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CAPITALSOURCE 10-K 2007
e10vk
 

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2006
 
Commission File No. 1-31753
 
 
     
Delaware   35-2206895
(State of Incorporation)
  (I.R.S. Employer Identification No.)
 
4445 Willard Avenue, 12th Floor
Chevy Chase, MD 20815
(Address of Principal Executive Offices, Including Zip Code)
 
 
Securities Registered Pursuant to Section 12(b) of the Act:
 
     
(Title of Each Class)
 
(Name of Exchange on Which Registered)
 
Common Stock, par value $0.01 per share
  New York Stock Exchange
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  o Yes  þ No
 
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  o 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.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
 
  þ  Large Accelerated Filer          o Accelerated Filer          o Non-Accelerated Filer
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  þ No
 
The aggregate market value of the Registrant’s Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 2006 was approximately $2,437,531,000.
 
As of February 15, 2007, the number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding was 183,822,181.
 
 
Portions of CapitalSource Inc.’s Proxy Statement for the 2007 annual meeting of shareholders, a definitive copy of which will be filed with the SEC within 120 days after the end of the year covered by this Form 10-K, are incorporated by reference herein as portions of Part III of this Form 10-K.
 


 

 
 
             
        Page
 
  Business   2
  Risk Factors   15
  Unresolved Staff Comments   34
  Properties   34
  Legal Proceedings   36
  Submission of Matters to a Vote of Security Holders   36
 
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   36
  Selected Financial Data   39
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   42
  Quantitative and Qualitative Disclosures About Market Risk   72
    Management Report on Internal Controls Over Financial Reporting   73
    Report of Ernst & Young LLP, Independent Registered Public Accounting Firm, on Internal Controls Over Financial Reporting   74
  Consolidated Financial Statements and Supplementary Data   75
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   134
  Controls and Procedures   134
  Other Information   134
 
  Directors, Executive Officers and Corporate Governance   135
  Executive Compensation   135
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   135
  Certain Relationships and Related Transactions, and Director Independence   135
  Principal Accounting Fees and Services   135
 
  Exhibits and Financial Statement Schedules   136
  137
  138
Certifications
   


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PART I
 
 
This Form 10-K, including the footnotes to our audited consolidated financial statements included herein, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. Our ability to predict results or the mutual effect of future plans or strategies is inherently uncertain. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, actual results and performance could differ materially from those set forth in the forward-looking statements. All statements regarding our expected financial position, business and financing plans are forward-looking statements. All forward-looking statements speak only to events as of the date on which the statements are made. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.
 
The information contained in this section should be read in conjunction with our audited consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A, Risk Factors.
 
ITEM 1.   BUSINESS
 
 
We are a commercial lending, investment and asset management company focused on the middle market. We operate as a real estate investment trust (“REIT”) and provide senior and subordinated commercial loans, invest in real estate, engage in asset management and servicing activities, and invest in residential mortgage assets. We expect to formally make an election to REIT status for 2006 when we file our tax return for the year ended December 31, 2006.
 
On January 1, 2006, we began operating as two reportable segments: 1) Commercial Lending & Investment and 2) Residential Mortgage Investment. Our Commercial Lending & Investment segment includes our commercial lending and investment business, and our Residential Mortgage Investment segment includes all of our activities related to our residential mortgage investments. For financial information about our segments, see Note 24, Segment Data, in our audited consolidated financial statements for the year ended December 31, 2006.
 
Through our commercial lending and investment activities, our primary goal is to be the leading provider of financing to middle market businesses that require customized and sophisticated financing. We provide a wide range of financial products that we negotiate and structure on a client-specific basis through direct interaction with the owners and senior managers of our clients. We also originate and participate in broadly syndicated debt financings for larger businesses. We seek to add value to our clients’ businesses by providing tailored financing that meets their specific business needs and objectives.
 
The financing needs of our clients are often specific to their particular business or situation. We believe we can most successfully meet these needs and manage risk through industry or sector expertise and flexibility in structuring financings. We offer a range of senior and subordinate mortgage loans, real estate lease financing, asset-based loans, cash flow loans, and equity investments to our clients. Because we believe specialized industry and/or sector knowledge is important to successfully serve our client base, we originate, underwrite and manage our financings through three focused commercial financing businesses organized around our areas of expertise. Focusing our efforts in these specific sectors, industries and markets allows us to rapidly design and implement


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products that satisfy the special financing needs of our clients. During 2006, we also began to make direct real estate investments and provide real estate lease financing to certain clients.
 
Our commercial finance and investment businesses are:
 
  •  Healthcare and Specialty Finance, which generally provides first mortgage loans, asset-based revolving lines of credit, real estate lease financing and other cash flow loans to healthcare businesses and a broad range of other companies;
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies; and
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in widely syndicated loan transactions.
 
As of December 31, 2006, we had 1,072 loans outstanding under which we had funded an aggregate of $7.9 billion and committed to lend up to an additional $4.1 billion to our clients. Although we make loans as large as $400.0 million, our average commercial loan size was $7.3 million as of December 31, 2006, and our average loan exposure by client was $11.3 million as of December 31, 2006. Our commercial loans generally have a maturity of two to five years with a weighted average maturity of 3.23 years as of December 31, 2006. Substantially all of our commercial loans require monthly interest payments at variable rates and, in many cases, our commercial 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 December 31, 2006, our geographically diverse client base consisted of 692 clients with headquarters in 47 states, the District of Columbia, Puerto Rico, and select international locations, primarily in Canada and the United Kingdom.
 
To optimize our REIT structure, we invest in certain residential mortgage assets. As of December 31, 2006, the balance of our residential mortgage investment portfolio was $5.8 billion, which included investments in residential mortgage loans and residential mortgage-backed securities (“RMBS”).
 
 
During 2006, we diversified our business to include real estate lease financing products and asset management services. We also continued to enhance our existing product and service offerings by improving our syndication capabilities and by participating in an increased number of syndicated loan transactions. In addition, we broadened our client base and the markets we serve by opening our first international office located in London.
 
During 2006, we began acquiring real estate for long-term investment purposes, all of which involved healthcare properties. All of these facilities are leased to clients through the execution of long-term, triple-net operating leases. We had $722.3 million in direct real estate assets as of December 31, 2006, which consisted primarily of land and buildings. We view these transactions as long-term financings for the seller/tenant of these facilities for which we receive rent, which generally escalates per terms set forth in the lease, and a real estate investment that may increase in value over time.
 
During 2006, we grew our asset management business. We completed our first collateralized loan obligation (“CLO”) issuance comprising a portfolio of originated and acquired cash flow loans. We also opened warehouse facilities for two additional CLOs that we intend to close over the next 12 months. In addition to our CLO business, we are party to a joint venture to acquire distressed and other types of debt investments. As with our CLOs, we are the asset manager for this joint venture and receive a fee for managing the assets owned by the joint venture. We view these and other potential asset management businesses as complementary opportunities for us to leverage our commercial finance expertise into managing financial assets owned by third parties. We intend to further build out our asset management businesses by focusing on additional product types, which, for example, may include managing subordinated debt and equity investments for others.
 
During 2006, we enhanced our syndication capabilities and increased our participation in syndicated loan transactions. Our syndication strategy for loans we originate allows us to limit our exposure to larger loans and typically results in greater fee income relative to our loan exposure than we receive for originating and holding the entire loan. As of December 31, 2006, we had syndicated $1.6 billion of loans in addition to the $7.9 billion of


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commercial loans held in our portfolio. Our enhanced syndication capabilities also provide us with opportunities to selectively purchase portions of loans originated by other lenders. By participating in these syndicated loans we are able to increase our loan portfolio without incurring the higher costs we incur for directly originating loans. As of December 31, 2006, approximately 10% of the $7.9 billion aggregate outstanding balance of our commercial loan portfolio comprised loans for which we are not the agent.
 
 
 
The types of loan products and services offered by each of our commercial finance businesses share common characteristics, and we generally underwrite the same types of loans across our three commercial finance businesses using similar criteria. When opportunities arise, we may offer a combination of products to a particular client. This single source approach often allows us to close transactions faster than our competitors by eliminating the need for complicated and time-consuming intercreditor negotiations. Our primary commercial loan products, services and investments are as follows:
 
  •  Senior Secured Asset-Based Loans.  Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. A loan is a “senior” loan when we have a first priority lien in the collateral securing the loan.
 
  •  First Mortgage Loans.  We make term loans secured by first mortgages. We make mortgage loans to clients including owners and operators of senior housing and skilled nursing facilities; owners and operators of office, industrial, hospitality, multi-family and residential properties; resort and residential developers; hospitals and companies backed by private equity firms that frequently take out mortgages in connection with buyout transactions.
 
  •  Senior Secured Cash Flow Loans.  Cash flow loans are made based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our senior cash flow term loans generally are secured by a security interest in all or substantially all of a client’s assets. In some cases, the equity owners of a client pledge their stock in the client to us.
 
  •  Direct Real Estate Investments.  During 2006, we began acquiring real estate for long-term investment purposes. These real estate investments are generally leased to clients through the execution of long-term, triple-net operating leases. Under a typical triple-net lease, the client agrees to pay a base monthly operating lease payment, subject to annual escalation, and all facility operating expenses, as well as make capital improvements. Our acquisition of these direct real estate investments are sometimes structured as sale-leaseback transactions, in which we purchase the clients’ real estate and simultaneously lease it back to them through the execution of a long-term, triple-net operating lease.
 
  •  Term B, Second Lien and Mezzanine Loans.  We make Term B, second lien and mezzanine loans. A Term B loan is a loan that shares a first priority lien in a client’s collateral with the lenders on a client’s senior loan but that comes after senior secured term loans in order of payment preference upon a borrower’s liquidation, and accordingly, generally involves greater risk of loss than a senior secured loan. Term B loans are senior loans and, therefore, are included with senior secured loans in our portfolio statistics. A second lien loan is a loan that has a lien on the client’s collateral that is junior in order of priority and also comes after the senior loans in order of payment. We also make mezzanine loans that may be either cash flow or real estate based loans. A mezzanine loan is a loan that does not share in the same collateral package as the client’s senior loans, may have no security interest in any of the client’s assets and comes after senior loans in order of payment preference. A mezzanine loan generally involves greater risk of loss than a senior loan.
 
  •  Equity Investments.  We commonly acquire equity in a borrower at the same time and on substantially the same terms as the private equity sponsor that is investing in the borrower with our loan proceeds. These equity investments generally represent less than 5% of a borrower’s equity. We do not agree to any interest rate or other lending concessions in the loans we make to these borrowers in return for the opportunity to make these investments.


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  •  HUD Mortgage Originations.  As a strategic supplement to our real estate lending business, we also act as an agent for the United States Department of Housing and Urban Development, or HUD, for the origination of federally insured mortgage loans through the Federal Housing Authority, or FHA. Because we are a fully approved FHA Title II mortgagee, we have the ability to originate, underwrite, fund and service mortgage loans insured by the FHA. FHA is a branch of HUD which works through approved lending institutions to provide federal mortgage and loan insurance for housing and healthcare facilities.
 
 
  •  Residential Mortgage-Backed Securities.  We invest in RMBS, which are securities collateralized by residential mortgage loans. These securities include mortgage-backed securities whose payments of principal and interest are guaranteed by the Federal National Mortgage Association (“Fannie Mae”) or Freddie Mac (hereinafter, “Agency MBS”). We also invest in RMBS issued by non-government-sponsored entities that are credit-enhanced through the use of subordination or in other ways that are inherent in a corresponding securitization transaction (hereinafter, “Non-Agency MBS”). Substantially all of our Agency and Non-Agency MBS are collateralized by adjustable rate mortgage loans, including hybrid adjustable rate mortgage loans. We account for our Agency MBS as debt securities that are classified as trading investments and included in mortgage-backed securities pledged, trading on our accompanying audited consolidated balance sheets. We generally account for our Non-Agency MBS as debt securities that are classified as available-for-sale and included in investments on our accompanying audited consolidated balance sheets.
 
  •  Mortgage-Related Receivables.  During 2006, we purchased beneficial interests in special purpose entities (“SPEs”) that acquired and securitized pools of residential mortgage loans. We determined that we were the primary beneficiary of these SPEs and, therefore, consolidated the assets and liabilities of such entities for financial statement purposes. We also determined that the SPEs’ interest in the underlying mortgage loans constituted, for accounting purposes, receivables secured by the underlying mortgage loans. As a result, through consolidation, we recognized on our accompanying audited consolidated balance sheet mortgage-related receivables, as well as the principal amount of related debt obligations incurred by SPEs to fund the origination of such receivables. Such mortgage-related receivables maintain all of the economic attributes of the underlying mortgage loans legally held in trust by such SPEs and, as a result of our interest in such SPEs, we maintain all of the economic benefits and related risks of ownership of the underlying mortgage loans.


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As of December 31, 2006, our portfolio of loan products, service offerings and investments by type was as follows (percentages by gross carrying values):
 
 
(PIE CHART)
 
 
(1)  Includes Term B loans.
 
Commercial Lending & Investment Segment Overview
 
 
                 
    December 31,  
    2006     2005  
    ($ in thousands)  
Commercial loans
  $ 7,850,198     $ 5,987,743  
Direct real estate investments
    722,303        
Equity investments
    150,090       126,393  
                 
Total
  $ 8,722,591     $ 6,114,136  
                 


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Our total commercial loan portfolio reflected in the portfolio statistics below includes loans, loans held for sale and receivables under reverse-repurchase agreements. The composition of our commercial loan portfolio by loan type and by commercial finance business as of December 31, 2006 and 2005 was as follows:
 
                                 
    December 31,  
    2006     2005  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                               
Senior secured asset-based loans (1)
  $ 2,599,014       33 %   $ 2,022,123       34 %
First mortgage loans (1)
    2,542,222       32       1,970,709       33  
Senior secured cash flow loans (1)
    2,105,152       27       1,740,184       29  
Subordinate loans
    603,810       8       254,727       4  
                                 
Total
  $ 7,850,198       100 %   $ 5,987,743       100 %
                                 
Composition of loan portfolio by business:
                               
Healthcare and Specialty Finance
  $ 2,775,748       35 %   $ 2,281,419       38 %
Structured Finance
    2,839,716       36       1,909,149       32  
Corporate Finance
    2,234,734       29       1,797,175       30  
                                 
Total
  $ 7,850,198       100 %   $ 5,987,743       100 %
                                 
 
 
(1) Includes Term B loans.
 
As of December 31, 2006, our commercial loan portfolio was well diversified, with 1,072 loans to 692 clients operating in multiple industries. We use the term “client” to mean the legal entity that is the party to whom we lend pursuant to a loan agreement with us. As of December 31, 2006, our Healthcare and Specialty Finance, Structured Finance and Corporate Finance businesses had commitments to lend up to an additional $2.1 billion, $1.5 billion and $0.5 billion, respectively, to 304, 216 and 172 existing clients, respectively. Commitments do not include transactions for which we have signed commitment letters but not yet signed loan agreements. Throughout this section, unless specifically stated otherwise, all figures relate to our commercial loans outstanding as of December 31, 2006.


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Our commercial loan and direct real estate investment portfolio by industry as of December 31, 2006 was as follows (percentages by gross carrying values as of December 31, 2006):
 
 
(PIE CHART)
 
 
(1) Industry classification is based on the North American Industry Classification System (NAICS).
 
As of December 31, 2006, our commercial loans ranged in size from $0.1 million to $380.7(2) million, per loan, and direct real estate investments ranged in size from $0.2 million to $16.7 million, per property. Our commercial loan and direct real estate investment portfolio by asset balance as of December 31, 2006 was as follows:
 
 
(PIE CHART)
 
 
(2) This balance represents loans on 79 properties in 6 states owned by one of our clients.


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Our commercial loan portfolio by client balance as of December 31, 2006 was as follows:
 
 
(PIE CHART)
 
We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this Annual Report on Form 10-K, we count each loan or client separately and do not aggregate loans to related entities.
 
No client accounted for more than 10% of our total revenues in 2006. The principal executive offices of our clients were located in 47 states and the District of Columbia. As of December 31, 2006, the largest geographical concentration was Florida, which made up approximately 17% of the outstanding aggregate balance of our commercial loan and direct real estate investment portfolio. In addition, 3% of our commercial loan and direct real estate investment portfolio as of December 31, 2006 comprised international borrowers, primarily located in Canada and the United Kingdom. Our largest loan was $380.7 million and the combined total of our largest ten loans represented 15% of our commercial loan portfolio as of December 31, 2006.


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Our commercial loan and direct real estate investment portfolio by geographic region as of December 31, 2006 was as follows:
 
 
(PIE CHART)
 
 
(1) Includes all states that have a loan balance that is less than 1% of the aggregate outstanding balance of our commercial loan portfolio.
 
Our commercial loans primarily provide financing at variable interest rates. To mitigate the risk of declining yields if interest rates fall, we sometimes include an interest rate floor in our loans. Whether we are able to include an interest rate floor in the pricing of a particular loan is determined by a combination of factors, including the potential client’s need for capital and the degree of competition we face in the origination of loans of the proposed type.
 
Our commercial loans generally have stated maturities at origination that generally range from two to five years. As of December 31, 2006, the weighted average maturity and weighted average remaining life of our entire commercial loan portfolio was approximately 3.23 years and 3.16 years, respectively. Our clients typically pay us an origination fee based on a percentage of the commitment amount and may also be required to pay a prepayment penalty for at least the first two years following origination. They may also pay us a fee based on any undrawn commitments, as well as a collateral management fee in the case of our asset-based revolving loans.
 
The number of loans, average loan size, number of clients and average loan size per client by commercial finance business as of December 31, 2006 were as follows:
 
                                 
                      Average Loan
 
    Number
    Average
    Number of
    Size per
 
    of Loans     Loan Size     Clients     Client  
    ($ in thousands)  
 
Composition of loan portfolio by finance business:
                               
Healthcare and Specialty Finance
    445     $ 6,238       304     $ 9,131  
Structured Finance
    255       11,136       216       13,147  
Corporate Finance
    372       6,007       172       12,993  
                                 
Overall loan portfolio
    1,072       7,323       692       11,344  
                                 


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During 2006, we began acquiring real estate for long-term investment purposes. These real estate investments primarily consist of skilled nursing facilities, currently leased to clients through the execution of long-term, triple-net operating leases. We had $722.3 million in direct real estate investments as of December 31, 2006, which consisted primarily of land and buildings.
 
See Item 2, Properties, for information about our direct real estate investment properties.
 
 
 
We invest directly in residential mortgage investments. As of December 31, 2006 and 2005, our portfolio of residential mortgage investments was as follows:
 
                 
    December 31,  
    2006     2005  
    ($ in thousands)  
 
Mortgage-related receivables(1)
  $ 2,295,922     $  
Residential mortgage-backed securities:
               
Agency
    3,502,753       2,290,952  
Non-Agency
    34,243        
                 
Total
  $ 5,832,918     $ 2,290,952  
                 
 
 
(1) Represents secured receivables that are backed by adjustable rate residential prime mortgage loans.
 
As of December 31, 2006, our portfolio of Agency MBS included 1-year adjustable-rate and hybrid adjustable-rate RMBS with varying fixed period terms issued and guaranteed by Fannie Mae or Freddie Mac. The coupons on the loans underlying these securities are fixed for a specified period of time and then reset annually thereafter. The weighted average net coupon of Agency MBS in our portfolio was 4.89% as of December 31, 2006, and the weighted average reset date for the portfolio was approximately 46 months.
 
As further discussed in Note 4, Mortgage-Related Receivables and Related Owners Trust Securitizations, of our accompanying audited consolidated financial statements for the year ended December 31, 2006, we had $2.3 billion in mortgage-related receivables that were secured by prime residential mortgage loans as of December 31, 2006. As of December 31, 2006, the weighted average interest rate on such receivables was 5.38%, and the weighted average contractual maturity was approximately 29 years.
 
 
We depend on external financing sources to fund our operations. We employ a variety of financing arrangements, including repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt, subordinated debt and equity. We expect that we will continue to seek external financing sources in the future. Our existing financing arrangements are described in further detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.
 
 
Our markets are highly competitive and are characterized by competitive factors that vary based upon product and geographic region. We compete with a large number of financial services companies, including:
 
  •  specialty and commercial finance companies;
 
  •  commercial banks;
 
  •  REITS and other real estate investors;
 
  •  private investment funds;


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  •  investment banks;
 
  •  insurance companies; and
 
  •  asset management companies.
 
Some of our competitors have substantial market positions. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors also have access to lower cost capital. We believe we compete based on:
 
  •  in-depth knowledge of our clients’ industries or sectors and their business needs from information, analysis, and effective interaction between the clients’ decision-makers and our experienced professionals;
 
  •  our breadth of product offerings and flexible and creative approach to structuring financings that meet our clients’ business and timing needs; and
 
  •  our superior client service.
 
