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CAPITALSOURCE 10-K 2008
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, 2007
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)
(800) 370-9431
 
 
     
(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. þ 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 þ  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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
     
þ Large accelerated filer
  o Accelerated filer
o Non-accelerated filer
  o Smaller reporting company
 
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, 2007 was $3,041,811,254.
 
As of February 15, 2008, the number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding was 224,734,693.
 
 
Portions of CapitalSource Inc.’s Proxy Statement for the 2008 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   17
  Unresolved Staff Comments   35
  Properties   35
  Legal Proceedings   37
  Submission of Matters to a Vote of Security Holders   37
 
PART II
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   37
  Selected Financial Data   40
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   43
  Quantitative and Qualitative Disclosures About Market Risk   74
    Management Report on Internal Controls Over Financial Reporting   76
    Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting   77
  Financial Statements and Supplementary Data   78
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   142
  Controls and Procedures   142
  Other Information   142
 
PART III
  Directors, Executive Officers and Corporate Governance   143
  Executive Compensation   144
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   144
  Certain Relationships and Related Transactions, and Director Independence   144
  Principal Accounting Fees and Services   144
 
PART IV
  Exhibits and Financial Statement Schedules   145
    Signatures   146
    Index to Exhibits   147
    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 the Private Securities Litigation Reform Act of 1995, which are subject to numerous assumptions, risks, and uncertainties. All statements contained in this Form 10-K that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “expect,” “estimate,” “plan,” and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding future financial and operating results) involve risks, uncertainties and contingencies, many of which are beyond our control which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: changes in economic or market conditions; continued or worsening disruptions in credit markets may make it difficult for us to obtain debt financing on attractive terms or at all and could prevent us from optimizing the amount of leverage we employ; movements in interest rates and lending spreads may adversely affect our borrowing strategy; we may be unsuccessful in pursuing our deposit funding strategy, despite significant efforts; competitive and other market pressures could adversely affect loan pricing; the nature, extent, and timing of any governmental actions and reforms, or changes in tax laws or regulations affecting REITs; hedging activities may result in reported losses not offset by gains reported in our consolidated financial statements; and other factors described in this Form 10-K and documents filed by us with the SEC. All forward-looking statements included in this Form 10-K are based on information available at the time the statement is made.
 
We are under no obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise.
 
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 finance, investment and asset management company focused on the middle market. We operate as a real estate investment trust (“REIT”) and provide senior and subordinate commercial loans, invest in real estate and residential mortgage assets, and engage in asset management and servicing activities.
 
We operate as three reportable segments: 1) Commercial Finance, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Our Commercial Finance segment comprises our commercial lending business activities; our Healthcare Net Lease segment comprises our direct real estate investment business activities; and our Residential Mortgage Investment segment comprises our residential mortgage investment activities. For financial information about our segments, see Note 24, Segment Data, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
Through our Commercial Finance segment 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. As of December 31, 2007, we had 1,214 loans outstanding under which we had funded an aggregate of $9.9 billion and committed to lend up to an additional $4.7 billion.
 
Through our Healthcare Net Lease segment activities, we invest in income-producing healthcare facilities, principally long-term care facilities in the United States. We provide lease financing to skilled nursing facilities and, to a lesser extent, assisted living facilities, rehabilitation and acute care facilities. As of December 31, 2007, we had


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$1.0 billion in direct real estate investments comprised of 186 healthcare facilities that were leased to 41 tenants through long-term, triple-net operating leases.
 
Through our Residential Mortgage Investment segment activities we invest in certain residential mortgage assets to optimize our REIT structure. As of December 31, 2007, our residential mortgage investment portfolio totaled $6.1 billion, which included investments in residential mortgage loans and residential mortgage-backed securities (“RMBS”). Over 99% of our investments in RMBS are represented by mortgage-backed securities that were issued and guaranteed by Fannie Mae or Freddie Mac (hereinafter, “Agency MBS”). In addition, we hold mortgage-related receivables secured by prime residential mortgage loans.
 
In our Commercial Finance and Healthcare Net Lease segments, 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 products that satisfy the special financing needs of our clients.
 
These three primary commercial finance businesses are:
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in widely syndicated loan transactions;
 
  •  Healthcare and Specialty Finance, which, including our Healthcare Net Lease segment activities, generally provides first mortgage loans, asset-based revolving lines of credit, and other cash flow loans to healthcare businesses and a broad range of other companies and makes investments in income-producing healthcare facilities, particularly long-term care facilities; and
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies.
 
Although we make loans as large as $400 million, our average commercial loan size was $8.1 million as of December 31, 2007, and our average loan exposure by client was $13.0 million as of December 31, 2007. Our commercial loans generally have a maturity of two to five years with a weighted average maturity of 3.3 years as of December 31, 2007. 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, 2007, our geographically diverse client base consisted of 759 clients with headquarters in 48 states, the District of Columbia, Puerto Rico and select international locations, primarily in Canada and Europe.
 
 
Maintaining broad and diverse funding sources has been a key to our funding strategy since inception. We have identified obtaining deposit based funding as a potentially attractive method of further broadening and diversifying our funding.
 
In May 2007, we announced an agreement to acquire TierOne Corporation (“TierOne”), the holding company for TierOne Bank, a Lincoln, Nebraska-based thrift with more than $3.5 billion in assets and $2.4 billion of deposits as of September 30, 2007. The transaction was approved by TierOne shareholders on November 29, 2007. TierOne Bank offers customers a wide variety of full-service consumer, commercial and agricultural banking products and services through a network of 69 banking offices located in Nebraska, Iowa and Kansas and nine loan production offices located in Arizona, Colorado, Florida, Minnesota, Nevada and North Carolina. As of December 31, 2007, the stock and cash merger under the original terms was valued at approximately $25.80 per share of TierOne common stock. We originally entered into the TierOne transaction to achieve our strategic goal of obtaining a depository charter to join our direct lending platform with the stability, efficiency and diversity of a sound community banking franchise. The transaction remains subject to approval by the Office of Thrift Supervision.


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Because the transaction was not completed by its nine-month anniversary, February 17, 2008, both parties have the right to terminate the transaction, and our Board of Directors has authorized our Chairman and Chief Executive Officer to either terminate the merger or negotiate new terms for the transaction.
 
In 2005, we applied for an Industrial Loan Corporation (“ILC”) charter with the State of Utah and for federal deposit insurance with the Federal Deposit Insurance Corporation (“FDIC”). We anticipate that once operational, the ILC would enable us to obtain an additional source of funding for our loans by raising wholesale deposits in the brokered deposit market. In March 2007, the FDIC approved our application for federal deposit insurance, subject to certain conditions. The Order issued by the FDIC expires on March 20, 2008 if the conditions of the Order have not been met. We have requested an extension of the expiration date to December 31, 2008 as it has taken longer than anticipated to satisfy certain conditions in the Order. The extension request is currently pending with the FDIC. We cannot assure you that the FDIC will act on our extension request prior to the expiration of the Order, or if it does act, that it will approve our request. If the FDIC does not grant our extension request, the Order will expire.
 
 
During the second half of 2007, we witnessed a significant disruption in the capital markets that affected many financial institutions. What began with concerns about rising delinquencies and potential defaults in sub-prime mortgages and related securities broadened to affect the mortgage markets more generally and, ultimately, all credit markets. The effects of this disruption resulted in a substantial reduction in liquidity for certain assets, greater pricing for risk and de-leveraging.
 
During the second half of 2007, we saw and continue to see negative effects from the disruption in the form of a higher cost of funds on our borrowings as measured by a spread to LIBOR. We also expect to experience greater difficulty and higher cost in securing term debt for our loans, especially commercial real estate.
 
Due to the market disruption, the financings we completed during the second half of 2007 were more expensive and provided lower leverage than similar financings we completed prior to that period. We expect to see higher borrowing costs and potentially lower advance rates on our secured credit facilities as we seek to renew them in 2008. We may not be able to renew all of those facilities at their existing commitment levels. However, our commercial finance business model has been built around low leverage, and we do not seek to maximize leverage. As a result, we believe we can withstand some reduction in the advance rates of our facilities and expect to retain sufficient committed capacity to fund our business. While we expect the trend toward lower leverage and incrementally more expensive financings to continue in 2008, we believe that these same market conditions that adversely affect us as a borrower have allowed and will continue to allow us, as a lender, to structure new loans on more favorable terms and at higher yields.
 
It is possible this market disruption could adversely affect the U.S. economy as a whole. While to date we have not seen signs of material deterioration in the credit performance of our portfolio, further declines in economic conditions could adversely affect our clients’ ability to fulfill their obligations to us and our ability to fund our business activities.
 
During 2007, we also saw decreases in the carrying value of certain of our residential mortgage investments, representing a decline of approximately 1.2% in the value of the portfolio, as the market dislocation impacted the pricing relationship between mortgage assets (including Agency MBS that we own) and low risk fixed income securities. Our investment strategy explicitly contemplates the potential for upward and downward shifts in the carrying value of the portfolio, including shifts of the magnitude that we saw during 2007. We believe that these reductions in value are temporary in nature. Given our intention to hold the investments to maturity, temporary variations in value up or down have no material impact on our investment strategy.
 
 
Prior to 2006, we operated as a single business segment as substantially all of our activity was related to our commercial finance business. On January 1, 2006, we began presenting financial results through two reportable segments: 1) Commercial Lending & Investment and 2) Residential Mortgage Investment. Our Commercial


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Lending & Investment segment comprised our commercial lending and direct real estate investment business activities and our Residential Mortgage Investment segment comprised all of our activities related to our investments in residential mortgage loans and RMBS. Beginning in the fourth quarter of 2007, we are presenting financial results through three reportable segments: 1) Commercial Finance, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Changes have been made in the way management organizes financial information to make operating decisions, resulting in the activities previously reported in the Commercial Lending & Investment segment being disaggregated into the Commercial Finance segment and the Healthcare Net Lease segment as described above. We have reclassified all comparative prior period segment information to reflect our three reportable segments. For financial information about our segments, see Note 24, Segment Data, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
 
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 Loans.  We make senior secured asset-based and cash flow loans. A loan is a “senior” loan when we have a first priority lien in the collateral securing the loan. Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. 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 as further collateral for 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 obtain mortgage-related financing in connection with buyout transactions.
 
  •  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 client’s other senior debt but that comes after other senior secured debt in order of payment preference, 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 debt in order of payment. We also make mezzanine loans that may 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 are junior to any lien holder both as to collateral (if any) and payment. A mezzanine loan generally involves greater risk of loss than a senior loan or a Term B 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.
 
  •  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.


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  •  Direct Real Estate Investments.  We invest in income-producing healthcare facilities, principally long-term care facilities located in the United States. These facilities are generally leased through 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 escalations, and all facility operating expenses, including real estate taxes, as well as make capital improvements. Although, to date these real estate investments have been in healthcare facilities, we expect to consider sale leaseback transactions with prospective clients in other industries that might find this financing product desirable.
 
 
  •  Residential Mortgage-Backed Securities.  We invest in RMBS, which are securities collateralized by residential mortgage loans. These securities include Agency MBS and 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 (“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 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.  We own beneficial interests in special purpose entities (“SPEs”) that acquired and securitized pools of residential mortgage loans. We are the primary beneficiary of these SPEs and, therefore, consolidate the assets and liabilities of such entities for financial statement purposes. The SPEs’ interest in the underlying mortgage loans constitutes, for accounting purposes, receivables secured by the underlying mortgage loans. As a result, through consolidation, we recognized on our accompanying audited consolidated balance sheets 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, 2007, our portfolio of loan products, service offerings and investments by type was as follows (percentages by gross carrying values):
 
 
 
 
(1) Includes Term B loans.
 
