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| CSE > SEC Filings for CSE > Form 10-Q on 4-Nov-2009 | All Recent SEC Filings |
4-Nov-2009
Quarterly Report
This Form 10-Q, including the footnotes to our consolidated financial statements included herein, contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to numerous assumptions, risks, and uncertainties, including certain plans, expectations, goals and projections and statements about our deposit base, loan portfolios and operations, managing our credit book, our expectations regarding future credit performance, charge offs and loan losses, particularly regarding commercial real estate loans, our liquidity, capital position, credit facilities and covenant compliance, our indebtedness, payment obligations and restrictions thereunder and use of proceeds from asset sales, CapitalSource Bank's capitalization and accessing of financing, our intention to sell assets and monetize the value of our healthcare net lease business, the commercial real estate participation interest ("the "A" Participation Interest"), economic and market conditions for our business, the impact of the U.S. economy and government supervision and regulation on our business and earnings, securitization markets, the performance of our loans, loan yields, the impact of accounting pronouncements, our share repurchase plan, taxes and tax audits and examinations, our unfunded commitments, our intention to originate loans at CapitalSource Bank, our portfolios and activities, our delinquent, non-accrual and impaired loans, our SPEs, risk management, and our valuation allowance with respect to, and our realization and utilization of, net deferred tax assets, net operating loss carryforwards and built-in losses. All statements contained in this Form 10-Q that are not clearly historical in nature are forward-looking, and the words "anticipate," "assume," "intend," "believe," "expect," "estimate," "plan," "will," "look forward" and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: changes in economic or market conditions or investment or lending opportunities may result in increased credit losses and delinquencies in our portfolio and impair our ability to consummate favorable loans; continued or worsening disruptions in economic and credit markets may continue to make it very difficult for us to obtain financing on attractive terms or at all, could prevent us from optimizing the amount of leverage we employ and could adversely affect our liquidity position; movements in interest rates and lending spreads may adversely affect our borrowing strategy; operating CapitalSource Bank under the California and FDIC regulatory regime could be more costly and restrictive than expected; we may not be successful in maintaining or growing deposits or deploying capital in favorable lending transactions or originating or acquiring assets in accordance with our strategic plan; competitive and other market pressures could adversely affect loan pricing; the nature, extent, and timing of any governmental actions and reforms; the success and timing of other business strategies and asset sales; continued or worsening charge offs, reserves and delinquencies may adversely affect our earnings and financial results; changes in tax laws or regulations could adversely affect our business; hedging activities may result in reported losses not offset by gains reported in our consolidated financial statements; we may not be able to successfully monetize our healthcare net lease business; and other risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2008 as filed with the SEC on March 2, 2009 ("Form 10-K"), this Quarterly Report on Form 10-Q and our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009 as filed with the SEC on August 10, 2009, and other documents filed by us with the SEC. All forward-looking statements included in this Form 10-Q are based on information available at the time the statement is made.
We are under no obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
The information contained in this section should be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Form 10-Q and in our Form 10-K.
Overview and Highlights
We are a commercial lender that, through our wholly owned subsidiary, CapitalSource Bank, provides financial products to middle market businesses and provides depository products and services in southern and central California. Prior to the formation of CapitalSource Bank, CapitalSource Inc. ("CapitalSource," and together with its subsidiaries other than CapitalSource Bank, the "Parent Company") conducted its commercial lending business through our other subsidiaries, whereas subsequent to CapitalSource Bank's formation, substantially all new loans have been originated at CapitalSource Bank and we expect this will continue to be the case for the foreseeable future. Our commercial lending activities in the Parent Company consist primarily of satisfying existing commitments made prior to CapitalSource Bank's formation. Consequently, we expect that our loans in the Parent Company will gradually runoff while CapitalSource Bank's loan portfolio will continue to grow.
We currently operate as three reportable segments: 1) CapitalSource Bank,
2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank
segment comprises our commercial lending and banking business activities; our
Other Commercial Finance segment comprises our loan portfolio and residential
mortgage business activities in the Parent Company; and our Healthcare Net Lease
segment comprises our direct real estate investment business activities.
For the three and nine months ended September 30, 2008, we presented financial results through three reportable segments: 1) Commercial Banking, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Beginning in the first quarter of 2009, changes were made in the way management organizes financial information to make operating decisions, resulting in the activities previously reported in the Commercial Banking segment being disaggregated into the CapitalSource Bank and Other Commercial Finance segments and the results of our Residential Mortgage Investment segment being combined into the Other Commercial Finance segment. We have reclassified all comparative prior period segment information to reflect our new three reportable segments. For financial information about our segments, see Note 20, Segment Data, in our consolidated financial statements for the three and nine months ended September 30, 2009.
