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CAPITALSOURCE 10-K 2009
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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
 
     
Delaware
 
35-2206895
 
(State of Incorporation)   (I.R.S. Employer Identification No.)
 
4445 Willard Avenue, 12th Floor
Chevy Chase, MD 20815
(Address of Principal Executive Offices, Including Zip Code)
(800) 370-9431
 
 
     
(Title of Each Class)
 
(Name of Exchange on Which Registered)
 
Common Stock, par value $0.01 per
share
  New York Stock Exchange
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  þ Yes  o No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  o Yes  þ No
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  o No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
     
þ Large accelerated filer
  o Accelerated filer
o Non-accelerated filer
  o Smaller reporting company
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  þ No
 
The aggregate market value of the Registrant’s Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 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.
 


 

 
 
             
        Page
 
  Business     2  
  Risk Factors     31  
  Unresolved Staff Comments     49  
  Properties     50  
  Legal Proceedings     52  
  Submission of Matters to a Vote of Security Holders     52  
 
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     52  
  Selected Financial Data     55  
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     58  
  Quantitative and Qualitative Disclosures About Market Risk     98  
    Management Report on Internal Controls Over Financial Reporting     99  
    Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting     100  
  Financial Statements and Supplementary Data     101  
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     180  
  Controls and Procedures     180  
  Other Information     180  
 
  Directors, Executive Officers and Corporate Governance     181  
  Executive Compensation     182  
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     182  
  Certain Relationships and Related Transactions, and Director Independence     182  
  Principal Accounting Fees and Services     182  
 
  Exhibits and Financial Statement Schedules     183  
    Signatures     184  
    Index to Exhibits     185  
    Certifications        


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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.
 
ITEM 1.   BUSINESS
 
 
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.


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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:
 
  •  Healthcare and Specialty Finance, which generally provides first mortgage loans, asset-based revolving lines of credit, and cash flow loans to healthcare businesses and, to a lesser extent, a broad range of other companies. We also make investments in income-producing healthcare facilities, particularly long-term care facilities;
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in syndicated loan transactions; and
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies.
 
 
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


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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


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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:
 
  •  Depository Products and Services.  Through CapitalSource Bank’s 22 branches in southern and central California, we provide savings and money market accounts, IRA products and certificates of deposit. These products are insured up to the maximum amounts permitted by the FDIC.
 
  •  Senior Secured Loans.  A loan is a “senior” loan when we have a first priority lien in the collateral securing the loan. Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. Cash flow loans are made based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our senior cash flow term loans generally are secured by a security interest in all or substantially all of a client’s assets. In some cases, the equity owners of a client pledge their stock in the client to us as further collateral for the loan.
 
  •  First Mortgage Loans.  A first mortgage loan is a loan secured by a senior mortgage on real property. We make mortgage loans to clients including owners and operators of senior housing and skilled nursing facilities; owners and operators of office, industrial, hospitality, multi-family and residential properties; resort and residential developers; hospitals and companies backed by private equity firms that frequently obtain mortgage-related financing in connection with buyout transactions.
 
  •  Term B, Second Lien and Mezzanine Loans.  A Term B loan is a loan that shares a first priority lien in a client’s collateral with the client’s other senior debt but that comes after other senior secured debt in order of payment preference, and accordingly, generally involves greater risk of loss than other senior secured loans. Term B loans are senior loans and, therefore, are included with senior secured loans in our portfolio statistics. A second lien loan is a loan that has a lien on the client’s collateral that is junior in order of priority and also comes after the senior debt in order of payment. A mezzanine loan is a loan that may not share in the same collateral package as the client’s senior loans, may have no security interest in any of the client’s assets and is junior to any lien holder both as to collateral (if any) and payment. A mezzanine loan generally involves greater risk of loss than a senior loan, Term B loan or second lien loan.
 
  •  Equity Investments.  We acquired equity in some borrowers at the same time and on substantially the same terms as the private equity sponsor that invested in the borrower with our loan proceeds. These equity investments generally represented less than 5% of a borrower’s equity. Since the formation of CapitalSource Bank, we have ceased making these equity investments.
 
 
  •  Direct Real Estate Investments.  We invest in income-producing healthcare facilities, principally long-term care facilities in the United States. These facilities are generally leased through long-term, triple-net operating leases. Under a typical triple-net lease, the client agrees to pay a base monthly operating lease payment, subject to annual escalations, and all facility operating expenses, including real estate taxes, as well as make capital improvements.
 
 
  •  Residential Mortgage-Backed Securities.  While we were a REIT, we invested in RMBS, which are securities collateralized by residential mortgage loans. These securities include Agency RMBS and RMBS issued by non-government-sponsored entities that are credit-enhanced through the use of subordination or in other ways that are inherent in a corresponding securitization transaction (“Non-Agency RMBS”). Substantially all of our Agency and Non-Agency RMBS are collateralized by adjustable rate mortgage loans,


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  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. During the first quarter of 2009, we revoked our REIT status and 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.
 
  •  Mortgage-Related Receivables.  We own beneficial interests in special purpose entities (“SPEs”) that acquired and securitized pools of residential mortgage loans. We are the primary beneficiary of these SPEs and, therefore, consolidate the assets and liabilities of such entities for financial statement purposes. The SPEs’ interest in the underlying mortgage loans constitutes, for accounting purposes, receivables secured by the underlying mortgage loans. As a result, through consolidation, we recognized on our accompanying audited consolidated balance sheets mortgage-related receivables, as well as the principal amount of related debt obligations incurred by SPEs to fund the origination of such receivables. Such mortgage-related receivables maintain all of the economic attributes of the underlying mortgage loans legally held in trust by such SPEs and, as a result of our interest in such SPEs, we maintain all of the economic benefits and related risks of ownership of the underlying mortgage loans. The SPEs also issued beneficial interests to third parties, which are senior to our interests in the SPE. These senior interests are reported as liabilities on our consolidated balance sheets. Cash flows from the underlying mortgage loans held by the SPEs are designated to pay off the related liabilities. Accordingly, our loss exposure is limited to our purchased investment in the SPEs.
 
As of December 31, 2008, our portfolio of assets by type was as follows (percentages by gross carrying values):
 
 
(PIE CHART)
 
 
(1) Includes Term B loans.


