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CAPITALSOURCE 10-K 2009 Documents found in this filing:
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, 2008 Commission File No. 1-31753
4445
Willard Avenue, 12th Floor
Chevy Chase, MD 20815 (Address of Principal Executive Offices, Including Zip Code) (800) 370-9431
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. (Check one):
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, 2008 was $2,103,115,809.
As of February 17, 2009, the number of shares of the
Registrant’s Common Stock, par value $0.01 per share,
outstanding was 302,595,100.
Portions of CapitalSource Inc.’s Proxy Statement for the
2009 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.
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, including certain plans,
expectations, goals and projections and statements about growing
our deposit base and operations, our liquidity forecasts, credit
facilities and covenant compliance, our intention to sell
assets, the commercial real estate participation interest
(“the “A” Participation Interest”), economic
and market conditions for our business, securitization markets,
the performance of our loans, loan yields, our dividend policy,
approval of our application to become a bank holding company,
and regarding potential acquisitions. All statements contained
in this
Form 10-K
that are not clearly historical in nature are forward-looking,
and the words “anticipate,” “assume,”
“intend,” “believe,” “expect,”
“estimate,” “plan,” “will,”
“look forward” and similar expressions are generally
intended to identify forward-looking statements. All
forward-looking statements (including statements regarding
future financial and operating results and future transactions
and their results) involve risks, uncertainties and
contingencies, many of which are beyond our control, which may
cause actual results, performance, or achievements to differ
materially from anticipated results, performance or
achievements. Actual results could differ materially from those
contained or implied by such statements for a variety of
factors, including without limitation: changes in economic or
market conditions may result in increased credit losses and
delinquencies in our portfolio; continued or worsening
disruptions in economic and credit markets may continue to make
it very difficult for us to obtain financing on attractive terms
or at all, could prevent us from optimizing the amount of
leverage we employ and could adversely affect our liquidity
position; movements in interest rates and lending spreads may
adversely affect our borrowing strategy; operating CapitalSource
Bank under the California and FDIC regulatory regime could be
more costly than expected; we may not be successful in operating
CapitalSource Bank or maintaining or growing CapitalSource
Bank’s deposits or deploying its capital in favorable
lending transactions or originating or acquiring assets in
accordance with our strategic plan; we may not receive all
approvals needed to become a bank holding company and convert to
a commercial bank; competitive and other market pressures could
adversely affect loan pricing; the nature, extent, and timing of
any governmental actions and reforms; the success and timing of
other business strategies and asset sales; hedging activities
may result in reported losses not offset by gains reported in
our consolidated financial statements; and other risk 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, except as required by law.
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.
We are a commercial lender that provides financial products to
middle market businesses, and, through our wholly owned
subsidiary, CapitalSource Bank, provides depository products and
services in southern and central California.
We currently operate as three reportable segments:
1) Commercial Banking, 2) Healthcare Net Lease, and
3) Residential Mortgage Investment. Our Commercial Banking
segment comprises our commercial lending and banking business
activities; our Healthcare Net Lease segment comprises our
direct real estate investment business activities; and our
Residential Mortgage Investment segment comprises our remaining
residential mortgage investment and other investment activities
in which we formerly engaged to optimize our qualification as a
real estate investment trust (“REIT”). For financial
information about our segments, see Note 26, Segment
Data, in our accompanying audited consolidated financial
statements for the year ended December 31, 2008.
Through our Commercial Banking segment activities, we provide a
wide range of financial products to middle market businesses and
participate in broadly syndicated debt financings for larger
businesses. As of December 31, 2008, we had 1,072 loans
outstanding under which we had funded an aggregate of
$9.5 billion and held a $1.4 billion participation in
a pool of commercial real estate loans (the “A”
Participation Interest”). Within this segment,
CapitalSource Bank also offers depository products and services
in southern and central California that are insured by the
Federal Deposit Insurance Corporation (“FDIC”) to the
maximum amounts permitted by regulation.
Through our Healthcare Net Lease segment activities, we invest
in income-producing healthcare facilities, principally long-term
care facilities in the United States. We provide lease financing
to skilled nursing facilities and, to a lesser extent, assisted
living facilities, and long term acute care facilities. As of
December 31, 2008, we had $1.0 billion in direct real
estate investments comprising 186 healthcare facilities leased
to 40 tenants through long-term,
triple-net
operating leases. We currently intend to evaluate all potential
transactions to monetize the value of this business, including
debt financings, asset sales and corporate transactions.
Through our Residential Mortgage Investment segment activities,
we invested in certain residential mortgage assets and other
REIT qualifying investments to optimize our REIT structure
through 2008. As of December 31, 2008, our residential
mortgage investment portfolio totaled $3.3 billion, which
included investments in residential mortgage loans and
residential mortgage-backed securities (“RMBS”). Over
99% of our investments in RMBS were represented by
mortgage-backed securities that were issued and guaranteed by
Fannie Mae or Freddie Mac (hereinafter, “Agency
RMBS”). In addition, we hold mortgage-related receivables
secured by prime residential mortgage loans. During the first
quarter of 2009, we sold all of our Agency RMBS, and we intend
to merge the remaining assets currently in this segment into our
Commercial Banking segment in 2009.
In our Commercial Banking and Healthcare Net Lease segments, we
have three primary commercial lending businesses:
2008 was a transformational year for us in which we
commenced operations of CapitalSource Bank and announced our
intention to revoke our REIT status in 2009. Given these changes
and the current challenging economic environment, our business
plan has evolved to encompass two distinct strategies.
CapitalSource Bank, our liquid and well-capitalized bank, will
be the vehicle through which we fund all our new loans, while
CapitalSource Bank’s ultimate parent company, CapitalSource
Inc., and its non-bank subsidiaries (collectively, the
“Parent Company”) will manage liquidity and credit
outcomes as its portfolio runs off.
In July 2008, we acquired approximately $5.2 billion of
deposits, the “A” Participation Interest and 22 retail
banking branches from Fremont Investment & Loan
(“FIL”) and commenced operations of CapitalSource
Bank. We did not acquire FIL or any contingent liabilities.
During 2008, CapitalSource Bank purchased from our other
subsidiaries approximately $2.2 billion in commercial loans.
CapitalSource Bank operates pursuant to approvals received from
the FDIC and the California Department of Financial Institutions
(“DFI”), which require CapitalSource Bank to maintain
a total risk-based capital ratio of not less than 15%, a
tangible equity to tangible asset ratio of not less than 10%, an
adequate allowance for loan and lease losses and other customary
requirements applicable to de novo banks. The Parent
Company and CapitalSource
Bank are parties to a Capital Maintenance and Liquidity
Agreement (“CMLA”) with the FDIC requiring the Parent
Company to maintain CapitalSource Bank’s total risk-based
capital ratio at not less than 15%, to maintain the capital
levels of CapitalSource Bank at all times to meet the levels
required for a bank to be considered “well
capitalized” under the relevant banking regulations, and
for the Parent Company to provide a $150 million unsecured
revolving credit facility that CapitalSource Bank may draw on at
any time it or the FDIC deems necessary. The Parent Company and
CapitalSource Bank also are parties to a Parent Company
Agreement (“Parent Agreement”) with the FDIC requiring
the Parent Company to maintain the capital levels of
CapitalSource Bank at the levels required in the CMLA, and
providing the Parent Company’s consent to examination by
the FDIC for the FDIC to monitor compliance with the laws and
regulations applicable to the Parent Company.
CapitalSource Bank has access to a significant base of deposits,
which has diversified and strengthened our funding platform by
providing a lower and more stable cost of funds with less
reliance on the capital markets, positioning us to take
advantage of attractive lending opportunities we believe are now
available in the market.
Consistent with the business plan approved by our regulators, we
are pursuing our strategy of converting CapitalSource Bank to a
commercial bank and becoming a Bank Holding Company. To date we
have obtained approvals from the DFI and FDIC to convert
CapitalSource Bank from an industrial bank to a California
commercial bank. For the conversion to become effective, we must
be approved by the Federal Reserve as a Bank Holding Company
under the Bank Holding Company Act of 1956. We filed our Bank
Holding Company application with the Board of Governors of the
Federal Reserve in October 2008. That application is being
processed by the Federal Reserve Bank of Richmond and has not
been approved at this time. We are cooperating with the Federal
Reserve in providing access to such information as is needed to
make its decision on the pending application. We believe that
becoming a commercial bank will allow CapitalSource Bank to
offer a wider variety of deposit products and services to
customers; however, we cannot assure you that the Federal
Reserve will approve our application in which case CapitalSource
Bank would not convert to a commercial bank. Current guidance
from the U.S. Treasury Department provides that, since
CapitalSource Inc. did not obtain approval as a Bank Holding
Company prior to December 31, 2008, CapitalSource Inc. is
not eligible to obtain funding under the Capital Assistance
Program (“CAP”) or the Capital Purchase Program.
Although CapitalSource Bank has applied for CAP funding, there
is no assurance that CapitalSource Bank will be able to obtain
CAP funding or that it would accept the funding if offered.
We operated as a REIT, from 2006 through 2008. Historically, we
complied with REIT requirements in part through the acquisition,
funding and ongoing management of a portfolio of residential
mortgage-related investments including Agency securities. Our
Board of Directors determined it would be imprudent and perhaps
impossible to maintain a large compliance portfolio of
residential investment assets in 2009 based on current and
anticipated market conditions. Consequently, we revoked our REIT
election effective January 1, 2009.
From January 1, 2006 to the third quarter of 2007, we
presented 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 activities
and our Residential Mortgage Investment segment comprised all of
our activities related to our investments in residential
mortgage loans and RMBS. In the fourth quarter of 2007, we began
presenting financial results through three reportable segments:
1) Commercial Finance, 2) Healthcare Net Lease, and
3) Residential Mortgage Investment. Changes were 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.
Beginning in the third quarter of 2008, we changed the name of
our Commercial Finance segment to Commercial Banking to
incorporate depository products, services and investments of
CapitalSource Bank. We have reclassified all comparative prior
period segment information to reflect our three reportable
segments. For
financial information about our segments, see Note 26,
Segment Data, in our accompanying audited consolidated
financial statements for the year ended December 31, 2008.
Our primary commercial lending products, services and
investments include:
As of December 31, 2008, our portfolio of assets by type
was as follows (percentages by gross carrying values):
Commercial
Banking Segment Overview
As of December 31, 2008 and 2007, the composition of our
Commercial Banking segment portfolio was as follows:
As of December 31, 2008, we owned $642.7 million in
marketable securities,
available-for-sale.
Included in these marketable securities,
available-for-sale,
were discount notes issued by Fannie Mae, Freddie Mac and
Federal Home Loan Bank (“FHLB”) (“Agency Discount
Notes”), callable notes issued by Fannie Mae, Freddie Mac,
FHLB and Federal Farm Credit Bank (“Agency Callable
Notes”), bonds issued by the FHLB (“Agency
Debt”), commercial and residential mortgage-backed
securities issued and guaranteed by Fannie Mae, Freddie Mac or
Ginnie Mae (“Agency MBS”) and a corporate debt
security issued by Wells Fargo & Company and
guaranteed by the FDIC (“Corporate Debt”). With the
exception of the Corporate Debt, CapitalSource Bank pledged all
of the marketable securities,
available-for-sale,
to the FHLB of San Francisco as a source of contingent
borrowing capacity as of December 31, 2008. For further
information on our marketable securities,
available-for-sale,
see Note 8, Marketable Securities and Investments,
in the accompanying audited consolidated financial
statements for the year ended December 31, 2008.
