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Form 10-Q for CAPITALSOURCE INC


6-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q, including the footnotes to our unaudited consolidated financial statements included herein, contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including certain plans, expectations, strategies, goals, and projections and including statements about our expectations regarding Parent Company liquidity, CapitalSource Bank liquidity, Parent Company asset run off, return of capital to shareholders, including the timing, form and magnitude of any return of capital, prepayment of trust preferred securities, intentions to expand the CapitalSource Bank's lending business, expectation about additional deferred tax asset valuation allowance reversal, accelerated disposition of Parent Company assets, calling of Parent Company securitized debt, Parent Company capital contributions to CapitalSource Bank, and realizing the allowed portion of the deferred tax asset, all which are subject to numerous assumptions, risks, and uncertainties. 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,' 'forecast,' 'plan,' 'position,' 'project,' 'will,' 'should,' 'would,' 'seek,' 'continue,' 'outlook,' 'look forward,' and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding preliminary and 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: continued or worsening disruptions in credit and other markets; borrowers' lack of financial strength to repay loans; the Parent Company's decision to make new loans or extend existing loans; the success and timing of other business strategies and asset sales; declines in asset values; lower than expected Parent Company's recurring tax basis income; lower than expected taxable income at CapitalSource Bank for which CapitalSource Bank has to reimburse the Parent Company for income tax expenses in accordance with the tax sharing agreement; the need to retain capital for strategic or regulatory reasons including the implementation of Basel III standards; lower than anticipated liquidity; inability to attract qualified professionals; drawdown of Parent Company unfunded commitments substantially in excess of historical drawings; changes in economic or market conditions or investment or lending opportunities; continued or worsening credit losses, charge-offs, reserves and

delinquencies; competitive and other market pressures on product pricing and services; reduced demand for our services; our inability to grow deposits and access wholesale funding sources; regulatory safety and soundness considerations; changes in tax laws or regulations affecting our business; changes in tax characteristics of income generated; loan repayments higher than expected; excess Parent Company liquidity; our inability to generate sufficient earnings; tax planning or disallowance of tax benefits by tax authorities; and other factors described in CapitalSource's 2011 Annual Report on Form 10-K and documents subsequently filed by CapitalSource with the Securities and Exchange Commission. All forward-looking statements included in this Form 10-Q are based on information available at the time of the release.

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

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its subsidiaries. References to CapitalSource Bank or the Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank.

For the three and nine months ended September 30, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our legacy loan portfolio and investment activities in the Parent Company. For additional information, see Note 16, Segment Data.

Through our CapitalSource Bank segment activities, we provide financial products primarily to small and middle market businesses throughout the United States and also offer depository products and services in southern and central California, which are insured by the Federal Deposit Insurance Corporation ("FDIC") to the maximum amounts permitted by regulation. As of September 30, 2012, CapitalSource Bank had an outstanding loan principal balance of $5.3 billion and deposits of $5.5 billion.

Through our Other Commercial Finance segment activities, the Parent Company satisfies existing loan commitments made prior to CapitalSource Bank's formation and receives payments on its existing loan portfolio. As of September 30, 2012, the Parent Company had an outstanding loan principal balance of $727.5 million.


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Current Developments

As part of the transformation to a more traditional bank structure, we have been liquidating Parent Company assets, reducing Parent Company debt, using excess capital to repurchase stock, simplifying our consolidated operations and focusing our strategic growth initiatives entirely on CapitalSource Bank.

In addition to growing assets and increasing profitability at CapitalSource Bank, our current strategy is to run off our remaining Parent Company assets over time. We intend to regularly assess alternatives for implementing our strategy and may consider accelerated disposition of Parent Company assets, prepayments of Trust Preferred Securities, calling the securitized debt and alternative uses of Parent Company capital, including contributions to CapitalSource Bank, if attractive opportunities become available.

In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and cancelled during the second quarter. We recorded a related pre-tax gain of $8.2 million on the extinguishment of debt. As of September 30, 2012, the aggregate outstanding balance of the subordinated debt was $409.9 million.