Commercial Finance Segment Overview
 
 
The composition of our Commercial Finance segment portfolio as of December 31, 2007 and 2006, was as follows:
 
                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Commercial loans
  $ 9,867,737     $ 7,850,198  
Investments
    227,144       150,090  
                 
Total
  $ 10,094,881     $ 8,000,288  
                 


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Our total commercial loan portfolio reflected in the 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, 2007 and 2006, was as follows:
 
                                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                               
Senior secured loans(1)
  $ 5,695,167       58 %   $ 4,704,166       60 %
First mortgage loans(1)
    2,995,048       30       2,542,222       32  
Subordinate loans
    1,177,522       12       603,810       8  
                                 
Total
  $ 9,867,737       100 %   $ 7,850,198       100 %
                                 
Composition of loan portfolio by business:
                               
Corporate Finance
  $ 2,979,241       30 %   $ 2,234,734       29 %
Healthcare and Specialty Finance
    2,934,666       30       2,775,748       35  
Structured Finance
    3,953,830       40       2,839,716       36  
                                 
Total
  $ 9,867,737       100 %   $ 7,850,198       100 %
                                 
 
 
(1) Includes Term B loans.
 
As of December 31, 2007, our commercial loan portfolio was well diversified, with 1,214 loans to 759 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. As of December 31, 2007, our Corporate Finance, Healthcare and Specialty Finance and Structured Finance businesses had commitments to lend up to an additional $0.6 billion, $2.0 billion and $2.1 billion, respectively, to 262, 287 and 210 existing clients, respectively. Commitments do not include transactions for which we have signed commitment letters but not yet signed definitive binding agreements. Throughout this section, unless specifically stated otherwise, all figures relate to our commercial loans outstanding as of December 31, 2007.
 
Our commercial loan portfolio by industry as of December 31, 2007, was as follows (percentages by gross carrying values as of December 31, 2007):
 
 
 
(1) Industry classification is based on the North American Industry Classification System (NAICS).


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As of December 31, 2007, our commercial loans ranged in size from $0.1 million to $341.5(1) million. Our commercial loan portfolio by loan balance as of December 31, 2007, was as follows:
 
 
 
 
(1) This balance represents loans on 62 properties in six states owned by one of our clients.
 
Our commercial loan portfolio by client balance as of December 31, 2007, was as follows:
 
 
 
We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this 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 2007. The principal executive offices of our clients were located in 48 states, the District of Columbia, Puerto Rico and selected international locations, primary


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in Canada and Europe. As of December 31, 2007, the largest geographical concentration was Florida, which made up approximately 15% of the outstanding aggregate balance of our commercial loan portfolio. In addition, 5% of the outstanding aggregate balance of our commercial loan portfolio as of December 31, 2007, comprised international borrowers, primarily located in Canada and Europe. For the year ended December 31, 2007, less than 10% of our revenues were generated through our foreign operations. As of December 31, 2007, our largest loan was $341.5 million, and the combined total of the outstanding aggregate balances of our largest ten loans represented 17% of our commercial loan portfolio.
 
Our commercial loan portfolio by geographic region as of December 31, 2007, was as follows:
 
 
 
 
(1) Includes all jurisdictions 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. In many cases, we include an interest rate floor in our loans to mitigate the risk of declining yields if interest rates fall. 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 have stated maturities at origination that generally range from two to five years. As of December 31, 2007, the weighted average maturity and weighted average remaining life of our entire commercial loan portfolio was approximately 3.3 years and 3.2 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 other fees for some 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.


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The number of loans, average loan size, number of clients and average loan size per client by commercial finance business as of December 31, 2007, were as follows:
 
                                 
                      Average Loan
 
    Number
    Average
    Number of
    Size per
 
    of Loans     Loan Size     Clients     Client  
    ($ in thousands)  
 
Composition of loan portfolio by business:
                               
Corporate Finance
    542     $ 5,497       262     $ 11,371  
Healthcare and Specialty Finance
    410       7,158       287       10,225  
Structured Finance
    262       15,091       210       18,827  
                                 
Overall loan portfolio
    1,214       8,128       759       13,001  
                                 
 
 
 
We acquire real estate for long-term investment purposes. These real estate investments are generally long-term care facilities leased through long-term, triple-net operating leases. We had $1.0 billion in direct real estate investments as of December 31, 2007, which consisted primarily of land and buildings.
 
Our direct real estate investment portfolio by geographic region as of December 31, 2007, was as follows:
 
 
 
 
(1) Includes all states that have a direct real estate investment balance that is less than 1% of the aggregate direct real estate investment balance.
 
No client accounted for more than 10% of our total revenues in 2007. As of December 31, 2007, the largest geographical concentration was Florida, which made up approximately 34% of our direct real estate investment portfolio. As of December 31, 2007, the single largest industry concentration in our direct real estate investment portfolio was skilled nursing, which made up approximately 98% of the investments.


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Our direct real estate investment portfolio by asset balance as of December 31, 2007, was as follows:
 
 
 
See Item 2, Properties, for information about our direct real estate investment properties.
 
 
 
As of December 31, 2007 and 2006, our portfolio of residential mortgage investments was as follows:
 
                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Mortgage-related receivables(1)
  $ 2,041,917     $ 2,295,922  
Residential mortgage-backed securities:
               
Agency
    4,060,605       3,502,753  
Non-Agency
    4,632       34,243  
                 
Total
  $ 6,107,154     $ 5,832,918  
                 
 
 
(1) Represents secured receivables that are backed by adjustable-rate residential prime mortgage loans.
 
As of December 31, 2007, we owned $4.0 billion in Agency MBS that were pledged as collateral for repurchase agreements used to finance the acquisition of these investments. As of December 31, 2007, our portfolio of Agency MBS comprised hybrid adjustable-rate securities 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 5.07% as of December 31, 2007, and the weighted average reset date for the portfolio was approximately 41 months.
 
As further discussed in Note 4, Mortgage-Related Receivables and Related Owner Trust Securitizations, of our accompanying audited consolidated financial statements for the year ended December 31, 2007, we had $2.0 billion in mortgage-related receivables that were secured by prime residential mortgage loans as of December 31, 2007. As of December 31, 2007, the weighted average interest rate on such receivables was 5.38%, and the weighted average contractual maturity was approximately 28 years.


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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. We cannot assure you, however, that we will have access to any of these funding sources. 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;
 
  •  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 of 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 products 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 in some jurisdictions;
 
  •  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.


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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 as discussed below and in Risk Factors on page 17.
 
  •  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 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.
 
 
When we filed our federal income tax return for the year ended December 31, 2006, we elected REIT status under the Internal Revenue Code (the “Code”). To continue 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. As a REIT, we generally are not subject to corporate-level income tax on the earnings distributed to our shareholders that we derive from our REIT qualifying activities. We are 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 for that year, would be subject to federal income tax at regular corporate rates, including any applicable alternative minimum tax. In addition, we also will be disqualified from taxation as a REIT for the four taxable years following the year during which qualification was lost, unless we were entitled to relief under specific statutory provisions. We are still 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.


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As of December 31, 2007, we employed 562 people. We believe that our relations with our employees are good.
 
 
Our executive officers and their ages and positions are as follows:
 
             
Name
 
Age
 
Position
 
John K. Delaney
    44     Chairman of the Board of Directors and Chief Executive Officer
Dean C. Graham
    42     President and Chief Operating Officer
Bryan M. Corsini
    46     Executive Vice President and Chief Credit Officer
Thomas A. Fink
    44     Senior Vice President and Chief Financial Officer
Steven A. Museles
    44     Executive Vice President, Chief Legal Officer and Secretary
Michael C. Szwajkowski
    41     President — Structured Finance
David C. Bjarnason
    38     Chief Accounting Officer (1)
Donald F. Cole
    37     Interim Chief Accounting Officer (2)
 
 
(1) On January 23, 2008, Mr. Bjarnason notified us of his resignation, to be effective the later of February 27, 2008 and the day we file this Form 10-K with the Securities and Exchange Commission, in each case after the filing of this Form 10-K. Mr. Bjarnason resigned to pursue an opportunity in Seattle, Washington.
 
(2) On February 12, 2008, we appointed Donald F. Cole to be our interim principal accounting officer while we conduct a search for a new permanent principal accounting officer. Mr. Cole’s appointment will be effective on the later of March 1, 2008 and the day after we file this Form 10-K with the Securities and Exchange Commission.
 
Biographies for our executive officers are as follows:
 
John K. Delaney, 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 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 has served as our Executive Vice President and 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 has served as our Senior Vice President and 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 has served as our Executive Vice President, 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 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


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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 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.
 
Donald F. Cole, an employee since March 2001, has served as our Chief Administrative Officer since January 2007 and a member of our Executive Committee since 2004. Mr. Cole served as our Chief Operations Officer from February 2005 until January 2007 and our Chief Information Officer from July 2003 until February 2005. He was promoted from loan officer to Control Systems Officer in 2002 and then to Director of Operations in January 2003. Mr. Cole earned both his undergraduate degree and his masters of business administration from the State University of New York at Buffalo and his juris doctor degree from the University of Virginia School of Law and was licensed in 1995 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 or by contacting Dennis Oakes, Vice President — Investor Relations, at 212-321-7212 or doakes@capitalsource.com.
 
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 require a substantial amount of money to make new loans and to fund obligations to existing clients. As a REIT, we are dependent on external sources of capital to fund our business. This 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. To date, 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. Sufficient funding or capital may not be available to us on terms that are acceptable to us, particularly if the existing credit markets disruption continues or worsens. 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.
 
 
As of December 31, 2007, we had nine credit facilities totaling $5.6 billion in commitments and 14 repurchase agreements totaling $3.9 billion in commitments. These credit facilities contain customary representations and warranties, covenants, conditions, events of default and cross-defaults that if breached, not satisfied or triggered could result in termination of the facilities. We may not be able to extend the term of any of our credit facilities or obtain sufficient funds to repay any amounts outstanding under any credit facility 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 upon its maturity, our liquidity position could 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.
 
 
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, suffers continued disruptions, we may be unable to complete term debt transactions on favorable terms or at all;
 
  •  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;


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  •  our ability to service our loan portfolio must continue to be perceived as adequate to make the securities issued attractive to investors;
 
  •  any material downgrade or withdrawal of ratings given to securities previously issued in our term debt transactions or to us as a servicer 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 as evidenced by the last two term debt transactions we completed in 2007.
 
If we are unable to continue completing term debt transactions on favorable terms or at all, our ability to obtain the capital needed for us to continue to fund our business would be adversely affected. Lack of access to adequate capital could have a material adverse effect on our growth and stock price.
 
 
We generally 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.
 
 
The poor performance of a pool of loans that we securitize could increase the expense and lower our leverage on 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 further 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.
 
Interest on some of our borrowings is based in part on the rates and maturities at which vehicles sponsored by our lenders issue asset backed commercial paper. Changes in market interest rates or the relationship between market interest rates and asset backed commercial paper rates could increase the effective cost at which we borrow funds under some of our debt facilities.
 
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 borrowed significant funds to finance the acquisition of 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


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to sell residential mortgage loans and/or mortgage-backed securities to meet a margin call or because our lenders fail to renew our borrowings and we cannot access replacement borrowings, we may suffer losses and our ability to comply with the REIT asset tests could be materially 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 or replace us as cash manager for our secured facilities and term debt. 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 materially adversely affected and our income generated from those loans significantly reduced.
 
 
We have entered into interest rate swap agreements and other contracts for interest rate risk management purposes. Our hedging activity varies 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 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.
 
Because we do not employ hedge accounting, our hedging activity may materially adversely affect our earnings. Therefore, while we pursue such transactions to reduce our interest rate risks, it is possible that changes in interest rates may result in losses that we would not otherwise have incurred if we had not engaged in any such hedging transactions. For additional information about our hedging instruments, see Note 20, Derivative Instruments, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
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. 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. In the event of default by a counterparty to hedging arrangements, we may lose unrealized gains associated with such contracts and may be required to execute replacement contract(s) on market terms which may be less favorable to us. Although generally we 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.


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Part of our investment strategy involves entering into derivative contracts that 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 materially adversely impact our financial condition. For additional information about our derivatives, see Note 20, Derivative Instruments, of our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
Risks Related to Our Operations as a REIT
 
 
On January 1, 2006, we began operating as a REIT and formally elected REIT status when we filed 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. In addition, our decision to convert to REIT status has imposed added challenges on our senior management and other employees, who together monitor our REIT compliance obligations, develop new product offerings consistent with our REIT status and make appropriate alterations to our loan origination, marketing and monitoring efforts.
 
 
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.
 
 
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.


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Given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations and the possibility of future changes in the law or 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;
 
  •  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.
 