As of December 31, 2008, the “A” Participation
Interest had an outstanding balance of $1.4 billion, which
includes $3.7 million of related accrued interest
receivable. For further information on the “A”
Participation Interest, see Note 7, Commercial Lending
Assets and Credit Quality, in our accompanying audited
consolidated financial statements for the year ended
December 31, 2008.
As of December 31, 2008 and 2007, our total commercial
portfolio had outstanding balances of $10.9 billion and
$9.9 billion, respectively. Included in these amounts were
loans, the “A” Participation Interest, loans held for
sale, and $93.3 million and $56.3 million of related
interest receivables (collectively, “Commercial Lending
Assets”) as of December 31, 2008 and 2007,
respectively.
Our total commercial loan portfolio reflected in the portfolio
statistics below includes loans, loans held for sale, and
$89.6 million and $56.3 million of related interest
receivables, as of December 31, 2008 and 2007,
respectively, and excludes the “A” Participation
Interest. The composition of our commercial loan portfolio by
loan type and by commercial lending business as of
December 31, 2008 and 2007, was as follows:
As of December 31, 2008, our commercial loan portfolio was
well diversified, with 1,072 loans to 679 clients operating in
multiple industries. We use the term “client” with
respect to loans to mean the legal entity that is the party to
whom we lend pursuant to a loan agreement. Throughout this
section, unless specifically stated otherwise, all figures
relate to our commercial loans outstanding as of
December 31, 2008.
As of December 31, 2008, our commercial loan portfolio by
industry was as follows (percentages by gross carrying values as
of December 31, 2008):
As of December 31, 2008, our largest commercial loan was a
$325.0 million mezzanine loan to a borrower which owns,
operates, leases or manages 205 skilled nursing facilities, 25
assisted living facilities and five transition care units in 13
states. As of December 31, 2008, our commercial loan
portfolio by loan balance was as follows:
As of December 31, 2008, our commercial loan portfolio by
client balance 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
2008. The principal executive offices of our clients were
located in 47 states, the District of Columbia, Puerto Rico
and selected international locations, primarily in Canada and
Europe. As of December 31, 2008, the largest geographical
concentration was New York, which made up approximately 13% 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, 2008,
comprised international borrowers, primarily located in Canada
and Europe. For the year ended December 31, 2008, less than
10% of our revenues were generated through our foreign
operations. As of December 31, 2008, our largest loan was
$325.0 million, and the combined total of the outstanding
aggregate balances of our ten largest loans represented 19% of
our commercial loan portfolio.
As of December 31, 2008, our commercial loan portfolio by
geographic region was as follows:
Our commercial loans have stated maturities at origination that
generally range from one to five years. As of December 31,
2008, the weighted average maturity and weighted average
remaining life of our entire commercial loan portfolio were
approximately 5.2 years and 2.5 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 ongoing fees.
As of December 31, 2008, the number of loans, average loan
size, number of clients and average loan size per client by
commercial lending business were as follows:
We own 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, 2008, which consisted
primarily of land and buildings.
As of December 31, 2008, our direct real estate investment
portfolio by geographic region was as follows:
No healthcare net lease client accounted for more than 10% of
our total revenues in 2008. We use the term “client”
with respect to our leased real estate investments to mean the
legal entity that is the party to whom we leased properties
pursuant to the lease agreement. As of December 31, 2008,
the largest geographical concentration was Florida, which made
up approximately 33% of our direct real estate investment
portfolio. As of December 31, 2008, the single largest
industry concentration in our direct real estate investment
portfolio was skilled nursing, which made up approximately 98%
of the investments.
As of December 31, 2008, our direct real estate investment
portfolio by asset balance was as follows:
See Item 2, Properties, for information about our
direct real estate investment properties.
As of December 31, 2008 and 2007, our portfolio of
residential mortgage investments was as follows:
While we were a REIT, we invested in Agency RMBS which are
mortgage-backed securities issued and guaranteed by Fannie Mae
or Freddie Mac. Non-Agency RMBS are 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.
Substantially all of our RMBS are collateralized by adjustable
rate residential mortgage loans, including hybrid adjustable
rate mortgage loans. We account for our Agency RMBS 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 RMBS 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
RMBS in our portfolio was 5.01% as of December 31, 2008,
and the weighted average reset date for the portfolio was
approximately 25 months. The weighted average net coupon of
Non-Agency RMBS in our portfolio was 3.73% as of
December 31, 2008. The fair
values of our Agency RMBS and Non-Agency RMBS, including accrued
interest, were $1.5 billion and $0.4 million,
respectively, as of December 31, 2008. During the first
quarter of 2009, we sold all of our Agency RMBS in this segment
and we intend to merge the remaining assets currently in this
segment into our Commercial Banking segment in 2009.
As further discussed in Note 5, Mortgage-Related
Receivables and Related Owner Trust Securitizations, of
our accompanying audited consolidated financial statements for
the year ended December 31, 2008, we had $1.8 billion
in mortgage-related receivables that were secured by prime
residential mortgage loans as of December 31, 2008. As of
December 31, 2008, the weighted average interest rate on
such receivables was 5.36%, and the weighted average contractual
maturity was approximately 27 years.
We depend on depository and external financing sources to fund
our operations. We employ a variety of financing arrangements,
including retail savings and money market accounts, certificates
of deposit, secured credit facilities, term debt, convertible
debt, subordinated debt, equity and repurchase agreements.
CapitalSource Bank has financing availability with the FHLB
equal to 15% of CapitalSource Bank’s total assets. The
financing is subject to various terms and conditions including,
but not limited to, the pledging of acceptable collateral,
satisfaction of the FHLB stock ownership requirement and certain
limits regarding the maximum term of debt. 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 competitive and characterized by varying
competitive factors. We compete with a large number of financial
services companies, including:
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:
Our bank operations are subject to extensive regulation by
federal and state regulatory agencies. This regulation is
intended primarily for the protection of depositors and the
deposit insurance fund, and secondarily for the stability of the
U.S. banking system. It is not intended for the benefit of
stockholders of financial institutions.
CapitalSource Bank is a California state-chartered industrial
bank and is subject to supervision and regular examination by
the FDIC and the DFI. In addition, CapitalSource Bank’s
deposits are insured by the FDIC.
Although the Parent Company is not directly regulated or
supervised by the DFI, the FDIC or any other federal or state
bank regulatory authority, it is subject to regulatory oversight
with respect to guidelines and agreements concerning its
relationship with CapitalSource Bank, transactions between it
and CapitalSource Bank and other areas required by the FDIC. The
Parent Company also is subject to regulation by other applicable
federal and state agencies, such as the SEC. We are required to
file periodic reports with these regulators and provide any
additional information that they may require.
The following summary describes some of the more significant
laws, regulations, and policies that affect our operations; it
is not intended to be a complete listing of all laws that apply
to us. From time to time, federal, state and foreign legislation
is enacted and regulations are adopted which may have the effect
of materially increasing the cost of doing business, limiting or
expanding permissible activities, or affecting the competitive
balance between banks and other financial services providers. We
cannot predict whether or when potential legislation will be
enacted, and if enacted, the effect that it, or any implementing
regulations, would have on our financial condition or results of
operations.
CapitalSource Bank is subject to supervision and regulation by
the DFI and FDIC and is a member of the FHLB System and its
deposits are insured up to applicable limits by the FDIC.
CapitalSource Bank must file reports with the DFI and the FDIC
concerning its activities and financial condition in addition to
obtaining regulatory approvals prior to undertaking changes to
its approved business plan for the first three years, or
entering into certain transactions such as mergers with, or
acquisitions of, other financial institutions. There are
periodic examinations by the DFI and FDIC to evaluate
CapitalSource Bank’s safety and soundness and compliance
with various regulatory requirements. The regulatory structure
also gives the regulatory authorities extensive discretion in
connection with their supervisory and enforcement activities and
examination policies, including policies with respect to the
classification of assets and the establishment of adequate loan
loss reserves for regulatory purposes. Any change in such
policies, whether by the regulators or Congress, could have a
material adverse impact on our operations.
The FDIC and DFI have extensive enforcement authority over our
operations which includes, among other things, the ability to
assess civil money penalties, issue
cease-and-desist
or removal orders and initiate injunctive actions. In general,
these enforcement actions may be initiated for violations of
laws and regulations and unsafe or unsound practices. Other
actions or inaction may provide the basis for enforcement
action, including misleading or untimely reports filed with the
FDIC or DFI. Except under certain circumstances, public
disclosure of final enforcement actions by the FDIC or DFI is
required.
In addition, the investment, lending and branching authority of
CapitalSource Bank is prescribed by state and federal laws and
CapitalSource Bank is prohibited from engaging in any activities
not permitted by these laws.
All FDIC member banks are required to pay assessments to the
FDIC to fund their operations. The general assessments, paid on
a semi-annual basis, are determined based on a bank’s total
assets, including consolidated subsidiaries.
California law provides that industrial banks are generally
subject to a limit on loans to one borrower. A bank may not make
a loan or extend credit to a single or related group of
borrowers in excess of 15% of its unimpaired capital and
surplus. An additional amount may be lent, equal to 10% of
unimpaired capital and surplus, if secured by specified readily
marketable collateral. At December 31, 2008, CapitalSource
Bank’s limit on loans to one borrower was $145 million
if unsecured and $242 million if secured by collateral.
The FDIC and DFI, as well as the other federal banking agencies,
have adopted guidelines establishing safety and soundness
standards on such matters as loan underwriting and
documentation, asset quality, earnings, internal controls and
audit systems, interest rate risk exposure and compensation and
other employee benefits. Any institution that fails to comply
with these standards must submit a compliance plan.
The Parent Company has entered into a supervisory agreement with
the FDIC (the “Parent Agreement”) consenting to
examination of the Parent Company by the FDIC to monitor
compliance with the laws and regulations applicable to
CapitalSource Bank and its affiliates. The Parent Company and
CapitalSource Bank are parties to a Capital Maintenance and
Liquidity Agreement (“CMLA”) with the FDIC providing
that, to the extent CapitalSource Bank independently is unable
to do so, the Parent Company must maintain CapitalSource
Bank’s total risk-based capital ratio at not less than 15%
and must maintain CapitalSource Bank’s total risk-based
capital ratio at all times to meet the levels required for a
bank to be considered “well-capitalized” under the
relevant banking regulations. Additionally, pursuant to
requirements of the FDIC, the Parent Company has provided a
$150 million unsecured revolving credit facility that
CapitalSource Bank may draw on at any time it or the FDIC deems
necessary. The Parent Agreement also requires the Parent Company
to maintain the capital levels of CapitalSource Bank at the
levels required in the CMLA.