During the three and nine months ended September 30, 2012, we repurchased $23.2 million and $29.0 million, respectively, of the outstanding principal of the 7.25% Convertible Debentures for $23.2 million and $29.1 million, respectively, and recorded related pre-tax losses of $0.1 million for the nine months ended September 30, 2012, on the extinguishment of debt. We did not incur any related pre-tax gain or loss for the three months ended September 30, 2012. The repurchase of $23.2 million in July 2012 amounted to the remaining outstanding balance of the 7.25% Convertible Debentures and therefore resulted in an extinguishment of debt.

As the Parent Company assets are repaid, the Company intends to return a substantial portion of our excess capital to shareholders through a combination of share repurchases and dividends. Since the Company began repurchasing shares in December 2010 through September 2012, we have repurchased approximately 112.8 million shares, or 34.9% of the shares outstanding since December 2010. Consistent with the objective of prudently returning excess capital to shareholders, on October 26, 2012, the Company's Board of Directors approved a new share repurchase program with authority to purchase up to $250.0 million of outstanding shares through the end of 2013.

While share buybacks have been the primary means of returning excess capital to shareholders to date, we are also considering

additional mechanisms to return excess capital in the near term. In this regard, our Board has been actively considering (i) modifying our dividend policy to pay a regular quarterly dividend more commensurate with our banking industry peers and (ii) possibly paying one or more special dividends, if appropriate in light of buyback and regular dividend levels. Our Board intends to further consider these alternatives in the near term, and it is possible that the board could determine to take further action in 2012. However, our Board has not yet made a decision on these specific actions, and we cannot assure you that any such action(s) will be taken. Any such determinations will be subject to market conditions and other developments, the level of available cash, and other factors.

Our broader business strategy focuses on developing and growing our banking operations. As of September 30, 2012, CapitalSource Bank had $7.3 billion of assets. We offer a broad range of specialized senior secured, commercial loan products to small and middle-market businesses, and we offer our loan products on a nationwide basis, despite the regional nature of our deposit base. With a low cost deposit gathering platform based in southern and central California, we believe our business model is well positioned to deliver a broad range of customized financial solutions to borrowers.

Since September 30, 2011, CapitalSource Bank's loan balance has grown by 17% and the Parent Company's loan balance has decreased by 43%. Since the formation of the Bank, we have launched or acquired five lending platforms - equipment finance, small business, professional practice, multifamily lending and premium finance lending. It is our intent to continue to seek lending platforms and experienced individuals who will further augment our specialized businesses.

Operating Results for the Three and Nine Months Ended September 30, 2012

As further described below, the most significant factors influencing our consolidated results of operations for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 were:

Decreased deferred tax asset valuation allowance;

Increased net interest margin;

Decreased interest-earning assets;

Decreased provision for loan and lease losses;

Decreased losses on our investments;

Decreased expense of real estate owned and other foreclosed assets, net;

Significant loss on extinguishment of debt in 2011; and

Decreased operating expenses.


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Our consolidated operating results for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, were as follows:

                                  Three Months Ended                          Nine Months Ended
                                     September 30,                              September 30,
                                                                %                                            %
                                  2012          2011         Change          2012           2011           Change
                                                                 ($ in thousands)
Interest income                 $ 115,234     $ 121,476         -5.1 %    $  353,293      $ 391,053            -9.7 %
Interest expense                   19,513        34,488        -43.4          60,535        127,047           -52.4
Provision for loan and lease
losses                              8,959        35,118        -74.5          30,567         81,450           -62.5
Non-interest income                 9,297        32,484        -71.4          29,297         74,973           -60.9
Non-interest expense               47,009       176,346        -73.3         144,259        301,357           -52.1
Income tax expense (benefit)       18,003       (11,280 )      259.6        (296,305 )       17,131        -1,829.6
Net income (loss)                  31,047       (80,712 )      138.5         443,534        (60,959 )         827.6

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the nine months ended September 30, 2012 and 2011 were as follows:

                                                                     Nine Months Ended September 30,
                                                       2012                                                    2011
                                 Weighted                                                Weighted
                                  Average          Net Interest          Average          Average          Net Interest          Average
                                  Balance         Income/Expense       Yield/Cost         Balance         Income/Expense       Yield/Cost
                                                                             ($ in thousands)
Loans(1)                        $ 5,929,715      $        322,437             7.26 %    $ 5,698,156      $        344,308             8.08 %
Investment securities             1,257,571                29,737             3.16        1,597,382                44,675             3.74
Cash and other
interest-earning assets             397,327                 1,119             0.38        1,018,800                 2,070             0.27
Total asset-related balances      7,584,613               353,293             6.22        8,314,338               391,053             6.29
Deposits                          5,347,534                38,669             0.97        4,749,229                40,203             1.13
Borrowings(2)                     1,272,592                21,866             2.30        2,083,481                86,844             5.57
Total liabilities-related
balances                          6,620,126                60,535             1.22        6,832,710               127,047             2.49
Net interest income/spread                       $        292,758             5.00 %                     $        264,006             3.80 %
Net interest margin                                                           5.16 %                                                  4.25 %

(1) Loans balances are net of deferred loan fees and discounts.