 
Some aspects of our operations are subject to supervision and regulation by governmental authorities and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things:
 
  •  regulate credit activities, including establishing licensing requirements in some jurisdictions;
 
  •  regulate mortgage lending activities, including establishing licensing requirements;
 
  •  establish the maximum interest rates, finance charges and other fees we may charge our clients;
 
  •  govern secured transactions;
 
  •  require specified information disclosures to our clients;
 
  •  set collection, foreclosure, repossession and claims handling procedures and other trade practices;
 
  •  regulate our clients’ insurance coverage;
 
  •  regulate our HUD mortgage origination business;
 
  •  prohibit discrimination in the extension of credit and administration of our loans; and
 
  •  regulate the use and reporting of certain client information.
 
In addition, many of the healthcare clients of Healthcare and Specialty Finance are subject to licensure, certification and other regulation and oversight under the applicable Medicare and Medicaid programs. These regulations and governmental oversight indirectly affect our business in several ways.
 
  •  With limited exceptions, the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than actual providers approved for participation in the applicable programs. Accordingly, while we lend money that is secured by pledges of Medicare and Medicaid receivables, if we were required to invoke our rights to the pledged receivables, we would be unable to collect receivables payable under these programs directly. We would need a court order to force collection directly against these governmental payers.
 
  •  Hospitals, nursing facilities and other providers of healthcare services are not always assured of receiving Medicare and Medicaid reimbursement adequate to cover the actual costs of operating the facilities. Many states are presently considering enacting, or have already enacted, reductions in the amount of funds appropriated to healthcare programs resulting in rate freezes or reductions to their Medicaid payment rates and often curtailments of coverage afforded to Medicaid enrollees. Most of our healthcare clients depend on Medicare and Medicaid reimbursements, and reductions in reimbursements caused by either payment cuts or census declines from these programs may have a negative impact on their ability to generate adequate revenues to satisfy their obligations to us. There are no assurances that payments from governmental payors


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  will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for coverage under these programs.
 
  •  For our clients to remain eligible to receive reimbursements under the Medicare and Medicaid programs, the clients must comply with a number of conditions of participation and other regulations imposed by these programs, and are subject to periodic federal and state surveys to ensure compliance with various clinical and operational covenants. A client’s failure to comply with these covenants and regulations may cause the client to incur penalties and fines and other sanctions, or lose its eligibility to continue to receive reimbursements under the programs, which could result in the client’s inability to make scheduled payments to us.
 
 
We have been operating as a REIT and expect to formally make an election to REIT status under the Internal Revenue Code (the “Code”) when we file our tax return for the year ended December 31, 2006. To qualify as a REIT, we are required to distribute at least 90% of our REIT taxable income to our shareholders and meet the various other requirements imposed by the Code, through actual operating results, asset holdings, distribution levels and diversity of stock ownership. Provided we qualify as a REIT, we generally will not be subject to corporate-level income tax on the REIT’s earnings, to the extent the earnings are distributed to our shareholders. We will continue to be subject to corporate-level tax on the earnings we derive from our taxable REIT subsidiaries (“TRSs”). If we fail to qualify as a REIT in any taxable year, all of our taxable income would be subject to federal income tax at regular corporate rates, including any applicable alternative minimum tax. We will still be subject to foreign, state and local taxation in various foreign, state and local jurisdictions, including those in which we transact business or reside.
 
As certain of our subsidiaries are TRSs, we continue to report a provision for income taxes within our consolidated financial statements. 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 the 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.
 
 
As of December 31, 2006, we employed 548 people. We believe that our relations with our employees are good.
 
 
Our executive officers and their ages and positions as of February 15, 2007 were as follows:
 
             
Name
 
Age
 
Position
 
John K. Delaney
  43   Chairman of the Board of Directors and Chief Executive Officer
Dean C. Graham
  41   President and Chief Operating Officer
Bryan M. Corsini
  45   Executive Vice President and Chief Credit Officer
Thomas A. Fink
  43   Senior Vice President and Chief Financial Officer
Steven A. Museles
  43   Executive Vice President, Chief Legal Officer and Secretary
Michael C. Szwajkowski
  40   President — Structured Finance
David C. Bjarnason
  37   Chief Accounting Officer


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Biographies for our executive officers are as follows:
 
John K. Delaney, 43, a co-founder of the company, is Chairman of our Board and Chief Executive Officer. He has been the Chief Executive Officer and has served on our board since our inception in 2000. Mr. Delaney received his undergraduate degree from Columbia University and his juris doctor degree from Georgetown University Law Center.
 
Dean C. Graham, 41, has served as the President and Chief Operating officer since January 2006. Mr. Graham served as the President — Healthcare and Specialty Finance from February 2005 until assuming his current responsibilities and as the Managing Director — Group Head of our Healthcare Finance group from September 2001 through January 2005. Mr. Graham received an undergraduate degree from Harvard College, a juris doctor degree from the University of Virginia School of Law and a masters degree from the University of Cambridge.
 
Bryan M. Corsini, 45, has served as our Chief Credit Officer since our inception in 2000. Mr. Corsini received his undergraduate degree from Providence College and was licensed in 1986 in the state of Connecticut as a certified public accountant.
 
Thomas A. Fink, 43, has served as our Chief Financial Officer since May 2003. Prior to joining CapitalSource, Mr. Fink worked as an independent management and finance consultant from December 2001 to May 2003. Mr. Fink received his undergraduate degree from the University of Notre Dame and his masters of business administration from the University of Chicago Graduate School of Business.
 
Steven A. Museles, 43, has served as our Chief Legal Officer and Secretary since our inception in 2000. Mr. Museles received his undergraduate degree from the University of Virginia and his juris doctor degree from Georgetown University Law Center.
 
Michael C. Szwajkowski, 40, has served as the President — Structured Finance since February 2005. Mr. Szwajkowski served as the Managing Director — Group Head of our Structured Finance group from September 2001 until assuming his current responsibilities. Mr. Szwajkowski received his undergraduate degree from Bowdoin College and a masters of business administration from the University of Chicago Graduate School of Business.
 
David C. Bjarnason, 37, has served as our Chief Accounting Officer since July 2006. Prior to joining us, from March 2003 until June 2006, Mr. Bjarnason was employed at Freddie Mac, where he was a finance officer responsible for the development and administration of accounting policy related to various investment, funding, financial risk management and securitization-related matters. From 1999 until February 2003, Mr. Bjarnason worked in the Global Capital Markets practice at Deloitte & Touche LLP. Mr. Bjarnason received his undergraduate degree in accounting from the College of William & Mary and was licensed in 1993 in the state of New York as a certified public accountant.
 
 
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website at www.capitalsource.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
 
We also provide access on our website to our Principles of Corporate Governance, Code of Business Conduct and Ethics, the charters of our Audit, Compensation, Credit Policy and Nominating and Corporate Governance Committees and other corporate governance documents. Copies of these documents are available to any shareholder upon written request made to our corporate secretary at our Chevy Chase, Maryland address. In addition, we intend to disclose on our website any changes to, or waivers for executive officers from, our Code of Business Conduct and Ethics.


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ITEM 1A.   RISK FACTORS
 
Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could suffer, and the trading price of our common stock could decline. You should know that many of the risks described may apply to more than just the subsection in which we grouped them for the purpose of this presentation. As a result, you should consider all of the following risks, together with all of the other information in this Annual Report on Form 10-K, before deciding to invest in our common stock.
 
Risks Impacting Our Funding and Growth
 
 
We believe that the success of a commercial finance business like ours depends on our ability to increase our interest-earning assets while continuing to maintain disciplined origination and credit decision-making. To that end, from our inception to December 31, 2006, our assets have grown to $15.2 billion and as of December 31, 2006, we had 548 employees and 21 offices. We must continue to refine and expand our marketing capabilities, our management procedures, our internal controls and procedures, our access to financing sources and our technology. As we grow, we must continue to hire, train, supervise and manage new employees. In addition, our decision to convert to REIT status has imposed added challenges on our senior management and other employees, who together must monitor our REIT compliance obligations, develop new real estate-related product offerings and make appropriate alterations to our loan origination, marketing and monitoring efforts. We may not be able to hire and train sufficient lending and administrative personnel or develop management and operating systems to manage our expansion effectively. If we are unable to manage our growth effectively, our operations, REIT compliance and financial results could be adversely affected.
 
 
We require a substantial amount of money to make new loans and to fund obligations to existing clients. As a REIT, we are even more dependent on external sources of capital than we have been in the past. This increased dependence results from the requirement that, to qualify as a REIT, we generally have to distribute to our shareholders 90% of our REIT taxable income, including taxable income where we do not receive corresponding cash. In the past, we have obtained the cash required for our operations through the issuance of equity, convertible debentures and subordinated debt, and by borrowing money through credit facilities, securitization transactions (hereinafter “term debt”) and repurchase agreements. Our continued access to these and other types of external capital depends upon a number of factors, including general market conditions, the market’s perception of our growth potential, our current and potential future earnings, cash distributions and the market price of our common stock. We cannot assure you that sufficient funding or capital will be available to us in the future on terms that are acceptable to us. If we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the market price of our common stock and our ability to pay dividends to our shareholders.
 
 
At December 31, 2006, we had seven credit facilities totaling $5.0 billion in commitments. These facilities contain customary representations and warranties, covenants, conditions and events of default that if breached, not satisfied or triggered could result in termination of the facilities. In addition, we cannot assure you that we will be able to extend the term of any of our existing financing arrangements or obtain sufficient funds to repay any amounts outstanding under any financing arrangement before it expires, either from one or more replacement financing arrangements or an alternative debt or equity financing. Consequently, if one or more of these facilities were to terminate prior to its expected maturity date or if any such facility were not renewed, our liquidity position would be materially adversely affected, and we may not be able to satisfy our outstanding loan commitments, originate new loans or continue to fund our operations.


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We have borrowed significant funds to finance the acquisition of the assets comprising our portfolio of residential mortgage loans and mortgage-backed securities. Our use of repurchase agreements to finance the purchase of residential mortgage loans and mortgage-backed securities exposes us to the risk that a decrease in the value of such assets may cause our lenders to make margin calls that we may not be able to satisfy. If we fail to meet a margin call, or if we are required to sell residential mortgage loans and/or mortgage-backed securities to meet a margin call, we may suffer losses and our ability to comply with the REIT asset tests could be adversely affected.
 
 
Upon the occurrence of specified servicer defaults, our lenders under our credit facilities and the holders of our asset-backed notes issued in our term debt may elect to terminate us as servicer of the loans under the applicable facility or term debt and appoint a successor servicer. If we were terminated as servicer, we would no longer receive our servicing fee. In addition, because there could be no assurance that any successor servicer would be able to service the loans according to our standards, the performance of our loans could be adversely affected and our income generated from those loans significantly reduced.
 
 
We have completed several term debt transactions involving loans in our commercial lending portfolio through which we raised a significant amount of debt capital to pay down our borrowings under our credit facilities and to create additional liquidity under our credit facilities for use in funding our loans.
 
Relevant considerations regarding our ability to complete additional term debt transactions include:
 
  •  to the extent that the capital markets generally, and the asset-backed securities market in particular, suffer disruptions, we may be unable to complete term debt transactions;
 
  •  disruptions in the credit quality and performance of our loan portfolio, particularly that portion which has been previously securitized and serves as collateral for existing term debt, could reduce or eliminate investor demand for our term debt in the future;
 
  •  our ability to service our loan portfolio must continue to be perceived as adequate to make the securities issued attractive to investors;
 
  •  any material downgrading or withdrawal of ratings given to securities previously issued in our term debt transactions would reduce demand for additional term debt by us; and
 
  •  structural changes imposed by the rating agencies or investors may reduce the leverage we are able to obtain, increase the cost and otherwise adversely affect the efficiency of our term debt transactions.
 
If we are unable to continue completing these term debt transactions on favorable terms or at all, our ability to obtain the capital needed for us to continue to grow our business would be adversely affected. In turn, this could have a material adverse effect on our growth and stock price.
 
 
We retain the most junior classes of securities issued in our term debt transactions. Our receipt of future cash flows on those junior securities is governed by provisions that control the distribution of cash flows from the loans included in our term debt transactions, which cash flows are tied to the performance of the underlying loans. To the extent the loans fail to perform in accordance with their terms, the timing and amount of the cash flows we receive from loans included in our term debt transactions would be adversely affected.


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The poor performance of a pool of loans that we securitize could increase the expense of any subsequent securitization we bring to market. Increased expenses on our securitizations could reduce the net interest income we receive on our loan portfolio. A change in the market’s demand for our term debt or a decline or disruption in the securitization market generally could have a material adverse effect on our results of operations, financial condition and business prospects.
 
 
We borrow money from our lenders at variable interest rates. We generally lend money at variable rates based on either the prime or LIBOR rates. Our operating results and cash flow depend on the difference between the interest rate at which we borrow funds and the interest rate at which we lend these funds.
 
We also make, on a more limited basis, fixed rate loans. Most of the borrowings that we use to finance our loans require the payment of interest at variable interest rates. To the extent that our costs of borrowing increase, our yields on our fixed rate loan products will decline and, if interest rates increased significantly, it could result in a negative yield. Such declines could materially adversely affect our net income and operating profits.
 
In addition, changes in market interest rates, or in the relationships between short-term and long-term market interest rates, or between different interest rate indices, could affect the interest rates charged on interest earning assets differently than the interest rates paid on interest bearing liabilities, which could result in an increase in interest expense relative to our interest income.
 
 
We have entered into interest rate swap agreements and other contracts for interest rate risk management purposes. Our hedging activity will vary in scope based on a number of factors, including the level of interest rates, the type of portfolio investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
 
  •  interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
 
  •  available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;
 
  •  the duration of the hedge may not match the duration of the related liability or asset;
 
  •  the amount of income that a REIT may earn from hedging transactions to offset interest rate losses is limited by federal tax provisions governing REITs;
 
  •  the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
 
  •  the party owing money in the hedging transaction may default on its obligation to pay.
 
Our hedging activity may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders. Therefore, while we pursue such transactions to reduce our interest rate risks, it is possible that unanticipated changes in interest rates may result in poorer overall performance than if we had not engaged in any such hedging transactions. Moreover, for a variety of reasons, we may not seek to establish, or there may not be, a perfect correlation between such hedging instruments and the holdings being hedged. Any such imperfect correlation may prevent us from achieving the intended hedge and expose us to risk of loss.


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The cost of using hedging instruments increases as the period covered by the instrument increases and during periods of rising and volatile interest rates. We may increase our hedging activity and, thus, increase our hedging costs during periods when interest rates are volatile or rising. In addition, hedging instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearinghouse, or regulated by any governmental authorities. Consequently, there are no regulatory requirements on our hedging counterparties with respect to matters such as record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements associated with derivative instruments we use may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in a default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our resale commitments, if any, at the then current market price. Although generally we will seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
 
 
Part of our investment strategy will involve entering into derivative contracts that could require us to fund cash payments in certain circumstances. Our ability to fund these contingent liabilities will depend on the liquidity of our assets and access to capital at the time, and the need to fund these contingent liabilities could adversely impact our financial condition.
 
Risks Related to Our Operations as a REIT
 
 
From our commencement of operations in September 2000 through December 31, 2006, we were organized first as a limited liability company and then as a C-corporation. On January 1, 2006, we began operating as a REIT and expect to formally make an election to REIT status for 2006 when we file our tax return for the year ended December 31, 2006. Our senior management has limited experience in managing a portfolio of assets under the highly complex tax rules governing REITs, which may hinder our ability to achieve our investment objectives. In addition, maintaining our REIT qualification will influence the types of investments we are able to make. We cannot assure you that we will be able to continue to operate our business successfully within the REIT structure or in a manner that enables us consistently to pay dividends to our shareholders.
 
 
As a REIT, we are required to distribute at least 90% of our REIT taxable income, excluding capital gains, to maintain our REIT qualification, and we need to distribute 100% of our REIT taxable income, including capital gains, to eliminate federal income tax liability. Moreover, we are subject to a 4% excise tax on the excess of the required distribution over the sum of the amounts actually distributed and amounts retained for which federal income tax was paid, if the amount we distribute during a calendar year (plus excess distributions made in prior years) does not equal at least the sum of 85% of our REIT ordinary income for the year, 95% of our REIT capital gain net income for the year and any undistributed taxable income from prior taxable years. We also could be required to pay taxes and liabilities attributable to periods and events prior to our REIT election and additional taxes if we were to fail to qualify as a REIT in any given year. The amount of funds, if any, available to us could be insufficient to meet our dividend and tax obligations.


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To maintain our qualification as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our shareholders and the ownership of our stock. Compliance with the REIT requirements may hinder our ability to make certain attractive investments, including investments in the businesses conducted by our TRSs.
 
Our ability to receive dividends from the TRSs from which we would make distributions to our shareholders is limited by the rules with which we must comply to maintain our status as a REIT. In particular, at least 75% of the value of our total assets must be represented by “real estate assets,” cash, cash items, and government securities. Real estate assets include debt instruments secured by mortgages on real property, shares of other REITs, and stock or debt instruments held for less than one year purchased with the proceeds of an offering of shares or long-term debt. In addition, at least 75% of our gross income for each taxable year as a REIT must be derived from interest on obligations secured by mortgages on real property or interests in real property, certain gains from the sale or other disposition of such obligations, and certain other types of real estate income. No more than 25% of our gross income may consist of dividends from the TRSs and other non-qualifying types of income. As a result, even if our non-REIT activities conducted through TRSs were to be highly profitable, we might be limited in our ability to receive dividends from the TRSs in an amount necessary to fund required dividends to our shareholders.
 
 
Given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations and the possibility of future changes in our circumstances, we might not satisfy the requirements applicable to REITs for any particular taxable year. Furthermore, our qualification as a REIT depends on our continuing satisfaction of certain asset, income, organizational, distribution, shareholder ownership and other requirements. Our ability to satisfy the asset tests will depend upon our analysis of the fair market values of our assets, some of which are not susceptible to a precise determination. Our compliance with the REIT annual income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. With respect to our compliance with the REIT organizational requirements, the Internal Revenue Service, or IRS, could contend that our ownership interests in TRSs or securities of other issuers would give rise to a violation of the REIT requirements.
 
If in any taxable year we fail to qualify as a REIT,
 
  •  we will not be allowed a deduction for distributions to shareholders in computing our taxable income; and
 
  •  we will be subject to federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates.
 
Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution to our shareholders, which in turn would likely have a material adverse impact on the value of our common stock. In addition, we would be disqualified from treatment as a REIT for the four taxable years following the year during which the qualification was lost, unless we were entitled to relief under certain statutory provisions. If we were to avail ourselves of one or more of these statutory savings provisions to maintain our REIT status, we nevertheless could be required to pay penalty taxes of $50,000 or more for each failure. As a result, net income and the funds available for distribution to our shareholders could be reduced for up to five years or longer, which would have a continuing material adverse impact on the value of our common stock. Even if we continue to qualify as a REIT, any gain or income recognized by our TRSs, either as a result of regular operations or in connection with our REIT election related restructuring transactions, will be subject to federal corporate income tax and applicable state and local taxes.


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REITs are generally passive entities and thus only can engage in those activities permitted by the Code, which for us generally includes our real estate based lending activities and the complementary activities in which we engage, such as direct real estate investment transactions and acquiring whole pools of mortgage loans and mortgage-backed securities. Accordingly, we conduct our non-real estate lending activities through multiple TRSs, which are subject to corporate level tax, because such activities generate non-qualifying REIT income.
 
Also, we limit the asset disposition activity that we engage in directly (that is, outside of our TRSs) because certain asset dispositions conducted regularly and directly by us could constitute “prohibited transactions” that could be subject to a 100% penalty tax. In general, prohibited transactions are defined by the Code to be sales or other dispositions of property held primarily for sale to customers in the ordinary course of a trade or business other than property with respect to which a “foreclosure property” election is made. By conducting our business in this manner, we believe that we satisfy the REIT requirements of the Code and avoid the 100% tax that could be imposed if a REIT were to conduct a prohibited transaction; however, this operational constraint may prevent us from disposing of one or more of our real estate-based loans to obtain liquidity or to reduce potential losses with respect to non-performing assets. We may not always be successful, however, in limiting such activities to any TRSs. Therefore, we could be subject to the 100% prohibited transactions tax if such instances were to occur.
 