It is important to meet minimum capital requirements to avoid
mandatory or additional discretionary actions initiated by these
regulatory agencies. These potential actions could have a direct
material effect on our consolidated financial statements. Based
upon the regulatory framework, we must meet specific capital
guidelines that involve quantitative measures of the banking
assets, liabilities and certain off-balance sheet items as
calculated under regulatory accounting practices. Our capital
amounts, the ability to pay dividends and other requirements and
classifications are also subject to qualitative judgments by the
regulators about risk weightings and other factors.
CapitalSource Bank is a member of the FHLB –
San Francisco, which is one of 12 regional FHLBs that
provide its members with a source of funding for mortgages and
asset-liability management, liquidity for a member’s
short-term needs and additional funds for housing finance and
community development. Each FHLB serves as a reserve or central
bank for its members within its assigned region. Each FHLB is
funded primarily from proceeds derived from the sale of
consolidated obligations of the FHLB System. Each FHLB makes
advances to members in accordance with policies and procedures
established by the Board of Directors of that FHLB, which are
subject to the oversight of the Federal Housing Finance Agency.
All advances from the FHLB are required to be fully secured by
sufficient collateral as determined by the FHLB. At
December 31, 2008, CapitalSource Bank had no outstanding
advances from the FHLB – San Francisco under its
available credit facility of $915.4 million, based on 15%
of total assets, which is limited to available collateral. A
letter of credit in the amount of $0.8 million is
outstanding under the facility which reduces our availability.
The financing is subject to various terms and conditions
including a pledge of acceptable collateral, satisfaction of the
FHLB stock ownership requirement and certain limits regarding
the maximum term of debt.
As a member, CapitalSource Bank is required to purchase and
maintain stock in the FHLB – San Francisco. At
December 31, 2008, CapitalSource Bank had
$20.0 million in FHLB-San Francisco stock, which was
in compliance with this requirement. The
FHLB-San Francisco, in past years, has paid substantial
dividends on its FHLB-San Francisco stock. There is no
guarantee that the FHLB-San Francisco will maintain its
dividend at these levels. For the fourth quarter of 2008, the
FHLB-San Francisco did not pay a dividend.
Under federal law, the FHLB is required to pay 20% of net
earnings to fund a portion of the interest on the Resolution
Funding Corporation debt and to contribute to low and moderately
priced housing programs through direct loans or interest
subsidies on advances targeted for community investment and low
and moderate income housing projects. These contributions have
adversely affected the level of FHLB dividends paid and could
continue to do so in the future. These contributions also could
have an adverse effect on the value of FHLB stock in the future.
A reduction in value of CapitalSource Bank’s FHLB stock may
result in a corresponding reduction in CapitalSource Bank’s
capital.
CapitalSource Bank’s deposits are insured up to applicable
limits by the Deposit Insurance Fund (“DIF”) of the
FDIC. As insurer, the FDIC imposes deposit insurance premiums
and is authorized to conduct examinations of and to require
reporting by FDIC insured institutions. It also may prohibit any
FDIC insured institution from engaging in
any activity the FDIC determines by regulation or order to pose
a serious risk to the insurance fund. The FDIC also has the
authority to initiate enforcement actions against insured
institutions.
The Federal Deposit Insurance Reform Act of 2005 (“Reform
Act”), requires the FDIC to establish and implement a
Restoration Plan if the DIF ratio falls below 1.15%. In 2008,
the DIF ratio fell below 1.15% and the FDIC established the
Restoration Plan, effective for the first quarter of 2009. Under
the Restoration Plan system, insured institutions are assigned
to one of four risk categories based on supervisory evaluations,
regulatory capital levels and other factors. An
institution’s assessment rate depends upon the category to
which it is assigned. Assessment rates are determined by the
FDIC and, on 2008, ranged from five to seven basis points for
the healthiest institutions to 43 basis points of
assessable deposits for those that pose the highest risk. The
FDIC may adjust rates uniformly from one quarter to the next,
except that no single adjustment can exceed three basis points.
No institution may pay a dividend if in default of the FDIC
assessment. For 2009, and potentially subsequent periods, the
FDIC has increased the assessment rate.
For the first quarter of 2009, the FDIC uniformly increased the
assessment rate by seven basis points for all risk categories.
Effective April 1, 2009, the FDIC will alter the assessment
rate to incorporate various depository risk elements to include,
among other items, the level of unsecured debt, secured
liabilities or brokered deposits held by a depository. For the
second quarter of 2009, and potentially subsequent quarters, the
assessment could be increased or decreased for CapitalSource
Bank depending on our level of these risk elements. In addition
to increased DIF assessment rates, the FDIC board recently
adopted a 20 basis point assessment applicable to all
insured depository institutions to be effective on June 30,
2009, and paid on September 30, 2009. The FDIC could
institute further assessments in an effort to return the DIF to
the statutory minimum ratio, and such assessments could be as
much as 10 basis points each quarter. The special
assessment charge to CapitalSource Bank is expected to be
$10 million.
A significant increase in insurance premiums would likely have
an adverse effect on the operating expenses and results of
operations of CapitalSource Bank. There can be no prediction as
to what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC upon a
finding that the institution has engaged in unsafe or unsound
practices, is in an unsafe or unsound condition to continue
operations or has violated any applicable law, regulation, rule,
order or condition imposed by the FDIC or the DFI.
In addition to the assessment for deposit insurance,
institutions are required to make payments on bonds issued in
the late 1980s by the Financing Corporation to recapitalize a
predecessor deposit insurance fund. For the quarter ended
March 31, 2008, which is the most recent information
available, this payment was established at 1.12 basis
points (annualized) of assessable deposits.
The FDIC and DFI are required to take certain supervisory
actions against undercapitalized banks, the severity of which
depends upon the institution’s degree of
undercapitalization. Generally, an institution is considered to
be “undercapitalized” if it has a core capital ratio
of less than 4.0% (3.0% or less for institutions with the
highest examination rating), a ratio of total capital to
risk-weighted assets of less than 8.0%, or a ratio of
Tier 1 capital to risk-weighted assets of less than 4.0%.
An institution that has a core capital ratio that is less than
3.0%, a total risk-based capital ratio less than 6.0%, and a
Tier 1 risk-based capital ratio of less than 3.0% is
considered to be “significantly undercapitalized” and
an institution that has a tangible capital ratio equal to or
less than 2.0% is deemed to be “critically
undercapitalized.” Subject to a narrow exception, the FDIC
or DFI is required to appoint a receiver or conservator for a
bank that is “critically undercapitalized.”
Regulations also require that a capital restoration plan be
filed with the FDIC and DFI within 45 days of the date an
institution receives notice that it is
“undercapitalized,” “significantly
undercapitalized” or “critically
undercapitalized.” In addition, numerous mandatory
supervisory actions become immediately applicable to an
undercapitalized institution, including, but not limited to,
increased monitoring by regulators and restrictions on growth,
capital distributions and expansion. “Significantly
undercapitalized” and “critically
undercapitalized” institutions are subject to more
extensive mandatory regulatory actions. The FDIC or DFI also
could take any one of a number of discretionary supervisory
actions, including the issuance of a capital directive and the
replacement of senior executive officers and directors.
The risk-based capital standard requires banks to maintain
Tier 1 and total capital (which is defined as core capital
and supplementary capital) to risk-weighted assets of at least
4% and 8%, respectively, to be considered
“adequately capitalized.” In determining the amount of
risk-weighted assets, all assets, including certain off-balance
sheet assets, recourse obligations, residual interests and
direct credit substitutes, are multiplied by a risk-weight
factor of 0% to 100%, and assigned by regulation based on the
risks believed inherent in the type of asset. Core capital is
defined as common stockholders’ equity (including retained
earnings), certain noncumulative perpetual preferred stock and
related surplus and minority interests in equity accounts of
consolidated subsidiaries, less intangibles other than certain
mortgage servicing rights and credit card relationships. The
components of supplementary capital currently include cumulative
preferred stock, long-term perpetual preferred stock, mandatory
convertible securities, subordinated debt and intermediate
preferred stock, the allowance for loan and lease losses limited
to a maximum of 1.25% of risk-weighted assets and up to 45% of
unrealized gains on
available-for-sale
equity securities with readily determinable fair market values.
Overall, the amount of supplementary capital included as part of
total capital cannot exceed 100% of core capital.
To remain in compliance with the conditions imposed by the FDIC,
for the first three years of operation, Capital Source Bank is
required to maintain a total risk-based capital ratio of not
less than 15% and must at all times be
“well-capitalized,” which requires CapitalSource Bank
to have a total risk-based capital ratio of 10%, a Tier 1
risk-based capital ratio of 6% and a Tier 1 leverage ratio
of at least 5%. Further, the DFI approval order requires that
CapitalSource Bank, during the first three years of operations,
maintain a minimum ratio of tangible shareholder’s equity
to total tangible assets of 10.0%. At December 31, 2008,
CapitalSource Bank had Tier-1 and total risk-based capital
ratios of 13.4% and 17.4%, respectively, each in excess of the
minimum percentage requirements for “well-capitalized”
institutions. At December 31, 2008, CapitalSource Bank
satisfied the DFI capital ratio requirement with a ratio of
12.0%. See Note 20, Bank Regulatory Capital, of the
“Notes to the Consolidated Financial Statements” under
Part II, Item 8 in this report.
FDIC and DFI regulations impose various restrictions on banks
with respect to their ability to make distributions of capital,
which include dividends, stock redemptions or repurchases,
cash-out mergers and other transactions charged to the capital
account. Generally, banks may make capital distributions during
any calendar year up to 100% of net income for the
year-to-date
plus retained net income for the two preceding years if they are
well-capitalized both before and after the proposed
distribution. However, an institution deemed to be in need of
more than normal supervision by the FDIC and DFI may have its
dividend authority restricted by the regulating bodies. In
accordance with the approval order, as a de novo bank,
CapitalSource Bank is prohibited from paying dividends during
its first three years of operations without consent from our
regulators.
CapitalSource Bank’s authority to engage in transactions
with “affiliates” is limited by Sections 23A and
23B of the Federal Reserve Act as implemented by the Federal
Reserve Board’s Regulation W. The term
“affiliates” for these purposes generally means any
company that controls or is under common control with an
institution, and includes the Parent Company as it relates to
CapitalSource Bank. In general, transactions with affiliates
must be on terms that are as favorable to the institution as
comparable transactions with non-affiliates. In addition,
specified types of transactions are restricted to an aggregate
percentage of the institution’s capital. Collateral in
specified amounts must be provided by affiliates to receive
extensions of credit from an institution. Federally insured
banks are subject, with certain exceptions, to restrictions on
extensions of credit to their parent holding companies or other
affiliates, on investments in the stock or other securities of
affiliates and on the taking of such stock or securities as
collateral from any borrower. In addition, these institutions
are prohibited from engaging in specified tying arrangements in
connection with any extension of credit or the providing of any
property or service.
