sovereign Bancorp

Consumer banking fees were $208.8 million for 2003 compared to $179.4 million in 2002. This increase was primarily due to an increase in deposit fees of $25 million to $174 million in 2003 from expansion of our overall deposit base along with a favorable shift in mix from time to core deposit products, and increased cross selling initiatives with existing customers. 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 $108 million for 2003 compared to $95.1 million in 2002. This increase was due to growth in both commercial loans and commercial core deposits, as well as expanded cash management capabilities and product offerings. Commercial banking loan fees increased by $9.9 million to $44.4 million while commercial deposit fees increased by $3.3 million to $46.2 million, in 2003.

Mortgage banking revenues were $50.0 million for 2003 compared to $28.6 million for 2002. The principal components of mortgage banking revenues are: gains or losses from the sale or securitization of mortgage 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 originations activity associated with record-level mortgage refinancings generated from the historic low rates experienced in 2003. In 2003 and 2002, Sovereign recorded gains related to the sale and securitizations of mortgage loans of $61.2 million and $42.0 million, respectively. The Company recorded an impairment charge related to its mortgage servicing rights of $13.7 million in 2002 compared to $0.8 million in 2003. An increase in the loss on servicing from $0.4 million to $12.1 million resulted from increased amortization of mortgage servicing rights due to anticipated increased prepayment speeds on the underlying loans. At December 31, 2003, Sovereign serviced for others $6.5 billion of residential loans as compared to $6.1 billion at December 31, 2002. Sovereign’s related mortgage servicing right asset was $77.2 million at December 31, 2003 and $55.5 million at December 31, 2002. See Note 8 in the consolidated financial statements for a discussion on the valuation techniques utilized to estimate the fair value of Sovereign’s mortgage servicing right capitalized asset, as well as the amount of mortgage servicing right impairment charges and amortization that was recorded in 2003 and 2002. The increase in interest rates in the third quarter of 2003 reduced mortgage origination activity, compared to the first half of the year. Management’s, as well as industry, expectations are for mortgage originations to decline significantly in 2004 compared to 2003, which will result in a reduction in Sovereign’s mortgage banking revenue.

Capital Markets revenues were $27.0 million in 2003 and $15.0 million in 2002. Since inception in 2000, Sovereign has expanded its Capital Markets product offerings. Initially, we provided risk management services for corporate clients including foreign exchange, investments and derivatives, and securitization expertise. We have since added merger and acquisitions expertise to assist corporate clients. In November 2001, we expanded our offerings further with the formation of a broker dealer. In August 2002, Sovereign added an agency underwriting group in Sarasota, Florida. We anticipate our capital markets revenues will continue to grow in 2004 as we penetrate our existing customer base and develop new customer relationships.

Net gains on sales of investment securities and related derivatives were $66.1 million for 2003, compared to $51.4 million for 2002. Included in 2003 and 2002 results were impairment charges of $7.4 million and $4.8 million, respectively, related to our retained interests in securitizations and charges of $1.1 million and $4.0 million, respectively, associated with certain venture capital and equity investments. See Note 23 in the consolidated financial statements for a discussion of our retained interests in securitized assets.

General and Administrative Expenses. Total general and administrative expenses were $865 million for 2003 compared to $820 million in 2002, or an increase of 5%. The 2003 results include a full year of expenses related to the acquisition of Main Street Bancorp in March 2002, as well as higher levels of technology costs related to the conversion of our item processing platform related to our branch network and other technology initiatives. In addition compensation and benefits, 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 recurring non-interest income) for 2003 was 52.0% compared to 53.2% for 2002, as net interest income and recurring non-interest income have risen at a faster rate than general and administrative expenses.

Sovereign Bancorp 19

Management’s Discussion and Analysis

     Other Expenses. Total other expenses were $146.5 million for 2003 compared to $159 million for 2002. Other expenses included amortization expense of core deposit intangibles of $73.8 million for 2003 compared to $80.3 million for 2002. Also the Company changed its method of accounting for trust preferred securities expenses beginning on July 1, 2003, to include these costs in interest expense (see Note 12 to the Consolidated Financial Statements). Prior period amounts were not reclassified. As previously discussed, Sovereign incurred debt extinguishment losses of $29.8 million in 2003 and merger related expenses in connection with the acquisition of Main Street of $15.9 million in 2002.