(2) Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.

Income Taxes

We provide for income taxes as a "C" corporation on income earned from operations. For the tax years ended 2010 and 2009, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We have consolidated our subsidiaries in 2011 for federal tax purposes. We are subject to federal, foreign, state and local taxation in various jurisdictions.

We account for income taxes under the asset and liability method. Under this 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 that includes the change.

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


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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.

In 2009, we established a valuation allowance against a substantial portion of our net deferred tax assets where we determined that there was significant negative evidence with respect to our ability to realize such assets. Negative evidence we considered in making this determination included the history of operating losses and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of September 30, 2012 and December 31, 2011, the valuation allowance was $159.4 million and $515.2 million, respectively.

In June 2012, we reversed $347.4 million of the valuation allowance. Each of the deferred tax assets was evaluated based on our evaluation of the available positive and negative evidence with respect to our ability to realize the deferred tax asset, including considering their associated character and jurisdiction. The decision to reverse a large portion of the valuation allowance was based on our evaluation of all positive and negative evidence which did not include any significant tax planning strategies. A cumulative loss position, such as we had for the previous three-year period ended December 31, 2011, is generally considered significant negative evidence in assessing the realizability of a deferred tax asset. However, subsequent to the establishment of the valuation allowance in 2009, significant positive evidence had developed which overcame this negative evidence such that, during the nine months ended September 30, 2012, management determined that it is more likely than not that the deferred tax asset will be realized. This determination was made not based upon a single event or occurrence, but based upon the accumulation of all positive and negative evidence including recent trends in our earnings and taxable income. Other positive evidence included the projection of future taxable income based on strong CapitalSource Bank earnings, improving asset performance trends, substantial decline in the Parent Company's operations and assets, and one-time losses included in the three-year cumulative pre-tax loss (i.e., debt extinguishment loss). Additionally, we believe we will be in a cumulative pre-tax income position by the end of 2012, for the three-year period then ended.

Consolidated income tax expense/(benefit) for the three months ended September 30, 2012 and 2011 was $18.0 million and $(11.3) million, respectively. The expense for the three months ended September 30, 2012 was primarily the result of the tax expense on the pre-tax book income from CapitalSource Bank. The tax benefit for the three months ended September 30, 2011 was primarily the result of the change in valuation allowance related to the deferred tax assets of CapitalSource Bank. Consolidated income tax (benefit) expense for the nine months ended September 30, 2012 and 2011 was $(296.3) million and $17.1 million, respectively. The tax benefit for the nine months ended September 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets. The tax expense recorded for the nine months ended September 30, 2011 was primarily related to the reestablishment of a valuation allowance at the consolidated group level with respect to CapitalSource Bank's net deferred tax assets, and state income tax expenses incurred by CapitalSource Bank.

Comparison of the Three and Nine Months Ended September 30, 2012 and 2011

CapitalSource Bank Segment

Our CapitalSource Bank segment operating results for the three and nine months
ended September 30, 2012, compared to the three and nine months ended
September 30, 2011, were as follows:



                                    Three Months Ended                         Nine Months Ended
                                       September 30,                             September 30,
                                                                  %                                         %
                                     2012          2011        Change         2012          2011         Change
                                                                 ($ in thousands)
Interest income                   $   99,807     $ 92,173          8.3 %    $ 294,539     $ 274,467          7.3 %
Interest expense                      15,521       15,982         -2.9         46,974        46,804          0.4
Provision (benefit) for loan
and lease losses                         273       13,725        -98.0         14,745        23,636        -37.6
Non-interest income                   13,585       14,614         -7.0         42,252        27,954         51.1
Non-interest expense                  39,964       35,345         13.1        124,307       108,255         14.8
Income tax expense                    23,782       16,513         44.0         62,047        38,448         61.4
Net income                            33,852       25,222         34.2         88,718        85,278          4.0