Under the Community Reinvestment Act, every FDIC-insured
institution has a continuing and affirmative obligation
consistent with safe and sound banking practices to help meet
the credit needs of its entire community, including low and
moderate income neighborhoods. The Community Reinvestment Act
does not establish specific lending requirements or programs for
financial institutions nor does it limit an institution’s
discretion to develop the types of products and services that it
believes are best suited to its particular community, consistent
with the
Community Reinvestment Act. The Community Reinvestment Act
requires the FDIC, in connection with the examination of
CapitalSource Bank, to assess the institution’s record of
meeting the credit needs of its community and to take such
record into account in its evaluation of certain applications,
such as a merger or the establishment of a branch, by
CapitalSource Bank. The FDIC may use an unsatisfactory rating as
the basis for the denial of an application. Due to the
heightened attention being given to the Community Reinvestment
Act in the past few years, CapitalSource Bank may be required to
devote additional funds for investment and lending in its local
community.
The FDIC and DFI have primary enforcement responsibility over
CapitalSource Bank and have the authority to bring action
against all “institution-affiliated parties,”
including stockholders, attorneys, appraisers and accountants
who knowingly or recklessly participate in wrongful action
likely to have an adverse effect on an insured institution.
Formal enforcement action may range from the issuance of a
capital directive or cease and desist order to removal of
officers or directors, receivership, conservatorship or
termination of deposit insurance. Civil penalties cover a wide
range of violations and can amount to $25,000 per day, or
$1.1 million per day in especially egregious cases. The
FDIC has the authority to take such action under certain
circumstances. Federal law also establishes criminal penalties
for specific violations.
The Comprehensive Environmental Response, Compensation and
Liability Act (“CERCLA”), a federal statute, generally
imposes strict liability on all prior and current “owners
and operators” of sites containing hazardous waste.
However, Congress acted to protect secured creditors by
providing that the term “owner and operator” excludes
a person whose ownership is limited to protecting its security
interest in the site. Since the enactment of the CERCLA, this
“secured creditor exemption” has been the subject of
judicial interpretations which have left open the possibility
that lenders could be liable for clean-up costs on contaminated
property that they hold as collateral for a loan. To the extent
that legal uncertainty exists in this area, all creditors,
including the Parent Company and CapitalSource Bank, that have
made loans secured by properties with potential hazardous waste
contamination (such as petroleum contamination) could be subject
to liability for cleanup costs, which costs often substantially
exceed the value of the collateral property.
The Gramm-Leach-Bliley Financial Services Modernization Act of
1999 (“GLBA”) modernized the financial services
industry by establishing a comprehensive framework to permit
affiliations among commercial banks, insurance companies,
securities firms and other financial service providers.
CapitalSource Bank is subject to regulations implementing the
privacy protection provisions of the GLBA. These regulations
require CapitalSource Bank to disclose its privacy policy,
including identifying with whom it shares “non-public
personal information” to customers at the time of
establishing the customer relationship and annually thereafter.
The State of California’s Financial Information Privacy Act
provides greater protection for consumer’s rights under
California Law to restrict affiliate data sharing.
As part of the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism
Act of 2001 (“USA Patriot Act”), Congress adopted the
International Money Laundering Abatement and Financial
Anti-Terrorism Act of 2001 (“IMLAFATA”). IMLAFATA
amended the Bank Secrecy Act (“BSA”) and adopted
additional measures that established or increased existing
obligations of financial institutions, including CapitalSource
Bank, to identify their customers, monitor and report suspicious
transactions, respond to requests for information by federal
banking regulatory authorities and law enforcement agencies,
and, at the option of CapitalSource Bank, share information with
other financial institutions. The U.S. Secretary of the
Treasury has adopted several regulations to implement these
provisions. Pursuant to these regulations, CapitalSource Bank is
required to implement appropriate policies and procedures
relating to anti-money laundering matters, including compliance
with applicable regulations, suspicious activities, currency
transaction reporting and customer due diligence. Our BSA
compliance program is subject to federal regulatory review.
CapitalSource Bank is subject to many other federal consumer
protection statutes and regulations, such as the Equal Credit
Opportunity Act, the Truth in Savings Act, the Truth in Lending
Act, the Real Estate Settlement Procedures Act, the Home
Ownership and Equity Protection Act, the Fair Credit Reporting
Act, the Fair Debt Collection Practices Act, the Home Mortgage
Disclosure Act, the Fair Housing Act, the National Flood
Insurance Act and various federal and state privacy protection
laws. These laws, rules and regulations, among other things,
impose licensing obligations, limit the interest rates and fees
that can be charged, mandate disclosures and notices to
consumers, mandate the collection and reporting of certain data
regarding customers, regulate marketing practices and require
the safeguarding of non-public information of customers.
Penalties for violating these laws could subject CapitalSource
Bank to lawsuits and could also result in administrative
penalties, including, fines and reimbursements. CapitalSource
Bank and the Parent Company are also subject to federal and
state laws prohibiting unfair or fraudulent business practices,
untrue or misleading advertising and unfair competition.
In recent years, examination and enforcement by the state and
federal banking agencies for non-compliance with consumer
protection laws and their implementing regulations have become
more intense. Due to these heightened regulatory concerns,
CapitalSource Bank may incur additional compliance costs or be
required to expend additional funds for investments in its local
community.
Some other 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:
In addition, many of our healthcare clients 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 Item 1A,
Risk Factors, on page 31.
As of December 31, 2008, we employed 716 people, 357
of whom were employed by CapitalSource Bank. We believe that our
relations with our employees are good.
Our executive officers and their ages and positions are as
follows:
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, in which capacities he
has served 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.
Douglas H. (Tad) Lowrey has served as the Chief Executive
Officer and President of CapitalSource Bank since its formation
on July 25, 2008. Prior to his appointment, Mr. Lowrey
served as Executive Vice President of Wedbush, Inc., a private
investment firm and holding company, from January 2006 until
June 2008. Mr. Lowrey served as Chairman, President and
Chief Executive Officer of Jackson Federal Bank from 1999 until
February 2005 when it was sold to Union Bank of California.
Previously, he was Chief Executive Officer of CenFed Bank and
its publicly owned holding company, CENFED Financial Corporation
from 1990 until its sale in 1998 to Glendale Federal Bank.
Additionally, Mr. Lowrey is an elected director of the
Federal Home Loan Bank of San Francisco.
Steven A. Museles has served as our Executive Vice
President, Chief Legal Officer and Secretary since our inception
in 2000 and in similar capacities for CapitalSource Bank since
July 2008. Mr. Museles received his undergraduate degree
from the University of Virginia and his juris doctor degree from
Georgetown University Law Center.
Thomas A. Fink has served as our Senior Vice
President — Finance and Chief Financial Officer since
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.
Bryan D. Smith has served as our Chief Accounting Officer
since September 2008. Prior to his appointment, Mr. Smith
worked as a consultant to us from June 2008 until his
appointment as our Chief Accounting Officer in September 2008.
Previously, he served as our Controller — Strategy
Execution from January 2007 until May 2008, Controller from
October 2003 until January 2007 and Assistant Controller from
March 2002 until October 2003. Mr. Smith earned his
undergraduate degree from Virginia Tech in 1993 and was licensed
in 1994 in the State of Maryland as a certified public
accountant.
Statistical
Disclosures
The following supplemental statistical disclosures are presented
as a result of our acquisition of 22 retail banking branches
from Fremont Investment & Loan and the commencement of
CapitalSource Bank’s operations on July 25, 2008
(“commencement date”). This information is prepared in
accordance with Industry Guide 3 and Staff Accounting
Bulletin Topic
11-K.
The financial data for the year ended December 31, 2008
comprised information from CapitalSource Inc. for the entire
year and CapitalSource Bank for the period from the commencement
date through December 31, 2008. Financial data as of and
for the years ended December 31, 2007, 2006, 2005 and 2004
do not include any information from CapitalSource Bank.
For purposes of the following statistical disclosures, we
determined separate disclosure of foreign data was unnecessary
because they are not material in relation to the domestic
activities of our operations for all years presented in the
consolidated financial statements. In addition, certain amounts
as of and for the years ended December 31, 2007, 2006, 2005
and 2004 have been reclassified from previous years’
presentations to conform to the current year presentation.
Table
1. Distribution of Assets, Liabilities, and Shareholders’
Equity
The following table summarizes our consolidated average
balances, including the related interest earned from
interest-earning assets, interest expensed on interest-bearing
liabilities and the resulting average interest yields and rates
for the years ended December 31, 2008, 2007 and 2006.
For the year ended December 31, 2008, the average balances
were calculated using daily amounts throughout the entire year,
even though CapitalSource Bank commenced operations on
July 25, 2008. This allows for the average yields (rates)
to be presented on an annual basis.
22
The following table presents the average total interest-earning
assets, net interest-earnings and net yield on interest-earning
assets for the years ended December 31, 2008, 2007 and 2006.
Table
2. Interest Income/Expense Variance Analysis
The following table presents the changes in interest income,
interest expense and net interest income for the years ended
December 31, 2008 and 2007, as a result of changes in
volume, changes in interest rates or both. Volume and interest
rate variances have been calculated based on movements in
average balances over the period and changes in interest rates
on average interest-earning assets and average interest-bearing
liabilities. Changes due to a combination of volume and interest
rates were allocated proportionally to the absolute change in
volume and interest rates.
Certain selected ratios associated with our financial
information are included in Item 6, Selected Financial
Data.
The following table presents the outstanding book values of our
trading and investment securities held as of December 31,
2008, 2007 and 2006.
As of December 31, 2008, we held $597.6 million and
$1.1 billion of securities issued by Fannie Mae and Freddie
Mac, respectively.
The following table presents the carrying amounts, contractual
maturities and weighted average yields of our debt securities
available-for-sale as of December 31, 2008. Actual
maturities of these securities may differ from contractual
maturity dates because issuers may have the right to call or
prepay obligations. The weighted average yields were calculated
based on the amortized costs of the individual securities and do
not reflect any changes in fair value, which were recorded in
accumulated other comprehensive income (loss) in our audited
consolidated balance sheets.
As of December 31, 2008, all debt securities
held-to-maturity had contractual maturity lives between one and
five years and a weighted average yield of 24.49%. The weighted
average yield was calculated based on the amortized costs of the
individual securities.
The debt trading securities were not included in this table
because these securities are expected to be traded within one
year.
The following table presents an analysis of our commercial loan
portfolio reflecting the sectors in which our borrowers
operated. The loan amounts, which exclude allowances for loan
losses and are net of unearned income, were as of December 31
2008, 2007, 2006, 2005 and 2004.
Although our loan portfolio included borrowers from more than 11
industries as of December 31, 2008, we had a high
concentration of our loan balances in four industries in
particular. The following are the highly-concentrated industries
and the respective percentage of loan balances of total loans:
The 1,072 loans within these industries are to 679 borrowers
located throughout most of the United States (47 states,
District of Columbia, and Puerto Rico). The largest loan was
$325.0 million, which was 3.5% of total loans. A discussion
of our commercial loan portfolio, including further statistical
analysis of the commercial loan portfolio, is in the Overview
section of Item 1, Business.
The following table presents an analysis of the contractual
maturity of our commercial loan portfolio as of
December 31, 2008.
The following table presents the total amount of loans due after
one year with predetermined interest rates and floating or
adjustable interest rates as of December 31, 2008. Loans
with predetermined interest rates are loans for which the
interest rate is fixed for the entire term of the loan. All
other loans are considered loans with floating or adjustable
rates.