     Income Tax Provision. The income tax provision was $153 million for 2003 compared to a provision of $125 million for 2002. The effective tax rate for 2003 was 27.6% compared to 26.7% for 2002. The current year tax rate differs from the statutory rate of 35% due principally to income from tax-exempt investments, non-taxable income related to bank-owned life insurance and low-income housing tax credits. The increase in the effective tax rate in 2003 was due to an increase in the proportion of taxable income to favorable permanent book/tax differences. For additional information with respect to Sovereign’s income taxes, see Note 19 in the Notes to Consolidated Financial Statements.

     Line of Business Results. The Company’s reportable segments are as follows: the Consumer Bank, the Corporate Bank and Treasury & Other. For additional discussion of these business lines and the Company’s related accounting policies, see Note 27 to the Notes to the Consolidated Financial Statements.

The Company’s business lines are focused principally around the customers Sovereign serves. The Consumer Bank provides a wide range of products and services to consumers including mortgage, automobile and other consumer loans and lines of credit. The Consumer Bank also attracts deposits within its primary market area by offering a variety of deposit instruments including demand and NOW accounts, money market and savings accounts, certificates of deposit and retirement savings plans. The Corporate Bank originates small business and middle market commercial loans (including asset-based loans) and provides cash management and capital markets services to customers in Sovereign’s market area. Treasury & Other includes interest expense on Sovereign’s borrowings and debt, earnings from the investment portfolio, trust preferred securities and other minority interest expense, amortization of intangible assets, merger-related and restructuring charges and certain unallocated corporate income and expenses.

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 primarily based on the net charge-offs of each line of business. 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 included in Treasury & Other. 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. Designations, assignments and allocations may change from time to time. Where practical, the results are adjusted to present consistent methodologies for the segments. However, no changes have occured in 2003 that required restatements of prior period information. 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.

Consumer Bank net interest income increased $49.1 million to $953.5 million in 2003. The increase in net interest income was principally due to loan growth, which was funded by an increase in the balance of low-cost deposits. The average balance of Consumer Bank loans was $13.7 billion with a yield of 5.75% versus $12.5 billion at a yield of 6.72% during 2003 and 2002, respectively. The average balance of deposits was $27.0 billion at a cost of 1.19% in 2003 compared to $25.4 billion at an average cost of 1.81% in 2002. The increase in non-interest income of $65.1 million to $310.7 million for 2003 was generated by deposit fees and loan fees, which grew in tandem with the increased level of deposits and loans. Mortgage banking revenues were significantly higher in 2003 compared to 2002 due to an increase on the gains on sale and securitization of mortgage loans and declines in impairment charges for mortgage servicing rights. The provision for loan losses declined modestly in 2003 to $38.7 million from $45.9 million in 2002 due to the lower level of consumer and residential loan charge-offs. General and administrative expenses (including allocated corporate and direct support costs) increased from $650.2 million for 2002 to $677.1

20 Sovereign Bancorp

million for 2003. The increase in general and administrative expenses is due principally to Sovereign’s continued investment in people and processes to support its expanding franchise.

Corporate Bank net interest income increased $32.4 million to $291.7 million for 2003 compared to 2002. The increase in net interest income was principally due to loan growth, combined with a reduction in costs to fund that loan growth. The average balance of Corporate Bank loans was $10.6 billion with a yield of 5.00% in 2003 versus $9.5 billion at a yield of 5.90% during 2002. Non-interest income has increased by $19.0 million to $88.7 million principally from an increase in loan fees and capital markets revenues. The provision for loan losses increased by $13.7 million in 2003 to $94.1 million compared to 2002 due to a higher level of net charge-offs in 2003. General and administrative expenses (including allocated corporate and direct support costs) increased from $131.0 million for 2002 to $143.9 million in 2003. The increase was due in part to increased costs to support the Corporate Bank’s loan growth, as well as additional investment in the cash management and capital markets businesses.

The net loss before income taxes for Treasury & Other increased from $104.9 million in 2002 to $128.3 million in 2003. Net interest expense increased from $4.1 million in 2002 to $39.5 million for 2003 due to the decline in yield on the investment portfolio and the classification of trust preferred securities expense in net interest margin effective July 1, 2003. The Treasury & Other segment includes net gains on security and derivative transactions of $73.5 million in 2003, as compared to $56.0 million recorded in 2002. The previously discussed impairment charges related to our retained interests in consumer loan securitizations are recorded in the Consumer Bank segment. The 2003 results also include a pre-tax loss of $29.8 million on the extinguishment of debt while 2002 results included charges of $15.9 million for merger and integration charges associated with the acquisition of Main Street Bancorp, Inc. (the “Main Street Acquisition”).

