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CAPITALSOURCE 10-K 2014
12.31.13 10-K



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, 2013
Commission File No. 1-31753
CapitalSource Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
35-2206895
(State of Incorporation)
 
(I.R.S. Employer
Identification No.)
633 West 5th Street, 33rd Floor
Los Angeles, CA 90071
(Address of Principal Executive Offices, Including Zip Code)
(213) 443-7700
(Registrant's Telephone Number, Including Area Code)
Securities Registered Pursuant to Section 12(b) of the Act:
 
(Title of Each Class) 
 
(Name of Exchange on Which Registered) 
Common Stock, par value $0.01 per share
 
New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act:
None
 
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.    þ  Yes     o  No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    þ  Yes     o  No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, 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
(Do not check if a smaller reporting company)
o Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 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, 2013 was $1,825,859,491.
As of February 26, 2014, the number of shares of the Registrant's Common Stock, par value $0.01 per share, outstanding was 196,869,521.
 
DOCUMENTS INCORPORATED BY REFERENCE
Portions of CapitalSource Inc.'s Proxy Statement for the 2014 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.

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Page  
 
PART I
 
 
 
 
Item 1.
Business
 
 
 
Item 1A.
Risk Factors
 
 
 
Item 1B.
Unresolved Staff Comments
 
 
 
Item 2.
Properties
 
 
 
Item 3.
Legal Proceedings
 
 
 
Item 4.
Mine Safety Disclosures
 
 
 
 
PART II
 
 
 
 
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
 
 
Item 6.
Selected Financial Data
 
 
 
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
 
Management Report on Internal Controls Over Financial Reporting
 
 
 
 
Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting
 
 
 
Item 8.
Financial Statements and Supplementary Data
 
 
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
 
 
Item 9A.
Controls and Procedures
 
 
 
Item 9B.
Other Information
 
 
 
 
PART III
 
 
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
 
 
 
Item 11.
Executive Compensation
 
 
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
 
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence
 
 
 
Item 14.
Principal Accountant Fees and Services
 
 
 
 
PART IV
 
 
 
 
Item 15.
Exhibits and Financial Statement Schedules
 
 
 
 
Signatures
 
 
 
 
 
Index to Exhibits


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PART I

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

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, including certain plans, expectations, strategies, goals, and projections and including statements about our expectations regarding the pending merger between the Parent Company and PacWest Bancorp (“PacWest”), CapitalSource Bank net interest margin (“NIM”), loan repayments, credit trends, funding of unfunded loan commitments, CapitalSource Bank and Parent Company liquidity, CapitalSource Bank tax payment to the Parent Company, realizing the allowed portion of the deferred tax asset, and interest rate risk management, all which are subject to numerous assumptions, risks, and uncertainties. All statements contained in this Form 10-K that are not clearly historical in nature are forward-looking, and the words 'anticipate,' 'assume,' 'intend,' 'believe,' 'expect,' 'estimate,' 'forecast,' 'plan,' 'position,' 'project,' 'will,' 'should,' 'would,' 'seek,' 'continue,' 'outlook,' 'look forward,' and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding preliminary and future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: the ability to complete the pending merger between the Parent Company and PacWest, including obtaining regulatory approvals, or any future transaction, successfully integrating the companies following completion of the merger or achieving expected beneficial synergies and/or operating efficiencies, in each case, within expected time frames or at all; the possibility that regulatory approvals may not be received on expected time frames or at all; the possibility that personnel changes in connection with the merger may not proceed as planned; the possibility that the cost of additional capital may be more than expected; changes in the Company’s stock price before completion of the merger, including as a result of the financial performance of PacWest prior to closing; the reaction to the merger by each of the company’s customers, employees and counterparties; change in interest rates and lending spreads; compression of spreads on newly originated loans; unfavorable changes in asset mix; higher than anticipated payoff levels; changes in our loan product could further compress NIM; deteriorations in credit and other markets; higher than anticipated credit losses; reserves and delinquencies; loan loss provisions; a borrower’s lack of financial strength to repay loans; continued or worsening credit losses; changes in economic or market conditions or investment or lending opportunities; competitive and other market pressures on product pricing and services; reduced demand for our services; loan repayments higher than expected; charge-offs; our inability to grow deposits and access wholesale funding sources; regulatory safety and soundness considerations; the success and timing of other business strategies and asset sales; drawdown of Parent Company unfunded commitments substantially in excess of historical drawings; lower than expected Parent Company's recurring tax basis income; lower than expected taxable income at CapitalSource Bank for which CapitalSource Bank has to reimburse the Parent Company for income tax expenses in accordance with the tax sharing agreement; higher than anticipated capital needs due to strategic or regulatory reasons; CapitalSource Bank dividend payment to the Parent Company is less than expected; changes in tax laws or regulations affecting our business; our inability to generate sufficient earnings; tax planning or disallowance of tax benefits by tax authorities; changes in the forward yield curve; increases or decreases in market interest rates; changes in the relationship between yields on investments and loans repaid and yields on assets reinvested; and other factors described in this Form 10-K and documents subsequently filed by CapitalSource with the Securities and Exchange Commission (the "SEC"). All forward-looking statements included in this Form 10-K are based on information available at the time of the release.
We are under no obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
The information contained in this section should be read in conjunction with our 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.
 