 
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 required to register as an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. We believe that we are primarily engaged in


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the business of commercial lending and real estate investment, and not in the business of investing, reinvesting, and trading in securities, and therefore are not required to register under the Investment Company Act.
 
While we do not believe we are engaged in an investment company business, we nevertheless endeavor to conduct our operations in a manner that would permit us to rely on one or more exemptions under the Investment Company Act. Our ability to rely on these exemptions may limit the types of loans we originate and the types of other assets we acquire.
 
One of our wholly owned TRSs, CapitalSource Finance LLC (“Finance”), is a guarantor on certain of our convertible debentures that were offered to the public in a registered offering. This guarantee could be deemed to cause Finance to have outstanding securities for purposes of the Investment Company Act. Finance or other subsidiaries may guarantee future indebtedness from time to time. Even if one or more of our subsidiaries were deemed to be engaged in investment company business, and the provisions of the Investment Company Act were deemed to apply on an individual basis to our wholly owned subsidiaries, generally they could rely on an exemption from registration under the Investment Company Act for entities who do not offer securities to the public and do not have more than 100 security holders. Because it is possible that this exemption could be deemed unavailable to Finance, we also conduct Finance’s business in a manner that we believe would permit it to rely on exemption from registration under the Investment Company Act.
 
If we or any subsidiary were required to register under the Investment Company Act and could not rely on an exemption or exclusion, we or such subsidiary could be characterized as an investment company. Such characterization would require us to either (i) change the manner in which we conduct our operations, or (ii) register the relevant entity as an investment company. Any modification of our business plan for these purposes could have a material adverse effect on us. Further, if we or a subsidiary were determined to be an unregistered investment company, we or such subsidiary:
 
  •  could be subject to monetary penalties and injunctive relief in an action brought by the SEC;
 
  •  may be unable to enforce contracts with third parties, and third parties could seek to rescind transactions undertaken during the period it was established that we or such subsidiary was an unregistered investment company;
 
  •  would have to significantly reduce the amount of leverage we currently employ in our business;
 
  •  would have to restructure our operations dramatically;
 
  •  may have to raise substantial amounts of additional equity to come into compliance with the limitations prescribed under the Investment Company Act; and
 
  •  may have to terminate agreements with our affiliates.
 
Any of these results likely would have a material adverse effect on our business, our financial results and our ability to pay dividends to stockholders.
 
 
If the market value or income potential of our mortgage-backed securities and our other real estate assets declines 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 materially 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 and negatively 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 $57.5 million in loans for the year ended December 31, 2007, 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. 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, loans made to these types of clients entail higher risks than loans 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 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 concerning their


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business, financial condition and prospects. We may not have access to all of the material information about a particular client’s business, financial condition and prospects, or a client’s accounting records may be poorly maintained or organized. In such instances, 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.
 
 
Most of our loans bear interest at variable interest rates. If 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.
 
 
The failure of a client to accurately report its financial position, compliance with loan covenants or eligibility for initial or 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.
 
Some of our clients require licenses, permits and other governmental authorizations to operate their businesses, which may be revoked or modified by applicable governmental authorities. Any revocation or modification could have a material adverse effect on the business of a client and, consequently, the value of our loan to that client.
 
In addition to clients in the healthcare industry subject to Medicare and Medicaid regulation, other clients in specified industries require permits and licenses from various governmental authorities to operate their businesses. These governmental authorities may revoke or modify these licenses or permits if a client 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 client’s ability to continue to operate its business in the manner in which it was operated when we made our loan to it, which could impair the client’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. See the Regulation section of Item 1, Business, above for additional discussion of specific regulatory and governmental oversight applicable to many of our healthcare clients.
 
 
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. An unsuccessful development, construction or renovation project could limit that client’s ability to repay its obligations to us.
 
 
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


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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 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 may be a higher risk of default on these loans due to the uncertain business prospects of these clients and the inherent risks with the bankruptcy process. Furthermore, if our calculations 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.
 
 
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, 2007, loans representing 21% 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, 2007, loans representing 20% 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, 2007, our ten largest clients collectively accounted for approximately 19% of the aggregate outstanding balance of our commercial loan portfolio, and our largest client accounted for approximately 3.46% of the aggregate outstanding balance of our commercial loan portfolio.
 
 
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 suffers 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


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same entity and, to the extent that management entity suffers financial distress or is 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.
 
 
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.
 
 
As of December 31, 2007, approximately 93% 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. 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 are limited in pursuing certain of our rights and remedies under our Term B, second lien and mezzanine loans, which may increase our risk of loss on these loans.
 
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 clients’ other senior debt. Second lien loans are junior as to both collateral and right of payment to clients’ senior debt. 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 12% of the aggregate outstanding balance of our loan portfolio as of December 31, 2007. 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 subordinated 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


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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 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 value of 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.
 
 
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 assets. These loans tend to be among the largest and to pose the highest risk of loss upon default in our portfolio. As of December 31, 2007, approximately 52% of the loans in our portfolio were cash flow loans under which we had advanced 36% 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. When a cash flow loan becomes non-performing, our primary recourse to recover some or all of the principal of our loan is to force the sale of the entire company as a going concern. We could also choose to restructure the company in a way we believe would enable it to generate sufficient cash flow over time to repay our loan. Neither of these alternatives may be an available or viable option or generate enough proceeds to repay the loan. If we were a subordinate lender rather than the senior lender in a cash flow loan, our ability to take remedial action would be constrained by our agreement with the senior lender.
 
 
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 on loans comprising approximately 15% of the aggregate outstanding balance of our loan portfolio as of December 31, 2007. 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 or would not 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 administering the loan, receiving all payments under the loan and/or controlling the collateral for purposes of administering the loan. As of December 31, 2007, we were either the


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paying, administrative or the collateral agent or all for a group of third-party lenders for loans with outstanding commitments of $12.4 billion. When we are the 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 applicable standard. 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 do not administer these loans in accordance with our obligations and the applicable legal standards and the lending syndicate suffered a loss on the loan, we may have liability to our co-lenders.
 
 
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 particularly high. We may not correctly evaluate the value of the assets collateralizing the loans or the prospects for a successful reorganization or similar action. 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.
 
 
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.
 
 
Courts may apply the doctrine of equitable subordination to subordinate the claim or lien of a lender against a borrower to claims or liens of other creditors of the borrower, when the lender or its affiliates is found to have engaged in unfair, inequitable or fraudulent conduct. The courts have also applied the doctrine of equitable subordination when a lender or its affiliates is found to have exerted inappropriate control over a client, including control resulting from the ownership of equity interests in a client. We have made direct equity investments or received warrants in connection with the origination of loans representing approximately 21% of the aggregate outstanding loan balance of our loan portfolio as of December 31, 2007. 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 we were deemed to have the ability to control or otherwise exercise influence over the business and affairs of one or more of our clients resulting in economic hardship to other creditors of our client, this control or influence may constitute grounds for equitable subordination and a court may treat one or more of our loans as if it were unsecured or common equity in the client. In that case, if the client were to liquidate, we would be entitled to repayment of our loan on a pro-rata basis with other unsecured debt or, if the effect of subordination was to place us at the level of common equity, then 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.


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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, 2007, we had 17 loans representing $188.4 million in committed funds to companies affiliated with our directors. We may make additional loans to affiliates of our directors in the future. Our conflict of interest policies, which generally require these transactions to be approved by the disinterested members of our board (or a committee thereof), may not be successful in eliminating the influence of conflicts. These transactions may divert our resources and benefit our directors and their affiliates to the detriment of our shareholders.
 
 
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. See the Regulation section of Item 1, Business, above, for additional information.
 
 
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. 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 our 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 other loans or that we will not become liable for a failure to comply with the myriad of regulations applicable to our lines of business. See the Regulation section of Item I, Business, above for additional information.
 
 
As of December 31, 2007, the amount of our unfunded commitments to extend credit to our clients exceeded our unused funding sources and unrestricted cash by $813.3 million. Commitments do not include transactions for which we have signed commitment letters but not yet signed definitive binding agreements. We expect that our commercial loan commitments will continue to exceed our available funds indefinitely. Our obligation to fund unfunded commitments 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. In some case unfunded commitments do not require additional collateral to be provided by a debtor as a prerequisite to future fundings by us. 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 our commitments, our failure to satisfy our full contractual funding commitment to one or more of our


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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.
 
 
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;
 
  •  insurance companies; and
 
  •  asset management 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, a mortgage investment will decline in value if long-term interest rates increase and increase in value if rates decrease. To the extent not matched by offsetting changes in fair value of hedging arrangements, changes in the market value of the mortgage investment 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 mortgage investments 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.
 
A significant risk associated with our residential mortgage investment portfolio of is the risk that both long-term and short-term interest rates will increase or decrease significantly. If long-term rates were to increase significantly, the market value of residential mortgage investments 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 residential mortgage investments.


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In the case of residential mortgage loans, there are seldom restrictions on borrowers’ abilities to prepay their loans. Homeowners tend to prepay mortgage loans faster when interest rates decline. Consequently, owners of the loans or securities backed by the loans have to reinvest the money received from the prepayments at the lower prevailing interest rates, resulting in reductions in fair value of the investments to the extent not offset by changes in fair value of hedges. This volatility in prepayment rates may affect our ability to maintain targeted amounts of leverage on our mortgage investment portfolio and may result in reduced earnings or losses for us and negatively affect the cash available for distribution to our shareholders.
 
 
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 materially 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.
 
 
We invest in residential mortgage related receivables that are secured by pools of residential mortgage loans. Accordingly, these investments are subject to all of the risks of the underlying mortgage loans. Residential mortgage loans are secured by single-family residential property. They are subject to risks of delinquency, foreclosure and loss. The ability of a borrower to repay a loan secured by a residential property depends on the income or assets of the borrower, and many factors may impair borrowers’ abilities to repay their loans. Foreclosure of a mortgage loan can be expensive and lengthy. Our investments in mortgage related receivables would be adversely affected by defaults under the loans underlying such securities. To the extent losses are realized on the loans underlying the mortgage related receivables in which we invest, we may not recover a portion or all of the amount invested in such mortgage related receivables.
 
 
 
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 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.


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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 many of our direct real estate investments.
 
 
Advocacy groups that monitor the quality of care at healthcare facilities, have sued healthcare operators and called upon state and federal legislatives to enhance their oversight of trends in healthcare facility ownership and quality of care. 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. Increased costs could limit our operators’ ability 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 continued 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. State laws mandate certain procedures for property foreclosures, and in certain states, we would face a time consuming foreclosure process, during which time the property could be subject to waste. 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 2007 and 2006. Future acquisitions may result in potentially dilutive issuances of equity securities and the incurrence of additional debt. In addition, we may face additional risks from future acquisitions, such as TierOne, 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;
 
  •  the potential loss of key employees of the acquired company; and
 
  •  inability to meet regulatory requirements applicable to us if the acquired company’s business is subject to regulation.
 
 
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.


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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 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 2007, 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, 2008, we had 224,734,693 shares of common stock outstanding and options then exercisable for 5,130,103 shares were held by our employees and directors. 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.


34


 

 
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;
 
  •  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. Our board of directors has provided a waiver to Farallon Capital Management and its affiliates to acquire common stock in excess of 15% for purposes of Section 203 of the Delaware General Corporation Law.
 
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 37% of the outstanding shares of our common stock as of December 31, 2007. 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.
 
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 space houses the bulk of our technology and administrative functions and serves as the primary base for our operations. We also maintain offices in Arizona, California, Connecticut, Florida, Georgia, Illinois, Maine, Maryland, Massachusetts, Missouri, New York, Ohio, Pennsylvania, Tennessee, Texas, Utah and in Europe. We believe our leased facilities are adequate for us to conduct our business.
 
Our Healthcare Net Lease segment acquires real estate for long-term investment purposes. These real estate investments primarily consist of long-term care facilities generally leased through long-term, triple-net operating leases. We had $1.0 billion in direct real estate investments as of December 31, 2007, which consisted primarily of land and buildings. As of December 31, 2007, 129 of our direct real estate investments, with a total carrying value of $695.0 million, were pledged as collateral to certain of our borrowings. For additional information about our borrowings, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.