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002 AND 2001

The major factors affecting comparison of earnings between 2002 and 2001 were:

	•		Merger related and integration costs and other restructuring charges, which on an after-tax basis totaled $14 million in 2002 and $170 million in 2001, respectively.
	•		Increase in provision for loan losses in 2002 of $49.4 million.
	•		Acquisition of Main Street Bancorp, Inc. in 2002.
	•		Adoption of Statements of Financial Accounting Standards No.123, “Accounting for Stock Based Compensation,” and No.142, “Goodwill and Other Intangible Assets” in 2002.
	•		Increase in net interest margin from 3.57% in 2001 to 3.61% in 2002 due to core deposit growth and an increase in the level of our interest earning assets coming from internal generation of capital.
	•		Continued growth in consumer and commercial banking fee income in 2002 of $41.2 million.
	•		Reduction in mortgage banking fee revenues in 2002 of $40.9 million.

Sovereign Bancorp 21

Management’s Discussion and Analysis

	•		Sale of retail branch locations in 2001 resulting in a gain of $28.1 million.
	•		Increase in net realized gains on sales of investment securities.

The results for 2002 and 2001 include the effects of certain items. These items should be considered in the comparison of the annual results. The 2002 results include charges related to the Main Street Acquisition of $21.9 million consisting of additional loan loss provision of $6 million ($3.9 million after-tax) and merger related expenses of $15.9 million ($10.3 million after-tax). The 2001 results include charges of $10.1 million ($6.5 million after-tax) related to extinguishment of debt, $8.5 million ($5.5 million after-tax) of restructuring charges related to the closure of 14 in-store offices and a redirection of e-commerce efforts, and as more fully discussed in Note 28 to the Consolidated Financial Statements, $243 million ($158 million after-tax) for payments to FleetBoston, pursuant to the terms of a non-solicitation agreement. Total payments made to FleetBoston under the non-solicitation agreement were $363 million. Sovereign expensed such payments ratably from the completion of the acquisition in 2000 until final payment in September 2001.

The items outlined above reduced diluted earnings per share by $0.05 and $0.66, respectively, for the years ended December 31, 2002 and 2001.

     Net Interest Income. Net interest income for 2002 was $1.16 billion compared to $1.05 billion for 2001, or an increase of 10%. The increase in net interest income in 2002 was due to an increase in interest-earning assets. The increase in our assets was funded principally by the increase in low cost core deposits. Net interest margin (net interest income divided by average interest-earning assets) was 3.61% for 2002 compared to 3.57% for 2001.

Interest on investment securities available for sale was $615 million for 2002 compared to $538 million for 2001. The increase in interest income was due to the increase in the average balance of investment securities available for sale from $8.0 billion in 2001 to $10.1 billion in 2002, offset in part by a lower yield on these securities due to declining market interest rates.

Interest on investment securities held to maturity was $47 million for 2002 compared to $69 million for 2001. The average balance of investment securities held to maturity was $749 million with an average yield of 6.28% for 2002 compared to an average balance of $1.0 billion with an average yield of 6.76% for 2001.

Interest on loans were $1.39 billion and $1.61 billion for 2002 and 2001, respectively. The average balance of net loans was $21.7 billion with an average yield of 6.45% for 2002 compared to an average balance of $20.9 billion with an average yield of 7.75% for 2001. The decline in average yields year to year is due to the decrease of market rates experienced during 2002. In addition, the decrease in market interest rates also resulted in higher prepayment experience on fixed rate loans with proceeds being reinvested in lower yielding assets. The overall growth in loans from $20.4 billion at December 31, 2001 to $23.2 billion at December 31, 2002 resulted from origination activity and purchases of bulk loans, principally in the consumer bank, as well as the acquisition of Main Street. At December 31, 2002, approximately 36% of our loan portfolio repriced monthly or more frequently.

Interest on total deposits was $458 million for 2002 compared to $706 million for 2001. The average balance of total deposits was $25.4 billion with an average cost of 1.81% for 2002 compared to an average balance of $23.5 billion with an average cost of 3.00% for 2001. The increase in the average balance was due primarily to the success of marketing initiatives to increase the amount of core deposits, such as our Extreme checking product, as well as the Main Street acquisition. The decrease in average cost of deposits in 2002 was the result of the declining interest rate environment.