Through our CapitalSource Bank segment activities, CapitalSource Bank provides a wide range of financial products to middle market businesses and participates in broadly syndicated debt financing for larger businesses, and also offers depository products and services in southern and central California that are insured by the Federal Deposit Insurance Corporation ("FDIC") to the maximum amounts permitted by regulation. As of September 30, 2009, our CapitalSource Bank segment had 321 loans outstanding with an aggregate principal balance of $3.0 billion and held a $714.2 million senior participation interest in the "A" Participation Interest.
Through our Other Commercial Finance segment activities, the Parent Company provides a wide range of financial products to middle market businesses and has participated in broadly syndicated debt financings for larger businesses. As of September 30, 2009, our Other Commercial Finance segment had 693 loans outstanding with an aggregate balance of $5.7 billion.
Through our Healthcare Net Lease segment activities, we invest in income-producing healthcare facilities - principally long-term care facilities in the United States. We provide lease financing to skilled nursing facilities and, to a lesser extent, assisted living facilities, and long term acute care facilities. As of September 30, 2009, this segment held $946.5 million in direct real estate investments comprising 181 healthcare facilities leased to 40 tenants through long-term, triple-net operating leases. We are currently evaluating potential transactions to monetize the value of this business, including debt financings, asset sales and corporate transactions.
Although we have made loans as large as $325.0 million, as of September 30, 2009, our average loan size was $9.0 million and our average loan exposure by client was $14.0 million. Our loans generally have a remaining life to maturity of one to five years with a weighted average life to maturity of 2.4 years as of September 30, 2009. Substantially all of our loans require monthly interest payments at variable rates and, in many cases, our loans provide for interest rate floors that help us maintain our yields when interest rates are low or declining. We price our loans based upon the risk profile of our clients. As of September 30, 2009, our geographically diverse client base consisted of 650 clients with headquarters in 46 states, the District of Columbia, Puerto Rico and select international locations, primarily in Canada and Europe.
Consolidated Results of Operations
Explanation of Reporting Metrics
Interest Income. In our CapitalSource Bank segment, interest income represents interest earned on loans, the "A" Participation Interest, investment securities and cash and cash equivalents. In our Other Commercial Finance segment, interest income represents interest earned on loans, coupon interest and the amortization of purchase discounts and premiums on our mortgage-related receivables, which are amortized into income using the interest method, other investments and cash and cash equivalents. Although the majority of our loans charge interest at variable rates that generally adjust daily, we also have loans charging interest at fixed rates. In our Healthcare Net Lease segment, interest income represents interest earned on cash and restricted cash.
Fee Income. In our CapitalSource Bank and Other Commercial Finance segments, fee income represents net fee income earned from our commercial loan operations. Fee income includes the amortization of loan origination fees, net of the direct costs of origination, prepayment-related fees as well as other fees charged to borrowers. We currently do not generate any fee income in our Healthcare Net Lease segment.
Operating Lease Income. In our Healthcare Net Lease segment, operating lease income represents lease income earned in connection with direct real estate investments. Our operating leases typically include fixed rental payments, subject to escalation over the life of the lease. We generally project a minimum escalation rate for the leases and recognize operating lease income on a straight-line basis over the life of the lease. We currently do not generate any operating lease income in our CapitalSource Bank and Other Commercial Finance segments.
Interest Expense. Interest expense is the amount paid on deposits and borrowings, including the amortization of deferred financing fees and debt discounts. In our CapitalSource Bank segment, interest expense includes interest paid to depositors and interest paid on Federal Home Loan Bank System of San Francisco ("FHLB SF") borrowings. In our Other Commercial Finance segment, interest expense includes borrowing costs associated with repurchase agreements, secured credit facilities, term debt, convertible debt and subordinated debt. In our Healthcare Net Lease segment, interest expense includes borrowing costs associated with mortgage debt and intercompany debt. The majority of our borrowings charge interest at variable rates based primarily on one-month LIBOR or Commercial Paper ("CP") rates plus a margin. Our convertible debt, three series of our subordinated debt, our term debt recorded in connection with our investments in mortgage-related receivables and the intercompany debt within our Healthcare Net Lease segment bear a fixed rate of interest. Deferred financing fees, debt discounts and the costs of issuing debt, such as commitment fees and legal fees, are amortized over the estimated life of the borrowing. Loan prepayments may materially affect interest expense on our term debt since in the period of prepayment the amortization of deferred financing fees and debt acquisition costs is accelerated.