35


 

Our direct real estate investment properties as of and for the year ended December 31, 2007, were as follows:
 
                                 
    Number of
                Total
 
Facility Location
  Facilities     Capacity(1)     Investment(2)     Revenues(3)  
                ($ in thousands)  
 
Assisted Living Facilities:
                               
Florida
    5       261     $ 8,668     $ 829  
Indiana
    1       99       2,108       129  
Wisconsin
    1       20       760       38  
                                 
      7       380       11,536       996  
Long-Term Acute Care Facilities:
                               
Florida
    1       185       6,609       817  
Kansas
    1       39       384       35  
Nevada
    1       61       2,825       322  
                                 
      3       285       9,818       1,174  
Skilled Nursing Facilities:
                               
Alabama
    1       174       8,436       839  
Arizona
    2       174       9,912       1,208  
Arkansas
    2       185       1,771       157  
California
    1       99       4,845       408  
Colorado
    3       453       9,133       751  
Florida
    56       6,895       330,279       36,794  
Indiana
    13       1,363       54,196       5,681  
Iowa
    1       201       11,505       1,274  
Kansas
    2       190       3,858       310  
Kentucky
    5       344       23,282       2,352  
Maryland
    3       438       27,117       2,616  
Massachusetts
    2       219       15,571       1,252  
Mississippi
    6       574       44,237       4,242  
Nevada
    3       407       19,607       2,295  
New Mexico
    1       102       3,263       276  
North Carolina
    6       682       41,937       3,293  
Ohio
    3       349       20,864       1,864  
Oklahoma
    5       697       19,425       1,527  
Pennsylvania
    4       600       24,396       2,565  
Tennessee
    10       1,589       96,596       9,829  
Texas
    47       5,574       206,067       13,522  
Washington(4)
                      29  
Wisconsin
    5       537       19,953       1,759  
                                 
      181       21,846       996,250       94,843  
Less multi-function facilities(5)
    (5 )                  
                                 
Total owned properties
    186       22,511     $ 1,017,604     $ 97,013  
                                 
 
 
(1) Capacity of assisted living and long-term acute care facilities, which are apartment-like facilities, is stated in units (studio, one or two bedroom apartments). Capacity of skilled nursing facilities is measured by licensed bed count.
 
(2) Represents the acquisition costs of the assets less any related accumulated depreciation as of December 31, 2007.
 
(3) Represents the amount of operating lease income recognized in our audited consolidated statement of income for the year ended December 31, 2007.
 
(4) During the year ended December 31, 2007, we sold the only property that we owned in the state of Washington.
 
(5) Three of our properties in Florida each serve as both an assisted living facility and a skilled nursing facility. One of our properties in Kansas serves as both a long-term acute care facility and a skilled nursing facility.


36


 

 
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 2007.
 
 
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 2007 and 2006, were as follows:
 
                 
    High     Low  
 
2007:
               
Fourth Quarter
  $ 22.42     $ 14.05  
Third Quarter
  $ 25.10     $ 14.76  
Second Quarter
  $ 27.40     $ 23.65  
First Quarter
  $ 28.28     $ 22.39  
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  
 
On February 15, 2008, the last reported sale price of our common stock on the NYSE was $16.44 per share.
 
 
As of December 31, 2007, there were 2,046 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.


37


 

Starting with the first quarter of 2006, we have paid a regular quarterly dividend. We declared and paid dividends as follows:
 
                 
    Dividends Declared
 
    and Paid per Share  
    2007     2006  
 
Fourth Quarter
  $ 0.60     $ 0.55  
Third Quarter
    0.60       0.49  
Second Quarter
    0.60       0.49  
First Quarter
    0.58       0.49  
                 
Total dividends declared and paid
  $ 2.38     $ 2.02  
                 
 
For shareholders who held our shares for the entire year, the $2.38 per share dividend paid in 2007 was classified for tax reporting purposes as follows: 31.50% ordinary dividends, 0.09% short-term capital gain, 1.36% long-term capital gain, and 67.05% return on capital. Of the sum of ordinary dividends and short-term capital gains, 20.79% was 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, 2007, 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, 2007
    5,583     $ 17.44              
November 1 — November 30, 2007
    13,969       14.93              
December 1 — December 31, 2007
    89,915       19.12              
                                 
Total
    109,467     $ 18.50              
                                 
 
 
(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.


38


 

 
 
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, 2007, 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.
 
 
                                                 
    Base
    Period
                         
    Period
    Ended
    Year Ended December 31,  
Company/Index
  8/7/03     12/31/2003     2004     2005     2006     2007  
 
CapitalSource Inc. 
  $ 100     $ 119.1     $ 141.0     $ 136.0     $ 179.4     $ 128.9  
S&P 500 Index
    100       115.0       127.5       133.8       154.9       163.5  
S&P 500 Financials Index
    100       113.5       125.9       134.0       159.7       130.0  


39


 

ITEM 6.   SELECTED FINANCIAL DATA
 
You should read the data set forth below in conjunction with our consolidated financial statements and related notes, 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 historical consolidated financial data as of and for the five years ended December 31, 2007. We derived our selected consolidated financial data as of and for the five years ended December 31, 2007, from our audited consolidated financial statements, which have been audited by Ernst & Young LLP, independent registered public accounting firm.
 
                                         
    Year Ended December 31,  
    2007     2006     2005     2004     2003  
    ($ in thousands, except per share data)  
 
Results of operations:
                                       
Interest income
  $ 1,277,903     $ 1,016,533     $ 514,652     $ 313,827     $ 175,169  
Fee income
    162,395       170,485       130,638       86,324       50,596  
                                         
Total interest and fee income
    1,440,298       1,187,018       645,290       400,151       225,765  
Operating lease income
    97,013       30,742                    
                                         
Total investment income
    1,537,311       1,217,760       645,290       400,151       225,765  
Interest expense
    847,241       606,725       185,935       79,053       39,956  
                                         
Net investment income
    690,070       611,035       459,355       321,098       185,809  
Provision for loan losses
    78,641       81,562       65,680       25,710       11,337  
                                         
Net investment income after provision for loan losses
    611,429       529,473       393,675       295,388       174,472  
Depreciation of direct real estate investments
    32,004       11,468                    
Other operating expenses
    235,987       204,584       143,836       107,748       67,807  
Total other (expense) income
    (74,650 )     37,328       19,233       17,781       25,815  
Noncontrolling interests expense
    4,938       4,711                    
                                         
Net income before income taxes and cumulative effect of accounting change
    263,850       346,038       269,072       205,421       132,480  
Income taxes(1)
    87,563       67,132       104,400       80,570       24,712  
                                         
Net income before cumulative effect of accounting change
    176,287       278,906       164,672       124,851       107,768  
Cumulative effect of accounting change, net of taxes
          370                    
                                         
Net income
  $ 176,287     $ 279,276     $ 164,672     $ 124,851     $ 107,768  
                                         
Net income per share:
                                       
Basic
  $ 0.92     $ 1.68     $ 1.36     $ 1.07     $ 1.02  
Diluted
  $ 0.91     $ 1.65     $ 1.33     $ 1.06     $ 1.01  
Average shares outstanding:
                                       
Basic
    191,697,254       166,273,730       120,976,558       116,217,650       105,281,806  
Diluted
    193,282,656       169,220,007       123,433,645       117,600,676       107,170,585  
Cash dividends declared per share
  $ 2.38     $ 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 for the years ended December 31, 2007 and 2006, based on effective tax rates of 39.4% and 39.9%, respectively, for the income earned by our TRSs. We did not provide for any income taxes for the income earned by our qualified REIT subsidiaries for the years ended December 31, 2007 and 2006. We provided for income taxes on the consolidated income earned based on a 33.2%, 19.4%, 38.8% and 39.2% effective tax rates in 2007, 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.
 


40


 

                                         
    December 31,  
    2007     2006     2005     2004     2003  
    ($ in thousands)  
 
Balance sheet data:
                                       
Mortgage-related receivables, net
  $ 2,041,917     $ 2,295,922     $ 39,438     $     $  
Mortgage-backed securities pledged, trading
    4,060,605       3,502,753       323,370              
Total loans, net(1)
    9,581,718       7,599,231       5,779,966       4,140,381       2,339,089  
Direct real estate investments, net
    1,017,604       722,303                    
Total assets
    18,040,349       15,210,574       6,987,068       4,736,829       2,567,091  
Repurchase agreements
    3,910,027       3,510,768       358,423             8,446  
Credit facilities
    2,207,063       2,251,658       2,450,452       964,843       736,700  
Term debt
    7,255,675       5,809,685       1,779,748       2,186,311       920,865  
Other borrowings
    1,594,870       1,288,575       786,959       555,000        
Total borrowings
    14,967,635       12,860,686       5,375,582       3,706,154       1,666,011  
Total shareholders’ equity
    2,582,271       2,093,040       1,199,938       946,391       867,132  
Portfolio statistics:
                                       
Number of loans closed to date
    2,457       1,986       1,409       923       504  
Number of loans paid off to date
    (1,243 )     (914 )     (486 )     (275 )     (87 )
                                         
Number of loans
    1,214       1,072       923       648       417  
                                         
Total loan commitments
  $ 14,602,398     $ 11,929,568     $ 9,174,567     $ 6,379,012     $ 3,673,369  
Average outstanding loan size
  $ 8,128     $ 7,323     $ 6,487     $ 6,596     $ 5,796  
Average balance of loans outstanding during year
  $ 8,858,968     $ 6,971,908     $ 5,046,704     $ 3,287,734     $ 1,760,638  
Employees as of year end
    562       548       520       398       285  
 
 
(1) “Total loans, net” include receivables under reverse-repurchase agreements, loans held for sale and loans, net of deferred loan fees and discounts and an allowance for loan losses.
 

41


 

                                         
    Year Ended December 31,  
    2007     2006     2005     2004     2003  
 
Performance ratios:
                                       
Return on average assets(1)
    1.05 %     2.22 %     3.04 %     3.59 %     4.34 %
Return on average equity(1)
    7.41 %     14.63 %     15.05 %     14.17 %     12.37 %
Yield on average interest earning assets
    9.31 %     9.80 %     12.15 %     11.59 %     11.92 %
Cost of funds
    6.01 %     5.79 %     4.43 %     3.08 %     3.32 %
Net finance margin
    4.20 %     4.94 %     8.65 %     9.30 %     9.81 %
Operating expenses as a percentage of average total assets
    1.59 %     1.72 %     2.65 %     3.09 %     3.58 %
Operating expenses (excluding direct real estate investment depreciation) as a percentage of average total assets
    1.40 %     1.62 %     2.65 %     3.09 %     3.58 %
Efficiency ratio (operating expenses/net interest and fee income and other income)
    43.55 %     33.32 %     30.05 %     31.80 %     32.01 %
Efficiency ratio (operating expenses excluding direct real estate depreciation/net interest and fee income and other income)
    38.35 %     31.55 %     30.05 %     31.80 %     32.01 %
Credit quality and leverage ratios:
                                       
Loans 60 or more days contractual delinquent as a percentage of loans (as of year end)
    0.75 %     1.12 %     0.70 %     0.76 %     0.18 %
Loans on non-accrual status as a percentage of loans (as of year end)
    1.73 %     2.34 %     2.30 %     0.53 %     0.36 %
Impaired loans as a percentage of loans (as of year end)
    3.23 %     3.58 %     3.33 %     0.77 %     0.63 %
Net charge offs (as a percentage of average loans)
    0.64 %     0.69 %     0.27 %     0.26 %     0.00 %
Allowance for loan losses as a percentage of loans (as of year end)
    1.41 %     1.54 %     1.46 %     0.82 %     0.75 %
Total debt to equity (as of year end)
    5.80 x     6.14 x     4.48 x     3.93 x     1.93 x
Equity to total assets (as of year end)
    14.31 %     13.76 %     17.17 %     19.98 %     33.78 %
 
 
(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 year ended December 31, 2003, 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%.

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
 
We are a commercial finance, 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 and residential mortgage assets, and engage in asset management and servicing activities.
 