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ITEM 1.
BUSINESS
Overview
CapitalSource Inc., a Delaware corporation, is a commercial lender that provides financial products to small and middle market businesses nationwide and provides depository products and services to consumers in southern and central California, primarily through our wholly owned subsidiary, CapitalSource Bank. References to we, us, the Company or CapitalSource refer to CapitalSource Inc. together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references to the Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank.
We offer a broad range of specialized senior secured, commercial loan products to small and middle-market businesses, and we offer our loan products on a nationwide basis. With a deposit gathering platform based in southern and central California, we believe our business model is well positioned to deliver a broad range of customized financial solutions to borrowers.
As of December 31, 2013, we had total assets of $8.9 billion, total loans of $6.8 billion, total deposits of $6.1 billion and stockholders' equity of $1.6 billion.
Our corporate headquarters is located in Los Angeles, California, and we have 21 retail bank branches located in southern and central California. Our loan origination efforts are conducted nationwide with key offices located in Chevy Chase, Maryland, Los Angeles, California, Denver, Colorado, Chicago, Illinois, and New York, New York. We also maintain a number of smaller lending offices throughout the country.
For the years ended December 31, 2013, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. The CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. For additional information, see Note 20, Segment Data.
Current Developments
On July 23, 2013, the Parent Company announced that it had entered into a Merger Agreement (the "Merger") with PacWest Bancorp ("PacWest") pursuant to which the Parent Company will merge with and into PacWest. Under the terms of the Merger, stockholders of the Parent Company will receive $2.47 in cash and 0.2837 shares of PacWest common stock for each share of CapitalSource common stock. The total value of the per share merger consideration, based on the closing price of PacWest shares on July 19, 2013, is $11.64. On January 13, 2014, the Company's shareholders approved the merger; however, the transaction continues to be subject to customary conditions, including the approval of bank regulatory authorities.
Our business focus includes operating CapitalSource Bank and liquidating our remaining Parent Company assets. As of December 31, 2013 and 2012, CapitalSource Bank had $8.1 billion and $7.4 billion of assets, respectively. During 2013, CapitalSource Bank's loan portfolio grew by approximately $1.1 billion or 19.2%, while the loan portfolio of the Parent Company decreased by $0.4 billion or 83.4%; resulting in net loan growth of $0.7 billion. During 2012, CapitalSource Bank's loan portfolio grew by approximately $0.9 billion or 18.6%, while the loan portfolio of the Parent Company decreased by $0.4 billion or 45.8%; resulting in net loan growth of $0.5 billion. CapitalSource Bank's non-performing assets as of December 31, 2013 were $48.6 million, or 0.6% of total assets, a decrease of $0.3 million from December 31, 2012. CapitalSource Bank's allowance for loan losses as of December 31, 2013 was $109.5 million or 1.6% of loans compared to $98.9 million or 1.8% of loans as of December 31, 2012.
CapitalSource Bank's net interest margin for the three months ended December 31, 2013 decreased to 4.76% from the previous quarter as the loan portfolio yields declined, however, the margin was partially offset by loan portfolio growth. We anticipate that the net interest margin will remain relatively flat as compared to the fourth quarter. Net interest margin was 4.86%, 4.79%, 5.08%, and 4.84% for the three months ended September 30, 2013, June 30, 2013, March 31, 2013, and December 31, 2012, respectively.
Loan Products and Service Offerings
Senior Secured Loans
We make senior secured real estate and asset-based loans which have a first priority lien in the collateral securing the loan. We also make cash flow loans which are secured by the enterprise value of the borrowing entity. Asset-based loans are collateralized by specified assets of the borrower, generally its accounts/notes receivable, inventory and/or machinery. Real estate loans are secured by senior mortgages on real property. We make cash flow loans 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 cash flow loans are generally secured by a security interest in all or substantially all of a borrower's assets.
Our lending activities are primarily focused on the following sectors:
Healthcare: real estate, asset-based and cash flow loans to healthcare providers;