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Commercial Banking Segment Overview
 
 
As of December 31, 2008 and 2007, the composition of our Commercial Banking segment portfolio was as follows:
 
                 
    December 31,  
    2008     2007  
    ($ in thousands)  
 
Marketable securities, available-for-sale
  $ 642,714     $  
Commercial real estate “A” Participation Interest, net(1)
    1,400,333        
Commercial loans(1)(2)
    9,494,873       9,867,737  
Investments
    178,595       227,128  
                 
Total
  $ 11,716,515     $ 10,094,865  
                 
 
 
(1) Includes related interest receivable.
 
(2) Includes loans held for sale.
 
 
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.


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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:
 
                                 
    December 31,  
    2008     2007  
    ($ in thousands)  
 
Composition of commercial loan portfolio by loan type:
                               
Senior secured loans(1)
  $ 5,640,559       59 %   $ 5,695,167       58 %
First mortgage loans(1)
    2,723,862       29       2,995,048       30  
Subordinate loans
    1,130,452       12       1,177,522       12  
                                 
Total
  $ 9,494,873       100 %   $ 9,867,737       100 %
                                 
Composition of commercial loan portfolio by business:
                               
Corporate Finance
  $ 2,659,038       28 %   $ 2,979,241       30 %
Healthcare and Specialty Finance
    2,998,747       32       2,934,666       30  
Structured Finance
    3,837,088       40       3,953,830       40  
                                 
Total
  $ 9,494,873       100 %   $ 9,867,737       100 %
                                 
 
 
(1) Includes Term B loans.
 
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):
 
 
(PIE CHART)
 
 
(1) Industry classification is based on the North American Industry Classification System (NAICS).
 
(2) Include all industry groups that have an aggregate loan balance less than 1% of the aggregate outstanding balance of our commercial loan portfolio.


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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:
 
 
(PIE CHART)
 
As of December 31, 2008, our commercial loan portfolio by client balance was as follows:
 
 
(PIE CHART)
 
We may have more than one loan to a client and its related entities. For purposes of determining the portfolio statistics in this Form 10-K, we count each loan or client separately and do not aggregate loans to related entities.


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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:
 
 
(PIE CHART)
 
 
(1) Includes each jurisdiction that has an aggregate loan balance less than 1% of the aggregate outstanding balance of our commercial loan portfolio.
 
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:
 
                                 
                      Average Loan
 
    Number
    Average
    Number of
    Size per
 
    of Loans     Loan Size     Clients     Client  
    ($ in thousands)  
 
Composition of commercial loan portfolio by business:
                               
Corporate Finance
    491     $ 5,416       246     $ 10,809  
Healthcare and Specialty Finance
    370       8,105       257       11,668  
Structured Finance
    211       18,185       176       21,802  
                                 
Overall commercial loan portfolio
    1,072       8,857       679       13,984  
                                 


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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:
 
 
(PIE CHART)
 
 
(1) Includes each state that has an aggregate direct real estate investment balance less than 1% of the aggregate direct real estate investment balance.
 
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.


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As of December 31, 2008, our direct real estate investment portfolio by asset balance was as follows:
 
 
(PIE CHART)
 
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:
 
                 
    December 31,  
    2008     2007  
    ($ in thousands)  
 
Mortgage-related receivables(1)
  $ 1,801,535     $ 2,033,296  
Residential mortgage-backed securities:
               
Agency(2)
    1,489,291       4,030,180  
Non-Agency(2)
    377       4,517  
                 
Total
  $ 3,291,203     $ 6,067,993  
                 
 
 
(1). Represents secured receivables that are backed by adjustable-rate residential prime mortgage loans.
 
(2). See following paragraph for a description of these securities.
 
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


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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:
 
  •  specialty and commercial finance companies;
 
  •  commercial banks and thrifts;
 
  •  REITS and other real estate investors;
 
  •  private investment funds;
 
  •  investment banks;
 
  •  insurance companies; and
 
  •  asset management companies.
 
Some of our competitors have substantial market positions. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors also have access to lower cost of capital. We believe we compete based on:
 
  •  in-depth knowledge of our clients’ industries or sectors and their business needs from information, analysis, and effective interaction between the clients’ decision-makers and our experienced professionals;
 
  •  our breadth of product offerings and flexible and creative approach to structuring products that meet our clients’ business and timing needs; and
 
  •  our superior client service.
 
 
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.


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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.


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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


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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


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“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


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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.


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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:
 
  •  regulate credit activities, including establishing licensing requirements in some jurisdictions;
 
  •  regulate lending activities, including establishing licensing requirements in some jurisdictions;
 
  •  establish the maximum interest rates, finance charges and other fees we may charge our clients;
 
  •  govern secured transactions;
 
  •  require specified information disclosures to our clients;
 
  •  set collection, foreclosure, repossession and claims handling procedures and other trade practices;
 
  •  regulate our clients’ insurance coverage;
 
  •  prohibit discrimination in the extension of credit and administration of our loans; and
 
  •  regulate the use and reporting of certain client information.
 
In addition, many of 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.
 
  •  With limited exceptions, the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than actual providers approved for participation in the applicable programs. Accordingly, while we lend money that is secured by pledges of Medicare and Medicaid receivables, if we were required to invoke our rights to the pledged receivables, we would be unable to collect receivables payable under these programs directly. We would need a court order to force collection directly against these governmental payers.
 
  •  Hospitals, nursing facilities and other providers of healthcare services are not always assured of receiving Medicare and Medicaid reimbursement adequate to cover the actual costs of operating the facilities. Many states are presently considering enacting, or have already enacted, reductions in the amount of funds appropriated to healthcare programs resulting in rate freezes or reductions to their Medicaid payment rates and often curtailments of coverage afforded to Medicaid enrollees. Most of our healthcare clients depend on Medicare and Medicaid reimbursements, and reductions in reimbursements caused by either payment cuts


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  or census declines from these programs may have a negative impact on their ability to generate adequate revenues to satisfy their obligations to us. There are no assurances that payments from governmental payors will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for coverage under these programs.
 
  •  For our clients to remain eligible to receive reimbursements under the Medicare and Medicaid programs the clients must comply with a number of conditions of participation and other regulations imposed by these programs, and are subject to periodic federal and state surveys to ensure compliance with various clinical and operational covenants. A client’s failure to comply with these covenants and regulations may cause the client to incur penalties and fines and other sanctions, or lose its eligibility to continue to receive reimbursements under the programs, which could result in the client’s inability to make scheduled payments to us.
 