Through our commercial finance activities, our primary goal is to be the leading provider of financing to middle market businesses that require customized and sophisticated financing. We operate through three primary commercial finance businesses:
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in widely syndicated loan transactions;
 
  •  Healthcare and Specialty Finance, which, including our Healthcare Net Lease segment activities, generally provides first mortgage loans, asset-based revolving lines of credit, and other cash flow loans to healthcare businesses and a broad range of other companies and makes investments in income-producing healthcare facilities, particularly long-term care facilities; and
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies.
 
To optimize our REIT structure, we also invest in certain residential mortgage assets which included investments in residential mortgage loans and RMBS as of December 31, 2007.
 
 
We operate as three reportable segments: 1) Commercial Finance, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Our Commercial Finance segment comprises our commercial lending business activities; our Healthcare Net Lease segment comprises our direct real estate investment business activities; and our Residential Mortgage Investment segment comprises our residential mortgage investment activities.
 
Prior to 2006, we operated as a single business segment as substantially all of our activity was related to our commercial finance business. On January 1, 2006, we began presenting financial results through two reportable segments: 1) Commercial Lending & Investment and 2) Residential Mortgage Investment. Our Commercial Lending & Investment segment comprised our commercial lending and direct real estate investment business and our Residential Mortgage Investment segment comprised all of our activities related to our investments in residential mortgage loans and RMBS. Beginning in the fourth quarter of 2007, we are presenting financial results through three reportable segments: 1) Commercial Finance, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Changes have been made in the way management organizes financial information to make operating decisions, resulting in the activities previously reported in the Commercial Lending & Investment segment being disaggregated into the Commercial Finance segment and the Healthcare Net Lease segment as described above. We have reclassified all comparative prior period segment information to reflect our three reportable segments. The discussion that follows differentiates our results of operations between our segments.
 
 
Interest Income.  In our Commercial Finance segment, interest income represents interest earned on our commercial loans. Although the majority of these loans charge interest at variable rates that generally adjust daily, we also have a number of loans charging interest at fixed rates. In our Healthcare Net Lease segment, interest income represents interest earned on cash and restricted cash. In our Residential Mortgage Investment segment, interest income consists of coupon interest and the amortization of purchase discounts and premiums on our investments in RMBS and mortgage-related receivables, which are amortized into income using the interest method.


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Fee Income.  In our Commercial Finance 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, prepayment-related fees as well as other fees charged to borrowers.
 
Operating Lease Income.  In our Healthcare Net Lease 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 generally project a minimum escalation rate for the leases and recognize operating lease income on a straight-line basis over the life of the lease. We currently do not generate any operating lease income in our Commercial Finance segment or 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 Finance segment, our borrowings consist of repurchase agreements, secured and unsecured credit facilities, term debt, convertible debt and subordinated debt. In our Healthcare Net Lease segment, our borrowings consist of a secured credit facility, mortgage debt and allocated intercompany 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 (“CP”) rates plus a margin. Currently, our convertible debt, three series of our subordinated debt, our term debt recorded in connection with our investments in mortgage-related receivables and the intercompany debt within our Healthcare Net Lease segment bear a fixed rate of interest. Deferred financing fees 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 Finance 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 finance portfolio and in our portfolio of residential mortgage-related receivables. As the size and mix of loans within these portfolios change, or if the credit quality of the portfolios change, we record a provision to appropriately adjust the allowance for loan losses. We do not have any loan receivables in our Healthcare Net Lease segment.
 
Other Income.  In our Commercial Finance segment, other income (expense) consists of gains (losses) on the sale of loans, gains (losses) on the sale of debt and equity investments, unrealized appreciation (depreciation) on certain investments, 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, income from our management of various loans held by third parties and other miscellaneous fees and expenses not attributable to our commercial finance operations. In our Healthcare Net Lease segment, other income (expense) consists of gain (loss) on the sale of assets. In our Residential Mortgage Investment segment, other income (expense) consists of realized and unrealized appreciation (depreciation) on certain of our residential mortgage investments and gains (losses) on derivatives that are used to hedge the residential mortgage investment portfolio.
 
Operating Expenses.  In our Commercial Finance segment, operating expenses include compensation and benefits, professional fees, travel, rent, insurance, depreciation and amortization, marketing and other general and administrative expenses. In our Healthcare Net Lease segment, operating expenses include depreciation of direct real estate investments, professional fees, an allocation of overhead expenses (including compensation and benefits) and other direct expenses. In our Residential Mortgage Investment segment, operating expenses include compensation and benefits, professional fees paid to our investment manager and other direct expenses.
 
Income Taxes.  We elected REIT status under the Code when we filed our tax return for the year ended December 31, 2006. As a REIT, we generally are not subject to corporate-level income tax on the earnings distributed to our shareholders that we derive from our REIT qualifying activities, but are subject to corporate-level tax on the earnings we derive from our TRSs. We do not expect income from our Healthcare Net Lease segment or Residential Mortgage Investment segment to be subject to corporate-level tax as all assets in these segments are considered REIT qualifying assets. A significant portion of our income from our Commercial Finance segment will remain subject to corporate-level income tax as many of the segment’s assets are originated and held in our TRSs.


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We were responsible for paying federal, state and local income taxes on all of our income for the year ended December 31, 2005.
 
Adjusted Earnings.  Adjusted earnings represents net income as determined in accordance with U.S. generally accepted accounting principles (“GAAP”), adjusted for certain items, including real estate depreciation, amortization of deferred financing fees, non-cash equity compensation, realized and unrealized gains and losses on investments in RMBS 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 net income 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 net 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, 2007, 2006 and 2005
 
Our results of operations in 2007 were driven primarily by a challenging credit market environment, our continued asset growth and the impact of our REIT election. As further described below, the most significant factors influencing our consolidated results of operations for 2007 were:
 
  •  Mark to market losses on our Residential Mortgage Investment Portfolio;
 
  •  Losses on derivatives and other investments in our Commercial Finance segment;
 
  •  Reduced prepayment-related fee income and reduced gains on equity sales;
 
  •  Growth in our commercial loan portfolio;
 
  •  Increased borrowings;
 
  •  Increased operating lease income related to our direct real estate investments;
 
  •  Decreased operating expenses as a percentage of average assets;
 
  •  Decreased lending spreads; and
 
  •  Increased borrowing spreads.


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Our consolidated operating results for the year ended December 31, 2007, compared to the year ended December 31, 2006, and for the year ended December 31, 2006, compared to the year ended December 31, 2005, were as follows:
 
                                                                 
    Year Ended
                Year Ended
             
    December 31,                 December 31,              
    2007     2006     $ Change     % Change     2006     2005     $ Change     % Change  
    ($ in thousands)           ($ in thousands)        
 
Interest income
  $ 1,277,903     $ 1,016,533     $ 261,370       26 %   $ 1,016,533     $ 514,652     $ 501,881       98 %
Fee income
    162,395       170,485       (8,090 )     (5 )     170,485       130,638       39,847       31  
Operating lease income
    97,013       30,742       66,271       216       30,742             30,742       N/A  
Interest expense
    847,241       606,725       240,516       40       606,725       185,935       420,790       226  
Provision for loan losses
    78,641       81,562       (2,921 )     (4 )     81,562       65,680       15,882       24  
Depreciation of direct real estate investments
    32,004       11,468       20,536       179       11,468             11,468       N/A  
Other operating expenses
    235,987       204,584       31,403       15       204,584       143,836       60,748       42  
Other (expense) income
    (74,650 )     37,328       (111,978 )     (300 )     37,328       19,233       18,095       94  
Noncontrolling interests expense
    4,938       4,711       227       5       4,711             4,711       N/A  
Income taxes
    87,563       67,132       20,431       30       67,132       104,400       (37,268 )     (36 )
Cumulative effect of accounting change, net of taxes
          370       (370 )     N/A       370             370       N/A  
Net income
    176,287       279,276       (102,989 )     (37 )     279,276       164,672       114,604       70  
 
Our consolidated yields on income earning assets and the costs of interest bearing liabilities for the years ended December 31, 2007 and 2006, were as follows:
 
                                                 
    Year Ended December 31,  
    2007     2006  
    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
          $ 1,277,903       8.26 %           $ 1,016,533       8.39 %
Fee income
            162,395       1.05               170,485       1.41  
                                                 
Total interest earning assets(1)
  $ 15,472,459       1,440,298       9.31     $ 12,112,492       1,187,018       9.80  
Total direct real estate investments
    947,929       97,013       10.23       260,313       30,742       11.81  
                                                 
Total income earning assets
    16,420,388       1,537,311       9.36       12,372,805       1,217,760       9.84  
Total interest bearing liabilities(2)
    14,105,355       847,241       6.01       10,479,447       606,725       5.79  
                                                 
Net finance spread
          $ 690,070       3.35 %           $ 611,035       4.05 %
                                                 
Net finance margin
                    4.20 %                     4.94 %
                                                 
 
 
(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.


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The increase in consolidated operating expenses from 2006 to 2007 was primarily due to a $21.8 million increase in total employee compensation and an increase of $21.2 million in depreciation and amortization expense primarily resulting from increases in our direct real estate investments over the previous year. The higher employee compensation was attributable to a $12.5 million increase in incentive compensation, including an increase in restricted stock awards, and a $6.1 million increase in employee salaries. For the years ended December 31, 2007 and 2006, incentive compensation totaled $81.7 million and $69.2 million, respectively. Incentive compensation comprises annual bonuses, as well as stock options and restricted stock awards, which generally have vesting periods ranging from eighteen months to five years. The remaining increase in operating expenses for the year ended December 31, 2007 was primarily attributable to a $2.6 million increase in administrative expenses and a $2.1 million increase in rent expense.
 
The increase in consolidated operating expenses from 2006 to 2005 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 $2.2 million in travel and entertainment expenses and an increase of $3.5 million in other general business expenses.
 
 
As a result of our decision to elect REIT status beginning with the tax year ended December 31, 2006, we provided for income taxes for the years ended December 31, 2007 and 2006, based on effective tax rates of 39.4% and 39.9%, respectively, for the income earned by our TRSs. We did not provide for any income taxes for the income earned by our qualified REIT subsidiaries for the years ended December 31, 2007 and 2006. We provided for income taxes on the consolidated income earned based on a 33.2%, 19.4% and 38.8% effective tax rates in 2007, 2006 and 2005, respectively. Our overall effective tax for the year ended December 31, 2006 included the reversal of $4.7 million in net deferred tax liabilities relating to REIT qualifying activities, into income, in connection with our REIT election. The increased effective tax rate on consolidated net income for the year ended December 31, 2007, compared to the year ended December 31, 2006, is due to our TRSs accounting for a greater percentage of our annual consolidated net income in 2007 than in 2006. All of our consolidated net income for the year ended December 31, 2005 was subject to income tax, which resulted in a higher effective tax rate.


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Adjusted earnings, as previously defined, were $448.2 million, or $2.32 per diluted share, for the year ended December 31, 2007, and $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 years ended December 31, 2007 and 2006, was as follows:
 
                 
    December 31,  
    2007     2006  
    ($ in thousands, except per
 
    share data)  
 
Net income
  $ 176,287     $ 279,276  
Add:
               
Real estate depreciation and amortization(1)
    31,785       10,323  
Amortization of deferred financing fees(2)
    29,783       30,842  
Non-cash equity compensation
    44,488       33,294  
Net realized and unrealized losses on residential mortgage investment portfolio, including related derivatives(3)
    81,022       5,862  
Unrealized losses (gains) on derivatives and foreign currencies, net
    51,233       (1,470 )
Unrealized losses on investments, net
    12,615       7,524  
Provision for loan losses
    78,641       81,662  
Recoveries(4)
           
Less:
               
Charge offs(5)
    57,679       16,510  
Nonrecurring items(6)
          4,725  
Cumulative effect of accounting change, net of taxes
          370  
                 
Adjusted earnings
  $ 448,175     $ 425,708  
                 
Net income per share:
               
Basic — as reported
  $ 0.92     $ 1.68  
Diluted — as reported
  $ 0.91     $ 1.65  
Average shares outstanding:
               
Basic — as reported
    191,697,254       166,273,730  
Diluted — as reported
    193,282,656       169,220,007  
Adjusted earnings per share:
               
Basic
  $ 2.34     $ 2.56  
Diluted(7)
  $ 2.32     $ 2.51  
Average shares outstanding:
               
Basic
    191,697,254       166,273,730  
Diluted(8)
    194,792,918       171,551,972  
 
 
(1) Depreciation and amortization for direct real estate investments only. Excludes depreciation for corporate leasehold improvements, fixed assets and other non-real estate items.
 