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Lender finance: loans to commercial finance companies with underlying portfolios of tax liens, loans secured by timeshare receivables, auto receivables, student loans and other consumer receivables;
Multifamily real estate: mortgage loans on multifamily properties;
Commercial real estate: mortgage loans on a variety of commercial property types;
Equipment leasing and finance: equipment loans and leases collateralized by the specific equipment financed;
Technology: loans to technology companies that provide critical product or service offerings, including wireless communication tower owner/operators, information technology hosting providers and managed service providers;
Security: asset-based and cash flow loans to companies in the physical security, government security, and public safety sectors;
Small business: loans guaranteed in part by the Small Business Administration (“SBA”) to small businesses; and
Premium finance: traditional life insurance premium finance loans secured by the cash surrender value of life insurance policies and other liquid assets.
Depository Products and Services
Through CapitalSource Bank's 21 branches in southern and central California, our website and our borrower relationships, we provide savings and money market accounts, individual retirement accounts and certificates of deposit. These products are insured up to the maximum amounts permitted by the FDIC. As an industrial bank, we are not permitted to offer demand deposit accounts.
Financing
We depend on deposits and external financing sources to fund our operations. We employ a variety of financing arrangements, including term debt, subordinated debt and equity. As a member of the Federal Home Loan Bank of San Francisco (“FHLB SF”), one of 12 regional banks in the Federal Home Loan Bank (“FHLB”) system, CapitalSource Bank had financing availability with the FHLB SF as of December 31, 2013 equal to 35% of CapitalSource Bank's total assets, subject to pledging adequate collateral.
We have issued subordinated debt to statutory trusts (“TP Trusts”) that are formed for the purpose of issuing preferred securities to outside investors, which we refer to as Trust Preferred Securities (“TPS”). We generally retained 100% of the common securities issued by the TP Trusts, representing 3% of their total capitalization. The terms of the subordinated debt issued to the TP Trusts and the TPS issued by the TP Trusts are substantially identical.
Competition
We offer a number of loan and deposit products with many of the loan product offerings focused on niche sectors, such as timeshare lending, security lending, technology and healthcare lending, among others. Generally, our loan products are marketed nationwide while our depository activities occur in California. The primary competition for each of our loan products varies by product type. Our markets are competitive and characterized by varying competitive factors. We compete with a large number of financial services companies, including:
commercial banks and thrifts that operate locally, regionally or nationally;
specialty and commercial finance companies;
private investment funds;
insurance companies; and
investment banks.
Competition is based on a number of factors, including: interest rates charged on loans and paid on deposits, the scope and type of banking and financial services offered, customer service and convenience, and regulatory constraints. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors have substantial market positions and have access to a lower cost of capital or a less expensive source of funds. We believe we compete based on:
in-depth knowledge of our borrowers' industries and their business needs based upon information received from our borrowers' key decision-makers, analysis by our experienced professionals and interaction between our borrowers' decision-makers and our experienced professionals;
our breadth of loan product offerings and flexible and creative approach to structuring products that meet our borrowers' business and timing needs; and