Interest on borrowings and other debt obligations was $442 million for 2002 compared to $462 million for 2001. The average balance of total borrowings and other debt obligations was $8.6 billion with an average cost of 5.11% for 2002 compared to an average balance of $8.0 billion with an average cost of 5.79% for 2001. The reduction in the cost of funds on borrowings and other debt obligations resulted principally from the lower rates on short-term sources of funding including repurchase agreements and overnight FHLB advances.

22 Sovereign Bancorp

     Provision for Loan Losses. The provision for loan losses is based upon credit loss experience and an estimation of losses inherent in the current loan portfolio. The provision for loan losses for 2002 was $146.5 million compared to $97.1 million for 2001. The higher provision was required because of growth in loan portfolios, increased levels of non-performing loans, and continued economic weakness resulting in charge-offs. The overall allowance as a percentage of loans outstanding has remained relatively consistent, declining from 1.30% in 2001 to 1.29% in 2002. Management regularly evaluates the risk inherent in its loan portfolio and increases its allowance for loan losses through increases to its loan loss provision as deemed necessary.

Sovereign’s net charge-offs for 2002 were $127.3 million and consisted of charge-offs of $162.6 million and recoveries of $35.3 million. This compares to 2001 net charge-offs of $88.8 million consisting of charge-offs of $121.0 million and recoveries of $32.2 million. The increase in charge-offs was driven by performance of our commercial loan portfolios where net charge-offs increased from $43.0 million in 2001 to $79.8 million in 2002. This increase in commercial charge-offs was impacted by one significant credit which resulted in a $15.5 million charge-off in 2002 as well as continued weakness in the general business climate. Residential loan net charge-offs increased $2.7 million from 2001 due to sales of non-performing residential loans in the first and fourth quarters of 2002.

The ratio of net loan charge-offs to average loans, including loans held for sale, was .58% for 2002, compared to .42% for 2001. Commercial loan net charge-offs as a percentage of average commercial loans were .84% for 2002, compared to .52% for 2001. Consumer loan net charge-offs as a percentage of average consumer loans were .51% for 2002, compared to .62% for 2001. Residential real estate mortgage loan net charge-offs as a percentage of average residential mortgage loans, including loans held for sale, were .16% for 2002 and .08% for 2001.

     Other Income. Total other income was $433 million for 2002 compared to $414 million for 2001. Several factors contributed to the increase in other income as discussed below.

Consumer banking fees were $179 million for 2002 compared to $158 million in 2001. This increase was primarily due to an expansion of our overall deposit base along with a favorable shift from time to core deposit products, increased cross selling initiatives with existing customers and attracting new customers. The Company continued 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 $95.1 million for 2002 compared to $75.8 million in 2001. This increase was due to growth in both commercial loans and commercial core deposits, as well as increased cash management capabilities and product offerings.

Mortgage banking revenues were $28.6 million for 2002 compared to $69.5 million for 2001. The principal components of mortgage banking revenues are gains from the sale or securitization of mortgage loans, servicing fees, amortization of mortgage servicing rights and changes in the valuation allowance related to mortgage servicing rights. The primary factor contributing to the decline in mortgage banking revenues was the reduction of gains on the sale or securitization of residential mortgage loans. In 2001, the Company generated gains of $72.4 million related to sales and securitizations of mortgage loans. In 2002, Sovereign had gains related to the sale and securitizations of mortgage loans of $42.0 million. At December 31, 2002, Sovereign serviced $6.1 billion of residential loans for others as compared to $5.1 billion at December 31, 2001. Sovereign’s related mortgage servicing right capitalized asset was $55.5 million at December 31, 2002 and $50.7 million at December 31, 2001. See Note 8 in the consolidated financial statements for a discussion on the valuation techniques utilized to estimate the fair value of Sovereign’s mortgage servicing right capitalized asset, as well as the amount of mortgage servicing right impairment charges and amortization that was recorded in 2002 and 2001.

The Capital Markets Group generated revenue of $15.0 million in 2002 and $11.2 million in 2001. Since inception in 2000, Sovereign has expanded its Capital Markets product offerings. Initially, we provided risk management services for corporate clients including foreign exchange, investments and derivatives, and securitization expertise. We have since added merger and acquisitions expertise to assist corporate clients. In November 2001, we expanded our offerings with the formation of a broker dealer. In late 2002, Sovereign added an agency underwriting group in Sarasota, Florida.