(2) Includes amortization of deferred financing fees and other non-cash interest expense.
 
(3) Includes adjustments to reflect the realized gains and losses and the period change in fair value of RMBS and related derivative instruments.
 
(4) Includes all recoveries on loans during the period.
 
(5) 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.
 
(6) 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.
 
(7) Adjusted to reflect the impact of adding back noncontrolling interests expense totaling $3.1 million and $4.7 million for the years ended December 31, 2007 and 2006, 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.
 
(8) Adjusted to include average non-managing member units of 1,113,259 and 2,331,965 for the years ended December 31, 2007 and 2006, respectively, which were considered dilutive to adjusted earnings per share, but are antidilutive to GAAP net income per share.


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   Comparison of the Years Ended December 31, 2007 and 2006
 
We have reclassified all comparative prior period segment information to reflect our three reportable segments. The discussion that follows differentiates our results of operations between our segments. All references to commercial loans below include loans, loans held for sale and receivables under reverse-repurchase agreements.
 
   Commercial Finance Segment
 
Our Commercial Finance segment operating results for the year ended December 31, 2007, compared to the year ended December 31, 2006, were as follows:
 
                                 
    Year Ended December 31,              
    2007     2006     $ Change     % Change  
    ($ in thousands)        
 
Interest income
  $ 928,190     $ 749,011     $ 179,179       24 %
Fee income
    162,395       170,485       (8,090 )     (5 )
Interest expense
    481,605       344,988       136,617       40  
Provision for loan losses
    77,576       81,211       (3,635 )     (4 )
Operating expenses
    220,550       193,053       27,497       14  
Other income
    883       37,297       (36,414 )     (98 )
Noncontrolling interests expense
    (1,037 )     (806 )     (231 )     (29 )
Income taxes
    87,563       67,132       20,431       30  
Cumulative effect of accounting change, net of taxes
          370       (370 )     N/A  
Net income
    225,211       271,585       (46,374 )     (17 )
 
 
The increase in interest income was due to the growth in average interest earning assets, primarily loans, of $2.0 billion, or 28%. This increase was partially offset by a decrease in the interest component of yield to 9.96% for the year ended December 31, 2007, from 10.28% for the year ended December 31, 2006. The decrease in the interest component of yield was primarily due to a decrease in our lending spread, partially offset by an increase in short-term interest rates. During the year ended December 31, 2007, our commercial finance spread to average one-month LIBOR was 4.71% compared to 5.19% for the year ended December 31, 2006. 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 finance portfolio as we continue to pursue the expanded opportunities afforded to us by our REIT election. As a REIT, we can make the same, or better, after tax return on loans with a lower interest rate than on loans with a higher interest rate held prior to becoming 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.
 
 
The decrease in fee income was primarily the result of a decrease in prepayment-related fee income, which totaled $56.1 million for the year ended December 31, 2007, compared to $66.7 million for the year ended December 31, 2006. Prepayment-related fee income contributed 0.60% and 0.92% to yield for the years ended December 31, 2007 and 2006, respectively. Yield from fee income, including prepayment related fees, decreased to 1.74% for the year ended December 31, 2007, from 2.34% for the year ended December 31, 2006.
 
 
We fund our growth largely through debt. The increase in interest expense was primarily due to an increase in average borrowings of $2.0 billion, or 35%. Our cost of borrowings increased to 6.31% for the year ended December 31, 2007, from 6.12% for the year ended December 31, 2006. This increase was the result of higher


49


 

LIBOR and CP rates on which interest on our term securitizations and credit facilities are based. The increase was also the result of higher borrowing spreads and higher deferred financing fees on some of our term securitizations and on some of our credit facilities, and increases in the cost of our convertible debt following the exchange in April 2007.
 
 
Net finance margin, defined as net investment income (which includes interest and fee income less interest expense) divided by average income earning assets, was 6.54% for the year ended December 31, 2007, a decrease of 135 basis points from 7.89% the year ended December 31, 2006. The decrease in net finance margin was primarily due to the increase in interest expense resulting from higher leverage, a higher cost of funds, and a decrease in yield on total income earning assets. Net finance spread, which represents the difference between our gross yield on income earning assets and the cost of our interest bearing liabilities, was 5.40% for the year ended December 31, 2007, a decrease of 110 basis points from 6.50% for the year ended December 31, 2006. Gross yield is the sum of interest and fee 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.
 
The yields of income earning assets and the costs of interest bearing liabilities in our Commercial Finance segment for the years ended December 31, 2007 and 2006, were as follows:
 
                                                 
    Year Ended December 31,  
    2007     2006  
    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
          $ 928,190       9.96 %           $ 749,011       10.28 %
Fee income
            162,395       1.74               170,485       2.34  
                                                 
Total interest earning assets(1)
  $ 9,316,088       1,090,585       11.70     $ 7,284,243       919,496       12.62  
Total interest bearing liabilities(2)
    7,633,687       481,605       6.31       5,639,481       344,988       6.12  
                                                 
Net finance spread
          $ 608,980       5.39 %           $ 574,508       6.50 %
                                                 
Net finance margin
                    6.54 %                     7.89 %
                                                 
 
 
(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.
 
 
The decrease in the provision for loan losses was the result of recognizing fewer allocated reserves during the year ended December 31, 2007.
 
 
The increase in operating expenses is due to the same factors which contributed to the increase in the consolidated operating expenses as described above. Operating expenses as a percentage of average total assets decreased to 2.31% for the year ended December 31, 2007, from 2.60% for the year ended December 31, 2006.
 
 
The decrease in other income was primarily attributable to a $48.6 million increase in net unrealized losses on derivative instruments, a $10.4 million increase in losses on foreign currency exchange and a $4.5 million decrease


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in the receipt of break-up fees. These decreases were partially offset by a $9.2 million increase in income relating to our equity interests in various investees that are not consolidated for financial statement purposes, an $8.9 million increase in net realized and unrealized gains in our equity investments and a $5.8 million increase in gains related to the sale of loans.
 
Our unrealized losses on derivative instruments were primarily due to the unrealized net change in the fair value of swaps used in hedging certain of our assets and liabilities to minimize our exposure to interest rate movements. We do not apply hedge accounting to these swaps and, as a result, changes in the fair value of such swaps are recognized in GAAP net income, while changes in the fair value of the underlying hedged exposures are not. To correct for this asymmetry and reflect the unrealized nature of the changes in fair value of such swaps, any such unrealized losses are added to, or any unrealized gains are subtracted from, GAAP earnings for purposes of determining our adjusted earnings, as previously defined.
 
Healthcare Net Lease Segment
 
Our Healthcare Net Lease segment operating results for the year ended December 31, 2007, compared to the year ended December 31, 2006, were as follows:
 
                                 
    Year Ended December 31,              
    2007     2006     $ Change     % Change  
          ($ in thousands)              
 
Operating lease income
  $ 97,013     $ 30,742     $ 66,271       216 %
Interest expense
    41,047       11,176       29,871       267  
Depreciation of direct real estate investments
    32,004       11,468       20,536       179  
Other operating expenses
    9,437       2,891       6,546       226  
Other (expense) income(1)
    993       (2,497 )     3,490       140  
Noncontrolling interests expense
    5,975       5,517       458       8  
Net income (loss)
    9,543       (2,807 )     12,350       440  
 
 
(1) Includes interest income.
 
 
The increase in operating lease income is due to an increase in our direct real estate investments, which are leased to healthcare industry clients through long-term, triple-net operating leases. During the years ended December 31, 2007 and 2006, our average balance of direct real estate investments was $947.9 million and $260.3 million, respectively.
 
 
The increase in interest expense was primarily due to an increase in average borrowings of $413.3 million, or 225%, corresponding to an increase in the size of the portfolio. Our cost of borrowings increased to 6.87% for the year ended December 31, 2007, from 6.08% for the year ended December 31, 2006. Our overall borrowing spread to average one-month LIBOR for the year ended December 31, 2007, was 1.62% compared to 0.99% for the year ended December 31, 2006.
 
 
Net finance margin, defined as net investment income (which includes interest and operating lease income less interest expense) divided by average income earning assets, was 5.84% for the year ended December 31, 2007, a decrease of 142 basis points from 7.26% for the year ended December 31, 2006. Net finance spreads were 3.36% and 5.73%, respectively, for the years ended December 31, 2007 and 2006. Net finance spread is the difference between yield on interest earning assets and the cost of our interest bearing liabilities. The decrease in net finance spread is attributable to the changes in its components as described above.


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The increase in depreciation was due to increases in our direct real estate investments over the previous year. As of December 31, 2007, we had $1.0 billion in direct real estate investments, an increase of $295.3 million, or 40.9%, from December 31, 2006.
 
 
The increase in operating expenses was consistent with the increase in operating expenses in the Commercial Finance Segment. Operating expenses as a percentage of average total assets decreased to 0.95% for the year ended December 31, 2007, from 1.04% for the year ended December 31, 2006.
 
Residential Mortgage Investment Segment
 
Our Residential Mortgage Investment segment operating results for the year ended December 31, 2007, compared to the year ended December 31, 2006, were as follows:
 
                                 
    Year Ended December 31,              
    2007     2006     $ Change     % Change  
          ($ in thousands)              
 
Interest income
  $ 348,351     $ 267,522     $ 80,829       30 %
Interest expense
    324,589       250,561       74,028       30  
Provision for loan losses
    1,065       351       714       203  
Operating expenses
    6,000       8,640       (2,640 )     (31 )
Other (expense) income
    (75,164 )     2,528       (77,692 )     (3,073 )
Net (loss) income
    (58,467 )     10,498       (68,965 )     (657 )
 
 
The increase in interest income was primarily due to the growth in average interest earning assets of $1.3 billion, or 27%.
 
 
The increase in interest expense was primarily due to an increase in average borrowings of $1.2 billion, or 26%, corresponding to an increase in the size of the portfolio. Our cost of borrowings increased to 5.53% for the year ended December 31, 2007, from 5.38% for the year ended December 31, 2006. This increase was primarily due to an increase in the short term interest rate market index on which our cost of borrowings is based.
 
 
The decrease in operating expenses was primarily due to a decrease in compensation and benefits and professional fees. Operating expenses as a percentage of average total assets decreased to 0.11% for the year ended December 31, 2007, from 0.18% for the year ended December 31, 2006.
 
 
The net loss was attributable to net realized and unrealized losses on derivative instruments related to our residential mortgage investments of $79.6 million and other-than-temporary declines in the fair value of our Non-Agency MBS of $30.4 million. These losses were partially offset by net unrealized gains on our Agency MBS of $34.9 million. The value of Agency MBS relative to risk-free investments was impacted during the year ended December 31, 2007 by the broad credit market disruption.
 
 
All amounts below relate only to our Commercial Finance segment for the year ended December 31, 2006 and are compared to our consolidated results for the year ended December 31, 2005, as substantially all activity for the


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year ended December 31, 2005, was related to commercial finance activity. All references to commercial loans below include loans, loans held for sale and receivables under reverse-repurchase agreements.
 
Commercial Finance Segment
 
Our Commercial Finance segment operating results for the year ended December 31, 2006, compared to the year ended December 31, 2005, were as follows:
 
                                 
    Year Ended December 31,              
    2006     2005     $ Change     % Change  
          ($ in thousands)              
 
Interest income
  $ 749,011     $ 514,652     $ 234,359       46 %
Fee income
    170,485       130,638       39,847       31  
Interest expense
    344,988       185,935       159,053       86  
Provision for loan losses
    81,211       65,680       15,531       24  
Operating expenses
    193,053       143,836       49,217       34  
Other income
    37,297       19,233       18,064       94  
Noncontrolling interests expense
    (806 )           (806 )     N/A  
Income taxes
    67,132       104,400       (37,268 )     (36 )
Cumulative effect of accounting change, net of taxes
    370             370       N/A  
Net income
    271,585       164,672       106,913       65  
 
 
The 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 10.28% 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 5.19% 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 finance 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 held 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.
 