 
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:
 
             
Name
 
Age
 
Position
 
John K. Delaney
    45     Chairman of the Board of Directors and Chief Executive Officer
Dean C. Graham
    43     President and Chief Operating Officer
Douglas H. (Tad) Lowrey
    56     Chief Executive Officer and President — CapitalSource Bank
Steven A. Museles
    45     Executive Vice President, Chief Legal Officer and Secretary
Thomas A. Fink
    45     Senior Vice President and Chief Financial Officer
Bryan D. Smith
    38     Chief Accounting Officer (1)
 
 
(1) Bryan D. Smith was appointed as our principal accounting officer effective September 8, 2008, and replaced our interim principal accounting officer, Donald F. Cole, who remains with us in other capacities.
 
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.


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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.
 


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    December 31,  
    2008     2007     2006  
          Interest
    Avg
          Interest
    Avg
          Interest
    Avg
 
    Average
    Income /
    Yield /
    Average
    Income /
    Yield /
    Average
    Income /
    Yield /
 
    Balance     (Expense)     Rate     Balance     (Expense     Rate     Balance     (Expense)     Rate  
    ($ in thousands)  
 
Interest-earning assets:
                                                                       
Cash and cash equivalents
  $ 1,346,552     $ 23,738       1.76 %   $ 560,440     $ 21,181       3.78 %   $ 492,768     $ 18,073       3.67 %
Marketable securities, available-for-sale(3)
    199,813       7,395       3.71 %                 N/A                   N/A  
Mortgage related receivables, net
    1,921,538       94,485       4.92 %     2,166,728       127,330       5.88 %     2,022,035       115,546       5.71 %
Mortgage-backed securities pledged, trading
    2,190,775       122,181       5.58 %     3,815,471       212,869       5.58 %     2,678,471       147,308       5.50 %
Commercial real estate “A” Participation Interest, net
    700,973       54,226       7.74 %                 N/A                   N/A  
Loans(1)(2)
    9,604,619       931,028       9.69 %     8,959,621       1,074,598       11.99 %     6,932,389       902,669       13.02 %
Investments(3)
    43,090       8,526       16.04 %     44,038       4,293       9.75 %     44,217       3,360       7.59 %
Other assets
    8,651       128       1.48 %     644       27       4.19 %     641       62       9.67 %
                                                                         
Total interest-earning assets
    16,016,011     $ 1,241,707       7.75 %     15,546,942     $ 1,440,298       9.26 %     12,170,521     $ 1,187,018       9.75 %
                                                                         
Non interest-earning assets
    1,589,583                       1,266,872                       424,247                  
                                                                         
Total assets
  $ 17,605,594                     $ 16,813,814                     $ 12,594,768                  
                                                                         
Interest-bearing liabilities:
                                                                       
Deposits
  $ 2,207,210     $ 76,245       3.45 %   $     $       N/A     $     $       N/A  
Repurchase agreements
    2,374,890       85,458       3.60 %     3,771,977       198,610       5.27 %     2,737,289       138,460       5.06 %
Credit facilities
    1,781,486       125,197       7.03 %     2,808,230       188,543       6.71 %     2,901,227       183,203       6.31 %
Term debt
    6,240,744       300,723       4.82 %     6,003,040       369,476       6.15 %     3,947,727       240,242       6.09 %
Other borrowings
    1,639,229       124,489       7.59 %     1,522,108       90,612       5.95 %     893,204       44,820       5.02 %
                                                                         
Total interest-bearing liabilities
    14,243,559     $ 712,112       5.00 %     14,105,355     $ 847,241       6.01 %     10,479,447     $ 606,725       5.79 %
                                                                         
Non interest-bearing liabilities
    409,518                       280,292                       153,475                  
                                                                         
Total liabilities
    14,653,077                       14,385,647                       10,632,922                  
Noncontrolling interests
    19,818                       47,544                       52,437                  
Shareholders’ equity
    2,932,699                       2,380,623                       1,909,409                  
                                                                         
Total liabilities, noncontrolling interests and shareholders’ equity
  $ 17,605,594                     $ 16,813,814                     $ 12,594,768                  
                                                                         
 
 
(1) For the years ended December 31, 2008, 2007 and 2006, interest income from outstanding loans included loan fees of $133.1 million, $162.4 million and $170.5 million, respectively.
 
(2) The average principal amounts of non-accrual loans have been included in the average loan balances to determine the average yield earned on loans. For the years ended December 31, 2008, 2007 and 2006, the average principal balances of non-accrual loans were $231.7 million, $162.1 million and $156.4 million, respectively.
 
(3) The average yields for investment securities available-for-sale 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. The average yields for investment securities held-to-maturity have also been calculated using amortized cost balances.

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.
 
                         
    Year Ended December 31,  
    2008     2007     2006  
    ($ in thousands)  
 
Average total interest-earning assets
  $ 16,016,011     $ 15,546,942     $ 12,170,521  
Net interest-earnings(1)
  $ 529,595     $ 593,057     $ 580,293  
Net yield on interest-earning assets(2)
    3.31 %     3.81 %     4.77 %
 
 
(1) Net interest-earnings is defined as the difference between total interest income and total interest expense.
 
(2) Net yield on interest-earning assets is defined as net interest earnings divided by average total interest-earning assets.
 
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.
 
                                                 
    2008 Compared to 2007     2007 Compared to 2006  
    (Decrease) Increase
          (Decrease) Increase
       
    Due to Changes in:     Net
    Due to Changes in:     Net
 
    Rate     Volume     Change     Rate     Volume     Change  
    ($ in thousands)  
 
Interest income:
                                               
Cash and cash equivalents
  $ (15,671 )   $ 18,228     $ 2,557     $ 565     $ 2,543     $ 3,108  
Marketable securities, available-for-sale
    N/A       7,395       7,395       N/A              
Mortgage related receivables, net
    (19,399 )     (13,446 )     (32,845 )     3,348       8,436       11,784  
Mortgage-backed securities pledged, trading
    (77 )     (90,611 )     (90,688 )     2,157       63,404       65,561  
Commercial real estate “A” Participation Interest, net
    N/A       54,226       54,226       N/A              
Loans
    (216,880 )     73,310       (143,570 )     (75,638 )     247,567       171,929  
Investments
    4,327       (94 )     4,233       946       (13 )     933  
Other assets
    (27 )     128       101       (37 )     2       (35 )
                                                 