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our superior client service.
Supervision and Regulation
Our bank operations are subject to regulation by federal and state regulatory agencies. This regulation is intended primarily for the protection of depositors and the deposit insurance fund, and secondarily for the stability of the U.S. banking system. It is not intended for the benefit of stockholders of financial institutions. CapitalSource Bank is a California industrial bank and is subject to supervision and regular examination by the Federal Deposit Insurance Corporation ("FDIC") and the California Department of Business Oversight ("DBO"). CapitalSource Bank's deposits are insured by the FDIC up to the maximum amounts permitted by law.  
Although the Parent Company is not directly regulated or supervised by the DBO, the FDIC, the Federal Reserve Board (“FRB”) or any other federal or state bank regulatory authority either as a bank holding company or otherwise, the Parent Company gave the FDIC authority pursuant to a contractual supervisory agreement (the “Parent Company Agreement”) to examine the Parent Company, the relationship and transactions between it and CapitalSource Bank and the effect of such relationship and transactions on CapitalSource Bank. The Parent Company is subject to regulation by other applicable federal and state agencies, such as the Securities and Exchange Commission ("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.
General
Like other banks, CapitalSource Bank must file reports in the ordinary course with applicable regulators concerning its activities and financial condition in addition to obtaining regulatory approvals prior to changing its approved business plan or entering into certain transactions such as mergers with, or acquisitions of, other financial institutions.
While CapitalSource Bank completed its initial three-year de novo period in July 2011, certain conditions contained in the FDIC Order remain in place pursuant to the continued existence of the Parent Company Agreement and the Capital Maintenance and Liquidity Agreement (the “CMLA”) until such time as we apply for and are granted relief by the FDIC from the requirements of these agreements. Under the provisions of the CLMA, the Parent Company has provided, and is required to continue to provide, a $150.0 million unsecured revolving credit facility that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. This revolving credit facility has been in place since the formation of CapitalSource Bank and has not been drawn upon. Other remaining conditions are the requirement that CapitalSource Bank maintain a total risk-based capital ratio of not less than 15% and also maintain all other capital ratios of well-capitalized banks, to be supported by the Parent Company. CapitalSource Bank remains subject to bank safety and soundness requirements as well as to various regulatory capital requirements established by federal and state regulatory agencies, including any new conditions that our regulators may determine. Pursuant to the Parent Company Agreement, the Parent Company has consented to an examination of itself by the FDIC for purposes of monitoring compliance with the laws and regulations applicable to CapitalSource Bank and its affiliates.
In 2011, CapitalSource Bank filed a revised business plan pursuant to guidance issued by the FDIC for de novo institutions, with the plan covering the time period from July 1, 2011 through December 31, 2015. During this time period, CapitalSource Bank is subject to increased supervision that would otherwise not be applicable to a bank that has been in existence longer than three years, including enhanced FDIC supervision for compliance examinations and Community Reinvestment Act evaluations.
The FDIC and DBO conduct periodic examinations 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.
In addition, the investment, lending and branch operating 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.
California law provides limits on loans to one borrower. In general, a California bank may not make unsecured loans or extensions of credit to a single or related group of borrowers in excess of 15% of the sum of its shareholders' equity, allowance for loan losses, capital notes and debentures. An additional amount may be lent, equal to 10% of such sum of shareholders' equity and other amounts, if secured by specified readily marketable collateral. As of December 31, 2013, this limit on loans to one borrower was $202.0 million if unsecured and $337.0 million if secured by readily marketable collateral.