Miscellaneous income was $19.6 million for 2002 compared to $42.2 million in 2001. 2001 results included a $28.1 million gain related to the sale of branches located in southern New Jersey, Delaware and eastern Pennsylvania.

Sovereign Bancorp 23

Management’s Discussion and Analysis

Net gains on sales of investment securities and related derivatives were $51.4 million for 2002, compared to $15.5 million for 2001. The 2002 results include increased realized gains of available for sale investment securities. Included in 2002 results were impairment charges of $4.8 million related to our retained interests in securitizations and $4.0 million associated with certain venture capital and equity investments. See Note 23 in the consolidated financial statements for a discussion of our retained interests in securitized assets. In 2001, as part of a balance sheet deleveraging strategy, Sovereign sold certain investment securities and used the proceeds to pay off borrowings. Upon repayment of these borrowings, the related swaps hedging these advances were terminated, resulting in a reclassification of $14.7 million of deferred losses out of accumulated other comprehensive income into earnings. In these instances of balance sheet deleveragings, such hedge gains or losses are netted against the offsetting security loss or gain.

     General and Administrative Expenses. Total general and administrative expenses were $820 million for 2002 compared to $777 million in 2001, or an increase of 6%. 2002 results included $10.4 million of stock option expense related to the adoption of SFAS No. 123 and additional expenses due to the acquisition of Main Street Bancorp in March 2002. Sovereign’s efficiency ratio (all general and administrative expenses as a percentage of net interest income and recurring non-interest income) for 2002 was 53.2% compared to 53.5% for 2001. If Sovereign had not adopted the expense provisions of SFAS No. 123 related to stock options, the 2002 efficiency ratio would have been 52.6%.

     Other Expenses. Total other expenses were $159 million for 2002 compared to $454 million for 2001. Other expenses included amortization expense for intangible assets of $80.3 million for 2002 compared to $134 million for 2001. The decrease in amortization expense resulted from the Company’s adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” which discontinued the amortization of indefinite lived intangible assets and goodwill effective January 1, 2002. Amortization of goodwill recorded in 2001 was $31.0 million. Trust preferred securities and other minority interest expense increased from $59.1 million in 2001 to $62.8 million in 2002.

In November 2000, the Company announced a restructuring initiative. In addition to realigning the Office of the Chief Executive Officer and the Company around customer channels, Sovereign analyzed front and back office operations and computer operating platforms and eliminated approximately 500 positions. In total, Sovereign recorded $27 million in restructuring costs, $8.5 million of which was recorded in 2001 related to the closure of 14 “in-store” offices and a redirection of e-commerce efforts. The balance of the costs associated with this program was recorded in 2000. In connection with Sovereign’s 2002 acquisition of Main Street Bancorp, Sovereign recorded charges of $15.9 million associated principally with the costs incurred for consolidation of branches and Sovereign offices closed and account conversions.

As part of the FleetBoston Acquisition, Sovereign was required to pay $363 million over a period from January 1, 2001 through September 2001, $120 million of which was expensed during 2000 and the remaining $243 million expensed in 2001 subject to FleetBoston’s performance of non-solicitation obligations under the purchase agreement and satisfaction of certain other conditions.

In March 2001, Sovereign completed a $400 million term and revolving credit facility with Bank of Scotland of which $350 million was drawn to prepay an existing $350 million senior secured credit facility. In connection with this transaction, Sovereign recorded a debt extinguishment loss of $10.1 million including the write-off of deferred issuance costs. This charge was reflected, net of tax, as an extraordinary item in accordance with generally accepted accounting principles at that time, in our 2001 financial statements. However, in accordance with SFAS No. 145 “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” this amount is no longer permitted to be classified as an extraordinary item and as such has been reclassified to other expenses.

     Income Tax Provision. The income tax provision was $125 million for 2002 compared to a provision of $23 million for 2001. The effective tax rate for 2002 was 26.7% compared to 16.5% for 2001. The 2002 tax rate differs from the statutory rate of 35% due in part to income from tax-exempt investments and income related to bank-owned life insurance. The effective tax rate for 2001 is lower than the 2002 rate due to the high proportion of permanent tax differences in relation to the recorded pretax income. For additional information with respect to Sovereign’s income taxes, see Note 19 in the Notes to Consolidated Financial Statements.

