When Fleet Financial Group Inc. chief executive Terrence Murray was asked at a press conference in March which bank he would like to see buy 300 branches his banking company was forced to sell, he paused.
"Medford Savings Bank," he chuckled.
The joke was clear: Mr. Murray was suggesting that he wanted a bank that would not pose a competitive threat to FleetBoston Corp., the $185 billion-asset banking powerhouse in New England formed this year by Mr. Murray's Fleet and BankBoston Corp.
In the end, the winning bidder was Sovereign Bancorp., a Wyomissing, Pa., thrift company with $24 billion of assets. By using a highly leveraged debt plan, Sovereign agreed to buy 278 branches for $1.4 billion.
On the surface, Sovereign wasn't exactly Medford Savings Bank. But as details of Sovereign's financing have emerged, banking observers say it may turn out to be just as good a butt for Mr. Murray's joke.
"Fleet did a masterful job of finding the most minimally competitive but acceptable divestiture candidate," said John S Carusone, president of Bank Analysis Center, a Hartford, Conn.-based consulting firm. "They threaded the eye of the needle. I don't see the Department of Justice letting Bill Gates buy his competition. It was a masterful coup."
The doubts that Sovereign can challenge FleetBoston in the region stem from the fact that Sovereign's branches-to-be would not offer nearly the range of products that FleetBoston does, especially for middle-market companies.
And analysts say the thrift company would not be offering them soon, because of the unusually large and leveraged debt Sovereign is taking on to buy the branches. To pay off the debt, the thrift company must meet what analysts say is an unusually rosy growth projection that allows little room for error.
For instance, Sovereign told analysts on Sept. 2, the day the deal was announced, that tangible capital generation would grow by at least $500 million annually through 2003 to $1.91 billion -- an expectation that capital would grow 134% by 2001 alone. Sovereign also promised the buyout would be 1% accretive to earnings in the first year -- a target described as "next to impossible" by analysts. On Wednesday, the thrift company said the numbers were being revised and not currently available.
In addition, Sovereign shocked debt analysts last week by paying unusually high market prices to investors in its $1.5 billion debt. The company's $700 million issue of senior notes pay more than 10% annually. Sovereign's trust-preferred coupons pay 7.5%.
Finally, on the basis of current interest rates it would pay about 9.5% on its $500 million bank loan, or about $49 million a year. And that cost won't decline much in 2001. Sovereign need repay only 5% ($25 million) of the principal in 2000, and only $75 million in the loan's second year.
Part of the reason the loan will pay close to the rate of Sovereign's bonds is that, although collateralized, the loan is secured by Sovereign stock. Such loans have been under fire by the comptroller of the currency because if a loan defaults, a company's stock usually has become devalued to the point of being worthless.
Mark R. McCollom, Sovereign's chief accounting officer, said the company is comfortable with the loan and would be happy to make one like it to a client with a similar profile.
Still, Mr. McCollom and Jacquelyn K. Blue, the thrift's treasurer, concede that the cost of financing came in over original estimates. The problem, they said, was that Sovereign's depressed stock price kept the thrift from tapping the equity market for more than $300 million. As a result it was forced into the loan market.
But the bankers are resolute that the acquisition will pay off next year. Said Ms. Blue, "We promised our shareholders this deal would be slightly accretive and we're committed to that."
All told, Sovereign is facing at least $140 million in financing costs the first year, not including fees it must pay Salomon Smith Barney and Lehman Brothers for underwriting and distributing the deal. When the deal was announced, Sovereign had projected only $49 million in after-tax financing costs in 2000. Now the estimate is $91 million.
"The spreads came in very wide," said Jon Vacko, an analyst with Duff & Phelps in Chicago. "I think they can service this debt and generate income if they can bring it off. However, we are very concerned about the capital mix."
Concern about higher-than-expected financing costs is one reason Mr. Vacko put Sovereign's debt ratings on watch for a downgrade. Last week, Standard & Poor's went a step further, lowering Sovereign debt from investment grade to junk.
"The bottom line is their fixed charge is substantial," said John Bartko, a debt analyst with S&P. "If they don't meet their projections, they will really struggle."
Erin Cullan, a senior vice president in Lehman's debt capital markets team, said there is a chance Sovereign can avoid the hefty interest rates on its syndicated loan by prepaying the loan before maturity.
However, neither Sovereign nor its advisers will be specific about where the cash will come from to pay off its debt. They do point to Sovereign's track record of acquisitions, including branch acquisitions from New Jersey-based Carnegie Bancorp and Peoples Bancorp, and the former CoreStates Financial Corp. in Pennsylvania. During that five-year buying spree, from 1994 through 1999, per-share earnings jumped from 63 cents a share to an expected $1.18.
One investment banker who lost out to Salomon and Lehman for a piece of Sovereign's financing said part of the reason Sovereign was picked was because "Fleet viewed them as not an aggressive competitor. A lot of people said it's going to be expensive financing, and I think they would have liked to have paid less."
All of this puts Sovereign at a competitive disadvantage, says Bank Analysis Center's Mr. Carusone, who estimates that in some business lines -- commercial lending, corporate trusts, treasury management, and stock transfers -- FleetBoston will control market share of between 75% and 100%.
"Fleet is dominant in the commercial and wholesale market," Mr. Carusone said. "There will be absolutely no competition. This merger was judged by deposits, and regulators have ignored other key businesses."
Not so, said FleetBoston spokesman James Mahoney, who points to the fact that Sovereign will retain many of the wholesale bank relationship managers. Sovereign, he said, "has proved to be a strong competitor to First Union in Philadelphia and in other markets.
Ultimately, analysts said, it will be Sovereign's near-term customer retention and integration that will convince them the transaction was worth the price