 
We conduct our operations so as not to be regulated as an investment company under the Investment Company Act of 1940, as amended, which we refer to as the Investment Company Act. We rely on the exemption provided by Section 3(c)(5) of the Investment Company Act. Our ability to originate loans and acquire other assets is limited by the provisions of the Investment Company Act and the rules and regulations promulgated under the Investment Company Act. If we fail to own a sufficient amount of qualifying assets to satisfy the requirements of Section 3(c)(5) of the Investment Company Act and could not rely on any other exemption or exclusion under the Investment Company Act, we could be characterized as an investment company. The characterization of us as an investment company would require us to either (i) change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) register as an investment company. Any modification of our business plan for these purposes could have a material adverse effect on us. Further, if we were determined to be an unregistered investment company, we could be subject to monetary penalties and injunctive relief in an action brought by the SEC, we may be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period it was established that we were an unregistered investment company. In addition, we currently employ a degree of leverage in our business that would not be permissible for a company regulated under the Investment Company Act. If we were determined to be an investment company, we would have to restructure our operations dramatically, and also possibly raise substantial amounts of additional equity to come into compliance with the limitations prescribed under the Investment Company Act. Finally, because affiliate transactions are prohibited under the Investment Company Act, failure to maintain our exemption would force us to terminate our agreements with affiliates. Any of these results would be likely to have a material adverse effect on our business, our financial results and our ability to pay dividends to shareholders.
 
 
If the market value or income potential of our mortgage-backed securities and our other real estate assets decline as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets to maintain our REIT status and/or our exemption from the Investment Company Act. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of many of our assets. We may have to make investment decisions that we otherwise would not make absent the REIT and Investment Company Act considerations.


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The rules dealing with federal income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Department of the Treasury. Changes to the tax laws, with or without retroactive application, could adversely affect our investors or us. We cannot predict how changes in the tax laws might affect our investors or us. New legislation, Treasury regulations, administrative interpretations or court decisions could significantly affect our ability to qualify as a REIT or the federal income tax consequences of such qualification.
 
 
The maximum marginal rate of tax payable by domestic noncorporate taxpayers on dividends received from a regular “C” corporation under current law generally is 15% through 2010, as opposed to higher ordinary income rates. The reduced tax rate, however, does not apply to ordinary income dividends paid to domestic noncorporate taxpayers by a REIT on its stock, except for certain limited amounts. Although the earnings of a REIT that are distributed to its stockholders generally remain subject to less federal income taxation than earnings of a non-REIT “C” corporation that are distributed to its stockholders net of corporate-level income tax, legislation that extends the application of the 15% rate to dividends paid after 2010 by “C” corporations could cause domestic noncorporate investors to view the stock of regular “C” corporations as more attractive relative to the stock of a REIT, because the dividends from regular “C” corporations would continue to be taxed at a lower rate while distributions from REITs (other than distributions designated as capital gain dividends) are generally taxed at the same rate as the investor’s other ordinary income.
 
Risks Related to Our Lending Activities
 
 
We charged off $48.0 million in loans for the year ended December 31, 2006 and expect to experience charge offs in the future. If we were to experience material losses on our portfolio in the future, such losses would have a material adverse effect on our ability to fund our business and on our revenues, net income and assets, to the extent the losses exceed our allowance for loan losses.
 
In addition, like other commercial finance companies, we have experienced missed and late payments, failures by clients to comply with operational and financial covenants in their loan agreements and client performance below that which we expected when we originated the loan. Any of the events described in the preceding sentence may be an indication that our risk of credit loss with respect to a particular loan has materially increased.
 
 
Our portfolio consists primarily of commercial loans to small and medium-sized, privately owned businesses with annual revenues ranging from $5 million to $1 billion. Compared to larger, publicly owned firms, these companies generally have more limited access to capital and higher funding costs, may be in a weaker financial position and may need more capital to expand or compete. These financial challenges may make it difficult for our clients to make scheduled payments of interest or principal on our loans. Accordingly, advances made to these types of clients entail higher risks than advances made to companies who are able to access traditional credit sources.
 
We may not have all of the material information relating to a potential client at the time that we make a credit decision with respect to that potential client or at the time we advance funds to the client. As a result, we may suffer losses on loans or make advances that we would not have made if we had all of the material information.
 
There is generally no publicly available information about the privately owned companies to which we generally lend. Therefore, we must rely on our clients and the due diligence efforts of our employees to obtain the information that we consider when making our credit decisions. To some extent, our employees depend and rely upon the management of these companies to provide full and accurate disclosure of material information


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concerning their business, financial condition and prospects. If we do not have access to all of the material information about a particular client’s business, financial condition and prospects, or if a client’s accounting records are poorly maintained or organized, we may not make a fully informed credit decision which may lead, ultimately, to a failure or inability to recover our loan in its entirety.
 
 
We underwrite our loans based on detailed financial information and projections provided to us by our clients. Even if clients provide us with full and accurate disclosure of all material information concerning their businesses, our investment officers, underwriting officers and credit committee members may misinterpret or incorrectly analyze this information. Mistakes by our staff and credit committee may cause us to make loans that we otherwise would not have made, to fund advances that we otherwise would not have funded or result in losses on one or more of our existing loans.
 
 
The failure of a client to accurately report its financial position, compliance with loan covenants or eligibility for additional borrowings could result in the loss of some or all of the principal of a particular loan or loans including, in the case of revolving loans, amounts we may not have advanced had we possessed complete and accurate information.
 
 
Defaults by our clients may be correlated with economic conditions affecting particular industries or geographic regions. As a result, if any particular industry or geographic region were to experience economic difficulties, the overall timing and amount of collections on our loans to clients operating in those industries or geographic regions may differ from what we expected and result in material harm to our revenues, net income and assets. For example, as of December 31, 2006, loans representing 18% of the aggregate outstanding balance of our loan portfolio were secured by commercial real estate other than healthcare facilities. If the commercial real estate sector were to experience economic difficulties, we could suffer losses on these loans. In addition, as of December 31, 2006, loans representing 22% of the aggregate outstanding balance of our loan portfolio were to clients in the healthcare industry. Reimbursements under the Medicare and Medicaid programs comprise the bulk of the revenues of many of these clients. Our clients’ dependence on reimbursement revenues could cause us to suffer losses in several instances.
 
  •  If clients fail to comply with operational covenants and other regulations imposed by these programs, they may lose their eligibility to continue to receive reimbursements under the program or incur monetary penalties, either of which could result in the client’s inability to make scheduled payments to us.
 
  •  If reimbursement rates do not keep pace with increasing costs of services to eligible recipients, or funding levels decrease as a result of increasing pressures from Medicare and Medicaid to control healthcare costs, our clients may not be able to generate adequate revenues to satisfy their obligations to us.
 
  •  If a healthcare client were to default on its loan, we would be unable to invoke our rights to the pledged receivables directly as the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than the actual providers. Consequently, we would need a court order to force collection directly against these governmental payors. There is no assurance that we would be successful in obtaining this type of court order.
 
As of December 31, 2006, our ten largest clients collectively accounted for approximately 16% of the aggregate outstanding balance of our commercial loan portfolio and our largest client accounted for approximately 5% of the aggregate outstanding balance of our commercial loan portfolio.


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We are party to joint ventures and may enter into additional joint ventures. We may not have control of the operations of the joint ventures in which we invest. Therefore, these investments may, under certain circumstances, involve risks such as the possibility that our partner in an investment might become bankrupt or have economic or business interests or goals that are inconsistent with ours, or be in a position to take action contrary to our instructions or requests or our policies or objectives. As a result, these investments may be subject to more risk than investments for which we have full operational or management responsibility.
 
 
We use the term “client” to mean the legal entity that is the borrower party to a loan agreement with us. We have several clients that are related to each other through common ownership and/or management. Because we underwrite all of these loans separately, we report each loan to one of these clients as a separate loan and each client as a separate client. In situations where clients are related through common ownership, to the extent the common owner suffered financial distress, the common owner may be unable to continue to support our clients, which could, in turn, lead to financial difficulties for those clients. Further, some of our healthcare clients are managed by the same entity and, to the extent that management entity suffered financial distress or was otherwise unable to continue to manage the operations of the related clients, those clients could, in turn, face financial difficulties. In both of these cases, our clients could have difficulty servicing their debt to us, which could have an adverse effect on our financial condition.
 
 
Our clients may experience operational or financial problems that, if not timely addressed by us, could result in a substantial impairment or loss of the value of our loan to the client. We may fail to identify problems because our client did not report them in a timely manner or, even if the client did report the problem, we may fail to address it quickly enough or at all. As a result, we could suffer loan losses which could have a material adverse effect on our revenues, net income and results of operations.
 
 
Most of our loans bear interest at variable interest rates. To the extent interest rates increase interest obligations of our clients will also increase. Some of our clients may not be able to make the increased interest payments, resulting in defaults on their loans.
 
 
As of December 31, 2006, approximately 90% of the outstanding balance of our loans comprised either balloon loans or bullet loans. A balloon loan is a term loan with a series of scheduled payment installments calculated to amortize the principal balance of the loan so that, upon maturity of the loan, more than 25%, but less than 100%, of the loan balance remains unpaid and must be satisfied. A bullet loan is a loan with no scheduled payments of principal before the maturity date of the loan. All of our revolving loans and some of our term loans are bullet loans.
 
Balloon loans and bullet loans involve a greater degree of risk than other types of loans because they require the borrower to, in many cases, make a large, final payment upon the maturity of the loan. The ability of a client to make this final payment upon the maturity of the loan typically depends upon its ability either to generate sufficient cash flow to repay the loan prior to maturity, to refinance the loan or to sell the related collateral securing the loan, if any. The ability of a client to accomplish any of these goals will be affected by many factors, including the availability of financing at acceptable rates to the client, the financial condition of the client, the marketability of the related collateral, the operating history of the related business, tax laws and the prevailing general economic conditions.


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Consequently, a client may not have the ability to repay the loan at maturity and we could lose some or all of the principal of our loan.
 
 
We make Term B, second lien and mezzanine loans. Term B loans generally are senior secured loans that are equal as to collateral and junior as to right of payment to obligations to clients’ other senior term loans. Second lien loans are junior as to both collateral and right of payment to obligations to clients’ senior loans. Mezzanine loans may not have the benefit of any lien against a client’s collateral and are junior to any lienholder both as to collateral and payment. Collectively, second lien and mezzanine loans comprised 8% of the aggregate outstanding balance of our loan portfolio as of December 31, 2006. As a result of the subordinate nature of these loans, we may be limited in our ability to enforce our rights to collect principal and interest on these loans or to recover any of the loan balance through our right to foreclose upon collateral. For example, we typically are not contractually entitled to receive payments of principal on a junior loan until the senior loan is paid in full, and may only receive interest payments on a Term B, second lien or mezzanine loan if the client is not in default under its senior loan. In many instances, we are also prohibited from foreclosing on a Term B, second lien or mezzanine loan until the senior loan is paid in full. Moreover, any amounts that we might realize as a result of our collection efforts or in connection with a bankruptcy or insolvency proceeding involving a client under a Term B, second lien or mezzanine loan must generally be turned over to the senior lender until the senior lender has realized the full value of its own claims. These restrictions may materially and adversely affect our ability to recover the principal of any non-performing Term B, second lien or mezzanine loans.
 
 
While most of our loans are secured by a lien on specified collateral of the client, there is no assurance that we have obtained or properly perfected our liens, or that the collateral securing any particular loan will protect us from suffering a partial or complete loss if the loan becomes non-performing and we move to foreclose on the collateral. The collateral securing our loans is subject to inherent risks that may limit our ability to recover the principal of a non-performing loan.
 
 
Cash flow lending involves lending money to a client based primarily on the expected cash flow, profitability and enterprise value of a client rather than on the value of its tangible assets. These loans tend to be among the largest and riskiest in our portfolio. As of December 31, 2006, approximately 41% of the loans in our portfolio were cash flow loans under which we had advanced 34% of the aggregate outstanding loan balance of our portfolio. While in the case of our senior cash flow loans we generally take a lien on substantially all of the client’s assets, the value of those assets is typically substantially less than the amount of money we advance to a client under a cash flow loan. Thus, if a cash flow loan became non-performing, our primary recourse to recover some or all of the principal of our loan would be to force the sale of the entire company as a going concern. If we were a subordinate lender rather than the senior lender in a cash flow loan, our ability to take such action would be further constrained by our agreement with the senior lender.
 
 
We engage in consumer mortgage lending activities which involve the collection of numerous accounts, as well as compliance with various federal, state and local laws that regulate consumer lending. Some of these laws require licensing.


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The various laws that regulate consumer lending could change at any time, and we cannot predict the effect of these changes on our business and profitability. Furthermore, compliance with these laws may subject us from time to time to various types of claims, legal actions, including class action lawsuits, investigations, subpoenas and inquiries in the course of our consumer mortgage lending business that could adversely affect our ability to operate profitably.
 
 
We may sell non-performing loans or the underlying collateral, at par or at a discount, to third parties to reduce our risk of loss. We consider non-performing loans to be either problem loans that we are actively seeking to out-place or loans that are in workout status. We may provide debt financing to the third parties to enable them to purchase these loans or collateral. The non-performing loan or the sold collateral may serve as the collateral for our loan to the purchaser. In these instances, we continue to bear the risk of loss associated with the collateral supporting our original non-performing loan. The loan to the purchaser, however, is reflected in our portfolio as a new loan. As of December 31, 2006, the aggregate outstanding principal balance of this type of financing that we provided to third parties totaled $16.6 million.
 
 
Courts have, in some cases, applied the doctrine of equitable subordination to subordinate the claim of a lending institution against a borrower to claims of other creditors of the borrower, when the lending institution is found to have engaged in unfair, inequitable or fraudulent conduct. The courts have also applied the doctrine of equitable subordination when a lending institution or its affiliates are found to have exerted inappropriate control over a client, including control resulting from the ownership of equity interests in a client. In connection with the origination of loans representing approximately 20% of the aggregate outstanding loan balance of our commercial loan portfolio as of December 31, 2006, we have made direct equity investments or received warrants. Payments on one or more of our loans, particularly a loan to a client in which we also hold an equity interest, may be subject to claims of equitable subordination. If, when challenged, these factors were deemed to give us the ability to control or otherwise exercise influence over the business and affairs of one or more of our clients, this control or influence could constitute grounds for equitable subordination. This means that a court may treat one or more of our loans as if it were common equity in the client. In that case, if the client were to liquidate, we would be entitled to repayment of our loan on an equal basis with other holders of the client’s common equity only after all of the client’s obligations relating to its debt and preferred securities had been satisfied. One or more successful claims of equitable subordination against us could have an adverse effect on our business, results of operation or financial condition.
 
 
In recent years, a number of judicial decisions have upheld the right of borrowers to sue lending institutions on the basis of various evolving legal theories, collectively termed “lender liability.” Generally, lender liability is founded on the premise that a lender has either violated a duty, whether implied or contractual, of good faith and fair dealing owed to the borrower or has assumed a degree of control over the borrower resulting in the creation of a fiduciary duty owed to the borrower or its other creditors or shareholders. We may be subject to allegations of lender liability. We cannot assure you that these claims will not arise or that we will not be subject to significant liability if a claim of this type did arise.
 
 
As of December 31, 2006, we had 23 loans representing $465.2 million in committed funds to companies controlled by affiliates of our directors. We may make additional loans to affiliates of our directors in the future. Our conflict of interest policies, which require these transactions to be approved by the disinterested members of our


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board (or a committee thereof) and be on substantially the same terms as loans to unrelated clients, may not be successful in eliminating the influence of conflicts. As a result, these transactions may divert our resources and benefit our directors and their affiliates to the detriment of our shareholders.
 
 
In many of our loans we are neither the agent of the lending group that receives payments under the loan nor the agent of the lending group that controls the collateral for purposes of administering the loan. As of December 31, 2006, approximately 10% of the aggregate outstanding balance of our loan portfolio comprised loans in which we are neither the paying nor the collateral agent. When we are not the agent for a loan, we may not receive the same financial or operational information as we receive for loans for which we are the agent and, in many instances, the information on which we must rely is provided to us by the agent rather than directly by the client. As a result, it may be more difficult for us to track or rate these loans than it is for the loans for which we are the agent. Additionally, we may be prohibited or otherwise restricted from taking actions to enforce the loan or to foreclose upon the collateral securing the loan without the agreement of other lenders holding a specified minimum aggregate percentage, generally a majority or two-thirds of the outstanding principal balance. It is possible that an agent for one of these loans may not manage the loan to our standards or may choose not to take the same actions to enforce the loan or to foreclose upon the collateral securing the loan that we would take if we were agent for the loan.
 
 
We are often the agent representing a syndicate of multiple lenders that has made a loan. In that capacity, we may act on behalf of our co-lenders in receiving all payments under the loan and/or controlling the collateral for purposes of administering the loan. As of December 31, 2006, we were either the paying or the collateral agent or both for a group of third-party lenders for loans with outstanding commitments of $2.2 billion. When we are agent for a loan, we often receive financial and/or operational information directly from the borrower and are responsible for providing some or all of this information to our co-lenders. We may also be responsible for taking actions on behalf of the lending group to enforce the loan or to foreclose upon the collateral securing the loan. It is possible that as agent for one of these loans we may not manage the loan to the standard of one or more of our co-lenders. In addition, we may choose a different course of action than one or more of our co-lenders would take to enforce the loan or to foreclose upon the collateral securing the loan if our co-lenders were in a position to manage the loan. If we make errors in our administration of these loans or, if our co-lenders do not approve of our performance as agent and the lending syndicate suffered a loss on the loan, we may have liability to our co-lenders.
 
 
As a FHA Title II mortgagee, or approved mortgagee, we could lose our ability to originate, underwrite and service FHA insured loans if, among other things, we commit fraud, violate anti-kickback laws, violate identity of interest rules, engage in a continued pattern of poor underwriting, or the FHA loans we originate show a high frequency of loan defaults. Our inability to engage in our HUD business would lead to a decrease in our net income.
 
Some of our borrowers require licenses, permits and other governmental authorizations to operate their businesses, which licenses, permits or authorizations may be revoked or modified by applicable governmental authorities. Any revocation or modification could have a material adverse effect on the business of a borrower and, consequently, the value of our loan to that borrower.
 
In addition to our loans to borrowers in the healthcare industry subject to Medicare and Medicaid regulation discussed above, other borrowers in specified industries require permits and/or licenses from various governmental authorities to operate their businesses. These governmental authorities may revoke or modify these licenses or permits if a borrower is found in violation of any regulation to which it is subject. In addition, these licenses may be subject to modification by order of governmental authorities or periodic renewal requirements. The loss of a permit, whether by termination, modification or failure to renew, could impair the borrower’s ability to continue to operate


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its business in the manner in which it was operated when we made our loan to it, which could impair the borrower’s ability to generate cash flows necessary to service our loan or repay indebtedness upon maturity, either of which outcomes would reduce our revenues, cash flow and net income.
 
 
We make loans to clients for development, construction and renovation projects. The ability of these clients to make required payments to us on these loans is subject to the risks associated with these projects.
 
If one of these projects is not successful, it could have a material adverse effect on the client’s financial condition and results of operations, which could limit that client’s ability to repay its obligations to us.
 
 
We acquire residential mortgages. Many states in which we do business require that we be licensed, or that we be eligible for an exemption from the licensing requirement, to conduct this business. We cannot assure you that we will be able to obtain all the necessary licenses and approvals, or be granted an exemption from the licensing requirements, that we will need to maximize the acquisition, funding or origination of residential mortgages or that we will not become liable for a failure to comply with the myriad of regulations applicable to this line of business.
 
 
Loans to foreign clients may expose us to risks not typically associated with loans to U.S. clients. These risks include changes in exchange control regulations, political and social instability, expropriation, imposition of foreign taxes, less liquid markets and less available information than is generally the case in the United States, higher transaction costs, less developed bankruptcy laws, difficulty in enforcing contractual obligations, lack of uniform accounting and auditing standards and greater price volatility.
 
To the extent that any of our loans are denominated in foreign currency, these loans will be subject to the risk that the value of a particular currency will change in relation to one or more other currencies. Among the factors that may affect currency values are trade balances, the level of short-term interest rates, differences in relative values of similar assets in different currencies, long-term opportunities for investment and capital appreciation, and political developments. We may employ hedging techniques to minimize these risks, but we can offer no assurance that these strategies will be effective.
 
 
From time-to-time we make “debtor-in-possession” loans to clients that have filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code, and that are used by these clients to fund on-going operations as part of the reorganization process. While our security position for these loans is generally better than that of the other asset-based loans we make, there is a higher risk of default on these loans due to the uncertain business prospects of these clients. Furthermore, if our predictions as to the outcome or timing of a reorganization are inaccurate, the client may not be able to make payments on the loan on time or at all.
 