Table
8. Non-performing and Potential Problem Loans
The following table presents the outstanding balances of our
non-performing loans as of December 31, 2008, 2007, 2006,
2005 and 2004. Non-performing loans are loans accounted for on a
non-accrual basis, accruing loans which are contractually past
due 90 days or more as to principal or interest payments,
and other loans under troubled debt restructurings (as defined
in Statement of Financial Accounting Standards No. 15,
Accounting by Debtors and Creditors for Troubled Debt
Restructurings).
Loans accounted for on a non-accrual basis are loans on which
interest income is no longer recognized on an accrual basis and
loans for which a specific provision is recorded for the full
amount of accrued interest receivable.
We place loans on non-accrual status when we expect, based on
judgment, that the borrower will not be able to service its debt
and other obligations.
Troubled debt restructurings are loans that have been
restructured as a result of the deterioration in the
borrower’s financial position and which we have granted a
concession to the borrower that we would not have otherwise
granted if those conditions did not exist. Certain conditions to
the borrower’s financial position that could result in the
restructuring of the loan are economic or legal conditions.
Troubled debt restructurings exclude loans that also meet the
criteria of loans on a non-accrual basis and loans contractually
past-due 90 days or more.
The gross interest income amounts that would have been recorded
for the year ended December 31, 2008 from the non-accrual
loans and troubled debt restructurings presented in the table
above if such loans had been current in accordance with their
original terms and had been outstanding throughout the period or
since origination, if held for part of the period, were
$50.3 million. For the period ended December 31, 2008,
interest income amounts earned on such loans that were recorded
and included in net income were $32.4 million.
The following table presents the outstanding balance of our
potential problem loans as of December 31, 2008. Potential
problem loans are loans that are not considered non-performing
loans, as previously discussed, but loans where management is
aware of information regarding potential credit problems of our
borrowers that leads to serious doubts as to the ability of
compliance with loan covenants or defaults by the borrowers.
Such non-compliance or defaults could eventually result in the
loans being reclassified as non-performing loans ($ in
thousands).
Table
9. Summary of Loan Loss Experience
The following table presents the movements in the loan loss
allowance according to the industry sectors of our loan
portfolio for the years ended December 31, 2008, 2007,
2006, 2005 and 2004. We establish allowances for loan losses in
our loan portfolio that represent management’s estimate of
probable losses as of the balance sheet date. See additional
discussion surrounding the factors, which influence such
judgments within Allowance for Loan Losses under the Critical
Accounting Estimates section of Item 7,
Management’s Discussion and Analysis of Financial
Condition and Results of Operation.
The following tables present the amount of loan loss allowances
allocated to each category of loans and the percentage of our
total loan portfolio, as of December 31, 2008, 2007, 2006,
2005, and 2004.
The following table presents the average balances and the
average interest rates on deposit categories in excess of 10% of
average total deposits as of December 31, 2008. There were
no deposits held as of December 31, 2007 or 2006.
The average deposit balances were calculated using daily amounts
throughout the entire year, even though CapitalSource Bank
commenced operations on July 25, 2008. This allows for the
average interest rates to be presented on an annual basis.
The following table presents the amount of time certificates of
deposit in the amount of $100,000 or more and categorized by
time remaining to maturity as of December 31, 2008 ($ in
thousands):
The following table presents certain our short-term borrowings
outstanding and weighted average interest rates for the years
ended December 31 2008, 2007 and 2006. Short-term borrowings are
borrowings with an original maturity of one year or less.
Securities sold under repurchase agreements were our only
significant category of short-term borrowings. See additional
discussion surrounding the general terms of these securities
sold under repurchase agreements in Note 13,
Borrowings, within our audited consolidated financial
statements.
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 CapitalSource Investor Relations, at
(800) 370-9431
or investor.relations@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.
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 risk
factors actually occur, our business, financial condition or
results of operations could suffer, and the trading price of our
securities could decline even further than it has over the past
several months. The U.S. economy is currently in an
economic recession and we expect this to have a significant
adverse impact on our business and operations, including,
without limitation, the credit quality of our loan portfolio,
our liquidity and our earnings. 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 securities.
Risks
Impacting Funding our Operations
We require a substantial amount of money to make new loans,
repay indebtedness, fund obligations to existing clients and
otherwise operate our business. To date, we have obtained this
money through issuing equity, convertible debentures and
subordinated debt, by borrowing money under our credit
facilities, securitization transactions (hereinafter “term
debt”) and repurchase agreements, and through deposits at
CapitalSource Bank. Our access to these and other types of
external funding depends on a number of factors, including
general market and deposit raising conditions, the markets’
and our lenders’ perceptions of our business, our current
and potential future earnings and the market price of our common
stock. The capital and credit markets have been experiencing
extreme volatility and disruption for more than 12 months
and recently the volatility and disruption have reached
unprecedented levels. These market forces have, in turn, put
significant constraints on our ability to access and maintain
prudent levels of liquidity through the sources described above.
Our available cash and cash equivalents are 7.3% of our total
assets, down from the levels we have historically maintained.
The markets have produced downward pressure on stock prices and
credit availability for certain issuers without regard to those
issuers’ underlying financial strength. In addition, the
economy is experiencing an economic recession with wide ranging
impacts. We anticipate generating some of this liquidity by
utilizing means we have not regularly used in the past,
including sales of loans, loan participations, real estate
investments and real estate owned. These sale activities are
dependent on and subject to market and economic conditions and
willing and able buyers entering into transactions with us and,
therefore, are highly speculative. Furthermore, due to current
market conditions, if we are able to consummate any asset sales
we expect them to be at prices discounted to our current
carrying value. If the current recession and levels of capital
markets disruption and volatility continue or worsen, it is not
certain that sufficient funding and capital will be available to
us on acceptable terms or at all. Without sufficient funding, we
would not be able to continue to operate our business.
We have made a significant investment in establishing
CapitalSource Bank as a well-capitalized depository institution.
Despite this investment, for regulatory reasons, CapitalSource
Bank and the Parent Company are required to be operated
independently of each other, and transactions between
CapitalSource Bank and the Parent Company are restricted. For
example, the Parent Company may not sell any loans to
CapitalSource Bank. Furthermore, as a de novo bank,
CapitalSource Bank is prohibited from paying dividends to the
Parent Company for its first three years of operation.
Consequently, while CapitalSource Bank may have more than
adequate liquidity, the Parent Company is unable to directly
benefit from that liquidity to fund its significant obligations
and operations and must rely to a large extent on external
sources of financing which, as described above, are extremely
limited.
As of February 25, 2009, we had six credit facilities
totaling $1.8 billion in commitments. Two of these credit
facilities aggregating $259.0 million in commitments, are
scheduled to mature during 2009. We may not be able to renew or
extend the term of these financings or to repay amounts
outstanding under them when due. Additionally, if we breach a
covenant or other provision of these facilities, the lenders
could terminate them prior to their maturity dates. If any of
these financings were terminated, not renewed upon its maturity
or renewed on materially worse terms, our liquidity position
could be materially adversely affected, and we may not be able
to satisfy our outstanding obligations or continue to fund our
operations. We have recently received waivers to potential
covenant defaults under several of our credit facilities and
have amended our largest credit facility to address our
inability to satisfy certain financial covenants in the future.
Nevertheless, we cannot assure you that we will be able to
continue to satisfy our obligations under our credit facilities
or receive additional waivers or amendments should they be
needed to avoid future defaults. We are currently in discussions
with our credit facility lenders to restructure our credit
facilities to extend maturities and gain funding efficiencies.
If successful, we expect to see higher borrowing costs,
potentially reduced committed capacity levels
and/or lower
advance rates on our secured credit facilities. We cannot assure
you that we will successfully restructure these facilities on
favorable terms or at all. If we are unsuccessful in this
restructuring, we may be unable to meet our obligations under
these credit facilities which could lead to an event of default,
termination and other consequences which would have a material
adverse effect on our business.
We are required under our syndicated bank credit facility to
make mandatory prepayments (which are accompanied by commitment
reductions) in $25.0 million increments with a portion of
the proceeds of specified events, including
Regardless of any such mandatory prepayments, the facility
commitment reduces to
If we are unable to sell sufficient assets, raise new capital or
restructure this credit facility, we may not have sufficient
liquidity to make these required prepayments by these dates.
Consequently, we could default under this facility which would
trigger cross-defaults under our other debt and could result in
accelerated maturity of all of our debt. In such circumstances,
our business, liquidity and operations would be materially
adversely affected, and we would not be able to continue
operating.
The Parent Company is required to comply with financial and
non-financial covenants and obligations under our indebtedness,
including, without limitation, with respect to interest
coverage, minimum tangible net worth, leverage, maximum
delinquent and charged-off loans and servicing standards. If we
were to default under our indebtedness by violating these
covenants or otherwise, our lenders’ remedies would include
the ability to, among other things, transfer servicing to
another servicer, accelerate payment of all amounts payable
under such
indebtedness
and/or
terminate their commitments under such indebtedness. A default
under our recourse indebtedness could trigger cross-default
provisions in our other debt facilities, and a default under
some of our non-recourse indebtedness would trigger
cross-default provisions in other of our non-recourse debt. We
have received waivers to potential breaches of some of these
provisions and may have difficulty complying with some of these
provisions if the economic recession continues or worsens. We
recently amended our largest credit facility to adjust some of
these covenants to levels we believe we can meet. Nevertheless,
we may need to obtain additional waivers or amendments again in
the future if we cannot satisfy all of the covenants and
obligations under our debt. There can be no assurance that we
will be able to obtain such waivers or amendments in the future.
A default under our indebtedness could have a material adverse
affect on our business, financial condition, liquidity position
and our ability to continue to operate our business.
In addition, upon the occurrence of specified servicer defaults,
our lenders under our credit facilities and the holders of the
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 can 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.
Substantially all of the assets of the Parent Company are
pledged or otherwise encumbered by liens we have granted in
favor of our lenders. Our syndicated bank credit facility also
contains customary operating and financial restrictions that may
impair our ability to operate our business, including, among
other things, covenants limiting our ability to:
These restrictions may, among other things, reduce our
flexibility in planning for, or reacting to, changes in our
business, the economy
and/or
markets and thereby may negatively impact our financial
condition and results of operations.
As of December 31, 2008, the amount of the Parent
Company’s unfunded commitments to extend credit with
respect to existing loans exceeded unused funding sources and
unrestricted cash by $1.4 billion. Due to their nature, we
can not know with certainty the aggregate amounts we will be
required to fund under these unfunded commitments. In many
cases, our obligation to fund unfunded commitments is subject to
our clients’ ability to provide collateral to secure the
requested additional fundings, the collateral’s
satisfaction of eligibility requirements, our clients’
ability to meet specified preconditions to borrowing, including
compliance with all provisions of the loan agreements,
and/or our
discretion pursuant to the terms of the loan agreements. In many
other cases, however, there are no such prerequisites to future
fundings by us and our clients may draw on these unfunded
commitments at any time. In the past, the amount of unfunded
commitments and potential for them to be drawn upon by our
clients have not adversely affected our business. In light of
current economic conditions and general lack of liquidity in the
credit markets, however, clients have drawn and are more likely
to continue to draw on our unfunded commitments to improve their
weakening cash positions. Due to this fact and because our
liquidity is more constrained than in the past, we expect that
these unfunded commitments will continue to indefinitely exceed
the Parent Company’s available funds. 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 irreparably damage our reputation in the
marketplace, which would have a material adverse effect on our
ability to continue in business.