24 Sovereign Bancorp

     Line of Business Results. During 2002, the Company established the following reportable segments: the Consumer Bank, the Corporate Bank and Treasury & Other. For additional discussion of these business lines and the Company’s related accounting policies, see Note 27 of the Notes to the Consolidated Financial Statements.

Consumer Bank net interest income increased $3.6 million to $904.3 million in 2002. The increase in net interest income was principally due to loan growth, as well as an increase in low-cost deposits. The increase in non-interest income of $10.9 million to $245.6 million is due to an increase in fees related to Consumer Bank loans, other than mortgages, and deposits generated in 2002, offset in part by a reduction in mortgage banking revenues. The provision for loan losses was $45.9 million in 2002. General and administrative expenses (including allocated corporate and direct support costs) increased from $646.2 million to $650.2 million.

Corporate Bank net interest income increased $35.5 million to $259.3 million in 2002. The increase in net interest income was principally due to loan growth. Non-interest income has increased by $1.9 million to $69.7 million. The provision for loan losses increased to $80.4 million in 2002 as a result of increased provisions required for the commercial loan portfolio due to the current economic environment and the increased level of non-performing assets. General and administrative expenses (including allocated corporate and direct support costs) increased from $102.8 million to $131.0 million. The increase was due in part to increased costs to support the Corporate Bank’s loan growth, as well as growth of the cash management and capital markets businesses.

The net loss before income taxes for Treasury & Other decreased from $449.3 million in 2001 to $104.9 million in 2002. In 2002, net interest income increased from net expense of $70.3 million to net expense of $4.1 million. In addition, the Treasury & Other segment includes net gains on security and derivative transactions of approximately $51 million in 2002, as compared to approximately $16 million recorded in 2001. The 2001 results also include expense of $243.2 million for the payments pursuant to FleetBoston’s non-solicitation obligations, as well as amortization of goodwill of $31.0 million. There was no expense for non-solicitation payments to FleetBoston or goodwill amortization recorded pursuant to the Company’s adoption of SFAS No. 142 in 2002.

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 and goodwill 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. The allowance for loan losses represents management’s best estimate of probable losses inherent in the loan portfolio. The adequacy of Sovereign’s allowance for loan losses is 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 loan losses recorded in the income

Sovereign Bancorp 25

Management’s Discussion and Analysis

statement and could result in a change in the recorded allowance. 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 a discussion of the factors driving changes in the amount of the allowance for loan losses 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 23 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 $1.0 billion at December 31, 2003.

The Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets, “ on January 1, 2002. This statement provides that goodwill and other indefinite lived intangible assets will no longer 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. Prior to adopting SFAS No. 142, the Company amortized goodwill over periods not exceeding 25 years.

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 initial impairment test within six months after adoption and annually thereafter. 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 2003 or 2002.

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.

26 Sovereign Bancorp

Recent and Pending Acquisitions

On February 6, 2004, Sovereign completed the acquisition of First Essex for approximately $406 million. A cash payment of $208 million was made in connection with the transaction with the remaining consideration consisting of the issuance of shares of Sovereign’s common stock. First Essex had approximately $1.7 billion in assets and was headquartered in Andover, Massachusetts, with 20 community banking offices throughout 2 counties in Massachusetts and 3 counties in New Hampshire. Management expects that this acquisition will further fortify our presence in both of these states and give us greater leverage in commercial and retail banking in these markets. Sovereign expects to record certain merger related and restructuring charges of approximately $.07 per diluted share, in the first quarter of 2004. The majority of these charges relate to closing Sovereign branch and office locations which will be serviced by acquired First Essex properties.

On January 26, 2004, Sovereign announced the execution of a definitive agreement to acquire Seacoast for approximately $1.1 billion in common stock. Upon completion of the acquisition, Seacoast shareholders will be entitled to receive 1.461 shares of Sovereign common stock, subject to specified adjustment. If Sovereign’s average closing share price drops below $23.96 per share during a 15 day period prior to receipt of shareholder and regulatory approvals, the exchange ratio shall increase to provide Seacoast shareholders with $35 of value, but in no event will the exchange ratio exceed 1.623 shares of Sovereign stock per share of Seacoast stock. Seacoast has $5.4 billion of assets (proforma for its pending acquisition of Abington Bancorp, Inc. (“Abington”) which is expected to close in the beginning of the second quarter of 2004) and is a bank holding company based in New Bedford, Massachusetts with 67 banking offices throughout Southeastern Massachusetts (proforma for its pending Abington acquisition). As a result of this transaction, Sovereign is expected to achieve a top four market share in each of the five fastest growing counties and the five largest counties in Massachusetts, including the Boston metro market. Sovereign’s acquisition of Seacoast is expected to close in the third quarter of 2004, subject to regulatory and Seacoast shareholder approval. Sovereign anticipates recording merger related and restructuring charges of approximately $.07 per diluted share that is primarily related to system conversion costs and office and branch consolidations.