 
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.
 
 
We fund our growth largely through borrowings. The increase in interest expense was primarily due to an increase in average borrowings of $1.4 billion, or 34%, 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


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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.
 
 
Net finance margin, defined as net investment income (which includes interest and fee income less interest expense) divided by average income earning assets, was 7.89% for the year ended December 31, 2006, a decrease of 76 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 6.50% for the year ended December 31, 2006, a decrease of 122 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.
 
The yields of income earning assets and the costs of interest bearing liabilities in our Commercial Finance 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       10.28 %           $ 514,652       9.69 %
Fee income
            170,485       2.34               130,638       2.46  
                                                 
Total interest earning assets(1)
  $ 7,284,243       919,496       12.62     $ 5,309,530       645,290       12.15  
Total interest bearing liabilities(2)
    5,639,481       344,988       6.12       4,193,128       185,935       4.43  
                                                 
Net finance spread
          $ 574,508       6.50 %           $ 459,355       7.72 %
                                                 
Net finance margin
                    7.89 %                     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.
 
 
The increase in the provision for loan losses 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.
 
 
The increase in operating expenses is due to the same factors which contributed to the increase in the consolidated operating expenses described above. Operating expenses as a percentage of average total assets decreased to 2.60% for the year ended December 31, 2006, from 2.65% 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


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$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.
 
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.
 
Financial Condition
 
Commercial Finance Segment
 
 
We provide commercial loans to clients that require customized and sophisticated financing. We also selectively make equity investments. The composition of our Commercial Finance segment portfolio as of December 31, 2007 and 2006, was as follows:
 
                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Commercial loans
  $ 9,867,737     $ 7,850,198  
Investments
    227,144       150,090  
                 
Total
  $ 10,094,881     $ 8,000,288  
                 
 
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, 2007 and 2006, was as follows:
 
                                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                               
Senior secured loans(1)
  $ 5,695,167       58 %   $ 4,704,166       60 %
First mortgage loans(1)
    2,995,048       30       2,542,222       32  
Subordinate loans
    1,177,522       12       603,810       8  
                                 
Total
  $ 9,867,737       100 %   $ 7,850,198       100 %
                                 
Composition of loan portfolio by business:
                               
Corporate Finance
  $ 2,979,241       30 %   $ 2,234,734       29 %
Healthcare and Specialty Finance
    2,934,666       30       2,775,748       35  
Structured Finance
    3,953,830       40       2,839,716       36  
                                 
Total
  $ 9,867,737       100 %   $ 7,850,198       100 %
                                 
 
 
(1) Includes Term B loans.


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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, 2007, were as follows:
 
                                 
                      Average Loan
 
    Number
    Average
    Number of
    Size per
 
    of Loans     Loan Size     Clients     Client  
    ($ in thousands)  
 
Composition of loan portfolio by business:
                               
Corporate Finance
    542     $ 5,497       262     $ 11,371  
Healthcare and Specialty Finance
    410       7,158       287       10,225  
Structured Finance
    262       15,091       210       18,827  
                                 
Overall loan portfolio
    1,214       8,128       759       13,001  
                                 
 
The scheduled maturities of our commercial loan portfolio by loan type as of December 31, 2007, 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 loans(1)
  $ 575,728     $ 4,556,300     $ 563,139     $ 5,695,167  
First mortgage loans(1)
    1,182,592       1,681,152       131,304       2,995,048  
Subordinate loans
    67,161       451,729       658,632       1,177,522  
                                 
Total
  $ 1,825,481     $ 6,689,181     $ 1,353,075     $ 9,867,737  
                                 
 
 
(1) Includes Term B loans.
 
The dollar amounts of all fixed-rate and adjustable-rate commercial loans by loan type as of December 31, 2007, were as follows:
 
                         
    Adjustable
    Fixed
       
    Rates     Rates     Total  
    ($ in thousands)  
 
Composition of loan portfolio by loan type:
                       
Senior secured loans(1)
  $ 5,661,098     $ 34,069     $ 5,695,167  
First mortgage loans(1)
    2,673,877       321,171       2,995,048  
Subordinate loans
    1,048,738       128,784       1,177,522  
                         
Total
  $ 9,383,713     $ 484,024     $ 9,867,737  
                         
Percentage of total loan portfolio     95%       5%       100%  
                         
 
 
(1) Includes Term B loans.
 
As of December 31, 2007, our Corporate Finance, Healthcare and Specialty Finance and Structured Finance businesses had commitments to lend up to an additional $0.6 billion, $2.0 billion and $2.1 billion, respectively, to 262, 287 and 210 existing clients, respectively. Commitments do not include transactions for which we have signed commitment letters but not yet signed definitive binding agreements. Throughout 2007, 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, 2007 and 2006, the principal balances of loans 60 or more days contractually delinquent, non-accrual loans and impaired loans in our commercial finance portfolio were as follows:
 
                 
    December 31,  
Commercial Loan Asset Classification
  2007     2006  
    ($ in thousands)  
 
Loans 60 or more days contractually delinquent
  $ 74,298     $ 88,067  
Non-accrual loans(1)
    170,522       183,483  
Impaired loans(2)
    318,945       281,377  
Less: loans in multiple categories
    (226,021 )     (230,469 )
                 
Total
  $ 337,744     $ 322,458  
                 
Total as a percentage of total loans     3.42%       4.11%  
                 
 
 
(1) Includes commercial loans with an aggregate principal balance of $55.5 million and $47.0 million as of December 31, 2007 and 2006, respectively, which were also classified as loans 60 or more days contractually delinquent. As of December 31, 2007 and 2006, there were no loans classified as held for sale that were placed on non-accrual status.
 
(2) Includes commercial loans with an aggregate principal balance of $55.5 million and $47.0 million as of December 31, 2007 and 2006, respectively, which were also classified as loans 60 or more days contractually delinquent, and commercial loans with an aggregate principal balance of $170.5 million and $183.5 million as of December 31, 2007 and 2006, respectively, which were also placed 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 include 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 as well as loans that we have assessed as impaired, but for which we ultimately expect to collect all payments.
 
During the year ended December 31, 2007, commercial loans with an aggregate carrying value of $189.6 million as of December 31, 2007, were involved in troubled debt restructurings as defined by SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructurings. As of December 31, 2007, commercial loans with an aggregate carrying value of $263.9 million were involved in troubled debt restructurings. Additionally, under SFAS No. 114, loans involved in 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 that were involved in troubled debt restructurings was $23.1 million as of December 31, 2007. For the year ended December 31, 2006, commercial loans with an aggregate carrying value of $194.7 million as of December 31, 2006, were involved in troubled debt restructurings. The allocated reserve for commercial loans that were involved in troubled debt restructurings was $31.5 million as of December 31, 2006.
 
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 $138.9 million and $120.6 million as of December 31, 2007 and 2006, respectively. These amounts equate to 1.41% and 1.54% of gross loans as of December 31, 2007 and 2006, respectively. Of our total allowance for loan losses as of December 31, 2007 and 2006, $27.4 million and $37.8 million, respectively, were allocated to impaired loans. During the years ended December 31, 2007 and 2006, we charged off loans totaling $57.5 million and $48.0 million, respectively. Net charge offs as a percentage of average loans were 0.64% and 0.69% for the years ended December 31, 2007 and 2006, respectively.


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We commonly make investments in our clients in connection with our loans. These investments usually comprise equity interests such as common stock, preferred stock, limited liability company interests, limited partnership interests and warrants, but sometimes are in the form of subordinated debt if that is the form in which the equity sponsor makes its investment.
 
As of December 31, 2007 and 2006, the carrying values of our investments in our Commercial Finance segment were $227.1 million and $150.1 million, respectively. Included in these balances were investments carried at fair value totaling $27.9 million and $34.6 million, respectively.
 
Healthcare Net Lease Segment
 
 
We acquire real estate for long-term investment purposes. These real estate investments are generally long-term care facilities leased through 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, 2007 and 2006, we had $1.0 billion and $722.3 million, respectively, in direct real estate investments, which consisted primarily of land and buildings.
 
Residential Mortgage Investment Segment
 
 
We invest directly in residential mortgage investments and as of December 31, 2007 and 2006, our portfolio of residential mortgage investments was as follows:
 
                 
    December 31,  
    2007     2006  
    ($ in thousands)  
 
Mortgage-related receivables(1)
  $ 2,041,917     $ 2,295,922  
Residential mortgage-backed securities:
               
Agency(2)
    4,060,605       3,502,753  
Non-Agency(2)
    4,632       34,243  
                 
Total
  $ 6,107,154     $ 5,832,918  
                 
 
 
(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. Agency MBS include mortgage-backed securities that were issued and are guaranteed by Fannie Mae or Freddie Mac. We also have invested in Non-Agency MBS, which are RMBS issued by non-government sponsored entities that are credit-enhanced through the use of subordination or in other ways. 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 5.07% as of December 31, 2007, and the weighted average reset date for the portfolio was approximately 41 months. The weighted average net coupon of Non-Agency MBS in our portfolio was 7.9% as of December 31, 2007. The fair values of our Agency MBS and Non-Agency MBS were $4.1 billion and $4.6 million, respectively, as of December 31, 2007.


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As of December 31, 2007, we had $2.0 billion in mortgage-related receivables secured by prime residential mortgage loans. As of December 31, 2007, the weighted average interest rate on these receivables was 5.38%, and the weighted average contractual maturity was approximately 28 years. See further discussion on our accounting treatment of mortgage-related receivables in Note 4, Mortgage-Related Receivables and Related Owner Trust Securitizations, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
During 2007, we also saw decreases in the carrying value of certain of our residential mortgage investments, representing a decline of approximately 1.2% in the value of the portfolio, as the market dislocation impacted the pricing relationship between mortgage assets (including Agency MBS that we own) and low risk fixed income securities. We actively manage the interest rate risk associated with this portfolio pursuant to a risk management strategy that is further described below in Market Risk Management. Our investment strategy explicitly contemplates the potential for upward and downward shifts in the carrying value of the portfolio, including shifts of the magnitude that we saw during 2007. We believe that these reductions in value are temporary in nature. Given our intention to hold the investments to maturity, temporary variations in value up or down have no material impact on our investment strategy.
 
 
As of December 31, 2007 and 2006, mortgage-related receivables, whose underlying mortgage loans are 90 or more days past due or were in the process of foreclosure and foreclosed were as follows:
 
                 
    December 31  
    2007     2006  
    ($ in thousands)  
 
Mortgage-related receivables whose underlying mortgage loans are 90 or more days past due or are in the process of foreclosure
  $ 14,751     $ 2,364  
Percentage of mortgage-related receivables
    0.72 %(1)     0.10 %
Foreclosed assets
  $ 3,264        
Percentage of mortgage-related receivables
    0.16 %      
 
 
(1) By comparison, in its January 2008 Monthly Summary Report, Fannie Mae reported a serious delinquency rate (“SDQ”) of 0.98% for December 2007, for conventional single family loans that are three months or more past due or in foreclosure process while, in its January 2008 Monthly Volume Summary, Freddie Mac reported an SDQ of 0.65% for December 2007, for comparable types of single family loans.
 
In connection with recognized mortgage-related receivables, we recorded provisions for loan losses of $1.1 million and $0.4 million for the years ended December 31, 2007 and 2006, respectively. During the year ended December 31, 2007, we charged off $0.7 million of these mortgage-related receivables. The allowance for loan losses was $0.8 million and $0.4 million as of December 31, 2007 and 2006, respectively, and was recorded in the accompanying audited consolidated balance sheets as a reduction to the carrying value of mortgage-related receivables. For the year ended December 31, 2007, we recognized $0.2 million in realized losses on such mortgage-related receivables.
 
 
We have financed our investments in RMBS primarily through repurchase agreements. As of December 31, 2007 and 2006, our outstanding repurchase agreements totaled $3.9 billion and $3.4 billion, respectively. As of December 31, 2007, repurchase agreements that we executed had maturities of between seven days and 13 months and a weighted average borrowing rate of 5.12%.
 