Total (decrease) increase in interest income
    (247,727 )     49,136       (198,591 )     (68,659 )     321,939       253,280  
                                                 
Interest expense:
                                               
Deposits
    N/A       76,245       76,245       N/A              
Repurchase agreements
    (52,145 )     (61,007 )     (113,152 )     5,879       54,271       60,150  
Credit facilities
    8,445       (71,791 )     (63,346 )     11,337       (5,997 )     5,340  
Term debt
    (82,893 )     14,140       (68,753 )     2,764       126,470       129,234  
Other borrowings
    26,483       7,394       33,877       9,585       36,207       45,792  
                                                 
Total (decrease) increase in interest expense
    (100,110 )     (35,019 )     (135,129 )     29,565       210,951       240,516  
                                                 
Net (decrease) increase in net interest income
  $ (147,617 )   $ 84,155     $ (63,462 )   $ (98,224 )   $ 110,988     $ 12,764  
                                                 


23


 

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.
 
                         
    December 31,  
    2008     2007     2006  
    ($ in thousands)  
 
Trading securities:
                       
Agency mortgage-backed securities
  $ 1,489,291     $ 4,030,180     $ 3,476,424  
                         
Securities available-for-sale:
                       
Agency debt obligations(1)
  $ 495,337     $     $  
Agency mortgage-backed securities
    142,236              
Non-Agency mortgage-backed securities
    377       4,518       34,155  
Other debt securities
    2,416       5,318       5,952  
Corporate debt securities
    38,972       3,000       15,000  
Equity securities
    213       473       6,569  
                         
Total securities available-for-sale (2)
  $ 679,551     $ 13,309     $ 61,676  
                         
Securities held-to-maturity:(3)
                       
Commercial mortgage-backed securities
  $ 14,389     $     $  
                         
 
 
(1) Agency debt obligations include discount notes, callable notes, and debt notes issued by various Government-Sponsored Enterprises (“GSEs”).
 
(2) As of December 31, 2008, 2007, and 2006, $36.8 million, $13.3 million, and $61.8 million of available-for-sale securities, respectively, are included in investments in our audited consolidated balance sheets and further discussed in Note 8, Marketable Securities and Investments, within our audited consolidated financial statements. The remaining amounts are presented in marketable securities, available-for-sale in our audited consolidated balance sheets.
 
(3) Such amounts are included in investments in our audited consolidated balance sheets and further discussed in Note 8, Marketable Securities and Investments, within our audited consolidated financial statements. We did not hold any securities held-to-maturity as of December 31, 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.


24


 

 
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.
 
                                         
          Due Between
    Due Between
             
    Due in One
    One and Five
    Five and Ten
    Due after Ten
       
    Year or Less     Years     Years     Years     Total  
    ($ in thousands)  
 
Debt securities available-for-sale:
                                       
Agency debt obligations
  $ 149,945     $ 345,392     $     $     $ 495,337  
Agency mortgage-backed securities
          142,236                   142,236  
Non-Agency mortgage-backed securities
                      377       377  
Other debt securities
                      2,416       2,416  
Corporate debt securities
          7,922       31,050             38,972  
                                         
Total debt securities available-for-sale
  $ 149,945     $ 495,550     $ 31,050     $ 2,793     $ 679,338  
                                         
Weighted average yield
    2.77 %     4.01 %     16.56 %     116.21 %     4.64 %
                                         
 
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.
 
                                         
    December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands)  
 
Commercial(1)
  $ 6,153,773     $ 6,237,073     $ 4,912,664     $ 3,796,912     $ 2,903,467  
Real estate
    2,109,233       2,212,406       2,384,210       1,936,402       1,137,112  
Real estate — construction
    959,428       1,120,578       360,898       91,486       98,843  
                                         
Total loans
  $ 9,222,434     $ 9,570,057     $ 7,657,772     $ 5,824,800     $ 4,139,422  
                                         
 
 
(1) For purpose of this table, commercial loans are either asset-based loans or cash flow loans and exclude loans secured by real estate. Asset-based loans are collateralized by specified assets of the client, generally the client’s accounts receivable and/or inventory. Cash flow loans are made based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan.


25


 

 
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:
 
         
    Percentage of
 
Industries
  Total Loans  
 
Health care and social assistance
    18 %
Accommodation and food services
    14 %
Finance and insurance
    12 %
Construction
    11 %
 
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.
 
                                 
          Due After One
             
    Due One Year or
    Year Through
    Due After Five
       
    Less     Five Years     Years     Total  
    ($ in thousands)  
 
Commercial
  $ 667,735     $ 4,734,792     $ 751,246     $ 6,153,773  
Real estate
    530,147       1,478,672       100,414       2,109,233  
Real estate — construction
    684,211       275,217             959,428  
                                 
Total loans
  $ 1,882,093     $ 6,488,681     $ 851,660     $ 9,222,434  
                                 
 
 
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.
 
                         
    Loans with
    Loans with Floating
       
    Predetermined
    or
       
    Rates     Adjustable Rates     Total  
    ($ in thousands)  
 
Commercial
  $ 113,243     $ 5,372,795     $ 5,486,038  
Real estate
    206,249       1,372,837       1,579,086  
Real estate — construction
          275,217       275,217  
                         
Total loans
  $ 319,492     $ 7,020,849     $ 7,340,341  
                         
 
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.


26


 

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.
 
                                         
    December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands)  
 
Loans on non-accrual basis
                                       
Commercial
  $ 278,190     $ 129,505     $ 140,571     $ 97,764     $ 15,615  
Real estate
    60,621       45,391       50,326       40,288        
Real estate — construction
    52,299       7,896       3,859             1,947  
                                         
Total loans on non-accrual basis
  $ 391,110     $ 182,792     $ 194,756     $ 138,052     $ 17,562  
                                         
Accruing loans contractually past-due 90 days or more
                                       
Commercial
  $ 6,804     $ 464     $     $     $  
Real estate
    23,182       1,703       12,602       77       4,253  
Real estate — construction
                1,728              
                                         
Total accruing loans contractually past-due 90 days or more
  $ 29,986     $ 2,167     $ 14,330     $ 77     $ 4,253  
                                         
Troubled debt restructurings
                                       
Commercial
  $ 137,813     $ 135,820     $ 63,888     $ 46,620     $ 33,470  
Real estate
    1,371       1,431       13,866              
                                         
Total troubled debt restructurings
  $ 139,184     $ 137,251     $ 77,754     $ 46,620     $ 33,470  
                                         
Total non-performing loans
                                       
Commercial
  $ 422,807     $ 265,789     $ 204,459     $ 144,384     $ 49,085  
Real estate
    85,174       48,525       76,794       40,365       4,253  
Real estate — construction
    52,299       7,896       5,587             1,947  
                                         
Total non-performing loans
  $ 560,280     $ 322,210     $ 286,840     $ 184,749     $ 55,285  
                                         
 
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.