Financial Condition

     Loan Portfolio. Sovereign’s loan portfolio at December 31, 2003 was $26.1 billion, compared to $23.2 billion at December 31, 2002, and was comprised of $11.1 billion of commercial loans, $10.0 billion of consumer loans and $5.1 billion of residential loans. This compares to $10.3 billion of commercial loans, $8.5 billion of consumer loans, and $4.3 billion of residential loans at December 31, 2002.

Commercial loans grew by 7% during 2003 to $11.1 billion principally due to loan origination activity. Consumer loans grew by 18% in 2003 to $10.0 billion as a result of loan origination activity as well as loan purchases. Residential loans increased to 19.4% of the total loan portfolio at December 31, 2003 as compared to 18.8% at December 31, 2002. This increase is due principally to loan purchases that were executed in the fourth quarter of 2003. Loan sales or conversion into mortgage-backed securities amounted to $0.2 billion during 2003, compared with sales or conversions of $0.9 billion during 2002.

Sovereign Bancorp 27

Management’s Discussion and Analysis

Table 3 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 3: Composition of Loan Portfolio

Table 4 presents the contractual maturity of Sovereign’s commercial loans at December 31, 2003 (in thousands):

Table 4: Commercial Loan Maturity Schedule

     Investment Securities. Sovereign’s investment portfolio is concentrated in mortgage-backed securities and collateralized mortgage obligations issued by federal agencies or private institutions. The portfolio is concentrated in 15-year contractual life mortgage-backed securities issued by FNMA, FHLMC and other non agency issuers. Sovereign’s strategy is to purchase liquid investments with intermediate maturities (average duration of 4-5 years). This strategy helps ensure that the Company’s overall interest rate risk position stays within policy requirements. The effective duration of the total investment portfolio at December 31, 2003 was 4.03 years, versus 1.6 years at December 31, 2002. The increase in duration principally resulted from a mild rise in interest rates during the last four months of 2003. Sovereign also holds $257 million of corporate trust preferred securities, all with maturities in excess of 10 years.

28 Sovereign Bancorp

In determining if and when a decline in market value below amortized cost is other-than-temporary, Sovereign evaluates the market conditions, offering prices, trends of earnings, price multiples, and other key measures for investments in marketable equity securities and debt instruments. When such a decline in value is deemed to be other-than-temporary, an impairment loss is recognized in current period operating results to the extent of the decline. See Note 6 for further discussion and analysis of why the unrealized losses in the investment portfolio at December 31, 2003 were considered temporary.

During 2003 and 2002, the Company converted $169 million and $776 million, respectively, of residential mortgage loans into mortgage-backed securities. The book value of these loans was reclassified from loans to investment securities upon securitization. Classification as available for sale or held to maturity was determined as discussed below.

     Investment Securities Available for Sale. Securities expected to be held for an indefinite period of time are classified as available for sale and are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity, net of estimated income taxes, unless a decline in value is deemed to be other-than-temporary in which case the decline is recorded in current period operating results. Substantially all our securities have readily determinable market prices that are derived from third party pricing services. Decisions to purchase or sell these securities are based on economic conditions, including changes in interest rates, liquidity, and asset/liability management strategies. For additional information with respect to the amortized cost and estimated fair value of Sovereign’s investment securities available for sale, see Note 6 to the Consolidated Financial Statements. The actual maturities of mortgage-backed securities available for sale will differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties. During 2003 and 2002, the Company recorded impairment charges of $7.4 million and $4.8 million on retained interests in securitized assets that are classified as available for sale.

     Investment Securities Held to Maturity. Securities that Sovereign has the intent and ability to hold to maturity are classified as held to maturity and reported at amortized cost. This portfolio is primarily comprised of U.S. Treasury and government agency securities; corporate debt securities; mortgage-backed securities issued by FHLMC, FNMA, the Government National Mortgage Association (“GNMA”), and private issuers; and collateralized mortgage obligations.