 
We may purchase loans of companies that are experiencing significant financial or business difficulties, including companies involved in bankruptcy or other reorganization and liquidation proceedings. Although these investments may result in significant returns to us, they involve a substantial degree of risk. Any one or all of the loans which we purchase may be unsuccessful or not show any return for a considerable period of time. The level of analytical sophistication, both financial and legal, necessary for making a profit on the purchase of loans to companies experiencing significant business and financial difficulties is unusually high. There is no assurance that


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we will correctly evaluate the value of the assets collateralizing the loans or the prospects for a successful reorganization or similar action. Unless the loans are most senior, in any reorganization or liquidation proceeding relating to a distressed company, we may lose the entire amount of our loan, may be required to accept cash or securities with a value less than our purchase price and/or may be required to accept payment over an extended period of time.
 
 
As of December 31, 2006, the amount of our unfunded commitments to extend credit to our clients exceeded our unused funding sources and unrestricted cash by $1.1 billion. We expect that our loan commitments will continue to exceed our available funds indefinitely. Under the terms of our loan agreements our clients generally cannot require us to fund the maximum amount of our commitments unless they are able to demonstrate, among other things, that they have sufficient collateral to secure all requested additional borrowings. There is a risk that we have miscalculated the likelihood that our clients will be eligible to receive and will, in fact, request additional borrowings in excess of our available funds. If our calculations prove incorrect, we will not have the funds to make these loan advances without obtaining additional financing. Our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract liability for us and damage our reputation in the marketplace, which could then have a material adverse effect on our business.
 
 
The commercial finance industry is highly competitive. We have competitors who also make the same types of loans to the small and medium-sized privately owned businesses that are our target clients.
 
Our competitors include a variety of:
 
  •  specialty and commercial finance companies;
 
  •  commercial banks;
 
  •  REITS and other real estate investors;
 
  •  private investment funds;
 
  •  investment banks; and
 
  •  insurance companies.
 
Some of our competitors have greater financial, technical, marketing and other resources than we do. They also have greater access to capital than we do and at a lower cost than is available to us. Furthermore, we would expect to face increased price competition if finance companies seek to expand within or enter our target markets. Increased competition could cause us to reduce our pricing and lend greater amounts as a percentage of a client’s eligible collateral or cash flows. Even with these changes, in an increasingly competitive market, we may not be able to attract and retain new clients and sustain the rate of growth that we have experienced to date, and our market share and future revenues may decline. If our existing clients choose to use competing sources of credit to refinance their loans, the rate at which loans are repaid may be increased, which could change the characteristics of our loan portfolio as well as cause our anticipated return on our existing loans to vary.
 
 
 
In most cases, an investment in RMBS will decline in value if long-term interest rates increase. To the extent not offset by changes in fair value of hedging arrangements, declines in the market value of RMBS may ultimately reduce earnings or result in losses. In this case, cash available for distribution to our shareholders would be negatively affected. Market values of RMBS may also decline without any general increase in interest rates for a number of reasons, such as increases in defaults, increases in voluntary prepayments and widening of credit spreads.


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A significant risk associated with our current portfolio of RMBS is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates were to increase significantly, the market value of these RMBS would decline and the weighted average life of the investments would increase. To the extent not offset by changes in fair value of hedging arrangements, we could realize a loss if such securities were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on the repurchase agreements we enter into to finance the purchase of RMBS.
 
 
In the case of residential mortgage loans, there are seldom any restrictions on borrowers’ abilities to prepay their loans. Homeowners tend to prepay mortgage loans faster when interest rates decline. Consequently, owners of the loans have to reinvest the money received from the prepayments at the lower prevailing interest rates. This volatility in prepayment rates may affect our ability to maintain targeted amounts of leverage on our RMBS portfolio and may result in reduced earnings or losses for us and negatively affect the cash available for distribution to our shareholders.
 
 
We believe that some of our residential mortgage investment portfolio is likely to be in forms that have limited liquidity or are not publicly-traded. The fair value of securities and other investments that have limited liquidity or are not publicly-traded may not be readily determinable. Because these valuations are inherently uncertain, may fluctuate over short periods of time and may be based on estimates, our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. The value of our common stock could be adversely affected if our determinations regarding the fair value of these investments are materially higher than the values that we ultimately realize upon their disposal.
 
In the future we may invest in mortgage-backed securities backed by non-prime or sub-prime residential mortgage loans that are subject to higher delinquency, foreclosure and loss rates than prime residential mortgage loans and, in turn, could result in losses to us.
 
Non-prime and sub-prime residential mortgage loans are made to borrowers who have poor or limited credit histories and, as a result, they do not qualify for traditional mortgage products. Because of the poor, or lack of, credit history, non-prime and sub-prime borrowers have a materially higher rate of payment delinquency, foreclosure and loss compared to prime credit quality borrowers. There is limited history with respect to the performance of mortgage-backed securities backed by residential mortgage loans over various economic cycles. Investments in non-prime and subprime mortgage-backed securities backed by sub-prime or non-prime residential mortgage loans have higher risk than investments in mortgage-backed securities backed by prime residential mortgage loans. We may realize credit losses if we invest in mortgage-backed securities backed by sub-prime and non-prime residential mortgage loans because these mortgage-backed securities are subject to all of the risks of the underlying sub-prime and non-prime residential mortgage loans.
 
 
 
Owning title to real estate can subject us to liabilities for injury to persons on the property or property damage. To the extent that any such liabilities are not adequately covered by insurance, our business, financial condition, liquidity and results of operations could be materially and adversely affected.
 
We could be subject to environmental liabilities with respect to properties we own. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances, or chemical releases, at a property. The costs associated with investigation or


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remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.
 
 
We own the properties leased to tenants from whom we receive rents during the terms of our leases. A tenant’s ability to pay rent is determined by the creditworthiness of the tenant. If a tenant’s credit deteriorates, the tenant may default on its obligations under our lease and the tenant may also become bankrupt. The bankruptcy or insolvency or other failure to pay of our tenants is likely to adversely affect the income produced by our direct real estate investments.
 
 
Advocacy groups have been created in certain states to monitor the quality of care at healthcare facilities, and these groups have sued healthcare operators. Patients have also sued healthcare facility operators and have, in certain cases, succeeded in winning very large damage awards for alleged abuses. The effect of this litigation and potential litigation in the future has been to materially increase the costs incurred by our operators for monitoring and reporting quality of care compliance. In addition, the cost of medical malpractice and liability insurance has increased and may continue to increase so long as the present litigation environment affecting the operations of healthcare facilities continues. Increases in the operators costs could cause our operators to be unable to make payments to us, potentially decreasing our revenue and increasing our collection and litigation costs. To the extent we are required to remove or replace the operators of our healthcare properties, our revenue from those properties could be reduced or eliminated for an extended period of time.
 
 
Real estate investments generally cannot be sold quickly. We may not be able to vary our portfolio promptly in response to changes in the real estate market. This inability to respond to changes in the performance of our investments could adversely affect our ability to service our debt. The real estate market is affected by many factors that are beyond our control, including:
 
  •  changes in interest rates and in the availability, costs and terms of financing;
 
  •  adverse changes in national and local economic and market conditions;
 
  •  the ongoing need for capital improvements, particularly in older structures;
 
  •  changes in governmental laws and regulations, fiscal policies and zoning and other ordinances and costs of compliance with laws and regulations;
 
  •  changes in operating expenses; and
 
  •  civil unrest, acts of war and natural disasters, including earthquakes and floods, which may result in uninsured and underinsured losses.
 
We cannot predict how long it may take us to find a willing purchaser and to close the sale of a property. We also cannot predict whether we will be able to sell any property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. In addition, there are provisions under the federal income tax laws applicable to REITs that may limit our ability to recognize the full economic benefit from a sale of our assets. These factors and any others that would impede our ability to respond to adverse changes in the performance of our properties could have a material adverse effect on our operating results and financial condition.


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Risks Related to our Common Stock
 
 
Our board of directors, in its sole discretion, will determine the amount and frequency of dividends to be provided to our shareholders based on consideration of a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations, borrowing capacity and other factors, including debt covenant restrictions that may impose limitations on cash payments. Consequently, our dividend levels may fluctuate, and the level of dividends we pay could be less than expected. If we lower our dividend or elect or are required to retain rather than distribute our income, our stock price could be adversely affected.
 
 
As part of our business strategy, we have in the past purchased other finance companies as well as loan portfolios and related assets from other finance companies, and we expect to continue these activities in the future. We also may acquire portfolios of real estate, as in our direct real estate investment transactions in 2006. Future acquisitions may result in potentially dilutive issuances of equity securities and the incurrence of additional debt. In addition, we face risks from our prior acquisitions and may face additional risks from future acquisitions, including:
 
  •  difficulties in integrating the operations, services, products and personnel of the acquired company or asset portfolio;
 
  •  heightened risks of credit losses as a result of acquired assets not having been originated by us in accordance with our rigorous underwriting standards;
 
  •  the diversion of management’s attention from other business concerns;
 
  •  the potentially adverse effects that acquisitions may have in terms of the composition and performance of our assets; and
 
  •  the potential loss of key employees of the acquired company.
 
 
We may face other tax liabilities as a REIT that reduce our cash flow.  We may be subject to certain taxes on our income and assets, including state or local income, property and transfer taxes, such as mortgage recording taxes. Any of these taxes would decrease cash available for distribution to our shareholders. In addition, to meet the REIT qualification requirements, and to avert the imposition of a 100% tax that applies to certain gains derived by a REIT from dealer property or inventory, we hold some of our assets through TRSs. TRSs are corporations subject to corporate-level income tax at regular rates. The rules applicable to TRSs limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis. We cannot assure you that we will be able to avoid application of the 100% excise tax imposed on certain non-arm’s length transactions.
 
If, during the ten-year period beginning on the first day of the first taxable year for which we qualified as a REIT, we recognize gain on the disposition of any property that we held as of such date, then, to the extent of the excess of (i) the fair market value of such property as of such date over (ii) our adjusted income tax basis in such property as of such date, we will be required to pay a corporate-level federal income tax on such gain at the highest regular corporate rate. Although we have no present intention to dispose of any property in a manner that would trigger such tax consequences, such dispositions could occur in the future.
 
In addition, the IRS may assert liabilities against us for corporate income taxes for taxable years prior to the time we qualified as a REIT, in which case we will owe these taxes plus interest and penalties, if any. Moreover, any increase in taxable income will result in an increase in accumulated undistributed earnings and profits, which could


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require us to pay additional taxable dividends to our then-existing shareholders within 90 days of the relevant determination.
 
State tax laws may not conform to federal tax law.  Though we expect to qualify as a REIT for federal income tax purposes in 2006, our qualification as a REIT under the laws of each individual state depends, among other things, on that state’s conformity with federal tax law. If you live in a state whose tax laws do not conform to the federal tax treatment of REITs, even if we do not do business in that state, cash distributions to you may be characterized as ordinary income rather than capital gains for purposes of computing your state taxes. You should consult with your tax advisor concerning the state tax consequences of an investment in our common shares.
 
We and some of our shareholders could have federal income tax liability if we recognize any “excess inclusion income.”  If we own a residual interest in either a real estate mortgage investment conduit, or REMIC, or taxable mortgage pool, we will be required to allocate excess inclusion income among our shareholders (and, in certain cases, holders of our convertible debt) to the extent that such amounts exceed our REIT taxable income, excluding any net capital gain. To the extent that a shareholder (and, in certain cases, holders of our convertible debt) is allocated a portion of our excess inclusion income, such excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the shareholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would be subject to federal withholding tax at the maximum rate (30%), generally being ineligible for a reduction or elimination of such tax under an applicable income tax treaty, in the hands of foreign shareholders. Generally, to the extent that we allocate any excess inclusion income to certain “disqualified shareholders” that are not subject to federal income taxation notwithstanding the foregoing sentence, we would be subject to tax on such excess inclusion income at the highest tax rate. Tax-exempt investors, non-U.S. shareholders and shareholders with net operating losses should carefully consider the tax consequences described above and are urged to consult their tax advisors in connection with their decision to invest in our shares of common stock.
 
Complying with REIT requirements may limit our ability to hedge effectively.  The existing REIT provisions of the Internal Revenue Code substantially limit our ability to hedge mortgage-backed securities and related borrowings. Under these provisions, our annual gross income from qualifying hedges of our borrowings, together with any other income not generated from qualifying real estate assets, is limited to 25% or less of our gross income. In addition, we must limit our aggregate gross income from non-qualifying hedges, fees and certain other non-qualifying sources to 5% or less of our annual gross income. As a result, we might in the future have to limit our use of advantageous hedging techniques or implement those hedges through a TRS. These changes could increase the cost of our hedging activities or leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear.
 
 
If our existing shareholders sell substantial amounts of our common stock in the public market, the market price of our common stock could decrease significantly. As of February 15, 2007, we had 183,822,181 shares of common stock outstanding. In addition, exercisable options for 3,267,545 shares are held by our employees. Subject, in some cases, to Rule 144 compliance, all of these shares are eligible for sale in the public market. The perception in the public market that our existing shareholders might sell shares of common stock could also depress our market price. A decline in the price of shares of our common stock might impede our ability to raise capital through the issuance of additional shares of our common stock or other equity securities.
 
 
Our certificate of incorporation and bylaws provide for, among other things:
 
  •  a classified board of directors;
 
  •  restrictions on the ability of our shareholders to fill a vacancy on the board of directors;
 
  •  REIT ownership limits;


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  •  the authorization of undesignated preferred stock, the terms of which may be established and shares of which may be issued without shareholder approval; and
 
  •  advance notice requirements for shareholder proposals.
 
We also are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which restricts the ability of any shareholder that at any time holds more than 15% of our voting shares to acquire us without the approval of shareholders holding at least 662/3% of the shares held by all other shareholders that are eligible to vote on the matter.
 
These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors of your choosing and cause us to take other corporate actions than you desire.
 
Insiders continue to have substantial control over us and could limit your ability to influence the outcome of key transactions, including a change of control.
 
Our directors and executive officers and entities affiliated with them beneficially owned approximately 40% of the outstanding shares of our common stock as of December 31, 2006. As a result, these shareholders, if acting together, would be able to influence or control matters requiring approval by our shareholders, including the election of directors and the approval of mergers or other extraordinary transactions. They may also have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. The concentration of ownership may have the effect of delaying, preventing or deterring a change of control of our company, could deprive our shareholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might ultimately affect the market price of our common stock.


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ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2.   PROPERTIES
 
Our headquarters are located in Chevy Chase, Maryland, a suburb of Washington, D.C., where we lease office space under long-term operating leases. This office houses the bulk of our technology and administrative functions and serves as the primary base for our operations. During 2006, we leased additional office space in a facility adjacent to our headquarters facility to accommodate our continued growth. We also maintain offices in Arizona, California, Connecticut, Florida, Georgia, Illinois, Maine, Maryland, Massachusetts, Missouri, New York, Ohio, Pennsylvania, Tennessee, Texas, Utah and in the United Kingdom. We believe our leased facilities are adequate for us to conduct our business.
 
During 2006, we began acquiring real estate for long-term investment purposes. These real estate investments primarily consist of skilled nursing facilities currently leased to clients through the execution of long-term, triple-net operating leases. We had $722.3 million in direct real estate investments as of December 31, 2006, which consisted primarily of land and buildings.


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Our direct real estate investment properties as of and for the year ended December 31, 2006 were as follows:
 
                                 
    Number of
                Total
 
Facility Location
  Facilities     Capacity(1)     Investment(2)     Revenues(3)  
                ($ in thousands)  
 
Long-Term Acute Care Facilities:
                               
Florida
    1       185     $ 6,979     $ 765  
Kansas
    1       39       391       1  
Nevada
    1       61       2,955       171  
                                 
      3       285       10,325       937  
Skilled Nursing Facilities:
                               
Alabama
    1       174       8,542       19  
Arizona
    2       174       10,069       65  
Arkansas
    2       185       1,823       13  
California
    1       99       4,864       37  
Colorado
    2       273       7,001       80  
Florida
    49       6,053       281,478       22,140  
Indiana
    11       1,051       49,473       293  
Iowa
    1       201       11,673       69  
Kansas
    2       190       3,927       19  
Kentucky
    5       344       23,643       201  
Maryland
    3       438       27,523       231  
Massachusetts
    1       124       11,834       79  
Mississippi
    5       481       37,422       312  
Nevada
    3       407       20,570       1,567  
New Mexico
    1       102       3,314       16  
North Carolina
    6       682       42,627       373  
Ohio
    2       249       15,805       96  
Oklahoma
    5       697       19,774       147  
Pennsylvania
    3       443       18,190       1,596  
Tennessee
    3       438       34,224       269  
Texas
    10       1,359       49,021       1,487  
Washington
    1       168       5,843       43  
Wisconsin
    4       452       17,244       458  
                                 
      123       14,784       705,884       29,610  
Assisted Living Facilities:
                               
Florida
    3       146       3,949       179  
Indiana
    1       99       2,145       16  
                                 
      4       245       6,094       195  
                                 
Total Owned Properties
    130       15,314     $ 722,303     $ 30,742  
                                 
 
 
(1) Assisted living and long-term acute care facilities are apartment-like facilities and, therefore, expressed capacity is stated in units (studio, one or two bedroom apartments). Skilled nursing facilities are measured by licensed bed count.
 
(2) Investment for owned properties represents the acquisition costs of the assets less any related accumulated depreciation.
 
(3) Represents the amount of operating lease income recognized on our audited consolidated statement of income for the year ended December 31, 2006.


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ITEM 3.   LEGAL PROCEEDINGS
 
From time to time, we are party to legal proceedings. We do not believe that any currently pending or threatened proceeding, if determined adversely to us, would have a material adverse effect on our business, financial condition or results of operations, including our cash flows.
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matter was submitted to a vote of our security holders during the fourth quarter of 2006.
 
 
ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
 
Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “CSE.” The high and low sales prices for our common stock as reported by the NYSE for the quarterly periods during 2006 and 2005 were as follows:
 
                 
    High     Low  
 
2006:
               
Fourth Quarter
  $ 28.57     $ 25.66  
Third Quarter
  $ 26.05     $ 22.39  
Second Quarter
  $ 25.50     $ 21.80  
First Quarter
  $ 25.35     $ 21.52  
2005:
               
Fourth Quarter
  $ 25.20     $ 20.81  
Third Quarter
  $ 23.70     $ 18.64  
Second Quarter
  $ 24.28     $ 17.95  
First Quarter
  $ 25.78     $ 22.01  
 
On February 15, 2007, the last reported sale price of our common stock on the NYSE was $27.00 per share.
 
 
As of December 31, 2006, there were 953 holders of record of our common stock. The number of holders does not include individuals or entities who beneficially own shares but whose shares are held of record by a broker or clearing agency, but does include each such broker or clearing agency as one recordholder. American Stock Transfer & Trust Company serves as transfer agent for our shares of common stock.
 
 
From our initial public offering in August 2003 through December 31, 2005, we did not pay any dividends. We began paying dividends in 2006 in conjunction with our decision to operate as a REIT.
 
In January 2006, we paid a special dividend of $2.50 per share, or $350.9 million in the aggregate, representing our cumulative undistributed earnings and profits, including earnings and profits of some of our predecessor entities, from our inception through December 31, 2005. We paid this special dividend $70.2 million in cash and $280.7 million in 12.3 million shares of common stock.


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We also began paying a regular quarterly dividend, which commenced in the first calendar quarter of 2006. We declared and paid dividends as follows:
 
         
    Dividend Declared
 
    per Share  
2006:
       
Fourth Quarter
  $ 0.55  
Third Quarter
    0.49  
Second Quarter
    0.49  
First Quarter
    0.49  
         
Total 2006 Dividends Declared
  $ 2.02  
         
 
For shareholders who held our shares for the entire year, the dividends paid in 2006, totaling $4.52 per share, were classified for tax reporting purposes as follows: $3.21 ordinary dividends, of which $2.35 are qualified dividends, $0.05 short-term capital gain, and $1.26 return on capital. Of the sum of ordinary dividends and short-term capital gains, 0.05% is considered excess inclusion income.
 
We intend to continue to pay regular cash quarterly dividends that, on an annual basis, represent at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid. Our actual dividend payments on our common stock are subject to final approval from our Board of Directors and are based on our results of operations, cash flow and prospects at the time, as well as any contractual limitations in our debt instruments.
 
 
A summary of our repurchases of shares of our common stock for the three months ended December 31, 2006 was as follows:
 
                                 
                Shares Purchased
    Maximum Number
 
    Total Number
    Average
    as Part of Publicly
    of Shares that May
 
    of Shares
    Price Paid
    Announced Plans
    Yet be Purchased
 
    Purchased(1)     per Share     or Programs     Under the Plans  
 
October 1 — October 31, 2006
    2,963     $ 26.33              
November 1 — November 30, 2006
    14,084       26.84              
December 1 — December 31, 2006
    97,137       28.00              
                                 
Total
    114,184     $ 27.81                  
                                 
 
 
(1) Represents the number of shares acquired as payment by employees of applicable statutory minimum withholding taxes owed upon vesting of restricted stock granted under the CapitalSource Inc. Third Amended and Restated Equity Incentive Plan.