27


 

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).
 
         
With specific allowance on principal
       
Commercial
  $ 51,201  
Real estate
    19,964  
Real estate — construction
    23,538  
         
Total with specific allowance on principal
    94,703  
         
Without specific allowance on principal
       
Commercial
    188,714  
Real estate
    36,618  
         
Total without specific allowance on principal
    225,332  
         
Total potential problem loans
  $ 320,035  
         
 
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.
 
                                         
    Year Ended December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands)  
 
Balance at the beginning of year
  $ 138,930     $ 120,575     $ 87,370     $ 35,208     $ 18,025  
Charge-offs:
                                       
Commercial
    (191,911 )     (46,314 )     (43,399 )     (8,680 )     (5,650 )
Real estate
    (64,363 )     (8,586 )     (4,592 )     (3,079 )     (2,876 )
Real estate — construction
    (15,909 )     (3,494 )     (115 )     (1,913 )      
                                         
Total charge-offs
    (272,183 )     (58,394 )     (48,106 )     (13,672 )     (8,526 )
Recoveries:
                                       
Commercial
    1,122                          
Real estate
          905                    
Real estate — construction
    161             100       123        
                                         
Total recoveries
    1,283       905       100       123        
                                         
Net charge-offs
    (270,900 )     (57,489 )     (48,006 )     (13,549 )     (8,526 )
Transfers to held for sale
    (20,991 )     (1,732 )                  
Increase to allowance charged to operations
    576,805       77,576       81,211       65,711       25,709  
                                         
Balance at end of year
  $ 423,844     $ 138,930     $ 120,575     $ 87,370     $ 35,208  
                                         
Net charge-offs as a percentage of average loans outstanding
    2.8%       0.7%       0.7%       0.3%       0.3%  
                                         


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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.
 
                                         
    December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands)  
 
Allocation by Category
                                       
Commercial
  $ 319,842     $ 109,101     $ 97,336     $ 68,273     $ 27,543  
Real estate
    72,139       20,821       18,170       19,097       6,193  
Real estate — construction
    31,863       9,008       5,069             1,472  
                                         
Total loan loss allowance
  $ 423,844     $ 138,930     $ 120,575     $ 87,370     $ 35,208  
                                         
% of Total Loan Portfolio by Category
                                       
Commercial
    66.7 %     65.2 %     64.2 %     65.2 %     70.1 %
Real estate
    22.9 %     23.1 %     31.1 %     33.2 %     27.5 %
Real estate — construction
    10.4 %     11.7 %     4.7 %     1.6 %     2.4 %
                                         
Total
    100.0 %     100.0 %     100.0 %     100.0 %     100.0 %
                                         
 
 
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.
 
                         
    Average Balance     Average Rate        
    ($ in thousands)              
 
Interest bearing demand deposits
  $ 282,194       2.79 %        
Time deposits
    1,925,016       3.55 %        
                         
Total deposits
  $ 2,207,210       3.45 %        
                         
 
 
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):
 
         
Remaining Maturity
       
Three months or less
  $ 534,179  
Three through six months
    629,163  
Six through twelve months
    446,193  
Greater than twelve months
    14,940  
         
Total
  $ 1,624,475  
         


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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.
 
                         
    Year Ended December 31,  
    2008     2007     2006  
    ($ in thousands)  
 
Securities sold under repurchase agreements:
                       
Balance at year end
  $ 1,499,250     $ 3,796,396     $ 3,510,768  
Average daily balance during the year
  $ 2,268,868     $ 3,727,665     $ 2,737,289  
Maximum outstanding month-end balance
  $ 3,780,942     $ 4,217,086     $ 3,547,881  
Weighted average interest rate during the year
    3.5 %     5.3 %     5.2 %
Weighted average interest rate at year end
    2.6 %     5.1 %     5.3 %
 
 
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.


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ITEM 1A.   RISK FACTORS
 
Our business faces many risks.  The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following 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.


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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
 
  •  75% of the cash proceeds of any unsecured debt issuance by the Parent Company,
 
  •  25% of the cash proceeds of specified equity issuances, and
 
  •  75% of any principal repayments on, or the cash proceeds received on the disposition of or the incurrence of secured debt with respect to, assets constituting collateral under the facility.
 
Regardless of any such mandatory prepayments, the facility commitment reduces to
 
  •  $1.0 billion on March 31, 2009,
 
  •  $900.0 million on June 30, 2009, and
 
  •  $700.0 million on December 31, 2009.
 
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


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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:
 
  •  incur various types of additional indebtedness and grant additional liens;
 
  •  make specified investments;
 
  •  merge with or into another person or consummate other transactions that could result in a change of control;
 
  •  make capital expenditures;
 
  •  pay dividends if we are in default; and/or
 
  •  enter into transactions with affiliates.
 
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


33


 

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


34


 

type of portfolio investments held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:
 
  •  interest rate hedging can be expensive, particularly during periods of volatile interest rates;
 
  •  available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;
 
  •  the duration of the hedge may not match the duration of the related liability or asset;
 
  •  the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
 
  •  the party owing money in the hedging transaction may default on its obligation to pay.
 
Because we do not employ hedge accounting, our hedging activity may materially adversely affect our earnings. Therefore, while we pursue such transactions to reduce our interest rate risks, it is possible that changes in interest rates may result in losses that we would not otherwise have incurred if we had not engaged in any such hedging transactions. For additional information about our hedging instruments, see Note 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.