Our investments in residential mortgage-related receivables were financed primarily through debt issued in connection with two securitization transactions. As of December 31, 2007, the total outstanding balance of these debt obligations was $2.0 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, 2007. The notes within each securitization are expected to mature at various dates through 2036.


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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, repaying borrowings, paying dividends and for other general business purposes. Commitments do not include transactions for which we have signed commitment letters but not yet signed definitive binding agreements. Our primary sources of funds consist of cash flows from operations, borrowings under our 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.
 
In 2005, we applied for an Industrial Loan Corporation (“ILC”) charter with the State of Utah and for federal deposit insurance with the Federal Deposit Insurance Corporation (“FDIC”). We anticipate that once operational, the ILC would enable us to obtain an additional source of funding for our loans by raising wholesale deposits in the brokered deposit market. In March 2007, the FDIC approved our application for federal deposit insurance, subject to certain conditions. The Order issued by the FDIC expires on March 20, 2008 if the conditions of the Order have not been met. We have requested an extension of the expiration date to December 31, 2008 as it has taken longer than anticipated to satisfy certain conditions in the Order. The extension request is currently pending with the FDIC. We cannot assure you that the FDIC will act on our extension request prior to the expiration of the Order, or if it does act, that it will approve our request. If the FDIC does not grant our extension request, the Order will expire.
 
If the TierOne merger does not close and our ILC does not become operational, we expect to continue to fund our business using our primary sources of funds identified above.
 
As of December 31, 2007, the amount of our unfunded commitments to extend credit to our clients exceeded our unused funding sources and unrestricted cash by $813.3 million, a decrease of $288.0, or 26% from December 31, 2006. Commitments do not include transactions for which we have signed commitment letters but not yet signed definitive binding agreements. We expect that our commercial loan commitments will continue to exceed our available funds indefinitely. Our obligation to fund unfunded commitments is generally 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 specified preconditions to borrowing. In some cases, our unfunded commitments do not require additional collateral to be provided by a debtor as a prerequisite to future fundings by us. 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 our commitments, our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract and lender liability for us and damage our reputation in the marketplace, which could have a material adverse effect on our business.
 
As discussed below, we have funded and expect to continue to fund purchases of residential mortgage investments primarily through repurchase agreements and term debt using leverage consistent with industry standards for these assets.
 
We 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. 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 equal to at least 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.


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We anticipate that we will need to raise additional capital from time to time to support our growth. We plan to continue to raise equity and, assuming the current dislocation in the credit markets improves, we plan to continue to access the debt markets 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.
 
Cash and Cash Equivalents
 
As of December 31, 2007 and 2006, we had $178.7 million and $396.2 million, respectively, in cash and cash equivalents. We invest cash on hand in short-term liquid investments.
 
We had $513.8 million and $240.9 million of restricted cash as of December 31, 2007 and 2006, 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.
 
Sources and Uses of Cash
 
For the years ended December 31, 2007, 2006 and 2005, we used cash from operations of $752.8 million, $0.4 million and $224.7 million, respectively. Included within these amounts are cash outflows related to the purchase of loans held for sale and Agency MBS that are classified as trading investments.
 
Cash from our financing activities is generated from proceeds from our issuances of equity, borrowings on our repurchase agreements, credit facilities and term debt and from our issuances 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, 2007, 2006 and 2005, we generated cash flow from financing activities of $2.2 billion, $4.8 billion and $2.1 billion, respectively.
 
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, 2007, 2006 and 2005, we used cash in investing activities of $1.7 billion, $4.8 billion and $1.7 billion, respectively.
 
Borrowings
 
As of December 31, 2007 and 2006, we had outstanding borrowings totaling $15.0 billion and $12.9 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, 2007.


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Our funding sources, maximum facility amounts, amounts outstanding, and unused capacity, subject to certain minimum equity requirements and other covenants and conditions as of December 31, 2007, were as follows:
 
                         
    Maximum
             
    Facility
    Amount
    Unused
 
Funding Source
  Amount     Outstanding     Capacity(1)  
    ($ in thousands)  
 
Repurchase agreements
  $ 4,210,027     $ 3,910,027     $ 300,000  
Credit facilities
    5,632,101       2,207,063       3,425,038  
Term debt(2)
    7,405,675       7,255,675       150,000  
Other borrowings(3)
          1,594,870        
                         
Total
  $ 17,247,803     $ 14,967,635     $ 3,875,038  
                         
 
 
(1) Excludes issued and outstanding letters of credit totaling $110.5 million as of December 31, 2007.
 
(2) As of December 31, 2007, only our series 2006-A class A-R, variable funding note provides the ability for additional capacity.
 
(3) As of December 31, 2007, our other borrowings, which includes convertible debt, subordinated debt, and mortgage debt, did not provide any ability for us to draw down additional amounts.
 
Our overall debt strategy emphasizes diverse sources of financing, including both secured and unsecured financings. As of December 31, 2007, approximately 88% of our debt was collateralized by our loans, equity investments, direct real estate investments and residential mortgage investments and approximately 12% was unsecured. We intend to increase our percentage of unsecured debt over time through both unsecured credit facilities and unsecured term debt. In April 2007, Standard and Poor’s issued a BBB- senior unsecured debt rating and Fitch Ratings affirmed our BBB- senior unsecured debt rating. We may apply for ratings from other rating agencies and our goal is to improve all of these ratings over time. As our ratings improve, we expect to 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 the combined portfolios of our Commercial Finance segment and Healthcare Net Lease segment to remain below 5x.
 
During the second half of 2007, we saw and continue to see negative effects from the credit market disruption in the form of a higher cost of funds on borrowings as measured by a spread to LIBOR. As a result, financings completed during the second half of 2007 were more expensive and provided lower leverage than similar financings we completed prior to that period. We expect to experience greater difficulty and higher cost in securing term debt for our loans, especially commercial real estate. We also expect to see higher borrowing costs and potentially lower advance rates on our secured credit facilities as we seek to renew them in 2008. We may not be able to renew all of those facilities at their existing commitment levels. However, our commercial finance business model has been built around low leverage, and we do not seek to maximize leverage. As a result, we believe we can withstand some reduction in the advance rates of our facilities and expect to retain sufficient committed capacity to fund our business. While we expect the trend toward lower leverage and incrementally more expensive financings to continue in 2008, we believe that these same market conditions that adversely affect us as a borrower have allowed and will continue to allow us, as a lender, to structure new loans on more favorable terms and at higher yields.
 
 
As of December 31, 2007, we had 12 repurchase agreements with various financial institutions, which we used to finance the purchases of RMBS during the year ended December 31, 2007. The terms of our borrowings pursuant to repurchase agreements typically reset every 30 days. During the year ended December 31, 2007, we negotiated longer terms for some of these repurchase agreements with several counterparties. As a result, as of December 31, 2007, approximately 37% of the borrowings outstanding under repurchase agreements had terms ranging from 30 days to 1.25 years. Agency MBS and short term liquid investments collateralize our repurchase agreements as of December 31, 2007. Substantially all of our repurchase agreements and related derivative instruments require us to deposit additional collateral if the market value of existing collateral declines below specified margin requirements, which may require us to sell assets to reduce our borrowings.


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Our committed credit facility capacities were $5.6 billion and $5.0 billion as of December 31, 2007 and 2006, respectively. As of December 31, 2007, we had nine credit facilities, seven of which are secured and two of which are unsecured, with a total of 25 financial institutions. We primarily use these facilities to fund our assets and for general corporate purposes. To date, many of our assets have been held, or warehoused, in our secured credit facilities until we complete a term debt transaction in which we securitize a pool of our assets 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, 2007, our credit facilities’ maturity dates, committed capacities and outstanding principal balances were as follows:
 
                 
    Committed
    Principal
 
    Capacity     Outstanding  
    ($ in thousands)  
 
Unsecured credit facility scheduled to mature February 19, 2008(1)
  $ 75,120     $ 71,338  
Secured credit facility scheduled to mature March 26, 2008
    200,000       89,120  
Secured credit facility scheduled to mature August 1, 2008
    1,500,000       500,000  
Secured credit facility scheduled to mature April 10, 2009
    220,000 (2)     40,971  
Secured credit facility scheduled to mature April 27, 2009
    1,400,000 (2)     442,150  
Secured credit facility scheduled to mature June 27, 2009
    700,000 (2)     352,481  
Unsecured credit facility scheduled to mature March 13, 2010(3)
    1,070,000       480,238  
Secured credit facility scheduled to mature July 19, 2010
    102,206       102,206  
Secured credit facility scheduled to mature September 30, 2010
    364,775       128,559  
                 
Total
  $ 5,632,101     $ 2,207,063  
                 
 
 
(1) Our CAD75 million credit facility matured on February 19, 2008, as scheduled, and was not renewed. At maturity, we repaid the outstanding balance using cash from our operating accounts and by drawing on other credit facilities. We do not expect the absence of this credit facility to materially affect our liquidity.
 
(2) Credit facility is subject to 364-day liquidity renewal. On termination or maturity, amounts due under the credit facility may, in the absence of a default, be repaid from proceeds from amortization of the collateral pool.
 
(3) As of December 31, 2007, the scheduled maturity date was March 13, 2009. In February 2008, we exercised our option to extend the maturity date of the credit facility to March 13, 2010.
 
As of February 27, 2008 our credit facilities’ committed capacity totaled $5.5 billion.
 
During 2007, we entered into four new credit facilities and amended various terms in certain of our existing credit facilities. For further information on our credit facilities, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
For our Commercial Finance segment, we have raised capital by securitizing pools of assets from our portfolio in permanent, on-balance-sheet term debt securitizations. For the year ended December 31, 2007, we completed four term debt securitizations totaling $3.2 billion. As of December 31, 2007, the outstanding balance of our term debt securitizations was $5.2 billion. For further information on these term debt securitizations, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
Within our Residential Mortgage Investment segment, we own beneficial interests in securitization trusts (the “Owner Trusts”), which, in 2006, issued $2.4 billion in senior notes and $105.6 million in subordinated notes backed by $2.5 billion of a diversified pool of adjustable rate commercial loans. As of December 31, 2007, the


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outstanding balance of our Owner Trust term debt was $2.0 billion. For further information on this debt, see Note 4, Mortgage-Related Receivables and Related Owner Trust Securitizations, and Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
We have raised capital through the issuance of convertible debt. During 2007, we issued one series of convertible debt, totaling $250.0 million. During 2007, we also completed exchange offers related to our two series of convertible debt issued in 2004. As of December 31, 2007, the outstanding balance of our convertible debt was $780.6 million. For further information on our convertible debt, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
We have raised junior subordinated capital through the issuance of trust preferred securities. During 2007,we issued two series of subordinated debt, totaling $79.9 million. As of December 31, 2007, the outstanding balance of our subordinated debt was $529.9 million. For further information our subordinated debt, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
For our Healthcare Net Lease segment, we use mortgage loans to finance certain of our direct real estate investments. As of December 31, 2007, the outstanding balance of our mortgage debt was $284.4 million. For further information on such mortgage loans, see Note 11, Borrowings, in our accompanying audited consolidated financial statements for the year ended December 31, 2007.
 
 
We, and some of our wholly owned subsidiaries, are required to comply with financial and non-financial covenants related to our debt financings and our servicing of loans collateralizing our secured credit facilities and term debt. 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 offer 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 years ended December 31, 2007 and 2006, we received proceeds of $607.8 million and $191.0 million, respectively, related to the direct purchase of 31.7 million and 7.7 million shares of our common stock pursuant to the DRIP, respectively. In addition, we received proceeds of $106.7 million and $17.2 million related to cash dividends reinvested in 5.4 million and 0.7 million shares of our common stock during the years ended December 31, 2007 and 2006, respectively.
 
 
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 in connection with our secured debt financings in order to legally isolate from us loans that we transfer to these vehicles if we were to be in bankruptcy.
 
We also use special purpose entities to facilitate the issuance of collateralized loan obligation transactions that are further described below in Commitments, Guarantees & Contingencies. Additionally, we purchase beneficial ownership interests in residential mortgage assets that are held by special purpose entities established by third parties.


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We evaluate all SPEs with which 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 if we also determine that we are the primary beneficiary of the entity. For special purpose entities for which we determine we are not the primary beneficiary, we account for our economic interests in these entities in accordance with the nature of our investments.