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The following graph compares the performance of our common stock during the period beginning on August 7, 2003, the date of our initial public offering, to December 31, 2006 with the S&P 500 Index and the S&P 500 Financials Index. The graph depicts the results of investing $100 in our common stock, the S&P 500 Index, and the S&P 500 Financials Index at closing prices on August 7, 2003, assuming all dividends were reinvested. Historical stock performance during this period may not be indicative of future stock performance.
 
(GRAPH)
 
                                         
    Base
  Period
           
    Period
  Ended
  Years Ended December 31,
Company/Index
 
08/07/2003
 
12/31/2003
  2004   2005   2006
CapitalSource Inc. 
  $ 100     $ 119.1     $ 141.0     $ 136.0     $ 179.4  
S&P 500 Index
    100       115.0       127.5       133.8       154.9  
S&P 500 Financials Index
    100       113.5       125.9       134.0       159.7  


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ITEM 6.   SELECTED FINANCIAL DATA
 
You should read the data set forth below in conjunction with our consolidated financial statements and related notes of CapitalSource Inc., Management’s Discussion and Analysis of Financial Condition and Results of Operations and other financial information appearing elsewhere in this report. The following tables show selected portions of audited historical consolidated financial data as of and for the five years ended December 31, 2006. We derived our selected consolidated financial data as of and for the five years ended December 31, 2006 from our audited consolidated financial statements, which have been audited by Ernst & Young LLP, independent registered public accounting firm.
 
                                         
    Year Ended December 31,  
    2006     2005     2004     2003     2002  
    ($ in thousands, except per share data)  
 
Results of operations:
                                       
Interest income
  $ 1,016,533     $ 514,652     $ 313,827     $ 175,169     $ 73,591  
Fee income
    170,485       130,638       86,324       50,596       17,512  
                                         
Total interest and fee income
    1,187,018       645,290       400,151       225,765       91,103  
Operating lease income
    30,742                          
                                         
Total investment income
    1,217,760                                  
Interest expense
    606,725       185,935       79,053       39,956       13,974  
                                         
Net investment income
    611,035       459,355       321,098       185,809       77,129  
Provision for loan losses
    81,562       65,680       25,710       11,337       6,688  
                                         
Net investment income after provision for loan losses
    529,473       393,675       295,388       174,472       70,441  
Total operating expenses
    216,052       143,836       107,748       67,807       33,595  
Total other income
    37,328       19,233       17,781       25,815       4,736  
Noncontrolling interests expense
    4,711                          
                                         
Net income before income taxes and cumulative effect of accounting change
    346,038       269,072       205,421       132,480       41,582  
Income taxes(1)
    67,132       104,400       80,570       24,712        
                                         
Net income before cumulative effect of accounting change
    278,906       164,672       124,851       107,768       41,582  
Cumulative effect of accounting change, net of taxes
    370                          
                                         
Net income
  $ 279,276     $ 164,672     $ 124,851     $ 107,768     $ 41,582  
                                         
Net income per share:
                                       
Basic
  $ 1.68     $ 1.36     $ 1.07     $ 1.02     $ 0.43  
Diluted
  $ 1.65     $ 1.33     $ 1.06     $ 1.01     $ 0.42  
Average shares outstanding:
                                       
Basic
    166,273,730       120,976,558       116,217,650       105,281,806       97,701,088  
Diluted
    169,220,007       123,433,645       117,600,676       107,170,585       99,728,331  
Cash dividends declared per share
  $ 2.02     $ 0.50     $     $     $  
 
 
(1) As a result of our decision to elect REIT status beginning with the tax year ended December 31, 2006, we provided for income taxes based on a 39.9% effective tax rate for the income earned by our taxable REIT subsidiaries. We did not provide for any income taxes for the income earned by our qualified REIT subsidiaries for the year ended December 31, 2006. We provided for income taxes on the consolidated income earned based on a 19.4%, 38.8% and 39.2% effective tax rate in 2006, 2005, and 2004, respectively. We provided for income taxes on the income earned from August 7, 2003 through December 31, 2003 based on a 38.0% effective tax rate. Prior to our reorganization as a “C” corporation on August 6, 2003, we operated as a limited liability company and did not provide for income taxes as all income taxes were paid directly by our members.


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    December 31,  
    2006     2005     2004     2003     2002  
    ($ in thousands)  
 
Balance sheet data:
                                       
Mortgage-related receivables, net
  $ 2,295,922     $ 39,438     $     $     $  
Mortgage-backed securities pledged, trading
    3,502,753       323,370                    
Loans, net
    7,520,818       5,687,134       4,140,381       2,339,089       1,036,676  
Direct real estate investments, net
    722,303                          
Total assets
    15,210,574       6,987,068       4,736,829       2,567,091       1,160,605  
Repurchase agreements
    3,510,768       358,423             8,446        
Unsecured credit facilities
    355,685                          
Secured credit facilities
    2,183,155       2,450,452       964,843       736,700       239,900  
Term debt
    5,809,685       1,779,748       2,186,311       920,865       425,615  
Convertible debt
    555,000       555,000       555,000              
Subordinated debt
    446,393       231,959                    
                                         
Total borrowings
    12,860,686       5,375,582       3,706,154       1,666,011       665,515  
Total shareholders’ equity
    2,093,040       1,199,938       946,391       867,132       473,682  
Portfolio statistics:
                                       
Number of loans closed to date
    1,986       1,409       923       504       209  
Number of loans paid off to date
    (914 )     (486 )     (275 )     (87 )     (24 )
                                         
Number of loans
    1,072       923       648       417       185  
                                         
Total loan commitments
  $ 11,929,568     $ 9,174,567     $ 6,379,012     $ 3,673,369     $ 1,636,674  
Average outstanding loan size
  $ 7,323     $ 6,487     $ 6,596     $ 5,796     $ 5,804  
Average balance of loans outstanding during year
  $ 6,971,908     $ 5,046,704     $ 3,287,734     $ 1,760,638     $ 672,015  
Employees as of year end
    548       520       398       285       164  
 


40


 

                                         
    Year Ended December 31,  
    2006     2005     2004     2003     2002  
 
Performance ratios:
                                       
Return on average assets(1)
    2.22 %     3.04 %     3.59 %     4.34 %     3.49 %
Return on average equity(1)
    14.63 %     15.05 %     14.17 %     12.37 %     7.76 %
Yield on average interest earning assets
    9.80 %     12.15 %     11.59 %     11.92 %     12.40 %
Cost of funds
    5.79 %     4.43 %     3.08 %     3.32 %     3.57 %
Net finance margin
    4.94 %     8.65 %     9.30 %     9.81 %     10.50 %
Operating expenses as a percentage of average total assets
    1.72 %     2.65 %     3.09 %     3.58 %     4.55 %
Operating expenses (excluding direct real estate investment depreciation) as a percentage of average total assets
    1.62 %     2.65 %     3.09 %     3.58 %     4.55 %
Efficiency ratio (operating expenses/net interest and fee income and other income)
    33.32 %     30.05 %     31.80 %     32.01 %     41.03 %
Efficiency ratio (operating expenses excluding direct real estate depreciation/net interest and fee income and other income)
    31.55 %     30.05 %     31.80 %     32.01 %     41.03 %
Credit quality and leverage ratios:
                                       
60 or more days contractual delinquencies as a percentage of loans (as of year end)
    1.12 %     0.70 %     0.76 %     0.18 %     0.00 %
Loans on non-accrual status as a percentage of loans (as of year end)
    2.34 %     2.30 %     0.53 %     0.36 %     0.00 %
Impaired loans as a percentage of loans (as of year end)
    3.58 %     3.33 %     0.77 %     0.63 %     0.00 %
Net charge offs (as a percentage of average loans)
    0.69 %     0.27 %     0.26 %     0.00 %     0.00 %
Allowance for loan losses as a percentage of loans (as of year end)
    1.54 %     1.46 %     0.82 %     0.75 %     0.62 %
Total debt to equity (as of year end)
    6.14 x     4.48 x     3.93 x     1.93 x     1.41 x
Equity to total assets (as of year end)
    13.76 %     17.17 %     19.98 %     33.78 %     40.81 %
 
 
(1) Adjusted to reflect results from our reorganization in 2003 as a “C” corporation. As a limited liability company prior to the August 6, 2003 reorganization, we did not provide for income taxes as all income taxes were paid directly by the members. As a “C” corporation, CapitalSource Inc. is responsible for the payment of all federal and state corporate income taxes. For the years ended December 31, 2003 and 2002, return on average assets and return on average equity were calculated based on unaudited pro forma net income that includes provision for income taxes with a combined federal and state effective tax rate of 38.0%.

41


 

 
ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
 
We are a commercial lending, investment and asset management company focused on the middle market. We operate as a REIT and provide senior and subordinate commercial loans, invest in real estate, engage in asset management and servicing activities and invest in residential mortgage assets. We expect to formally make an election to REIT status for 2006 when we file our tax return for the year ended December 31, 2006.
 
Through our commercial lending and investment activities, our primary goal is to be the provider of financing of choice for middle market businesses that require customized and sophisticated financing. We operate through three principal commercial finance businesses:
 
  •  Healthcare and Specialty Finance, which generally provides first mortgage loans, asset-based revolving lines of credit, real estate lease financing and cash flow loans to healthcare businesses and a broad range of other companies;
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies; and
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in widely syndicated loan transactions.
 
In 2006, we grew our asset management business. We completed our first CLO issuance comprising a portfolio of originated and acquired cash flow loans. We also opened warehouse facilities for two additional CLOs that we intend to close over the next 12 months. In addition to our CLO business, we are party to a joint venture to acquire distressed and other types of debt investments. As with our CLOs, we are the asset manager for this joint venture and receive a fee for managing the assets owned by the joint venture. We view these and other potential asset management businesses as complementary opportunities for us to leverage our commercial finance expertise into managing financial assets owned by third parties. We intend to further build out our asset management businesses by focusing on additional product types, which, for example, may include managing subordinated debt and equity investments for others.
 
To optimize our REIT structure, we also invest in certain residential mortgage assets. As of December 31, 2006, the balance of our residential mortgage investment portfolio was $5.8 billion, which included investments in residential mortgage loans and RMBS.
 
 
On January 1, 2006, we began operating as two reportable segments: 1) Commercial Lending & Investment and 2) Residential Mortgage Investment. Our Commercial Lending & Investment segment includes our commercial lending and investment business and our Residential Mortgage Investment segment includes all of our activities related to our residential mortgage investments. The discussion that follows differentiates our results of operations between our segments.
 
 
Interest Income.  In our Commercial Lending & Investment segment, interest income represents interest earned on our commercial loans. The majority of these loans charge interest at variable rates that generally adjust daily, with an increasing number of loans charging interest at fixed rates. As of December 31, 2006 and 2005, approximately 6% of our outstanding loan balance had a fixed rate of interest. In our Residential Mortgage Investment segment, interest income represents interest earned on our residential mortgage-related receivables and RMBS.
 
Fee Income.  In our Commercial Lending & Investment segment, fee income represents net fee income earned from our commercial loan operations. Fee income primarily includes the amortization of loan origination fees, net of the direct costs of origination, the amortization of fees related to syndicated loans that we originate and


42


 

other fees charged to borrowers. We amortize these loan fees into income over the contractual life of our loans and do not take loan fees into income when a loan closes. Loan prepayments may materially affect fee income since, in the period of prepayment, the amortization of remaining net loan origination fees and discounts is accelerated and prepayment penalties may be assessed on the prepaid loans and recognized in the period of the prepayment. We consider both the acceleration of any unamortized fees and fees related to prepayment penalties to be prepayment-related fee income. We currently do not generate fee income in our Residential Mortgage Investment segment.
 
Operating Lease Income.  In our Commercial Lending & Investment segment, operating lease income represents lease income earned in connection with our direct real estate investments. Our operating leases typically include fixed rental payments, subject to escalation over the life of the lease. We 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 Residential Mortgage Investment segment.
 
Interest Expense.  Interest expense is the amount paid on borrowings, including the amortization of deferred financing fees. In our Commercial Lending & Investment segment, our borrowings consist of repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt and subordinated debt. In our Residential Mortgage Investment segment, our borrowings consist of repurchase agreements and term debt. The majority of our borrowings charge interest at variable rates based primarily on one-month LIBOR or commercial paper rates plus a margin. Currently, our convertible debt, three series of our subordinated debt and our term debt issued in connection with our investments in mortgage-related receivables bear a fixed rate of interest. As our borrowings increase and as short term interest rates rise, our interest expense will increase. Deferred financing fees 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 both our Commercial Lending & Investment segment and our Residential Mortgage Investment segment. 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.
 
Other Income.  In our Commercial Lending & Investment segment, other income (expense) consists of gains (losses) on the sale of debt and equity investments, unrealized appreciation (depreciation) on certain investments, gains (losses) on derivatives, due diligence deposits forfeited, fees associated with the United States Department of Housing and Urban Development, or HUD, origination activities, unrealized appreciation (depreciation) of our equity interests in certain non-consolidated entities, third-party servicing income and other miscellaneous fees and expenses not attributable to our commercial lending and investment operations. In our Residential Mortgage Investment segment, other income (expense) consists of unrealized appreciation (depreciation) on certain of our residential mortgage investments and gains (losses) on derivatives used to economically hedge the residential mortgage investment portfolio.
 
Operating Expenses.  Operating expenses for both our Commercial Lending & Investment segment and our Residential Mortgage Investment segment include compensation and benefits, professional fees, travel, rent, insurance, depreciation and amortization, marketing and other general and administrative expenses.
 
Income Taxes.  We expect to formally make an election to REIT status for 2006 under the Code when we file our tax return for our taxable year ended December 31, 2006. Provided we qualify for taxation as a REIT, we generally will not be subject to corporate-level income tax on the earnings distributed to our shareholders that we derive from our REIT qualifying activities, but we will continue to be subject to corporate-level tax on the earnings we derive from our TRSs. We do not expect our Residential Mortgage Investment segment to be subject to corporate-level tax as all assets are considered REIT qualifying assets. A significant portion of our Commercial Lending & Investment segment will remain subject to corporate-level income tax as many of the segment’s assets are originated and held in our TRSs. We were responsible for paying federal, state and local income taxes on all of our income for the years ended December 31, 2005 and 2004.


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Adjusted Earnings.  Adjusted earnings represents net income as determined in accordance with U.S. generally accepted accounting principles (“GAAP”), adjusted for certain non-cash items, including real estate depreciation, amortization of deferred financing fees, non-cash equity compensation, unrealized gains and losses on our residential mortgage investment portfolio and related derivatives, unrealized gains and losses on other derivatives and foreign currencies, net unrealized gains and losses on investments, provision for loan losses, charge offs, recoveries, nonrecurring items and the cumulative effect of changes in accounting principles. We view adjusted earnings and the related per share measures as useful and appropriate supplements to net income and earnings per share. These measures serve as an additional measure of our operating performance because they facilitate evaluation of the company without the effects of certain adjustments determined in accordance with GAAP that may not necessarily be indicative of current operating performance. Adjusted earnings should not be considered as an alternative to net income or cash flows (each computed in accordance with GAAP). Instead, adjusted earnings should be reviewed in connection with income and cash flows from operating, investing and financing activities in our consolidated financial statements, to help analyze how our business is performing. Adjusted earnings and other supplemental performance measures are defined in various ways throughout the REIT industry. Investors should consider these differences when comparing our adjusted earnings to other REITs.
 
Operating Results for the Years Ended December 31, 2006, 2005 and 2004
 
Our results of operations in 2006 continued to be driven primarily by our continued growth as well as the impact of our REIT election. As further described below, the most significant factors influencing our consolidated results of operations for the time period were:
 
  •  A decrease in our effective tax rate;
 
  •  Significant growth in our commercial loan portfolio;
 
  •  Addition of operating lease income related to our direct real estate investments;
 
  •  Increased borrowings to fund our growth;
 
  •  Increased operating expenses, including higher employee compensation related to increases in the number of our employees;
 
  •  An increase in short-term interest rates; and
 
  •  Decreased lending and borrowing spreads.
 
Our consolidated operating results for the year ended December 31, 2006 compared to the year ended December 31, 2005 and for the year ended December 31, 2005 compared to the year ended December 31, 2004 were as follows:
 
                                                                 
    Year Ended
                Year Ended
             
    December 31,                 December 31,              
    2006     2005     $ Change     % Change     2005     2004     $ Change     % Change  
    ($ in thousands)           ($ in thousands)        
 
Interest income
  $ 1,016,533     $ 514,652     $ 501,881       98 %   $ 514,652     $ 313,827     $ 200,825       64 %
Fee income
    170,485       130,638       39,847       31 %     130,638       86,324       44,314       51 %
Operating lease income
    30,742             30,742       N/A                         N/A  
Interest expense
    606,725       185,935       420,790       226 %     185,935       79,053       106,882       135 %
Provision for loan losses
    81,562       65,680       15,882       24 %     65,680       25,710       39,970       155 %
Operating expenses
    216,052       143,836       72,216       50 %     143,836       107,748       36,088       33 %
Other income
    37,328       19,233       18,095       94 %     19,233       17,781       1,452       8 %
Noncontrolling interests expense
    4,711             4,711       N/A                         N/A  
Income taxes
    67,132       104,400       (37,268 )     (36 )%     104,400       80,570       23,830       30 %
Cumulative effect of accounting change, net of taxes
    370             370       N/A                         N/A  
Net income
    279,276       164,672       114,604       70 %     164,672       124,851       39,821       32 %


44


 

Our consolidated yields on income earning assets and the costs of interest bearing liabilities for the years ended December 31, 2006 and 2005 were as follows:
 
                                                 
    Year Ended December 31,  
    2006     2005  
    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
          $ 1,016,533       8.39 %           $ 514,652       9.69 %
Fee income
            170,485       1.41               130,638       2.46  
                                                 
Total interest earning assets (1)
  $ 12,112,492       1,187,018       9.80     $ 5,309,530       645,290       12.15  
Total direct real estate investments
    260,313       30,742       11.81                    
                                                 
Total income earning assets
    12,372,805       1,217,760       9.84       5,309,530       645,290       12.15  
Total interest bearing liabilities (2)
    10,479,447       606,725       5.79       4,193,128       185,935       4.43  
                                                 
Net finance spread
          $ 611,035       4.05 %           $ 459,355       7.72 %
                                                 
Net finance margin
                    4.94 %                     8.65 %
                                                 
 
 
(1) Interest earning assets include cash, restricted cash, mortgage-related receivables, RMBS, loans, and investments in debt securities.
 
(2) Interest bearing liabilities include repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt and subordinated debt.
 
 
All amounts below relating to our Commercial Lending & Investment segment for the year ended December 31, 2006 are compared to our consolidated results for the year ended December 31, 2005 as we did not report our operations in segments in 2005, and all activity for the year ended December 31, 2005 was related to commercial lending and investment activity. All references to commercial loans below include loans, loans held for sale and receivables under reverse-repurchase agreements.
 
 
In our Commercial Lending & Investment segment, interest income was $749.0 million for the year ended December 31, 2006, an increase of $234.4 million, or 46%, from total interest income for the year ended December 31, 2005. This increase was due to the growth in average interest earning assets, primarily loans, of $2.0 billion, or 37%, as well as an increase in the interest component of yield to 10.27% for the year ended December 31, 2006 from 9.69% for the year ended December 31, 2005. The increase in the interest component of yield was largely due to the increase in short-term interest rates, partially offset by a decrease in our lending spread. During the year ended December 31, 2006, our commercial lending spread to average one-month LIBOR was 5.18% compared to 6.31% for the year ended December 31, 2005. This decrease in lending spread reflects overall trends in financial markets, the increase in competition in our markets, as well as the changing mix of our commercial lending portfolio as we pursue the expanded opportunities afforded to us by our decision to elect to be taxed as a REIT. By operating as a REIT, we can make the same, or better, after tax return on a loan with a lower interest rate than on a loan with a higher interest rate originated prior to our decision to elect to be taxed as a REIT. Fluctuations in yields are driven by a number of factors, including changes in short-term interest rates (such as changes in the prime rate or one-month LIBOR), the coupon on new loan originations, the coupon on loans that pay down or pay off and modifications of interest rates on existing loans.
 