Prior to 2008, we had 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. Our credit facilities were not designed to be
long term financings, and their continued use depends on
regularly paying them down with term debt proceeds. We have been
unable to complete any term debt transactions since 2007, and
the market for securitized loans has effectively been closed
since that time. Consequently, we have been unable to pay down
our credit facilities as anticipated using the proceeds from
term debt transactions, which has constrained our liquidity
position.
We generally have retained the most junior classes of securities
issued in our term debt transactions. Our receipt of 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. As more delinquencies among
loans included in the collateral pools of $4.6 billion of
our outstanding term debt securitizations have occurred, the
timing and amount of the cash flows we receive from loans
included in our term debt transactions have been adversely
affected and we expect these cash flows will continue to be
adversely affected if delinquencies increase. In addition, under
our term debt securitizations, the priority of payments are
altered if the notes remain outstanding beyond the stated
maturity dates and upon other termination events, in which case
we would receive no cash flow from these transactions until the
notes senior to our retained interests are retired.
We borrow money from our lenders at variable interest rates and
raise short-term deposits at prevailing rates in the relevant
markets. We generally lend money at variable rates based on
either prime or LIBOR indices. Our operating results and cash
flow depend on the difference between the interest rates at
which we borrow funds and raise deposits and the interest rates
at which we lend these funds. Because many of our loans are
currently well below their contractual interest rate floors,
upward movements in interest rates will not immediately result
in additional interest income, although these movements would
increase our cost of funds. Therefore, any upward movement in
rates may result in a reduction of our net interest income. For
additional information about interest rate risk, see Market
Risk Management, in Management’s Discussion and
Analysis of Financial Condition and Results of Operations.
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 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:
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 23,
Derivative Instruments, in our accompanying audited
consolidated financial statements for the year ended
December 31, 2008.
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.
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 funding sources 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 23, Derivative Instruments, of
our accompanying audited consolidated financial statements for
the year ended December 31, 2008.
Risks
Related to Our Operations
We believe that our July 2008 formation of CapitalSource Bank
will result in significant liquidity, operational and
competitive benefits for us. Achieving these benefits will
depend in part on overcoming our lack of experience operating in
closely regulated markets and continuing to integrate
CapitalSource Bank’s products, services, personnel and
operations with the rest of our products, services, personnel
and operations. Bank regulatory authorities have imposed
requirements and limitations that could negatively affect the
way we conduct CapitalSource Bank’s and the rest of our
business and, therefore, could cause us to fail to realize the
expected benefits of operating CapitalSource Bank. Further, the
attention and effort devoted to the operation of CapitalSource
Bank may divert management’s attention from other important
issues. There are no assurances that we can successfully operate
CapitalSource Bank or realize any anticipated benefits from
operating CapitalSource Bank.
CapitalSource Bank’s ability to maintain or raise
sufficient deposits may be limited by several factors, including:
While we expect to maintain and continue to raise deposits at a
reasonable rate of interest, there is no assurance that we will
be able to do so successfully.
In addition, given the relatively short average maturity of
CapitalSource Bank’s deposits compared to the maturity of
its loans, the inability of CapitalSource Bank to raise or
maintain deposits could compromise our ability to operate our
business, impair our liquidity and threaten the solvency of
CapitalSource Bank and the rest of CapitalSource.
Aside from deposit funding, CapitalSource Bank may obtain
back-up
liquidity from the Federal Home Loan Bank-San Francisco and
from the Parent Company. The current financial crisis threatens
the availability of both of these sources of funds. Through its
FHLB membership, CapitalSource Bank has access to a potential
secondary source of liquidity. The Federal Home Loan Bank system
is currently indicating that it may fail one or more capital
requirements imposed upon it. If the Federal Home Loan Bank
system is dissolved by Congress, CapitalSource Bank’s
ability to access the Federal Home Loan Bank as a potential
secondary course of liquidity and manage liquidity risk could be
materially impacted. In addition, given the Parent
Company’s general liquidity constraints, CapitalSource Bank
may not be able to draw on the $150 million revolving
credit facility it has established with the Parent Company. As a
result, if the ability of CapitalSource Bank to attract and
retain suitable levels of deposits weakens, our business,
financial condition, results of operations and the market price
of our common stock could be negatively affected.
We are subject to extensive federal and state regulation and
supervision that govern, limit or otherwise affect the
activities in which we may engage, our ability to use our
capital for certain business purposes and our ability to expand
our business. Banking regulations are primarily intended to
protect depositors’ funds, federal deposit insurance funds
and the banking system as a whole, not our shareholders. These
regulations affect our lending practices, capital structure,
investment practices, dividend policy and growth, among other
things. Congress and federal regulatory agencies continually
review banking laws, regulations and policies for possible
changes. Changes to banking laws or regulations, including
changes in their interpretation or implementation, could
materially affect us in substantial and unpredictable ways. Such
changes could subject us to additional costs, limit or restrict
our ability to use capital for business purposes, limit the
types of financial services and products we may offer or
increase the ability of non-banks to offer competing financial
services and products, among other things. In addition,
increased regulatory requirements, whether due to the adoption
of new laws and regulations, changes in
existing laws and regulations, or more expansive or aggressive
interpretations of existing laws and regulations, may have a
material adverse effect on our business, financial condition,
results of operations and reputation.
Failure to comply with laws, regulations or policies or the
regulatory orders pursuant to which CapitalSource Bank operates,
even if unintentionally or inadvertently, could result, among
other things, in sanctions by regulatory agencies, increased
deposit insurance costs, civil monetary penalties or fines,
issuing cease and desist or other supervisory orders or
reputation damage. Supervisory actions also could result in
higher capital requirements, higher insurance premiums and
additional limitations on our activities, which could have a
material adverse effect on our business, financial condition,
results of operations and reputation. See the Supervision and
Regulation section of Item 1, Business, above,
and Note 20, Bank Regulatory Capital, in the notes
to consolidated financial statements included in Item 8,
Financial Statements and Supplementary Data, which are
located elsewhere in this report.
As the holder of the “A” Participation Interest, we
are entitled to receive 70% of principal payments received with
respect to the assets underlying the “A” Participation
Interest, which include both loans and real estate owned.
Certain of the loans underlying the “A” Participation
Interest are in default from time to time. The loan portfolio
underlying the “A” Participation Interest includes
commercial real estate construction loans which may be more
susceptible to default than other commercial loans. Given
current economic conditions affecting the commercial and
residential real estate markets, we expect the level of
defaults, and the level of losses associated with such defaults,
to increase. To the extent losses on the underlying assets
exceed expectations, the amount of principal available for
distribution to us as the holder of the “A”
Participation Interest could be reduced to a level which would
cause us to experience credit losses. If losses reach levels in
excess of the credit-enhancement features of the “A”
Participation Interest, we could experience losses which would
adversely impact our financial results. Although as the holder
of the “A” Participation Interest we have no
obligation to make any further advances with respect to the
assets underlying the “A” Participation Interest, the
failure of iStar Financial, Inc. and its subsidiaries
(“iStar”) as the lender with respect to the underlying
assets to meet its funding obligations could also contribute to
losses on the assets underlying the “A” Participation
Interest.
We also could experience losses in the event of the bankruptcy
of iStar. iStar is the guarantor of the payment obligations to
us as the holder of the “A” Participation Interest and
such guaranty may be impaired if iStar files for bankruptcy. In
the event of its bankruptcy, it is possible that iStar could
commingle collections on the “A” Participation
Interest with its other funds making it difficult to indentify
the funds as our property and for us to receive our money.
Moreover, the characterization of the “A”
Participation Interest as a true participation could be
challenged in the bankruptcy of iStar. If the challenge were
successful, the “A” Participation Interest would
likely be viewed as a secured loan to iStar, entitling iStar in
certain circumstances to use the collections on the
“A” Participation Interest and to restructure the
obligations owed to us as the holder of the “A”
Participation Interest as part of a bankruptcy reorganization
plan.
We operated as a REIT through 2008, but revoked our REIT
election as of January 1, 2009. Commencing in 2009, we will
be subject to corporate tax on all of our net income and we will
no longer be required to pay any dividends to our shareholders.
Further, we had agreed in contracts relating to some of our
financings that we will use reasonable efforts to remain
qualified as a REIT. While we believe our decision not to
qualify as a REIT for 2009 was reasonable, it could nevertheless
be deemed to breach certain of our agreements. If the
counterparties to these financings allege breaches of those
agreements, we may be subject to lengthy and costly litigation,
and if we were not to prevail in such litigation, we may be
required to repay certain indebtedness prior to stated maturity,
which would materially impair our liquidity.
We operated as a REIT from January 1, 2006 through
December 31, 2008. Our senior management had limited
experience in managing a portfolio of assets under the highly
complex tax rules governing REITs and we cannot assure you that
we successfully operated our business within the REIT
requirements. Given the highly complex nature of the rules
governing REITs and the importance of factual determinations,
the Internal Revenue Service, or IRS, could contend that we
violated REIT requirements in one or more of these years. We are
currently under audit by the IRS for our 2006 and 2007 tax
returns. To the extent it were to be determined that we did not
comply with REIT requirements for one or more of our REIT years,
we could be required to pay corporate federal income tax and
certain state and local income taxes on our net income for the
relevant years or we could be required to pay taxes that would
be due if we were to avail ourselves of certain savings
provisions to preserve our REIT status for the relevant years,
either of which could have adverse affects on our historical,
current and future financial results and the value of our common
stock.
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 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 and other assets we own.
One of our wholly owned subsidiaries, CapitalSource Finance LLC
(“Finance”), is a guarantor on certain of our
convertible debentures that were offered to the public in
registered offerings. 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 either on an
exemption from registration under the Investment Company Act for
banks or entities that do not offer securities to the public and
do not have more than 100 security holders or on their operation
as a REIT owning real property. Because it is possible such
reliance could be deemed unavailable to Finance, we also conduct
Finance’s business in a manner that we believe would permit
it to rely on exemptions 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 change the manner in which we conduct our
operations, or register the relevant entity as an
investment company. Any modification of our business 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:
Any of these results likely would have a material adverse effect
on our business, operations, financial results and the price of
our common stock.
If the market value of or net income from our non-qualifying
assets at the Parent Company increase or the market value of or
net income from CapitalSource Bank or our qualifying assets at
the Parent Company decrease, we may need to increase our real
estate investments and income
and/or
liquidate our non-qualifying assets to maintain our exemptions
from the Investment Company Act. If the declines or increases
occur 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 Investment Company
Act consideration, which would likely have a material adverse
effect on our business, operations, financial results and the
price of our common stock.