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Interest Income

Three months ended September 30, 2012 and 2011

Total interest income increased to $99.8 million for the three months ended September 30, 2012 from $92.2 million for the three months ended September 30, 2011, with an average yield on interest-earning assets of 5.88% for the three months ended September 30, 2012 compared to 5.97% for the three months ended September 30, 2011. Total interest income increased due to a $12.0 million increase in total loan interest income, offset by a $4.4 million decrease in total investment interest income. During the three months ended September 30, 2012 and 2011, total interest income on loans was $91.3 million and $79.3 million, respectively, yielding 6.95 % and 7.51% on average loan balances of $5.2 billion and $4.2 billion, respectively. Total loan interest income increased due to $12.3 million and $0.9 million increases on interest generated from loans held for investment and from direct financing lease interest and fees, respectively. Increases were offset by a $1.1 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on loans held for investment. During the three months ended September 30, 2012 and 2011, $2.2 million and $2.9 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the loan yields by 0.16% and 0.27%, respectively. During the three months ended September 30, 2012 and 2011, $77 thousand and $20 thousand, respectively, of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the three months ended September 30, 2012 and 2011, total interest income from our investments, including available-for-sale and held-to-maturity securities, was $8.1 million and $12.5 million, respectively, yielding 2.68% and 3.14% on an average balance of $1.2 billion and $1.6 billion, respectively. Total interest income on investments decreased $4.4 million primarily due to $2.5 million and $1.9 million decreases in interest income from the available-for-sale and held-to-maturity securities, respectively. The available-for-sale portfolio is mostly comprised of agency mortgage-backed securities, which have been experiencing an acceleration of premium amortizations due to updated prepayment assumptions. During the three months ended September 30, 2012, we purchased $26.0 million of investment securities, available-for-sale, while $80.5 million and $0.9 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively. For the three months ended September 30, 2011, we purchased $143.8 million of investment securities, available-for-sale while $100.4 million and $35.9 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the three months ended September 30, 2012 and 2011, interest income on cash and cash equivalents was $0.4 million, yielding 0.39% and 0.38% on average balances of $286.3 million and $325.1 million, respectively.

Nine months ended September 30, 2012 and 2011

Total interest income increased to $294.5 million for the nine months ended September 30, 2012 from $274.5 million for the nine months ended September 30, 2011, with an average yield on interest-earning assets of 5.96% for the nine months ended September 30, 2012 compared to 6.19% for the nine months ended September 30, 2011. Total interest income increased due to a $33.2 million increase in total loan interest income, offset by a $13.2 million decrease in total investment interest income. During the nine months ended September 30, 2012 and 2011, total interest income on loans was $267.9 million and $234.7 million, respectively, yielding 7.09% and 7.87% on average loan balances of $5.0 billion and $4.0 billion, respectively. Total loan interest income increased $33.2 million due to a $45.6 million increase in interest generated on loans held for investment and a $4.1 million increase in direct financing lease interest and fees. Increases were offset by a $16.5 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on loans held for investment. During the nine months ended September 30, 2012 and 2011, $7.3 million and $12.4 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the loan yields by 0.19% and 0.42%, respectively. During the nine months ended September 30, 2012 and 2011, $0.9 million and $55 thousand, respectively, of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the nine months ended September 30, 2012 and 2011, total interest income from our investments, including available-for-sale and held-to-maturity securities, was $25.6 million and $38.8 million, respectively, yielding 2.78% and 3.28% on an average balance of $1.2 billion and $1.6 billion, respectively. Total interest income on investments decreased $13.2 million due to a $5.4 million decrease in income from the available-for-sale portfolio and a $7.8 million decrease in held-to-maturity securities. The agency mortgage-backed securities within the available-for-sale portfolio experienced decelerated premium amortizations in the first quarter offset by accelerated amortization arising from updated prepayment assumptions. The held-to-maturity portfolio primarily includes commercial mortgage-backed securities which experienced a decrease due to fluctuations in interest rates and prepayment assumptions. During the nine months ended September 30, 2012, we purchased $175.4 million of investment securities, available-for-sale, while $260.3 million and $4.9 million of principal repayments were received


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