In our Residential Mortgage Investment segment, interest income was $267.5 million for the year ended December 31, 2006. Included in this amount is the amortization of purchase discounts on our investments in RMBS and mortgage-related receivables, which are amortized into income using the interest method. Average interest


45


 

earning assets, which consist primarily of residential mortgage-related receivables and RMBS, were $4.8 billion as of December 31, 2006. Yield on average interest earning assets was 5.55% for the year ended December 31, 2006.
 
 
In our Commercial Lending & Investment segment, the increase in fee income was primarily the result of the growth in interest earning assets as well as an increase in prepayment-related fee income, which totaled $66.7 million for the year ended December 31, 2006 compared to $34.4 million for the year ended December 31, 2005. Prepayment-related fee income contributed 0.92% and 0.65%, to yield for the years ended December 31, 2006 and 2005, respectively. Yield from fee income decreased to 2.34% for the year ended December 31, 2006 from 2.46% for year ended December 31, 2005.
 
 
In our Commercial Lending & Investment segment, $30.7 million of operating lease income was earned in connection with our direct real estate investments acquired during the year ended December 31, 2006.
 
 
We fund our growth largely through borrowings. In our Commercial Lending & Investment segment, interest expense was $356.2 million for the year ended December 31, 2006, an increase of $170.2 million, or 92%, from total interest expense for the year ended December 31, 2005. This increase in interest expense was primarily due to an increase in average borrowings of $1.6 billion, or 39%, as well as rising interest rates during the year. Our cost of borrowings increased to 6.12% for the year ended December 31, 2006 from 4.43% for the year ended December 31, 2005. This increase was the result of rising interest rates, the use of our unsecured credit facility, which has a higher borrowing spread relative to our secured credit facilities, and an increase in the amortization of deferred financing fees. The increase in deferred financing fees was primarily due to additional financings and higher loan prepayments on loans that secure our term debt. These increases were partially offset by lower borrowing margins and our use of more cost effective sources of financing. Our overall borrowing spread to average one-month LIBOR for the year ended December 31, 2006 was 1.03% compared to 1.05% for the year ended December 31, 2005.
 
In our Residential Mortgage Investment segment, interest expense was $250.6 million for the year ended December 31, 2006, resulting from average borrowings of $4.7 billion. Our cost of borrowings for this segment was 5.31% for the year ended December 31, 2006.
 
 
In our Commercial Lending & Investment segment, net finance margin, defined as net investment income (which includes interest, fee and operating lease income less interest expense) divided by average income earning assets, was 7.86% for the year ended December 31, 2006, a decrease of 79 basis points from 8.65% for the year ended December 31, 2005. The decrease in net finance margin was primarily due to the increase in interest expense resulting from a higher cost of funds, offset partially by an increase in yield on total income earning assets resulting from higher loan prepayments. Net finance spread, which represents the difference between our gross yield on income earning assets and the cost of our interest bearing liabilities, was 6.46% for the year ended December 31, 2006, a decrease of 126 basis points from 7.72% for the year ended December 31, 2005. Gross yield is the sum of interest, fee and operating lease income divided by our average income earning assets. The decrease in net finance spread is attributable to the changes in its components as described above.


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The yields of income earning assets and the costs of interest bearing liabilities in our Commercial Lending & Investment segment for the year ended December 31, 2006 and 2005 were as follows:
 
                                                 
    Year Ended December 31,  
    2006     2005  
    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
          $ 749,011       10.27 %           $ 514,652       9.69 %
Fee income
            170,485       2.34               130,638       2.46  
                                                 
Total interest earning assets (1)
  $ 7,293,568       919,496       12.61     $ 5,309,530       645,290       12.15  
Total direct real estate investments
    260,313       30,742       11.81                    
                                                 
Total income earning assets
    7,553,881       950,238       12.58       5,309,530       645,290       12.15  
Total interest bearing liabilities (2)
    5,823,368       356,164       6.12       4,193,128       185,935       4.43  
                                                 
Net finance spread
          $ 594,074       6.46 %           $ 459,355       7.72 %
                                                 
Net finance margin
                    7.86 %                     8.65 %
                                                 
 
 
(1) Interest earning assets include cash, restricted cash, loans and investments in debt securities.
 
(2) Interest bearing liabilities include repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt and subordinated debt.
 
In our Residential Mortgage Investment segment, net finance spread was 0.24% for the year ended December 31, 2006. Net finance spread is the difference between yield on interest earning assets of 5.55% and the cost of our interest bearing liabilities of 5.31% for the year ended December 31, 2006. Interest earning assets include cash, restricted cash, mortgage-related receivables and RMBS. Interest bearing liabilities include repurchase agreements and term debt.
 
 
The increase in the provision for loan losses in our Commercial Lending & Investment segment is the result of growth in our commercial loan portfolio, an increase in the balance of impaired loans in the portfolio and additional allocated reserves recorded during the year ended December 31, 2006.
 
 
In our Commercial Lending & Investment segment, other income was $34.8 million for the year ended December 31, 2006, an increase of $15.6 million, or 81%, from total other income for the year ended December 31, 2005. The increase in other income was primarily attributable to the receipt of a break-up fee of $4.5 million related to a prospective loan, a $2.9 million increase in net realized and unrealized gains in our equity investments, a $2.6 million increase on net gains on derivatives, a $2.1 million increase in income relating to our equity interests in certain non-consolidated entities and a $1.9 million increase in diligence deposits forfeited. These increases were partially offset by a $3.1 million decrease in third-party servicing fees and a $2.5 million loss incurred on the extinguishment of debt in connection with one of our direct real estate investments entered into during the year ended December 31, 2006.
 
In our Residential Mortgage Investment segment, other income consisted of a gain on the residential mortgage investment portfolio of $2.5 million for the year ended December 31, 2006. This gain was attributable to net realized and unrealized gains on related derivative instruments of $7.3 million, partially offset by net realized and unrealized losses on residential mortgage investments of $4.8 million.
 
Included in unrealized gains on derivative instruments is not only the change in fair value of these instruments, but also the net of interest income and expense accruals related to certain of our derivatives.


47


 

 
 
The increase in consolidated operating expenses was primarily due to higher total employee compensation, which increased $40.9 million, or 43%. The higher employee compensation was attributable to an increase in our average number of employees to 555 for the year ended December 31, 2006, from 457 for the year ended December 31, 2005, as well as higher incentive compensation, including an increase in the value of restricted stock awards and stock options granted. For the years ended December 31, 2006 and 2005, incentive compensation totaled $69.2 million and $44.5 million, respectively. Incentive compensation comprises annual bonuses, as well as stock options and restricted stock awards, which generally have a three- to five-year vesting period. The remaining increase in operating expenses for the year ended December 31, 2006 was primarily attributable to an increase of $12.2 million in professional fees, an increase of $11.9 million in depreciation and amortization primarily resulting from our direct real estate investments, an increase of $2.2 million in travel and entertainment expenses and an increase of $3.5 million in other general business expenses. Operating expenses in our Residential Mortgage Investment segment, which consist primarily of compensation and benefits, professional fees and other direct expenses, were $8.6 million for the year ended December 31, 2006.
 
In our Commercial Lending & Investment segment, operating expenses as a percentage of average total assets increased slightly to 2.69% for the year ended December 31, 2006 from 2.65% for the year ended December 31, 2005. Our Commercial Lending & Investment segment’s efficiency ratio, which represents operating expenses as a percentage of net investment income and other income, increased to 32.98% for the year ended December 31, 2006 from 30.05% for the year ended December 31, 2005 primarily attributable to the increase in operating expenses described above.
 
 
Our effective tax rate on our consolidated net income was 19.4% for the year ended December 31, 2006, which is impacted by a reduction in net deferred tax liabilities as a result of our REIT election. Our effective income tax rate for the year ended December 31, 2006 attributable to our TRSs was 39.9%. Our effective tax rate was 38.8% for the year ended December 31, 2005.


48


 

 
 
Adjusted earnings, as previously defined, were $425.7 million, or $2.51 per diluted share, for the year ended December 31, 2006. A reconciliation of our reported net income to adjusted earnings for the year ended December 31, 2006 was as follows ($ in thousands, except per share data):
 
         
Net income
  $ 279,276  
Add:
       
Real estate depreciation (1)
    10,323  
Amortization of deferred financing fees
    30,842  
Non-cash equity compensation
    33,294  
Net unrealized loss on residential mortgage investment portfolio, including related derivatives (2)
    5,862  
Unrealized gain on derivatives and foreign currencies, net
    (1,470 )
Unrealized loss on investments, net
    7,524  
Provision for loan losses
    81,662  
Recoveries (3)
     
Less:
       
Charge offs (4)
    16,510  
Nonrecurring items (5)
    4,725  
Cumulative effect of accounting change, net of taxes
    370  
         
Adjusted earnings
  $ 425,708  
         
Net income per share:
       
Basic — as reported
  $ 1.68  
Diluted — as reported
  $ 1.65  
Average shares outstanding:
       
Basic — as reported
    166,273,730  
Diluted — as reported
    169,220,007  
Adjusted earnings per share:
       
Basic
  $ 2.56  
Diluted (6)
  $ 2.51  
Average shares outstanding:
       
Basic
    166,273,730  
Diluted (7)
    171,551,972  
 
 
(1) Depreciation for direct real estate investments only. Excludes depreciation for corporate leasehold improvements, fixed assets and other non-real estate items.
 
(2) Includes adjustments to reflect the period change in fair value of RMBS and related derivative instruments.
 
(3) Includes all recoveries on loans during the period.
 
(4) To the extent we experience losses on loans for which we specifically provided a reserve prior to January 1, 2006, there will be no adjustment to earnings. All charge offs incremental to previously established allocated reserves will be deducted from net income.
 
(5) Represents the write-off of a net deferred tax liability recorded in connection with our conversion to a REIT for the year ended December 31, 2006.
 
(6) Adjusted to reflect the impact of adding back noncontrolling interests expense of $4.7 million to adjusted earnings due to the application of the if-converted method on non-managing member units, which are considered dilutive to adjusted earnings per share, but are antidilutive to GAAP net income per share for all periods presented.
 
(7) Adjusted to include average non-managing member units of 2,331,965, which are considered dilutive to adjusted earnings per share, but are antidilutive to GAAP net income per share.


49


 

 
Comparison of the Years Ended December 31, 2005 and 2004
 
 
The increase in interest income was due to the growth in average interest earning assets of $1.9 billion, or 54%, as well as an increase in the interest component of yield to 9.69% for the year ended December 31, 2005 from 9.09% for the year ended December 31, 2004. Interest earning assets increased during 2005 primarily from the growth in loans in our commercial lending portfolio. The increase in the interest component of yield was largely due to the increase in short-term interest rates, offset by a decrease in our lending spread. During 2005, our overall lending spread to the average prime rate was 3.50% compared to 4.80% for the year ended December 31, 2004. This decrease in lending spread reflects both the increase in competition in our markets, as well as the changing mix of our commercial lending portfolio toward a greater percentage of asset-based and real estate loans. Fluctuations in yields are driven by a number of factors including the coupon on new loan originations, the coupon on loans that pay down or pay off and the effect of external interest rates.
 
 
The increase in fee income was primarily the result of the growth in interest earning assets as well as an increase in prepayment fees, which aggregated $34.4 million for the year ended December 31, 2005 compared to $25.9 million for the year ended December 31, 2004. Yield from fee income decreased to 2.46% for the year ended December 31, 2005 from 2.50% for the year ended December 31, 2004, primarily due to lower prepayment and other fees relative to the growth of average interest earning assets.
 
 
We fund our growth largely through borrowings. Consequently, the increase in our interest expense was primarily due to an increase in average borrowings of $1.6 billion, or 63%, as well as rising interest rates during the period. Our cost of borrowings increased to 4.43% for the year ended December 31, 2005 from 3.08% for the year ended December 31, 2004. This increase was the result of rising interest rates and an increase in amortization of deferred financing fees due to additional financings and higher loan prepayments in our term debt, partially offset by lower borrowing margins and our use of more cost effective sources of financing. Our overall borrowing spread to average one-month LIBOR for the year ended December 31, 2005 was 1.05% compared to 1.58% for the year ended December 31, 2004.
 
 
Net finance margin, defined as net interest income divided by average interest earning assets, was 8.65% for the year ended December 31, 2005, a decline of 65 basis points from 9.30% for the year ended December 31, 2004. The decrease in net finance margin was primarily due to the increase in interest expense resulting from a higher cost of funds and higher leverage, offset partially by an increase in yield. Net finance spread, the difference between our gross yield on interest earning assets and the cost of our interest bearing liabilities, was 7.72% for the year ended December 31, 2005, a decrease of 79 basis points from 8.51% for the year ended December 31, 2004. Gross yield is the sum of interest and fee income divided by our average interest earning assets. The decrease in net finance spread is attributable to the changes in its components as described above.


50


 

 
The yields of interest earning assets and the costs of interest bearing liabilities for the years ended December 31, 2005 and 2004 were as follows:
 
                                                 
    Year Ended December 31,  
    2005     2004  
          Interest and
                Interest and
       
    Weighted
    Fee Income/
    Average
    Weighted
    Fee Income/
    Average
 
    Average
    Interest
    Yield/
    Average
    Interest
    Yield/
 
    Balance     Expense     Cost     Balance     Expense     Cost  
    ($ in thousands)  
 
Interest earning assets:
                                               
Interest income
          $ 514,652       9.69 %           $ 313,827       9.09 %
Fee income
            130,638       2.46               86,324       2.50  
                                                 
Total interest earning assets (1)
  $ 5,309,530       645,290       12.15     $ 3,453,888       400,151       11.59  
Total interest bearing liabilities (2)
    4,193,128       185,935       4.43       2,567,077       79,053       3.08  
                                                 
Net finance spread
          $ 459,355       7.72 %           $ 321,098       8.51 %
                                                 
Net finance margin (net yield on interest earning assets)
                    8.65 %                     9.30 %
                                                 
 
 
(1) Interest earning assets include cash, restricted cash, mortgage-backed securities accounted for on a gross basis, loans and investments in debt securities.
 
(2) Interest bearing liabilities include repurchase agreements accounted for on a gross basis, secured credit facilities, term debt, convertible debt and subordinated debt.
 
 
The increase in the provision for loan losses is the result of the growth in our loan portfolio, the increase in the balance of impaired loans in the portfolio and a change in our loan loss reserve estimates. During the year ended December 31, 2005, we changed our loan loss reserve policy, which included increasing our loan loss reserve estimates based on revised reserve factors by loan type that consider historical loss experience, the seasoning of our portfolio, overall economic conditions and other factors.
 
 
The increase in other income was primarily due to an increase in gain on investments, net of $6.8 million and the recognition of gains on the sale of loans of $1.3 million occurring during 2005, partially offset by a decrease in fees arising from our HUD mortgage origination services of $4.0 million and an increase in loss on derivatives of $1.7 million.
 
 
The increase in operating expenses was primarily due to higher total employee compensation, which increased $22.6 million, or 31%. The higher employee compensation was attributable to an increase in employees to 520 as of December 31, 2005 from 398 as of December 31, 2004, as well as higher incentive compensation, including an increase in restricted stock awards granted during 2005. A significant portion of employee compensation is composed of annual bonuses and restricted stock awards, which generally have a three to five year vesting period. During 2004, we established a variable methodology for employee bonuses partially based on the performance of the company, pursuant to which we accrued for employee bonuses throughout the year. For the years ended December 31, 2005 and 2004, incentive compensation totaled $44.5 million and $34.7 million, respectively. In the fourth quarter 2005, we reversed $3.7 million of accrued incentive compensation that was recorded in the first three quarters of 2005. This reversal was made to align overall incentive compensation, for our Chief Executive Officer and our Vice Chairman and former Chief Investment Officer with financial performance targets. The remaining $13.5 million increase in operating expenses for the year ended December 31, 2005 was attributable to an increase of $8.0 million in professional fees incurred in connection with our REIT election plan, an increase of $2.0 million


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in rent, an increase of $1.7 million in travel and entertainment, an increase of $0.4 million in depreciation and amortization and an increase of $1.4 million in other general business expenses.
 
Operating expenses as a percentage of average total assets decreased to 2.65% for the year ended December 31, 2005 from 3.09% for the year ended December 31, 2004. Our efficiency ratio, which represents operating expenses as a percentage of our net interest and fee income and other income, decreased to 30.05% for the year ended December 31, 2005 from 31.80% for the year ended December 31, 2004. The improvements in operating expenses as a percentage of average total assets and the efficiency ratio were attributable to controlling our operating expenses and spreading those expenses over a growing portfolio of loans. The improvement in our efficiency ratio also partially resulted from the significant increase in our net interest and fee income.
 
 
We provided for income taxes on the income earned for the year ended December 31, 2005 based on a 38.8% effective tax rate compared to a 39.2% effective tax rate for the year ended December 31, 2004.
 
Financial Condition
 
Commercial Lending & Investment Segment
 
 
We provide commercial loans to businesses that require customized and sophisticated financing. We also invest in real estate and selectively make equity investments. As of December 31, 2006 and 2005, our commercial lending and investment portfolio comprised the following:
 
                 
    December 31,  
    2006     2005  
    ($ in thousands)  
 
Commercial loans
  $ 7,850,198     $ 5,987,743  
Direct real estate investments
    722,303        
Equity investments
    150,090       126,393  
                 
Total
  $ 8,722,591     $ 6,114,136  
                 


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Our total commercial loan portfolio reflected in the portfolio statistics below includes loans, loans held for sale and receivables under reverse-repurchase agreements. The composition of our commercial loan portfolio by loan type and by commercial finance business as of December 31, 2006 and 2005 was as follows:
 
                                 
    December 31,  
    2006     2005  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                               
Senior secured asset-based loans (1)
  $ 2,599,014       33 %   $ 2,022,123       34 %
First mortgage loans (1)
    2,542,222       32       1,970,709       33  
Senior secured cash flow loans (1)
    2,105,152       27       1,740,184       29  
Subordinate loans
    603,810       8       254,727       4  
                                 
Total
  $ 7,850,198       100 %   $ 5,987,743       100 %
                                 
Composition of loan portfolio by business:
                               
Healthcare and Specialty Finance
  $ 2,775,748       35 %   $ 2,281,419       38 %
Structured Finance
    2,839,716       36       1,909,149       32  
Corporate Finance
    2,234,734       29       1,797,175       30  
                                 
Total
  $ 7,850,198       100 %   $ 5,987,743       100 %
                                 
 
 
(1) Includes Term B loans.
 
We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this section, we count each loan or client separately and do not aggregate loans to related entities. The number of loans, average loan size, number of clients and average loan size per client by commercial finance business as of December 31, 2006 was as follows:
 
                                 
                      Average Loan
 
    Number
    Average
    Number of
    Size per
 
    of Loans     Loan Size     Clients     Client  
    ($ in thousands)  
 
Composition of loan portfolio by business:
                               
Healthcare and Specialty Finance
    445     $ 6,238       304     $ 9,131  
Structured Finance
    255       11,136       216       13,147  
Corporate Finance
    372       6,007       172       12,993  
                                 
Overall loan portfolio
    1,072       7,323       692       11,344  
                                 


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The scheduled maturities of our commercial loan portfolio by loan type as of December 31, 2006 were as follows:
 
                                 
    Due in
    Due in
             
    One Year
    One to
    Due After
       
    or Less     Five Years     Five Years     Total  
    ($ in thousands)  
 
Scheduled maturities by loan type:
                               
Senior secured asset-based loans (1)
  $ 647,092     $ 1,949,704     $ 2,218     $ 2,599,014  
First mortgage loans (1)
    771,500       1,595,166       175,556       2,542,222  
Senior secured cash flow loans (1)
    276,151       1,686,068       142,933       2,105,152  
Subordinate loans
    150,399       135,425       317,986       603,810  
                                 
Total
  $ 1,845,142     $ 5,366,363     $ 638,693     $ 7,850,198  
                                 
 
 
(1) Includes Term B loans.
 
The dollar amounts of all fixed-rate and adjustable-rate commercial loans by loan type as of December 31, 2006 were as follows:
 
                         
    Adjustable
    Fixed
       
    Rates     Rates     Total  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                       
Senior secured asset-based loans (1)
  $ 2,562,916     $ 36,098     $ 2,599,014  
First mortgage loans (1)
    2,198,996       343,226       2,542,222  
Senior secured cash flow loans (1)
    2,087,634       17,518       2,105,152  
Subordinate loans
    530,146       73,664       603,810  
                         
Total
  $ 7,379,692     $ 470,506     $ 7,850,198  
                         
Percentage of total loan portfolio     94%       6%       100%  
                         
 
 
(1) Includes Term B loans.
 