We rely on the computer systems and network infrastructure we
use to conduct our business. These systems and infrastructure
could be vulnerable to unforeseen problems. Our operations are
dependent upon our ability to protect our computer equipment
against damage from fire, power loss, telecommunications failure
or a similar catastrophic event. Any damage or failure that
causes an interruption in our operations could have an adverse
effect on our clients. In addition, we must be able to protect
the computer systems and network infrastructure utilized by us
against physical damage, security breaches and service
disruption caused by the internet or other users. Such computer
break-ins and other disruptions would jeopardize the security of
information stored in and transmitted through our computer
systems and network infrastructure, which may result in
significant liability to us and deter potential clients. While
we have systems, policies and procedures designed to prevent or
limit the effect of the failure, interruption or security breach
of our systems and infrastructure, there can be no assurance
that these measures will be successful and that any such
failures, interruptions or security breaches will not occur or,
if they do occur, that they will be adequately addressed. In
addition, the failure of our clients to maintain appropriate
security for their systems also may increase our risk of loss in
connection with loans made to them. The occurrence of any
failures, interruptions or security breaches of systems and
infrastructure could damage our reputation, result in a loss of
business
and/or
clients, result in losses to us or our clients, subject us to
additional regulatory scrutiny, cause us to incur additional
expenses, or expose us to civil litigation and possible
financial liability, any of which could have a material adverse
effect on our business, financial condition and results of
operations.
We review and update our internal controls, disclosure controls
and procedures, and corporate governance policies and
procedures. Any system of controls, however well designed and
operated, is based in part on certain assumptions and can
provide only reasonable, not absolute, assurances that the
objectives of the system are met. Any failure or circumvention
of our controls and procedures or failure to comply with
regulations related to controls and procedures could have a
material adverse effect on our business, results of operations
and financial condition. In addition, if we identify material
weaknesses in our internal control over financial reporting or
are otherwise required to restate our financial statements, we
could be required to implement expensive and time-consuming
remedial measures and could lose investor confidence in the
accuracy and completeness of our financial reports. This could
have an adverse effect on our business, financial condition and
results of operations, including our stock price, and could
potentially subject us to litigation.
Risks
Related to Our Lending Activities
We charged off $292.6 million in loans for the year ended
December 31, 2008, and, in light of current economic and
market conditions, we expect to experience additional
charge-offs and delinquencies in the future. If we experience
material losses on our portfolio, 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 lenders, 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 these events may be an indication
that our risk of credit loss with respect to a particular loan
has materially increased.
We
make loans to other lenders and commercial real estate
developers which have been disproportionately negatively
impacted by the economic recession. These clients face a variety
of risks relating to their underlying loans and development,
construction and renovation projects, any of which may
negatively impact their results of operations and impair their
ability to pay principal and interest on our
loans.
We make loans to other lenders to finance their lending
operations and to other 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 their loans and these projects. An unsuccessful
loan by, or development, construction or renovation project of,
any such client could limit that client’s ability to repay
its obligations to us.
Our
concentration of loans to a limited number of clients within a
particular industry or region could impair our revenues if the
industry or region were to experience continued or worsening
economic difficulties or changes in the regulatory
environment.
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 continuing or worsening 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, 2008, loans representing 20.1% of the
aggregate outstanding balance of our commercial loan portfolio
were secured by commercial real estate other than healthcare
facilities and three or $355.8 million of our 10 largest
loans fall into this category. The commercial real estate sector
is currently experiencing severe economic difficulties, and we
expect this sector to deteriorate further in which case we are
likely to suffer additional losses on these types of loans with
increases in
loan-to-value,
delinquencies and foreclosures. In addition, as of
December 31, 2008, loans representing 21.5% of the
aggregate outstanding balance of our commercial 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.
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
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. The client’s business, financial condition and
prospects may also change rapidly in the current economic
environment. 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 may
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, clients in other 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 to be 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 or changes as a result of changes in the
law. 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 and Supervision section of
Item 1, Business, above for additional discussion of
specific regulatory and governmental oversight applicable to
many of our healthcare clients.
Loans to foreign clients may expose us to risks not typically
associated with loans to U.S. clients. These risks include
changes in exchange control regulations, political and social
instability, expropriation, imposition of foreign taxes, less
liquid markets and less available information than is generally
the case in the United States, higher transaction costs, less
developed bankruptcy laws, difficulty in enforcing contractual
obligations, lack of uniform accounting and auditing standards
and greater price volatility.
To the extent that any of our loans are denominated in foreign
currency, these loans will be subject to the risk that the value
of a particular currency will change in relation to one or more
other currencies. Among the factors that may affect currency
values are trade balances, the level of short-term interest
rates, differences in relative values of similar assets in
different currencies, long-term opportunities for investment and
capital appreciation, and political developments. We may employ
hedging techniques to minimize these risks, but we can offer no
assurance that these strategies will be effective.
We use the term “client” to mean the legal entity that
is the borrower party to a loan agreement with us or the tenant
of one of our healthcare owned properties. We have several
clients that are related to each other through common ownership
or management. Because we underwrite each transaction
separately, we report each transaction with one of these clients
as a separate transaction 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 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 committees 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, 2008, approximately 93% of the
outstanding balance of our commercial 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.
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 (if any) and payment.
Collectively, Term B, second lien and mezzanine loans comprised
12% of the aggregate outstanding balance of our commercial loan
portfolio as of December 31, 2008. 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 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, 2008, approximately 56% of the commercial
loans in our portfolio were cash flow loans under which we had
advanced 37% of the aggregate outstanding commercial 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. Additionally, in an
economic recession such as the current one, many businesses
suffer decreases in revenues and net income, and we expect that
many of our cash flow clients will suffer these decreases making
them more likely to underperform and default on our loans and
making it less likely that we could obtain sufficient proceeds
from a restructuring or sale of the company. If we are a
subordinate lender rather than the senior lender in a cash flow
loan, our ability to take remedial action is 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 20% of the aggregate
outstanding balance of our commercial loan portfolio as of
December 31, 2008. 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 or otherwise exercise remedies
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, to foreclose upon the collateral securing the loan or
to exercise remedies 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, 2008, we were either the paying,
administrative or the collateral agent or all for a group of
third-party lenders for loans with outstanding commitments of
$2.7 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, to foreclose
upon the collateral securing the loan or to exercise remedies.
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, to foreclose upon the
collateral securing the loan or to exercise remedies 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 suffers
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.
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 loans representing
approximately 21.3% of the aggregate outstanding balance of our
commercial loan portfolio as of December 31, 2008. 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.
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 does arise.
As of December 31, 2008, we had 9 loans representing
$111.5 million in committed funds to companies affiliated
with our directors. We may make additional loans to affiliates
of our directors in the future. Although we generally require
these transactions to be approved by the disinterested members
of our board (or a committee thereof), such policy may not be
successful in eliminating the influence of conflicts of
interest. These transactions may divert our resources and
benefit our directors and their affiliates to the detriment of
our shareholders.
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.
Our markets are competitive and characterized by varying
competitive factors. We compete with a large number of financial
services companies, including:
Some of our competitors have greater financial, technical,
marketing and other resources and market positions 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 or
maintain or grow our business 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.
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, which increased
significantly in 2008 as the economy contracted, real estate
values declined and credit markets froze. 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,
including the current economic recession. 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.
“Debtor-in-possession”
loans to clients that have filed for bankruptcy under
Chapter 11 of the United States Bankruptcy Code 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.
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.
Owning 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 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.
We own healthcare 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 could
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 and
sales have become extremely difficult in the current real estate
market disruption and economic recession. 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:
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. State laws mandate certain procedures for property
foreclosures, and in certain states, we would face a time
consuming foreclosure process with respect to mortgage loans
that default, 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.
Risks
Related to our Common Stock
Given our desire to maintain and improve our liquidity position
and our declining stock price, we may issue equity or equity
linked securities at prices that are dilutive to our
shareholders, which may result in a significant decrease in the
market price of our common stock. These issuances could be for
cash or in exchange for outstanding debt securities in cases
where we either do not have sufficient cash to pay off those
debt securities or believe it would be more prudent to conserve
our cash.
We expect to retain a majority of our earnings, consistent with
dividend policies of other commercial depository institutions,
to redeploy in our business. Our board of directors, in its sole
discretion, will determine the amount and frequency of dividends
to our shareholders based on 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
prohibiting the payment of dividends after defaults.
Consequently, we can not assure you that we will pay any
dividend on our common stock or that dividend levels will not
fluctuate or be more or less than expected. If we change our
dividend policy our stock price could be adversely affected.
As part of our business strategy, we have made acquisitions in
the past and we may continue to do so in the future. 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,
including:
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 17, 2009, we had 302,595,100 shares of
common stock outstanding and options then exercisable for
5,203,209 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.
As of January 1, 2009, 6,655,053 shares of our common
stock were beneficially owned by certain trusts that are
affiliates of Farallon Capital Management and its affiliates
(the “Farallon Trusts”), the principal business of
each of which is to liquidate its assets over time. Dispositions
of some or all of the shares of our common stock beneficially
owned by the Farallon Trusts or other Farallon entities could
adversely impact the price of our common stock. The perception
in the public market that Farallon entities might sell shares of
common stock also could depress our market price.
Similarly, if we were to issue a substantial amount of common
stock in exchange for outstanding indebtedness, as we did in
October 2008 and February 2009, and the recipients were to sell
such common stock in the public market, the market price of our
common stock could decrease significantly.
Our certificate of incorporation and bylaws provide for, among
other things:
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, executive officers and entities affiliated with
them owned shares of common stock equaling approximately 26% of
the outstanding shares of our common stock as of
February 17, 2009. 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.
None.
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
California, Connecticut, Florida, Georgia, Illinois,
Massachusetts, Missouri, New York, North Carolina, Pennsylvania,
Tennessee, Texas, Utah and in the United Kingdom. We believe our
leased facilities are adequate for us to conduct our business.
Our Healthcare Net Lease segment owns 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, 2008, which consisted
primarily of land and buildings. As of December 31, 2008,
all of our direct real estate investments were pledged either
directly or indirectly as collateral for certain of our
borrowings. For additional information about our borrowings, see
Note 13, Borrowings, in our accompanying audited
consolidated financial statements for the year ended
December 31, 2008.
Our direct real estate investment properties as of and for the
year ended December 31, 2008, were as follows:
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.
No matter was submitted to a vote of our security holders during
the fourth quarter of 2008.
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 2008 and 2007 were as
follows:
On February 27, 2009, the last reported sale price of our
common stock on the NYSE was $1.87 per share.
As of December 31, 2008, there were 1,828 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.
During 2008 and 2007, we declared dividends as follows:
For shareholders who held our shares for the entire year, the
$1.25 per share dividend paid in 2008 was classified for tax
reporting purposes as follows: 33.59% ordinary dividends, of
which 27.16% was considered excess inclusion income;
31.92 % long-term capital gain, of which 12.82% was
considered unrecaptured Sec. 1250 gain; and 34.49 %
return on capital.
We declared a $0.05 quarterly dividend per share in the third
and fourth quarters of 2008. We expect to retain a majority of
our earnings, consistent with dividend policies of other
commercial depository institutions, to redeploy in our business.