Provision for Loan Losses. We record a provision for loan losses in our CapitalSource Bank and Other Commercial Finance segments. The provision for loan losses is the periodic cost of maintaining an appropriate allowance for loan losses inherent in our commercial lending portfolio and in our portfolio of residential mortgage-related receivables. As the size and mix of loans within these portfolios change, or if the credit quality of the portfolios change, we record a provision to appropriately adjust the allowance for loan losses. We do not have any loan receivables in our Healthcare Net Lease segment.
Other (Expense) Income. In our CapitalSource Bank and Other Commercial Finance segments, other income (expense) consists of gains (losses) on the sale of loans, gains (losses) on the sale of debt and equity investments, unrealized appreciation (depreciation) on certain investments, other-than-temporary impairment on investment securities, available for sale, gains (losses) on derivatives, due diligence deposits forfeited, unrealized appreciation (depreciation) of our equity interests in certain non-consolidated entities, servicing income, income from our management of various loans held by third parties, income (expenses) on our real estate owned, and other miscellaneous fees and expenses not attributable to our commercial lending and banking operations. In our Healthcare Net Lease segment, other income (expense) consists of gain (loss) on the sale of assets.
Operating Expenses. In our CapitalSource Bank and Other Commercial Finance segments, operating expenses include compensation and benefits, professional fees, travel, rent, insurance, depreciation and amortization, marketing and other general and administrative expenses, including deposit insurance premiums. In our
Healthcare Net Lease segment, operating expenses include depreciation of direct real estate investments, professional fees, an allocation of overhead expenses (including compensation and benefits) and other direct expenses.
Income Taxes. We revoked our REIT election effective January 1, 2009 and recognized the resulting deferred tax effects in the consolidated financial statements as of December 31, 2008. We provide for income taxes as a "C" corporation on income earned from operations. Certain of our subsidiaries do not participate in the filing of a consolidated federal tax return and as a result have taxable income that is not offset by losses of other entities. The group continues to be subject to federal, foreign, state and local taxation in various jurisdictions.
We use the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates for the periods in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which the change occurs.
Periodic reviews of the carrying amount of deferred tax assets are made to determine if the establishment of a valuation allowance is necessary. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. All evidence, both positive and negative, is evaluated when making this determination. Items considered in this analysis include the ability to carry back losses to recoup taxes previously paid, the reversal of temporary differences, tax planning strategies, historical financial performance, expectations of future earnings and the length of statutory carryforward periods. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences.
Operating Results for the Three and Nine Months Ended September 30, 2009
Our results of operations for the three and nine months ended September 30, 2009 were impacted by the global recession, a challenging credit market environment, the availability of liquidity, and the effect of revoking our REIT election effective January 1, 2009. As further described below, the most significant factors influencing our consolidated results of operations for the three and nine months ended September 30, 2009, compared to the equivalent time periods in 2008 were:
• Increased provision for loan losses;
• Increased income tax expense due to additions to the valuation allowance for our deferred tax assets;
• Decreased balance of our commercial lending portfolio;
• Gains and losses on our residential mortgage investment portfolio;
• Gains and losses on extinguishment of our debt;
• Losses on derivatives and other investments in our Other Commercial Finance segment; and
• Changes in lending and borrowing spreads.
Our consolidated operating results for the three and nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008, were as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
2009 2008 $ Change % Change 2009 2008 $ Change % Change
($ in thousands)
Interest income $ 188,527 $ 274,012 $ (85,485 ) (31 )% $ 607,689 $ 836,559 $ (228,870 ) (27 )%
Fee income 25,281 29,974 (4,693 ) (16 ) 81,583 104,882 (23,299 ) (22 )
Operating lease income 27,247 28,140 (893 ) (3 ) 82,533 80,040 2,493 3
Interest expense 105,346 174,850 (69,504 ) (40 ) 347,246 523,437 (176,191 ) (34 )
Provision for loan losses 221,385 110,261 111,124 101 580,499 147,594 432,905 293
Depreciation of direct real estate
investments 8,713 8,898 (185 ) (2 ) 26,515 26,804 (289 ) (1 )
Operating expenses 64,628 52,621 12,007 23 202,865 172,866 29,999 17
Other (expense) income (17,026 ) 28,163 (45,189 ) (160 ) (103,858 ) (27,950 ) (75,908 ) (272 )
Income tax expense 98,193 58 98,135 169,198 135,947 40,377 95,570 237
Net (loss) income (274,236 ) 13,601 (287,837 ) (2,116 ) (625,125 ) 82,453 (707,578 ) (858 )
Net income (loss) attributable to
noncontrolling interests 10 (100 ) 110 110 (28 ) 1,480 (1,508 ) (102 )
Net (loss) income attributable to
CapitalSource Inc. (274,246 ) 13,701 (287,947 ) (2,102 ) (625,097 ) 80,973 (706,070 ) (872 )
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Our consolidated yields on income earning assets and the costs of interest bearing liabilities for the nine months ended September 30, 2009 and 2008 were as follows:
Nine Months Ended September 30,
2009 2008
Weighted Net Average Weighted Net Average
Average Investment Yield/ Average Investment Yield/
Balance Income Cost Balance Income Cost
($ in thousands)
Interest earning assets:
Interest income $ 607,689 5.98 % $ 836,559 7.19 %
Fee income 81,583 0.80 104,882 0.90
Total interest earning assets(1) $ 13,587,085 689,272 6.78 $ 15,508,148 941,441 8.09
Total direct real estate investments 1,060,649 82,533 10.40 1,068,530 80,040 9.98
Total income earning assets 14,647,734 771,805 7.04 16,576,678 1,021,481 8.21
Total interest bearing liabilities(2) 12,595,298 347,246 3.69 13,903,078 523,437 5.02
Net finance spread $ 424,559 3.35 % $ 498,044 3.19 %
Net finance margin 3.88 % 4.00 %
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(1) Interest earning assets include cash and cash equivalents, restricted cash, investment securities (including mortgage-backed securities), mortgage-related receivables, loans and the "A" Participation Interest.