In December 2003, the Company reclassified $2.1 billion of investments from available for sale to held to maturity. These investments, for which management intends and has the ability to hold to maturity, had an unrealized loss at the time of transfer of $23 million. This unrealized loss will be amortized from accumulated other comprehensive income and into earnings over the life of the related investment securities. However, this reclassification is not expected to have an impact on net interest income as the investments are expected to be amortized to par over the same period.

The actual maturities of the mortgage-backed securities held to maturity will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. No impairment associated with held-to-maturity securities was recorded in 2003 or 2002.

Sovereign Bancorp 29

Management’s Discussion and Analysis

Table 5 presents the book value of investment securities by obligor and Table 6 presents the securities of single issuers (other than obligations of the United States and its political subdivisions, agencies and corporations) having an aggregate book value in excess of 10% of Sovereign’s stockholders’ equity that were held by Sovereign at December 31, 2003 (dollars in thousands):

Table 5: Investment Securities by Obligor

Table 6: Investment Securities of Single Issuers

     Goodwill and Intangible Assets. Goodwill and other intangible assets decreased to $1.30 billion at December 31, 2003, from $1.37 billion in 2002. Goodwill and other intangibles represented 2% of total assets and 32% of stockholders’ equity at December 31, 2003, and is comprised of goodwill of $1.0 billion and core deposit intangible assets of $269 million. The decrease in goodwill and other intangible assets was due to core deposit intangible asset amortization.

Sovereign established core deposit intangibles (CDI) in instances where core deposits were acquired in purchase business combinations. Sovereign determined the value of its CDI based on the present value of the difference in expected future cash flows between the cost to replace such deposits (based on applicable equivalent time deposit rates) versus the then-current yield on core deposits acquired. The aggregate future cash flows were based on the average expected life of the deposits acquired for each product less cost to service the deposits. The CDI associated with our various acquisitions are being amortized over the expected life of the underlying deposits, which is for periods up to 10 years.

     Other Assets. Other assets at December 31, 2003 were $1.6 billion compared to $1.8 billion at December 31, 2002. Included in other assets at December 31, 2003 and December 31, 2002 were $214 million and $467 million of loans in process, respectively, $391 million and $362 million of assets associated with our precious metals business, respectively, $122 million and $87 million of investments in low income housing partnerships and other equity method investment partnerships, respectively, and net deferred tax assets of $155 million and $125 million, respectively.

30 Sovereign Bancorp

     Deposits and Other Customer Accounts. Sovereign attracts deposits within its primary market area by offering a variety of deposit instruments, including demand and NOW accounts, money market accounts, savings accounts, customer repurchase agreements, certificates of deposit and retirement savings plans. Total deposits and other customer accounts at December 31, 2003 were $27.3 billion, compared to $26.9 billion at December 31, 2002. The increase is attributable to Sovereign’s continued emphasis on strategies to grow core deposits and limit higher priced time deposits. Core deposits increased in 2003 by $1.5 billion while time deposits declined by $1.0 billion. Comparative detail of average balances and rates by deposit type is included in Table 1: Net Interest Margin in a prior section of this MD&A.

     Borrowings and Other Debt Obligations. Sovereign utilizes borrowings and other debt obligations as a source of funds for its asset growth and its asset/liability management. Collateralized advances are available from the Federal Home Loan Bank of Pittsburgh (“FHLB”) provided certain standards related to creditworthiness have been met. Sovereign also utilizes reverse repurchase agreements, which are short-term obligations collateralized by securities fully guaranteed as to principal and interest by the U.S. Government or an agency thereof, and federal funds lines with other financial institutions. Total borrowings and other debt obligations at December 31, 2003 were $12.2 billion, compared to $8.8 billion at December 31, 2002. We increased our level of borrowings in 2003 to fund earning asset growth. All obligations with the exception of the Senior secured credit facility, the Senior notes and the Junior subordinated debentures to Capital Trusts are Sovereign Bank obligations and have priority over holding company obligations.

Sovereign Bancorp 31

Management’s Discussion and Analysis

Table 7 summarizes information regarding borrowings and other debt obligations (in thousands):

Table 7: Details of Borrowings

(1) Effective July 1, 2003, Sovereign reclassified these obligations to liabilities.

Refer to Note 12 in the Notes to Consolidated Financial Statements for more information related to Sovereign’s borrowings.

32 Sovereign Bancorp