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CapitalSource Bank’s ability to maintain or raise sufficient deposits may be limited by several factors, including:
 
  •  competition from a variety of competitors, many of which offer a greater selection of products and services and have greater financial resources, including, without limitation, other banks, credit unions and brokerage firms;
 
  •  as a California state-chartered industrial bank, CapitalSource Bank is permitted to offer only savings, money market and time deposit products, which limitations may adversely impact its ability to compete effectively;
 
  •  the California deposit gathering markets where CapitalSource Bank’s branches are located have exhibited volatile and highly competitive deposit pricing strategies, and regulatory actions with respect to troubled institutions in those markets have spurred defensive pricing that we believe have caused, and may continue to cause, the impacted institutions to offer higher interest rates to their customers as they attempt to stave off significant outflows due to a lack of consumer confidence, all of which could require CapitalSource Bank to offer higher interest rates than desired to retain or grow our deposit base; and
 
  •  perceptions of CapitalSource Bank’s quality could be adversely affected by depositors’ negative views of the Parent Company, which could cause depositors to withdraw their deposits or seek higher rates.
 
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


36


 

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.


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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:
 
  •  could be subject to monetary penalties and injunctive relief in an action brought by the SEC and could be found to be in default of some of our indebtedness;
 
  •  may be unable to enforce contracts with third parties, and third parties could seek to rescind transactions undertaken during the period it was established that we or such subsidiary was an unregistered investment company;
 
  •  would have to significantly reduce the amount of leverage in our business;
 
  •  would have to restructure operations dramatically;


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  •  may have to raise substantial amounts of additional equity to come into compliance with the limitations prescribed under the Investment Company Act; and
 
  •  may have to terminate agreements with our affiliates.
 
Any of these results likely would have a material adverse effect on our business, 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.


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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.
 
  •  If clients fail to comply with operational covenants and other regulations imposed by these programs, they may lose their eligibility to continue to receive reimbursements under the program or incur monetary penalties, either of which could result in the client’s inability to make scheduled payments to us.
 
  •  If reimbursement rates do not keep pace with increasing costs of services to eligible recipients, or funding levels decrease as a result of increasing pressures from Medicare and Medicaid to control healthcare costs, our clients may not be able to generate adequate revenues to satisfy their obligations to us.
 
  •  If a healthcare client were to default on its loan, we would be unable to invoke our rights to the pledged receivables directly as the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than the actual providers. Consequently, we would need a court order to force collection directly against these governmental payors. There is no assurance that we would be successful in obtaining this type of court order.


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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.


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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


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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


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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.


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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.


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Our markets are competitive and characterized by varying competitive factors. We compete with a large number of financial services companies, including:
 
  •  specialty and commercial finance companies;
 
  •  commercial banks and thrifts;
 
  •  REITS and other real estate investors;
 
  •  private investment funds;
 
  •  investment banks;
 
  •  insurance companies; and
 
  •  asset management companies.
 
Some of our competitors have greater financial, technical, marketing and other resources 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


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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:
 
  •  changes in interest rates and in the availability, costs and terms of financing;
 
  •  adverse changes in national and local economic and market conditions;
 
  •  the ongoing need for capital improvements, particularly in older structures;
 
  •  changes in governmental laws and regulations, fiscal policies and zoning and other ordinances and costs of compliance with laws and regulations;


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  •  changes in operating expenses; and
 
  •  civil unrest, acts of war and natural disasters, including earthquakes and floods, which may result in uninsured and underinsured losses.
 
We cannot predict how long it may take us to find a willing purchaser and to close the sale of a property. We also cannot predict whether we will be able to sell any property for the price or on the terms set by us, or whether any price or other terms offered by a prospective purchaser would be acceptable to us. 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:
 
  •  difficulties in integrating the operations, services, products and personnel of the acquired company or asset portfolio;
 
  •  heightened risks of credit losses as a result of acquired assets not having been originated by us in accordance with our rigorous underwriting standards;
 
  •  the diversion of management’s attention from other business concerns;
 
  •  the potentially adverse effects that acquisitions may have in terms of the composition and performance of our assets;
 
  •  the potential loss of key employees of the acquired company; and
 
  •  inability to meet applicable regulatory requirements.
 
 
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


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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:
 
  •  a classified board of directors;
 
  •  restrictions on the ability of our shareholders to fill a vacancy on the board of directors;
 
  •  the authorization of undesignated preferred stock, the terms of which may be established and shares of which may be issued without shareholder approval; and
 
  •  advance notice requirements for shareholder proposals.
 
We also are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which restricts the ability of any shareholder that at any time holds more than 15% of our voting shares to acquire us without the approval of shareholders holding at least 662/3% of the shares held by all other shareholders that are eligible to vote on the matter. Our board of directors has provided a waiver to Farallon Capital Management and its affiliates to acquire common stock in excess of 15% for purposes of Section 203 of the Delaware General Corporation Law.
 
These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors of your choosing and cause us to take other corporate actions than you desire.
 
Insiders continue to have substantial control over us and could limit your ability to influence the outcome of key transactions, including a change of control.
 
Our directors, 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.
 
ITEM 1B.   UNRESOLVED STAFF COMMENTS
 
None.


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ITEM 2.   PROPERTIES
 
Our headquarters are located in Chevy Chase, Maryland, a suburb of Washington, D.C., where we lease office space under long-term operating leases. This office space houses the bulk of our technology and administrative functions and serves as the primary base for our operations. We also maintain offices in 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.


50


 

Our direct real estate investment properties as of and for the year ended December 31, 2008, were as follows:
 
                                 
    Number of
                Total
 
Facility Location
  Facilities     Capacity(1)     Investment(2)     Revenues(3)  
                ($ in thousands)  
 
Assisted Living Facilities:
                               
Florida
    5       222     $ 8,401     $ 918  
Indiana
    1       39       2,038       91  
Wisconsin
    1       20       738       97  
                                 
      7       281       11,177       1,106  
Long-Term Acute Care Facilities:
                               
Kansas
    1       26       1,421       169  
Nevada
    1       61       2,670       325  
                                 
      2       87       4,091       494  
Skilled Nursing Facilities:
                               
Alabama
    1       174       8,185       990  
Alaska
    1       90       10,336       1,102  
Arizona
    2       192       9,600       971  
Arkansas
    2       185       1,686       381  
California
    1       99       4,749       398  
Colorado
    3       283       8,923       888  
Florida
    57       7,080       321,237       38,082  
Indiana
    13       1,353       52,440       5,295  
Iowa
    1       201       11,157       1,158  
Kansas
    2       82       2,753       371  
Kentucky
    5       344       22,549       2,397  
Maryland
    3       413       26,279       2,581  
Massachusetts
    2       231       15,204       1,375  
Mississippi
    6       634       43,037       4,620  
Nevada
    3       407       18,706       2,317  
New Mexico
    1       102       3,157       268  
North Carolina
    6       682       40,377       2,966  
Ohio
    3       349       20,232       1,849  
Oklahoma
    5       657       18,766       1,344  
Pennsylvania
    4       585       23,175       2,774  
Tennessee
    10       1,589       93,867       10,442  
Texas
    46       5,517       198,910       21,323  
Washington
                      (305 )
Wisconsin
    5       562       19,123       2,561  
                                 
      182       21,811       974,448       106,148  
Less multi-function facilities(4)
    (5 )                  
                                 
Total owned properties
    186       22,179     $ 989,716     $ 107,748  
                                 
 
 
(1) Capacity of assisted living and long-term acute care facilities, which are apartment-like facilities, is stated in units (studio, one or two bedroom apartments). Capacity of skilled nursing facilities is measured by licensed bed count.
 