(2) Interest bearing liabilities include deposits, FHLB SF borrowings, repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt and subordinated debt.
Operating Expenses
During the three months ended September 30, 2009, consolidated operating expenses increased by $12.0 million over the three months ended September 30, 2008. The increase was primarily due to the inclusion of three months of operating expenses related to CapitalSource Bank for the three months ended September 30, 2009, while only two months of its operations were included in the 2008 period. Also contributing to the increase was a $3.6 million increase in administrative expenses, primarily due to FDIC premiums paid by CapitalSource Bank, including a one time special
assessment of $2.5 million paid by CapitalSource Bank to the FDIC's Deposit Insurance Fund, which was part of a required payment for all insured institutions, a $2.1 million increase in rental expenses, primarily due to the addition of CapitalSource Bank occupancy expenses for two of the three months in the quarter, and a $7.8 million increase in professional fees. These increases were offset by a $1.4 million decrease in marketing expenses, related primarily to the one-time promotion and advertising expenses related to the commencement of CapitalSource Bank's operations in the three months ended September 30, 2008.
During the nine months ended September 30, 2009, consolidated operating expenses increased by $30.0 million over the nine months ended September 30, 2008. The increase was primarily due to the inclusion of nine months of operating expenses related to CapitalSource Bank for the nine months ended September 30, 2009, while only two months of its operations were included in the 2008 period. Also contributing to the increase was a $15.9 million increase in professional fees, a $9.7 million increase in administrative expenses, primarily due to FDIC premiums paid by CapitalSource Bank, a $6.0 million increase in rental expense resulting from the addition of CapitalSource Bank occupancy expenses, and a $3.7 million increase in depreciation and amortization expense, primarily resulting from the addition of CapitalSource Bank's fixed assets to our operations. These increases were partially offset by a $1.6 million decrease in marketing expenses and a $4.3 million decrease in travel and entertainment expenses.
Income Taxes
During the three months ended September 30, 2009, consolidated income tax expense was $98.2 million, compared to $0.1 million for the three months ended September 30, 2008. The increase was caused in part by the establishment of a valuation allowance for the deferred tax assets of a subsidiary that continued to incur operating losses during the quarter.
During the nine months ended September 30, 2009, consolidated income tax expense was $135.9 million, compared to $40.4 million for the nine months ended September 30, 2008. The increase was caused in part by the establishment of a valuation allowance for the deferred tax assets of several subsidiaries that continued to incur operating losses during 2009.
Comparison of the Three Months Ended September 30, 2009 and 2008
We have reclassified all comparative prior period segment information to reflect our three reportable segments. The discussion that follows differentiates our results of operations between our segments. All references to loans below include loans held for investment and loans held for sale, including related interest receivable.
CapitalSource Bank Segment
Our CapitalSource Bank segment operating results for the three months ended
September 30, 2009, compared to the three months ended September 30, 2008, were
as follows:
Three Months Ended
September 30,
2009 2008(1) $ Change % Change
($ in thousands)
Interest income $ 71,673 $ 64,887 $ 6,786 10 %
Fee income 7,112 1,665 5,447 327
Interest expense 23,602 32,178 (8,576 ) (27 )
Provision for loan losses 48,451 3,535 44,916 1,271
Operating expenses 25,365 19,106 6,259 33
Other income 7,409 4,573 2,836 62
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