As of December 31, 2006, our Healthcare and Specialty Finance, Structured Finance and Corporate Finance businesses had commitments to lend up to an additional $2.1 billion, $1.5 billion and $0.5 billion, respectively, to 304, 216 and 172 existing clients, respectively. Throughout 2006, the mix of outstanding loans in our commercial loan portfolio has shifted to a greater percentage of first mortgage and asset-based loans, including complementary fixed rate and low leverage real estate products, which have become more attractive as a result of our status as a REIT.


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As of December 31, 2006 and 2005, the principal balances of loans 60 or more days contractually delinquent, non-accrual loans and impaired loans in our commercial lending portfolio were as follows:
 
                 
    December 31,  
Commercial Loan Asset Classification
  2006     2005  
    ($ in thousands)  
 
Loans 60 or more days contractually delinquent
  $ 88,067     $ 41,785  
Non-accrual loans(1)
    183,483       137,446  
Impaired loans(2)
    281,377       199,257  
Less: loans in multiple categories
    (230,469 )     (175,070 )
                 
Total
  $ 322,458     $ 203,418  
                 
Total as a percentage of total loans     4.11%       3.40%  
Total as a percentage of all commercial assets     3.76%       3.40%  
 
 
(1) Includes commercial loans with an aggregate principal balance of $47.0 million and $37.6 million as of December 31, 2006 and 2005, respectively, which were also classified as loans 60 or more days contractually delinquent.
 
(2) Includes commercial loans with an aggregate principal balance of $47.0 million and $37.6 million as of December 31, 2006 and 2005, respectively, which were also classified as loans 60 or more days contractually delinquent, and commercial loans with an aggregate principal balance of $183.5 million and $137.4 million as of December 31, 2006 and 2005, respectively, which were also classified as loans on non-accrual status.
 
Reflective of principles established in Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan (“SFAS No. 114”), we consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the original loan agreement. In this regard, impaired loans includes those loans where we expect to encounter a significant delay in the collection of, and/or shortfall in the amount of, contractual payments due to us.
 
During the year ended December 31, 2006, we classified commercial loans with an aggregate carrying value of $194.7 million as of December 31, 2006 as troubled debt restructurings as defined by SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructurings. As of December 31, 2006, commercial loans with an aggregate carrying value of $194.7 million were classified as troubled debt restructurings. Additionally, under SFAS No. 114, loans classified as troubled debt restructurings are also assessed as impaired, generally for a period of at least one year following the restructuring. The allocated reserve for commercial loans classified as troubled debt restructurings was $31.5 million as of December 31, 2006. For the year ended December 31, 2005, commercial loans with an aggregate carrying value of $73.7 million as of December 31, 2005 were classified as troubled debt restructurings. The allocated reserve for commercial loans classified as troubled debt restructurings was $13.6 million as of December 31, 2005.
 
Middle market lending involves credit risks that we believe will result in further credit losses in our portfolio. We have provided an allowance for loan losses to cover estimated losses inherent in our commercial loan portfolio. Our allowance for loan losses was $120.6 million and $87.4 million as of December 31, 2006 and 2005, respectively. These amounts equate to 1.54% and 1.46% of gross loans as of December 31, 2006 and 2005, respectively. This increase is primarily due to additional charge offs recognized during the year ended December 31, 2006 as compared to the year ended December 31, 2005. Of our total allowance for loan losses as of December 31, 2006 and 2005, $37.8 million and $33.1 million, respectively, were allocated to impaired loans. During the years ended December 31, 2006 and 2005, we charged off loans totaling $48.0 million and $13.5 million, respectively. Net charge offs as a percentage of average loans were 0.69% and 0.27% for the years ended December 31, 2006 and 2005, respectively.


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During 2006, we began acquiring real estate for long-term investment purposes. These direct real estate investments are generally leased to clients through the execution of long-term, triple-net operating leases. Under a typical triple-net lease, the client agrees to pay a base monthly operating lease payment and all facility operating expenses as well as make capital improvements. As of December 31, 2006, we had $722.3 million in direct real estate investments which consisted primarily of land and buildings.
 
 
We commonly acquire equity interests in connection with loans to clients. These investments include common stock, preferred stock, limited liability company interests, limited partnership interests and warrants to purchase equity instruments. In the past, we have also invested in debt securities, the majority of which were sold during the year ended December 31, 2006.
 
As of December 31, 2006 and 2005, the carrying values of our investments in our Commercial Lending & Investment segment were $150.1 million and $126.4 million, respectively. Included in these balances were investments carried at fair value totaling $34.6 million and $60.7 million, respectively.
 
Residential Mortgage Investment Segment
 
 
We invest directly in residential mortgage investments and as of December 31, 2006 and 2005, our portfolio of residential mortgage investments was as follows:
 
                 
    December 31,  
    2006     2005  
    ($ in thousands)  
 
Mortgage-related receivables(1)
  $ 2,295,922     $  
Residential mortgage-backed securities:
               
Agency(2)
    3,502,753       2,290,952  
Non-Agency(2)
    34,243        
                 
Total
  $ 5,832,918     $ 2,290,952  
                 
 
 
(1) Represents secured receivables that are backed by adjustable rate residential prime mortgage loans.
 
(2) See following paragraph for a description of these securities.
 
We invest in RMBS, which are securities collateralized by residential mortgage loans. These Agency MBS include mortgage-backed securities whose payments of principal and interest are guaranteed by Fannie Mae or Freddie Mac. We also have invested in Non-Agency MBS, which are RMBS that are not issued by Fannie Mae or Freddie Mac and that are credit-enhanced through various mechanisms inherent in the corresponding securitization structures. Substantially all of our RMBS are collateralized by adjustable rate residential mortgage loans, including hybrid adjustable rate mortgage loans. We account for our Agency MBS as debt securities that are classified as trading investments and included in mortgage-backed securities pledged, trading on our accompanying audited consolidated balance sheets. We account for our Non-Agency MBS as debt securities that are classified as available-for-sale and included in investments on our accompanying audited consolidated balance sheets. The coupons on the loans underlying RMBS are fixed for stipulated periods of time and then reset annually thereafter. The weighted average net coupon of Agency MBS in our portfolio was 4.89% as of December 31, 2006 and the weighted average reset date for the portfolio was approximately 46 months. The weighted average net coupon of Non-Agency MBS in our portfolio was 8.41% as of December 31, 2006. The fair values of our Agency MBS and Non-Agency MBS were $3.5 billion and $34.2 million, respectively, as of December 31, 2006.
 
As of December 31, 2005, we owned $2.0 billion of Agency MBS that were simultaneously financed with repurchase agreements with the same counterparty from whom the investments were purchased. Because of this purchase and financing relationship, these transactions were recorded net on our accompanying


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audited consolidated balance sheet as of December 31, 2005 such that a forward commitment to purchase Agency MBS was recognized for financial statement purposes as well as a margin-related cash deposit that was made in connection with the related repurchase agreements. These commitments, which were accounted for as derivatives, were considered forward commitments to purchase mortgage-backed securities and were recorded at their estimated fair value with changes in fair value included in income for the year ended December 31, 2005. The fair value, including accrued interest, of these forward commitments to purchase Agency MBS was $11.8 million as of December 31, 2005. In March 2006, we exercised our right to substitute collateral assigned to repurchase agreements that were executed to finance the purchase of Agency MBS. In so doing, we concluded that we obtained effective control over the Agency MBS and, therefore, recognized acquired Agency MBS and the principal balance of amounts used pursuant to the corresponding repurchase agreements on our balance sheet at fair value at the date the substitution was completed.
 
As of December 31, 2006, we had $2.3 billion in mortgage-related receivables secured by prime residential mortgage loans. As of December 31, 2006, the weighted average interest rate on these receivables was 5.38%, and the weighted average contractual maturity was approximately 29 years. See further discussion on our accounting treatment of mortgage-related receivables in Note 4, Mortgage-Related Receivables and Related Owners Trust Securitizations, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
 
We recorded a provision for loan losses of $0.4 million related to our mortgage-related receivables during the year ended December 31, 2006 and the allowance for loan losses was $0.4 million as of December 31, 2006. To date, we have experienced no charge offs on these investments.
 
 
We have financed our investments in RMBS primarily through repurchase agreements. As of December 31, 2006 and 2005, our outstanding repurchase agreements totaled $3.4 billion and $2.2 billion, respectively. As of December 31, 2006, repurchase agreements that we executed had maturities of between 8 and 38 days and a weighted average borrowing rate of 5.32%.
 
Our investments in residential mortgage-related receivables were financed primarily through debt issued in connection with two securitization transactions. As of December 31, 2006, the total outstanding balance of these debt obligations was $2.3 billion. The interest rates on all classes of the notes within each securitization are fixed for various periods of time and then reset annually thereafter, with a weighted average interest rate of 4.94% as of December 31, 2006. The notes within each securitization are expected to mature at various dates through 2036.
 
The interest rates on our repurchase agreements, securitization-based debt and other financings may change at different times and in different magnitudes than the interest rates earned on our residential mortgage investments. See Market Risk Management below for a discussion of our interest rate risk management program related to our residential mortgage investment portfolio.
 
 
Liquidity is a measurement of our ability to meet potential cash requirements, which include funding our existing commercial loan and investment commitments, acquiring residential mortgage investments, funding ongoing commitments to repay borrowings, paying dividends and for other general business purposes. Our primary sources of funds consist of cash flows from operations, borrowings under our existing and future repurchase agreements, credit facilities, term debt, subordinated debt and convertible debt, proceeds from issuances of equity and other sources. We believe these sources of financing are sufficient to meet our short-term liquidity needs. We have applied for an Industrial Loan Corporation charter with the Federal Deposit Insurance Corporation (“FDIC”). If the charter is granted, we expect to obtain additional funds through the brokered deposit market.
 
As of December 31, 2006, the amount of our unfunded commitments to extend credit to our clients exceeded our unused funding sources and unrestricted cash by $1.1 billion. We expect that our commercial loan commitments


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will continue to exceed our available funds indefinitely. Our obligation to fund unfunded commitments generally is based on our clients’ ability to provide additional collateral to secure the requested additional fundings, the additional collateral’s satisfaction of eligibility requirements and our clients’ ability to meet certain other preconditions to borrowing. Provided our clients’ additional collateral meets all of the eligibility requirements of our funding sources, we believe that we have sufficient funding capacity to meet short-term needs related to unfunded commitments. If we do not have sufficient funding capacity to satisfy these commitments, our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract liability for us and damage our reputation in the marketplace, which could have a material adverse effect on our business.
 
As a result of our decision to make an election to REIT status, we may continue to acquire additional residential mortgage investments. As discussed below, we have funded and expect to continue to fund these purchases primarily through repurchase agreements and term debt using leverage consistent with industry standards for these assets.
 
We will determine our long-term liquidity and capital resource requirements based on the growth rate of our portfolio and other assets. Additionally, as a REIT, our growth must be funded largely by external sources of capital due to the requirement to distribute at least 90% of our REIT taxable income to our shareholders to qualify as a REIT. We are not required to distribute the taxable income related to our TRSs and, therefore, have the flexibility to retain these earnings. We intend to pay dividends at least equal to 90% of our REIT taxable income. We may cause our TRSs to pay dividends to us to increase our REIT taxable income, subject to the REIT gross income limitations. If we are limited in the amount of dividends we can receive from our TRSs, we intend to use other sources of cash to fund dividend payments. In 2006, our TRSs paid a $75.0 million dividend to us.
 
We anticipate that we will need to raise additional capital from time to time to support our growth. In addition to raising equity, we plan to continue to access the debt market for capital and to continue to explore additional sources of financing. We expect these financings will include additional secured and unsecured credit facilities, secured and unsecured term debt, subordinated debt, repurchase agreements, equity-related securities such as convertible debt and/or other financing sources. We cannot assure you, however, that we will have access to any of these funding sources in the future.
 
 
As of December 31, 2006 and 2005, we had $396.2 million and $323.9 million, respectively, in cash and cash equivalents. We invest cash on hand in short-term liquid investments.
 
We had $240.9 million and $284.8 million of restricted cash as of December 31, 2006 and 2005, respectively. The restricted cash primarily represents both principal and interest collections on loans collateralizing our term debt and on loans pledged to our credit facilities. We also have restricted cash representing other items such as client holdbacks, escrows and securities pledged as collateral to secure our repurchase agreements and related derivatives. Principal repayments, interest rate swap payments, interest payable and servicing fees are deducted from the monthly principal and interest collections funded by loans collateralizing our credit facilities and term debt, and the remaining restricted cash is returned to us and becomes unrestricted at that time.
 
 
For the years ended December 31, 2006 and 2005, we used cash from operations of $0.4 million and $224.7 million, respectively. Included within these amounts are cash outflows related to the purchase of Agency MBS that are classified as trading investments and loans held for sale. For the year ended December 31, 2004, we generated cash flow from operations of $140.8 million.
 
Cash from our financing activities is generated from proceeds from our issuance of equity, borrowings on our repurchase agreements, credit facilities and term debt and from our issuance of convertible debt and subordinated debt. Our financing activities primarily use cash to repay term debt borrowings and to pay cash dividends. For the years ended December 31, 2006, 2005 and 2004, we generated cash flow from financing activities of $4.8 billion, $2.1 billion and $1.9 billion, respectively.


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Investing activities primarily relate to loan origination, purchases of residential mortgage investments, primarily mortgage-related receivables, and acquisitions of direct real estate investments. For the years ended December 31, 2006, 2005 and 2004, we used cash in investing activities of $4.8 billion, $1.7 billion and $2.0 billion, respectively.
 
 
As of December 31, 2006 and 2005, we had outstanding borrowings totaling $12.9 billion and $5.4 billion, respectively. Borrowings under our repurchase agreements, credit facilities, term debt, convertible debt and subordinated debt have supported our growth. For a detailed discussion of our borrowings, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
Our funding sources, maximum facility amounts, amounts outstanding, and unused available commitments, subject to certain minimum equity requirements and other covenants and conditions as of December 31, 2006 were as follows:
 
                         
    Maximum
             
    Facility
    Amount
    Unused
 
Funding Source
  Amount     Outstanding     Capacity (2)  
    ($ in thousands)  
 
Repurchase agreements
  $  3,810,768     $ 3,510,768     $ 300,000  
Unsecured credit facilities
    640,000       355,685       284,315  
Secured credit facilities
    4,310,820       2,183,155       2,127,665  
                         
Subtotal
  $ 8,761,588       6,049,608     $ 2,711,980  
                         
Term debt(1)
            5,809,685          
Convertible debt(1)
            555,000          
Subordinated debt(1)
            446,393          
                         
Total
          $ 12,860,686          
                         
 
 
(1) Our term debt, convertible debt and subordinated debt are one-time fundings that do not provide any ability for us to draw down additional amounts.
(2) Excludes issued and outstanding letters of credit totaling $130.1 million as of December 31, 2006.
 
Our overall debt strategy emphasizes diverse sources of financing including both secured and unsecured financings. As of December 31, 2006, approximately 89% of our debt was collateralized by our loans and residential mortgage investments and 11% was unsecured. We intend to increase our percentage of unsecured debt over time through both unsecured credit facilities and unsecured term debt. Fitch Ratings issued an investment grade rating to our senior unsecured debt during 2005. As we continue to grow, we expect to obtain investment grade ratings from other rating agencies and to improve these ratings over time. As our ratings improve, we should be able to issue more unsecured debt relative to the amount of our secured debt. In any case, we intend to maintain prudent levels of leverage and currently expect our debt to equity ratio on our commercial lending portfolio to remain below 5x.
 
 
We entered into seven new master repurchase agreements during the year ended December 31, 2006. We also borrowed under our new and existing repurchase agreements with various financial institutions to finance purchases of RMBS during the year. RMBS and short term liquid investments collateralize our repurchase agreements as of December 31, 2006. Substantially all of our repurchase agreements and related derivative instruments require us to deposit additional collateral if interest rates change or the market value of existing collateral declines, which may require us to sell assets to reduce our borrowings.


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During the year ended December 31, 2006, we increased our committed credit facility capacity by $870.6 million to $5.0 billion. This net increase in capacity primarily resulted from the addition of a $640.0 million unsecured credit facility, the addition of a $834.8 million secured credit facility in our QRS and a $930.0 million capacity increase in our previously existing QRS secured credit facility. These increases were partially offset by decreased capacity, totaling $1.5 billion, in one of our TRS’s subsidiary’s credit facilities. As of December 31, 2006, we had seven credit facilities, six of which are secured and one of which is unsecured, with a total of 20 financial institutions that we primarily use to fund our loans and for general corporate purposes. To date, many loans have been held, or warehoused, in our secured credit facilities until we complete a term debt transaction in which we securitize a pool of loans from these facilities. We primarily use the proceeds from our term debt transactions to pay down our credit facilities, which results in increased capacity to redraw on them as needed. As of December 31, 2006, one of our credit facilities, with a total capacity of $906.0 million, is scheduled to mature within one year. The amount outstanding under this facility was $403.4 million as of December 31, 2006. Our other six credit facilities, with a total capacity of $4.1 billion, have scheduled maturity dates between one and three years, of which $3.1 billion is subject to annual renewal.
 
In addition, in December 2006, we entered into a $287.1 million loan agreement with Column Financial Inc. to finance the acquisition of 65 of the healthcare properties we hold as direct real estate investments. Under the terms of this agreement, we are required to make monthly payments based upon a 25-year amortization and an interest rate equal to the sum of the bid side yield of a U.S. Treasury obligation having a maturity of January 2017 plus the prevailing ten-year U.S. Treasury swap rate plus 1.90%. Under the terms of a letter agreement signed at closing, we were provided with an option to modify the loan agreement by mutual consent or to prepay the outstanding principal balance without penalty. As extended this option expires on March 29, 2007. As of December 31, 2006, the balance of this loan agreement is included in secured credit facilities on our accompanying audited consolidated balance sheet.
 
 
In April 2006, we completed a $782.3 million term debt transaction. The transaction covers the sale of $715.8 million of floating-rate asset-backed notes, which are backed by a $782.3 million diversified pool of commercial loans from our TRS portfolio. The offered notes represent 91.5% of the collateral pool, and we retained an 8.5% interest in the collateral pool. The blended pricing for the offered notes (excluding fees) was one-month LIBOR plus 25.3 basis points. We used the proceeds primarily to repay outstanding indebtedness under certain of our credit facilities.
 
In September 2006, we completed a $1.5 billion term debt transaction that includes a three-year replenishment period allowing us, subject to certain restrictions, to reinvest principal payments into new loan collateral from our TRSs. The transaction covers the sale of $1.3 billion of floating-rate asset-backed notes, which are backed by a $1.5 billion diversified pool of senior and subordinated commercial loans from our TRS portfolio. The value of the offered notes represents 88.5% of the value of the collateral pool, and we retained an 11.5% interest in the collateral pool. The blended pricing for the offered notes (excluding fees) was one-month LIBOR plus 39.4 basis points. In October 2006, we sold $20.0 million of the floating-rate asset-backed notes initially retained, increasing the total value of the notes sold to 89.8% of the value of the collateral pool. We used the proceeds from this offering primarily to repay outstanding indebtedness under certain of our credit facilities.
 
In December 2006, we completed our inaugural term debt issuance from our QRS, which was a $1.3 billion term debt transaction that includes a five-year replenishment period allowing us, subject to certain restrictions, to reinvest principal payments into new loan collateral. The transaction covers the sale of $1.2 billion of floating-rate asset-backed notes which are backed by a $1.3 billion diversified pool of commercial real estate loans from our QRS portfolio. The value of the offered notes represents 91.7% of the value of the collateral pool, and we retained an 8.3% interest in the collateral pool. The blended pricing for the offered notes (excluding fees) was three-month LIBOR plus 39.7 basis points. We used the proceeds to repay outstanding indebtedness under certain of our credit facilities.


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In February 2006, we purchased beneficial interests in securitization trusts (the “Owner Trusts”) which issued $2.4 billion in notes (the “Senior Notes”) and $105.6 million in subordinate notes backed by $2.5 billion of a diversified pool of adjustable rate commercial loans.
 
In the first securitization, the Owner Trusts issued $1.5 billion in Senior Notes and $65.4 million in subordinate notes. The interest rates on the Class I-A1 and I-A2 Senior Notes have an initial fixed interest rate of 4.90% until the initial reset date of February 1, 2010. The interest rates on the Class II-A1 and II-A2 Senior Notes have an initial fixed interest rate of 4.70% until the initial reset date of October 1, 2010. The interest rates on the Class III-A1 and III-A2 Senior Notes have an initial fixed interest rate of 5.50% until the initial reset date of January 1, 2011. After the initial reset date, the interest rates on all classes of the Senior Notes will reset annually based on a blended rate of one-year constant maturity treasury index (“CMT”) plus 240 basis points, up to specified caps. These Senior Notes, which were sold to third parties, are expected to mature at various dates through March 25, 2036. One of our subsidiaries purchased the subordinate notes. The outstanding balance of these Senior Notes and subordinate notes was $1.4 billion as of December 31, 2006.
 