Our Board of Directors, in its sole discretion, will determine
the amount and frequency of dividends to be provided to our
shareholders based on 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
prohibiting the payment of dividends after defaults.
Consequently, we cannot assure you that we will pay any dividend
on our common stock or that dividend levels will not fluctuate
or be more or less than expected. In addition, based on existing
and expected market conditions, we currently do not anticipate
paying dividends on our common stock at historical levels.
A summary of our repurchases of shares of our common stock for
the three months ended December 31, 2008, was as follows:
The following graph compares the performance of our common stock
during the period beginning on December 31, 2003 to
December 31, 2008, 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
December 31, 2003, assuming all dividends were reinvested.
Historical stock performance during this period may not be
indicative of future stock performance.
Comparison
of Cumulative Total Return
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, 2008. We derived our selected consolidated
financial data as of and for the five years ended
December 31, 2008, from our audited consolidated financial
statements, which have been audited by Ernst & Young
LLP, independent registered public accounting firm.
56
57
We are a commercial lender that provides financial products to
middle market businesses, and, through our wholly owned
subsidiary, CapitalSource Bank, provides depository products and
services in southern and central California.
We currently operate as three reportable segments:
1) Commercial Banking, 2) Healthcare Net Lease, and
3) Residential Mortgage Investment. Our Commercial Banking
segment comprises our commercial lending and banking business
activities; our Healthcare Net Lease segment comprises our
direct real estate investment business activities; and our
Residential Mortgage Investment segment comprises our remaining
residential mortgage investment and other investment activities
in which we formerly engaged to optimize our qualification as
real estate investment trust (“REIT”). For financial
information about our segments, see Note 26, Segment
Data, in our accompanying audited consolidated financial
statements for the year ended December 31, 2008.
Through our Commercial Banking segment activities, we provide a
wide range of financial products to middle market businesses and
participate in broadly syndicated debt financings for larger
businesses. As of December 31, 2008, we had 1,072 loans
outstanding under which we had funded an aggregate of
$9.5 billion and held a $1.4 billion participation in
a pool of commercial real estate loans (the “A”
Participation Interest”). Within this segment,
CapitalSource Bank also offers depository products and services
in southern and central California that are insured by the
Federal Deposit Insurance Corporation (“FDIC”) to the
maximum amounts permitted by regulation.
Through our Healthcare Net Lease segment activities, we invest
in income-producing healthcare facilities, principally long-term
care facilities in the United States. We provide lease financing
to skilled nursing facilities and, to a lesser extent, assisted
living facilities, and long term acute care facilities. As of
December 31, 2008, we had $1.0 billion in direct real
estate investments comprising 186 healthcare facilities leased
to 40 tenants through long-term,
triple-net
operating leases. We currently intend to evaluate all potential
transactions to monetize the value of this business including
debt financings, asset sales and corporate transactions.
Through our Residential Mortgage Investment segment activities,
we invested in certain residential mortgage assets and other
REIT qualifying investments to optimize our REIT structure
through 2008. As of December 31, 2008, our residential
mortgage investment portfolio totaled $3.3 billion, which
included investments in residential mortgage loans and
residential mortgage-backed securities (“RMBS”),
including related interest receivables. Over 99% of our
investments in RMBS were represented by mortgage-backed
securities that were issued and guaranteed by Fannie Mae or
Freddie Mac (hereinafter, “Agency RMBS”). In addition,
we hold mortgage-related receivables secured by prime
residential mortgage loans. During the first quarter of 2009, we
sold all of our Agency RMBS and we intend to merge the remaining
assets currently in this segment into our Commercial Banking
segment in 2009.
In our Commercial Banking, and Healthcare Net Lease segments, we
have three primary commercial lending businesses:
Although we have made loans as large as $325.0 million, as
of December 31, 2008, our average commercial loan size was
$8.9 million and our average loan exposure by client was
$14.0 million. Our commercial loans generally have a
maturity of one to five years with a weighted average maturity
of 2.5 years as of December 31, 2008. 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, 2008, our geographically
diverse client base consisted of 679 clients with headquarters
in 47 states, the District of Columbia, Puerto Rico and
select international locations, primarily in Canada and Europe.
Consistent with the business plan approved by our regulators, we
are pursuing our strategy of converting CapitalSource Bank to a
commercial bank and becoming a Bank Holding Company. To date we
have obtained approvals from the DFI and FDIC to convert
CapitalSource Bank from an industrial bank to a California
commercial bank. For the conversion to become effective, we must
be approved by the Federal Reserve as a Bank Holding Company
under the Bank Holding Company Act of 1956. We filed our Bank
Holding Company application with the Board of Governors of the
Federal Reserve in October 2008. That application is being
processed by the Federal Reserve Bank of Richmond and has not
been approved at this time. We are cooperating with the Federal
Reserve in providing access to such information as is needed to
make its decision on the pending application. We believe that
becoming a commercial bank will allow CapitalSource Bank to
offer a wider variety of deposit products and services to
customers; however, we cannot assure you that the Federal
Reserve will approve our application in which case CapitalSource
Bank would not convert to a commercial bank. Current guidance
from the U.S. Treasury Department provides that, since
CapitalSource Inc. did not obtain approval as a Bank Holding
Company prior to December 31, 2008, CapitalSource Inc. is
not eligible to obtain funding under the Capital Assistance
Program (“CAP”) or the Capital Purchase Program.
Although CapitalSource Bank has applied for CAP funding, there
is no assurance that CapitalSource Bank will be able to obtain
CAP funding or that it would accept the funding if offered.
The U.S. economy is currently in a recession. Consequently,
we expect that the credit performance of our portfolio will
continue to decline in light of the current difficult economic
conditions that are likely to adversely affect our clients’
ability to fulfill their obligations to us.
In addition, the recession has generally had a
disproportionately adverse impact on financial institutions,
including a substantial reduction in liquidity, greater pricing
for risk and de-leveraging. In our Commercial Banking segment,
macroeconomic conditions have also adversely impacted our
business through reduced funding alternatives and a higher cost
of funds on our credit facilities, term debt and other
borrowings as measured by a spread to one-month LIBOR. We expect
to continue to experience higher costs and less advantageous
terms for financing the Parent Company’s portfolio which
will continue to negatively impact our liquidity.
Financing the Parent Company’s portfolio has recently
become more challenging as our lenders have sought to reduce
their exposure to us. To maintain our financings, we have agreed
to less favorable terms, including collateralizing our
previously unsecured credit facility and agreeing to repay it
more rapidly. As a result of these less favorable terms, as well
as other factors, our liquidity has been materially adversely
affected and may continue to worsen. You should carefully read
the Liquidity and Capital Resources portion of this
Management Discussion and Analysis of Financial Condition and
Results of Operations for more details on the factors
adversely affecting our current and expected liquidity and our
plans to address them.
CapitalSource Bank, however, has significantly diversified and
strengthened our funding and, with the addition of a significant
amount of deposits, reduced our cost of funds overall. We
believe current economic conditions present significant
near-term market opportunities for CapitalSource Bank to
originate assets with increased spreads and tighter structures
and to selectively purchase high quality assets or businesses at
attractive prices. With the liquidity and lower cost of funds at
CapitalSource Bank, we believe we have positioned ourselves to
take advantage of the attractive opportunities we perceive in
the current environment.
We currently operate as three reportable segments:
1) Commercial Banking, 2) Healthcare Net Lease, and
3) Residential Mortgage Investment. Our Commercial Banking
segment comprises our commercial lending and
banking 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 and other investment activities
in which we formerly engaged to optimize our qualification as a
REIT.
From January 1, 2006 to the third quarter of 2007, we
presented 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 activities
and our Residential Mortgage Investment segment comprised all of
our activities related to our investments in residential
mortgage loans and RMBS. In the fourth quarter of 2007, we began
presenting financial results through three reportable segments:
1) Commercial Finance, 2) Healthcare Net Lease, and
3) Residential Mortgage Investment. Changes were 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.
Beginning in the third quarter of 2008, we changed the name of
our Commercial Finance segment to Commercial Banking to
incorporate depository products, services and investments of
CapitalSource Bank. We have reclassified all comparative prior
period segment information to reflect our three reportable
segments. For financial information about our segments, see
Note 26, Segment Data, in our accompanying audited
consolidated financial statements for the year ended
December 31, 2008.
The discussion that follows differentiates our results of
operations between our segments.
Interest Income. In our Commercial Banking
segment, interest income represents interest earned on our
commercial loans, the “A” Participation Interest,
marketable securities, other investments and cash and cash
equivalents. 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.
Interest on CapitalSource Bank investments is primarily derived
from agency discount notes and agency callable debt obligations.
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.
Fee Income. In our Commercial Banking 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 Banking segment or our Residential
Mortgage Investment segment.
Interest Expense. Interest expense is the
amount paid on deposits and borrowings, including the
amortization of deferred financing fees and debt discounts. In
our Commercial Banking segment, interest expense includes
interest paid to depositors and the borrowing costs associated
with repurchase agreements, secured and unsecured credit
facilities, term debt, convertible debt and subordinated debt.
In our Healthcare Net Lease segment, our borrowings consist of
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, debt discounts and the
costs of issuing debt, such as commitment fees and legal fees,
are amortized over the estimated life of the borrowing. Loan
prepayments may
materially affect interest expense on our term debt since in the
period of prepayment the amortization of deferred financing fees
and debt acquisition costs is accelerated.
Provision for Loan Losses. We record a
provision for loan losses in both our Commercial Banking segment
and our Residential Mortgage Investment segment. The provision
for loan losses is the periodic cost of maintaining an
appropriate allowance for loan losses inherent in our commercial
lending portfolio and in our portfolio of residential
mortgage-related receivables. As the size and mix of loans
within these portfolios change, or if the credit quality of the
portfolios change, we record a provision to appropriately adjust
the allowance for loan losses. We do not have any loan
receivables in our Healthcare Net Lease segment.
Other Income. In our Commercial Banking
segment, other (expense) income 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, 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 lending and
banking operations. In our Healthcare Net Lease segment, other
expense consists of gain (loss) on the sale of assets. In our
Residential Mortgage Investment segment, other 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 Banking
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 an allocation of overhead expenses, compensation and
benefits, professional fees paid to our investment manager and
other direct expenses.
Income Taxes. We elected REIT status under the
Internal Revenue Code (the “Code”) when we filed our
tax return for the year ended December 31, 2006. We
operated as a REIT through 2008, but revoked our REIT election
effective January 1, 2009. While a REIT, we generally were
not subject to corporate-level income tax on the earnings
distributed to our shareholders that we derived from our REIT
qualifying activities, but were subject to corporate-level tax
on the earnings we derived from our taxable REIT subsidiaries
(“TRSs”). While a REIT, a significant portion of our
income from our Commercial Banking segment remained subject to
corporate-level income tax as many of the segment’s assets
were originated and held in our TRSs.
Operating
Results for the Years Ended December 31, 2008, 2007 and
2006
Our results of operations in 2008 were driven primarily by the
global recession, a challenging credit market environment and
the impact of operating as a REIT. As further described below,
the most significant factors influencing our consolidated
results of operations for the year ended December 31, 2008,
compared to 2007 were:
Our consolidated operating results for the year ended
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