(2) Represents the acquisition costs of the assets less any related accumulated depreciation as of December 31, 2008.
 
(3) Represents the amount of operating lease income recognized in our audited consolidated statement of income for the year ended December 31, 2008.
 
(4) Three of our properties in Florida and one property in Wisconsin serve as both assisted living facilities and skilled nursing facilities. In addition, we have one property in Kansas that serves as both long-term acute care facility and a skilled nursing facility.


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ITEM 3.   LEGAL PROCEEDINGS
 
From time to time, we are party to legal proceedings. We do not believe that any currently pending or threatened proceeding, if determined adversely to us, would have a material adverse effect on our business, financial condition or results of operations, including our cash flows.
 
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matter was submitted to a vote of our security holders during the fourth quarter of 2008.
 
 
ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
 
Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “CSE.” The high and low sales prices for our common stock as reported by the NYSE for the quarterly periods during 2008 and 2007 were as follows:
 
                 
    High     Low  
 
2008:
               
Fourth Quarter
  $ 12.99     $ 2.75  
Third Quarter
  $ 14.75     $ 9.11  
Second Quarter
  $ 16.95     $ 9.75  
First Quarter
  $ 18.14     $ 7.56  
2007:
               
Fourth Quarter
  $ 22.42     $ 14.05  
Third Quarter
  $ 25.10     $ 14.76  
Second Quarter
  $ 27.40     $ 23.65  
First Quarter
  $ 28.28     $ 22.39  
 
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:
 
                 
    Dividends Declared
 
    and Paid per Share  
    2008     2007  
 
Fourth Quarter(1)
  $ 0.05     $ 0.60  
Third Quarter
    0.05       0.60  
Second Quarter
    0.60       0.60  
First Quarter
    0.60       0.58  
                 
Total dividends declared and paid
  $ 1.30     $ 2.38  
                 
 
 
(1) Dividend declared for the fourth quarter of 2008 was paid in January 2009.


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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:
 
                                 
                Shares Purchased
    Maximum Number
 
    Total Number
    Average
    as Part of Publicly
    of Shares that May
 
    of Shares
    Price Paid
    Announced Plans
    Yet be Purchased
 
    Purchased(1)     per Share     or Programs     Under the Plans  
 
October 1 — October 31, 2008
    7,127     $ 7.04              
November 1 — November 30, 2008
    16,248       3.45              
December 1 — December 31, 2008
    207,431       4.97              
                                 
Total
    230,806       4.92              
                                 
 
 
(1) Represents the number of shares acquired as payment by employees of applicable statutory minimum withholding taxes owed upon vesting of restricted stock granted under the CapitalSource Inc. Third Amended and Restated Equity Incentive Plan.


53


 

 
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
 
(PERFORMANCE GRAPH)
 
                                                 
    Base
                               
    Period
    Year Ended December 31,  
Company/Index
  12/31/03     2004     2005     2006     2007     2008  
 
CapitalSource Inc. 
  $ 100     $ 118.4     $ 114.1     $ 150.6     $ 108.2     $ 32.3  
S&P 500 Index
    100       110.9       116.3       134.7       142.1       89.5  
S&P 500 Financials Index
    100       110.9       118.1       140.7       114.5       51.2  


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ITEM 6.   SELECTED FINANCIAL DATA
 
You should read the data set forth below in conjunction with our consolidated financial statements and related notes, 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.
 
                                         
    Year Ended December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands, except per share data)  
 
Results of operations:
                                       
Interest income
  $ 1,108,561     $ 1,277,903     $ 1,016,533     $ 514,652     $ 313,827  
Fee income
    133,146       162,395       170,485       130,638       86,324  
                                         
Total interest and fee income
    1,241,707       1,440,298       1,187,018       645,290       400,151  
Operating lease income
    107,748       97,013       30,742              
                                         
Total investment income
    1,349,455       1,537,311       1,217,760       645,290       400,151  
Interest expense
    712,110       847,241       606,725       185,935       79,053  
                                         
Net investment income
    637,345       690,070       611,035       459,355       321,098  
Provision for loan losses
    593,046       78,641       81,562       65,680       25,710  
                                         
Net investment income after provision for loan losses
    44,299       611,429       529,473       393,675       295,388  
Depreciation of direct real estate investments
    35,889       32,004       11,468              
Other operating expenses
    255,306       235,987       204,584       143,836       107,748  
Total other (expense) income
    (174,083 )     (74,650 )     37,328       19,233       17,781  
Noncontrolling interests expense
    1,426       4,938       4,711              
                                         
Net (loss) income before income taxes and cumulative effect of accounting change
    (422,405 )     263,850       346,038       269,072       205,421  
Income tax (benefit) expense(1)
    (199,781 )     87,563       67,132       104,400       80,570  
                                         
Net (loss) income before cumulative effect of accounting change
    (222,624 )     176,287       278,906       164,672       124,851  
Cumulative effect of accounting change, net of taxes
                370              
                                         
Net (loss) income
  $ (222,624 )   $ 176,287     $ 279,276     $ 164,672     $ 124,851  
                                         
Net (loss) income per share:
                                       
Basic
  $ (0.89 )   $ 0.92     $ 1.68     $ 1.36     $ 1.07  
Diluted
  $ (0.89 )   $ 0.91     $ 1.65     $ 1.33     $ 1.06  
Average shares outstanding:
                                       
Basic
    251,213,699       191,697,254       166,273,730       120,976,558       116,217,650  
Diluted
    251,213,699       193,282,656       169,220,007       123,433,645       117,600,676  
Cash dividends declared per share
  $ 1.30     $ 2.38     $ 2.02     $ 0.50     $  
Dividend payout ratio
    (1.47 )     2.59       1.20       0.37        
 
 
(1) As a result of our decision to elect REIT status beginning with the tax year ended December 31, 2006, we provided for income taxes for the years ended December 31, 2008, 2007 and 2006, based on effective tax rates of 36.5%, 39.4% and 39.9%, respectively, for the income earned by our taxable REIT subsidiaries (“TRSs”). We did not provide for any income taxes for the income earned by our qualified REIT subsidiaries for the years ended December 31, 2008, 2007 and 2006. We provided for income (benefit) expense on the consolidated (loss) incurred or income earned based on effective tax rates of 47.3%, 33.2%, 19.4%, 38.8% and 39.2% in 2008, 2007, 2006, 2005 and 2004, respectively.
 