In the second securitization, the Owner Trusts issued $940.9 million in Senior Notes and $40.2 million in subordinate notes. The interest rates on all classes of the Senior Notes, which were sold to third parties, have an initial fixed interest rate of 4.63% until the initial reset date of November 1, 2010. After the initial reset date, the interest rates of the Senior Notes will reset annually based on a blended rate of one-year CMT plus 225 basis points, up to specified caps. These Senior Notes are expected to mature on February 26, 2036. One of our subsidiaries purchased the subordinate notes. The outstanding balance of these Senior Notes and subordinate notes was $895.0 million as of December 31, 2006.
 
The accounting treatment of these two securitization transactions is further discussed in Note 4, Mortgage-Related Receivables and Related Owners Trust Securitizations, and Note 11, Borrowings.
 
 
We have outstanding $225.0 million in aggregate principal amount of senior convertible debentures due 2034 (the “March 2004 Debentures”) and $330.0 million in aggregate principal amount of senior convertible debentures due July 2034 (the “July 2004 Debentures”, together with the March 2004 Debentures, the “Debentures” or “Contingent Convertibles”). Until March 2009, the March 2004 Debentures will bear interest at a rate of 1.25%, after which time the debentures will not bear interest. As of December 31, 2006, the March 2004 Debentures are convertible, subject to certain conditions described below, into shares of our common stock at a rate of 39.6859 shares of common stock per $1,000 principal amount of debentures. The conversion rate will adjust each time we pay a dividend on our common stock, with the fair value of each adjustment taxable to the holders. The March 2004 Debentures will be redeemable for cash at our option at any time on or after March 15, 2009 at a redemption price of 100% of their principal amount plus accrued interest. Holders of the March 2004 Debentures will have the right to require us to repurchase some or all of their debentures for cash on March 15, 2009, March 15, 2014, March 15, 2019, March 15, 2024 and March 15, 2029 at a price of 100% of their principal amount plus accrued interest. Holders of the March 2004 Debentures will also have the right to require us to repurchase some or all of their March 2004 Debentures upon certain events constituting a fundamental change.
 
Holders of the March 2004 Debentures may convert their debentures prior to maturity only if: (1) the sale price of our common stock reaches specified thresholds, (2) the trading price of the March 2004 Debentures falls below a specified threshold, (3) the March 2004 Debentures have been called for redemption, or (4) specified corporate transactions occur. See Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2006 for a detailed discussion of these conditions.
 
The July 2004 Debentures will pay contingent interest, subject to certain limitations, beginning on July 15, 2011. As of December 31, 2006, the July 2004 Debentures are convertible, subject to certain conditions described below, into shares of our common stock at a rate of 37.9561 shares of common stock per $1,000 principal amount of debentures. The conversion rate will adjust each time we pay a dividend on our common stock, with the fair value of each adjustment taxable to the holders. The July 2004 Debentures will be redeemable for cash at our option at any


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time on or after July 15, 2011 at a redemption price of 100% of their principal amount plus accrued interest. Holders of the July 2004 Debentures will have the right to require us to repurchase some or all of their July 2004 Debentures for cash on July 15, 2011, July 15, 2014, July 15, 2019, July 15, 2024 and July 15, 2029 at a price of 100% of their principal amount plus accrued interest. Holders of the July 2004 Debentures will also have the right to require us to repurchase some or all of their July 2004 Debentures upon certain events constituting a fundamental change.
 
Holders of the July 2004 Debentures may convert their debentures prior to maturity only if: (1) the sale price of our common stock reaches specified thresholds, (2) the trading price of the July 2004 Debentures falls below a specified threshold, (3) the July 2004 Debentures have been called for redemption, or (4) specified corporate transactions occur. See Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2005 for a detailed discussion of these conditions.
 
To the extent that the respective conversion prices are adjusted below the price of our common stock at the time the Debentures were issued, we would be required to record a beneficial conversion option which would impact both our net income and net income per share. This has not occurred as of December 31, 2006.
 
 
We periodically issue subordinated debt to statutory trusts (“TP Trusts”) that are formed for the purpose of issuing preferred securities to outside investors, which we refer to as Trust Preferred Securities (“TPS”). We generally retain 100% of the common securities issued by the TP Trusts, representing 3% of their total capitalization. As of December 31, 2006, we had completed seven subordinated debt transactions, of which four bear interest at a floating interest rate and three bear fixed interest rates for a specified period and then bear interest at a floating interest rate until maturity. The terms of the subordinated debt issued to the TP Trusts and the TPS issued by the TP Trusts are substantially identical. The subordinated debt is unsecured and ranks subordinate and junior in right of payment to all of our other indebtedness.
 
 
CapitalSource Finance LLC, one of our wholly owned indirect subsidiaries, services loans collateralizing our secured credit facilities and term debt and is required to meet various financial and non-financial covenants. Failure to meet the covenants could result in the servicing being transferred to another servicer. The notes under the trusts established in connection with our term debt include accelerated amortization provisions that require cash flows to be applied to pay the noteholders if the notes remain outstanding beyond the stated maturity dates. We, and certain of our other wholly owned subsidiaries, also have certain financial and non-financial covenants related to our unsecured credit facility, subordinated debt and our other debt financings. As of December 31, 2006, we believe we were in compliance with all of our covenants.
 
 
In March 2006, we sold 17.6 million shares of our common stock in a public offering at a price of $23.50 per share. In connection with this offering, we received net proceeds of $395.7 million, which were used to repay outstanding borrowings under our credit facilities.
 
In March 2006, we began offering a Dividend Reinvestment and Stock Purchase Plan (the “DRIP”) to current and prospective shareholders. Participation in the DRIP allows common shareholders to reinvest cash dividends and to purchase additional shares of our common stock, in some cases at a discount from the market price. During the year ended December 31, 2006, we received proceeds of $191.0 million related to the purchase of 7.7 million shares of our common stock pursuant to the DRIP. In addition, we received proceeds of $17.2 million related to cash dividends reinvested for 0.7 million shares of our common stock during the year ended December 31, 2006.
 
 
We use SPEs as an integral part of our funding activities. We commonly service loans that we have transferred to these vehicles. The use of these special purpose entities is generally required by our lenders in connection with


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our secured debt financings. Loans that we transfer to these vehicles are legally isolated from us including if we were to be in bankruptcy.
 
We also used special purpose entities to facilitate the issuance of collateralized loan obligation transactions that are further described in Part I, Item 1, Business, of this Annual Report on Form 10-K. Additionally, we purchase beneficial ownership interests in residential mortgage assets that are held by special purpose entities established by third parties.
 
We evaluate all SPEs with whom we are affiliated to determine whether such entities must be consolidated for financial statement purposes. If we determine that such entities represent variable interest entities as defined by FASB Interpretation No. 46 (Revised 2003), Consolidation of Variable Interest Entities — An Interpretation of ARB No. 51, (“FIN 46(R)”). We consolidate these entities when we determine that we are the primary beneficiary of the entity. For special purpose entities which we determine that we are not the primary beneficiary, we account for our economic interests in these entities in accordance with the nature of our investments. As further discussed in Note 4, Mortgage-Related Receivables and Related Owners Trust Securitizations, in February 2006, we acquired beneficial interests in two special purpose entities that acquired and securitized pools of residential mortgage loans. In accordance with the provisions of FIN 46(R), we determined that we were the primary beneficiary of these SPEs and, therefore, consolidated the assets and liabilities of such entities for financial statement purposes. Additionally, and as further discussed in Note 11, Borrowings, the assets and related liabilities of all special purpose entities that we use to issue our term debt are recognized on our accompanying audited consolidated balance sheets as of December 31, 2006 and 2005.
 
 
As of December 31, 2006 and, 2005, we had unfunded commitments to extend credit to our clients of $4.1 billion and $3.2 billion, respectively. A discussion of these commitments is included in Note 21, Credit Risk, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
We have non-cancelable operating leases for office space and office equipment. The leases expire over the next ten years and contain provisions for certain annual rental escalations. A discussion of these contingencies is included in Note 18, Commitments and Contingencies, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
As of December 31, 2006, we had issued $253.2 million in letters of credit which expire at various dates over the next seven years. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be responsible to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. A discussion of these contingencies is included in Note 18, Commitments and Contingencies, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
As of December 31, 2006, we had identified conditional asset retirement obligations primarily related to the future removal and disposal of asbestos that is contained within certain of our direct real estate investment properties. For reasons further discussed in Note 18, Commitments and Contingencies, in our accompanying audited consolidated financial statements for the year ended December 31, 2006, no liability for conditional asset retirement obligations was recorded on our accompanying audited consolidated balance sheet as of December 31, 2006.
 
One of our wholly owned indirect subsidiaries has provided a limited financial guarantee to a third party warehouse lender, which financed the purchase of $125.6 million of commercial loans by a special purpose entity to which we provide advisory services in connection with its purchase of commercial loans. We have provided the warehouse lender with a limited guarantee under which we agreed to assume a portion of net losses realized in connection with those loans held by the special purpose entity up to a specified loss limit. This guarantee is due to expire on September 24, 2007 or earlier to the extent that the warehouse facility is refinanced prior to the guarantee’s expiry. In accordance with the provisions of FIN 46(R) and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, we determined that we are not required to


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recognize the assets and liabilities of this special purpose entity for financial statement purposes as of December 31, 2006.
 
In connection with certain securitization transactions, we typically make customary representations and warranties regarding the characteristics of the underlying transferred assets. Prior to any securitization transaction, we perform due diligence with respect to the assets to be included in the securitization transaction to ensure that they satisfy the representations and warranties. Due to these procedures, we believe that the potential for loss is remote and therefore no liability is recorded in our consolidated financial statements related to these representations and warranties. The outstanding loan balance related to these securitization transactions was approximately $2.3 billion as of December 31, 2006.
 
In our capacity as originator and servicer in certain securitization transactions, we may be required to repurchase or substitute loans which breach a representation and warranty as of their date of transfer to the securitization vehicle.
 
From time to time we are party to legal proceedings. We do not believe that any currently pending or threatened proceeding, if determined adversely to us, would have a material adverse effect on our business, financial condition or results of operations, including our cash flows.
 
Contractual Obligations
 
In addition to our scheduled maturities on our repurchase agreements, credit facilities, term debt, convertible debt and subordinated debt, we have future cash obligations under various types of contracts. We lease office space and office equipment under long-term operating leases and we have committed to contribute up to an additional $15.5 million to 13 private equity funds, $6.0 million to a joint venture and $0.8 million to an equity investment. The contractual obligations under our repurchase agreements, credit facilities, term debt, convertible debt and subordinated debt are included in the accompanying audited consolidated balance sheet as of December 31, 2006. The expected contractual obligations under our repurchase agreements, credit facilities, term debt, convertible debt, subordinated debt, operating leases and commitments under non-cancelable contracts as of December 31, 2006 were as follows:
 
                                                                         
          Unsecured
                                  Non-
       
    Repurchase
    Credit
    Secured Credit
    Term
    Convertible
    Subordinated
    Operating
    Cancelable
       
    Agreements     Facilities     Facilities     Debt (1)     Debt     Debt     Leases     Contracts     Total  
    ($ in thousands)  
 
                                                                         
2007
  $ 3,510,768     $     $ 403,400     $ 1,143,246     $     $     $ 7,899     $     $ 5,065,313  
2008
                358,602       587,596                   7,736             953,934  
2009
          355,685       1,133,970       553,857       225,000             6,617             2,275,129  
2010
                      383,382                   6,159       818       390,359  
2011
                      387,717       330,000             5,842       2,175       725,734  
Thereafter
                287,183       2,775,502             446,393       9,389       19,283       3,537,750  
                                                                         
Total
  $ 3,510,768     $ 355,685     $ 2,183,155     $ 5,831,300     $ 555,000     $ 446,393     $ 43,642     $ 22,276     $ 12,948,219  
                                                                         
 
 
(1) Excludes net unamortized discounts of $21.6 million.
 
The contractual obligations for credit facilities are computed based on the stated maturities of the facilities not considering optional annual renewals.
 
Except for our series 2006-2 Term Debt (“2006-2”) and series 2006-A Term Debt (“2006-A”), the contractual obligations for term debt are based on the contractual maturities of the underlying loans held by the securitization trusts and an assumed constant prepayment rate of 10%. 2006-2 and 2006-A have replenishment periods that allow us, subject to certain restrictions, to reinvest principal payments into eligible new loan collateral and we assumed no prepayments would be made during these replenishment periods, but use a constant prepayment rate of 10% once the replenishment period ends. The underlying loans are subject to prepayment, which would shorten the life of the term debt transactions. The underlying loans may be amended to extend their term, which will lengthen the life of the term debt transactions. At our option, we may substitute new loans for prepaid loans up to specified limitations,


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which may also impact the life of the term debt transactions. In addition, the contractual obligations for our term debt transactions are computed based on the initial call date.
 
The contractual obligations for convertible debt are computed based on the initial put/call date. The legal maturity of the convertible debt is 2034. For further discussion of terms of our convertible debt and factors impacting their maturity see Note 2, Summary of Significant Accounting Policies, and Note 11, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2006.
 
The contractual obligations for subordinated debt are computed based on the legal maturities of the subordinated debt, which are between 2035 and 2037.
 
We enter into derivative contracts under which we are required to either receive cash or pay cash to counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the accompanying audited consolidated balance sheet as of December 31, 2006, with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of the contracts changes daily as market interest rates change. Further discussion of derivative instruments is included in Note 2, Summary of Significant Accounting Policies, and Note 20, Derivative Instruments, in our accompanying audited consolidated financial statements for the year ended December 31, 2006.
 
 
Credit risk is the risk of loss arising from adverse changes in a borrower’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. Credit risk exists primarily in our lending and derivative portfolios. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the borrower, the contractual terms of the agreement and the availability and quality of collateral. We manage credit risk of our derivatives and credit-related arrangements by limiting the total amount of arrangements outstanding by an individual counterparty, by obtaining collateral based on management’s assessment of the client and by applying uniform credit standards maintained for all activities with credit risk.
 
We have established a Credit Committee to evaluate and approve credit standards and to oversee the credit risk management function related to our commercial loans and investments. The Credit Committee’s primary responsibilities include ensuring the adequacy of our credit risk management infrastructure, overseeing credit risk management strategies and methodologies, monitoring conditions in real estate and other markets having an impact on lending activities, and evaluating and monitoring overall credit risk.
 
 
Credit risk management for the commercial loan and investment portfolio begins with an assessment of the credit risk profile of a client based on an analysis of the client’s financial position. As part of the overall credit risk assessment of a client, each commercial credit exposure or transaction is assigned a risk rating that is subject to approval based on defined credit approval standards. While rating criteria vary by product, each loan rating focuses on the same three factors: credit, collateral, and financial performance. Subsequent to loan origination, risk ratings are monitored on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the borrower’s or counterparty’s financial condition, cash flow or financial situation. We use risk rating aggregations to measure and evaluate concentrations within portfolios. In making decisions regarding credit, we consider risk rating, collateral, industry and single name concentration limits.
 
We use a variety of tools to continuously monitor a borrower’s or counterparty’s ability to perform under its obligations. Additionally, we utilize syndication of exposure to other entities, loan sales and other risk mitigation techniques to manage the size and risk profile of the loan portfolio.
 
 
We are exposed to changes in the credit performance of the mortgage loans underlying the Agency MBS, the Non-Agency MBS, and the mortgage related receivables. With respect to Agency MBS, while we benefit from a full guaranty from Fannie Mae or Freddie Mac, variation in the level of credit losses may impact the duration of our investments since a credit loss results in the prepayment of the relevant loan by the guarantor. With respect to Non-


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Agency MBS, the value or performance of our investment may be impacted by higher levels of credit losses, depending on the specific provisions of the relevant securitizations. With respect to mortgage related receivables, we are directly exposed to the level of credit losses on the underlying mortgage loans.
 
 
In our normal course of business, we engage in commercial lending activities with borrowers primarily throughout the United States. As of December 31, 2006 and 2005, the entire loan portfolio was diversified such that no single borrower was greater than 10% of the portfolio. As of December 31, 2006, the single largest industry concentration was skilled nursing, which made up approximately 18% of our commercial loan portfolio. As of December 31, 2006, the largest geographical concentration was Florida, which made up approximately 15% of our commercial loan portfolio. As of December 31, 2006, the single largest industry concentration in our direct real estate investment portfolio was skilled nursing, which made up approximately 98% of the investments. As of December 31, 2006, the largest geographical concentration in our direct real estate investment portfolio was Florida, which made up approximately 40% of the investments.
 
 
Derivative financial instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where we are in a favorable position. Credit risk related to derivative financial instruments is considered and provided for separately from the allowance for loan losses. We manage the credit risk associated with various derivative agreements through counterparty credit review, counterparty exposure limits and monitoring procedures. We obtain collateral from certain counterparties for amounts in excess of exposure limits and monitor all exposure and collateral requirements daily. We continually monitor the fair value of collateral received from a counterparty and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. Our agreements generally include master netting agreements whereby the counterparties are entitled to settle their positions “net.” As of December 31, 2006 and 2005, the gross positive fair value of our derivative financial instruments was $23.7 million and $5.2 million, respectively. Our master netting agreements reduced the exposure to this gross positive fair value by $16.1 million and $4.4 million as of December 31, 2006 and 2005, respectively. We did not hold collateral against derivative financial instruments as of December 31, 2006 and 2005. Accordingly, our net exposure to derivative counterparty credit risk as of December 31, 2006 and December 31, 2005 was $7.6 million and $0.8 million, respectively.
 
 
Market risk is the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions such as market movements. This risk is inherent in the financial instruments associated with our operations and/or activities including loans, securities, short-term borrowings, long-term debt, trading account assets and liabilities and derivatives. Market-sensitive assets and liabilities are generated through loans associated with our traditional lending activities and market risk mitigation activities.
 
The primary market risk to which we are exposed is interest rate risk, which is inherent in the financial instruments associated with our operations, primarily including our loans, residential mortgage investments and borrowings. Our traditional loan products are non-trading positions and are reported at amortized cost. Additionally, debt obligations that we incur to fund our business operations are recorded at historical cost. While GAAP requires a historical cost view of such assets and liabilities, these positions are still subject to changes in economic value based on varying market conditions. Interest rate risk is the effect of changes in the economic value of our loans, and our other interest rate sensitive instruments and is reflected in the levels of future income and expense produced by these positions versus levels that would be generated by current levels of interest rates. We seek to mitigate interest rate risk through the use of various types of derivative instruments. For a detailed discussion of our derivatives, see Note 20, Derivative Instruments of our accompanying audited consolidated financial statements for the year ended December 31, 2006.


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Interest rate risk in our commercial lending portfolio refers to the change in earnings that may result from changes in interest rates, primarily various short-term interest rates, including LIBOR-based rates and the prime rate. We attempt to mitigate exposure to the earnings impact of interest rate changes by conducting the majority of our lending and borrowing on a variable rate basis. The majority of our commercial loan portfolio bears interest at a spread to the prime or a LIBOR-based rate with almost all of our other loans bearing interest at a fixed rate. The majority of our borrowings bear interest at a spread to LIBOR or commercial paper rates, with the remainder bearing interest at a fixed rate. We are also exposed to changes in interest rates in certain of our fixed rate loans and investments. We attempt to mitigate our exposure to the earnings impact of the interest rate changes in these assets by engaging in hedging activities as discussed below.
 
The estimated changes in net interest income for a 12-month period based on changes in the interest rates applied to our commercial lending portfolio as of December 31, 2006 were as follows:
 
         
    Estimated (Decrease)
 
    Increase in
 
Rate Change
  Net Interest Income
 
(Basis Points)
  Over 12 Months  
    ($ in thousands)  
 
−100
  $ (12,910 )
− 50
    (5,766 )
+  50
    10,033  
+ 100
    17,346  
 
For the purposes of the above analysis, we included related derivatives, excluded principal payments and assumed a 75% advance rate on our variable rate borrowings.
 
Approximately 45% of the aggregate outstanding principal amount of our commercial loans had interest rate floors as of December 31, 2006. The loans with interest rate floors as of December 31, 2006 were as follows:
 
                 
    Amount
    Percentage of
 
    Outstanding     Total Portfolio  
    ($ in thousands)        
 
Loans with contractual interest rates:
               
Exceeding the interest rate floor
  $ 3,460,686       43 %
At the interest rate floor
    39,948       1  
Below the interest rate floor
    36,544       1  
Loans with no interest rate floor
    4,313,020       55  
                 
Total
  $ 7,850,198       100 % <