55


 

                                         
    December 31,  
    2008     2007     2006     2005     2004  
    ($ in thousands)  
 
Balance sheet data:
                                       
Marketable securities, available-for-sale
  $ 642,714     $     $     $     $  
Mortgage-related receivables, net
    1,801,535       2,033,296       2,286,083       39,438        
Mortgage-backed securities pledged, trading
    1,489,291       4,030,180       3,476,424       322,027        
Commercial real estate “A” Participation Interest, net
    1,396,611                          
Total loans, net(1)
    8,807,133       9,525,454       7,563,718       5,737,430       4,104,214  
Direct real estate investments, net
    989,716       1,017,604       722,303              
Total assets
    18,414,901       18,040,349       15,210,574       6,987,068       4,736,829  
Deposits
    5,043,695                          
Repurchase agreements
    1,595,750       3,910,027       3,510,768       358,423        
Credit facilities
    1,445,062       2,207,063       2,251,658       2,450,452       964,843  
Term debt
    5,338,456       7,146,437       5,766,370       1,774,475       2,162,321  
Other borrowings
    1,560,224       1,704,108       1,331,890       792,232       578,990  
Total borrowings
    9,939,492       14,967,635       12,860,686       5,375,582       3,706,154  
Total shareholders’ equity
    2,839,121       2,582,271       2,093,040       1,199,938       946,391  
Portfolio statistics:
                                       
Number of loans closed to date
    2,596       2,457       1,986       1,409       923  
Number of loans paid off to date
    (1,524 )     (1,243 )     (914 )     (486 )     (275 )
                                         
Number of loans
    1,072       1,214       1,072       923       648  
                                         
Total loan commitments
  $ 13,296,755     $ 14,602,398     $ 11,929,568     $ 9,174,567     $ 6,379,012  
Average outstanding loan size
  $ 8,857     $ 8,128     $ 7,323     $ 6,487     $ 6,596  
Average balance of loans outstanding during year
  $ 9,604,619     $ 8,959,621     $ 6,932,389     $ 5,008,933     $ 3,265,390  
Employees as of year end
    716       562       548       520       398  
 
 
(1) “Total loans, net” includes loans held for sale and loans, net of deferred loan fees and discounts and allowance for loan losses.
 

56


 

                                         
    Year Ended December 31,  
    2008     2007     2006     2005     2004  
 
Performance ratios:
                                       
Return on average assets
    (1.26 )%     1.05 %     2.22 %     3.04 %     3.59 %
Return on average equity
    (7.59 )%     7.41 %     14.63 %     15.05 %     14.17 %
Yield on average interest earning assets
    7.83 %     9.31 %     9.80 %     12.15 %     11.59 %
Cost of funds
    5.00 %     6.01 %     5.79 %     4.43 %     3.08 %
Net finance margin
    3.77 %     4.20 %     4.94 %     8.65 %     9.30 %
Operating expenses as a percentage of average total assets
    1.65 %     1.59 %     1.72 %     2.65 %     3.09 %
Operating expenses (excluding direct real estate investment depreciation) as a percentage of average total assets
    1.45 %     1.40 %     1.62 %     2.65 %     3.09 %
Efficiency ratio (operating expenses/net interest and fee income and other income)
    62.86 %     43.55 %     33.32 %     30.05 %     31.80 %
Efficiency ratio (operating expenses excluding direct real estate depreciation/net interest and fee income and other income)
    55.11 %     38.35 %     31.55 %     30.05 %     31.80 %
Core lending spread
    6.99 %     6.25 %     7.18 %     8.77 %     9.92 %
Credit quality ratios:
                                       
Loans 30-89 days contractually delinquent as a percentage of commercial lending assets (as of year end)
    2.75 %     0.85 %     2.15 %     0.30 %     2.11 %
Loans 90 or more days contractually delinquent as a percentage of commercial lending assets (as of year end)
    1.30 %     0.59 %     0.79 %     0.70 %     0.12 %
Loans on non-accrual status as a percentage of commercial lending assets (as of year end)
    4.03 %     1.73 %     2.34 %     2.30 %     0.53 %
Impaired loans as a percentage of commercial lending assets (as of year end)
    6.35 %     3.23 %     3.58 %     3.33 %     0.77 %
Net charge offs (as a percentage of average commercial lending assets)
    2.89 %     0.64 %     0.69 %     0.27 %     0.26 %
Allowance for loan losses as a percentage of commercial lending assets (as of year end)
    3.89 %     1.41 %     1.54 %     1.46 %     0.82 %
Capital and leverage ratios:
                                       
Total debt and deposits to equity (as of year end)
    5.28 x     5.80 x     6.14 x     4.48 x     3.93 x
Average equity to average assets
    16.87 %     14.16 %     15.15 %     20.18 %     25.30 %
Equity to total assets (as of year end)
    15.42 %     14.31 %     13.76 %     17.17 %     19.98 %

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
 
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:
 
  •  Healthcare and Specialty Finance, which generally provides first mortgage loans, asset-based revolving lines of credit, and cash flow loans to healthcare businesses and, to a lesser extent, a broad range of other companies. We also make investments in income-producing healthcare facilities, particularly long-term care facilities;
 
  •  Corporate Finance, which generally provides senior and subordinate loans through direct origination and participation in syndicated loan transactions; and
 
  •  Structured Finance, which generally engages in commercial and residential real estate finance and also provides asset-based lending to finance companies.
 
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


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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


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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


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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 diligen