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The FDIC and DBO, 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 may be subject to potential enforcement actions by the federal or state banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance for deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, or the issuance of removal and prohibition orders against institution-affiliated parties.
The international Basel Committee on Banking Supervision published the final text of Basel III on December 16, 2010, which introduced new minimum capital requirements. On July 9, 2013, the federal banking agencies issued final rules (the “Basel III Capital Rules”), which become effective on January 1, 2015 (subject to phase-in periods for certain provisions), establishing a new comprehensive capital framework for U.S. banking organizations. The Basel III Capital Rules revise the definitions and components of regulatory capital, expand the scope of the deductions from and adjustments to capital, expand the number of risk-weighting categories and assign higher risk weights to certain assets and make other changes that affect the calculation of regulatory capital ratios. The Basel III Capital Rules also implement certain provisions of the Dodd-Frank Act, including the requirements to remove references to credit ratings from the federal agencies’ rules. These changes, and other regulatory initiatives in the United States, in the wake of the financial crisis, including provisions of the Dodd-Frank Act, are expected to result in higher regulatory capital standards and expectations for banking organizations.
The Basel III Capital Rules (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”) and related regulatory capital ratio of CET1 to risk-weighted assets, (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain revised requirements, and (iii) require that most deductions from and adjustments to capital be made to CET1 rather than to the other components of capital.
Under the Basel III Capital Rules, the minimum capital ratios as of January 1, 2015, will be: (1) 4.5% CET1 to risk-weighted assets; (2) 6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1 capital) to risk-weighted assets; (3) 8.0% total capital (i.e., Tier 1 capital plus Tier 2 capital ) to risk-weighted assets; and (4) 4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (i.e., the “leverage ratio”). The Basel III Capital Rules also limit a banking organization’s ability to pay dividends, repurchase shares or pay discretionary bonus if a banking organization does not have a “capital conservation buffer,” comprised of CET1 capital, in an amount greater than 2.5% CET1 of risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. Phase-in of the capital conservation buffer requirements will begin on January 1, 2016 and must be fully phased-in by January 1, 2019.
Federal Home Loan Bank System
CapitalSource Bank is a member of the FHLB SF. Among other benefits, each FHLB serves its members within its assigned region and makes available loans to its members. Each FHLB is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. As a member, CapitalSource Bank is required to purchase and maintain stock in the FHLB SF. As of December 31, 2013, CapitalSource Bank owned $31.3 million in par value of FHLB SF stock, which was in compliance with this requirement.
Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), an initiative directed at the financial services industry, represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the “BCFP”), and will require the BCFP and other federal agencies, including the SEC, to undertake assessments and rulemaking. A number of the provisions in the Dodd-Frank Act are aimed at financial institutions that are larger than the Parent Company or CapitalSource Bank. Nonetheless, there are provisions with which we will have to comply both as a public company and a financial institution.
The Dodd-Frank Act imposes a number of significant regulatory and compliance changes in the banking and financial services industry. Many provisions of the Dodd-Frank Act must be implemented by regulations yet to be adopted by various government agencies. These regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that may impact us. Certain provisions of the Dodd-Frank Act and implementing regulations that may have a material effect on our business are noted below.

The Dodd-Frank Act required a study regarding the continued exemption of industrial banks from the Bank Holding Company Act of 1956, as amended, or BHC Act. As a state-chartered industrial bank, CapitalSource Bank is currently exempt from the definition of “bank” under the BHC Act. The required study, which has been completed by the General Accounting Office, did not state a definitive conclusion on this question but did report that the Treasury Department and the FRB believe that the current exemption poses risks to the financial system. If the current exemption

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is eliminated, in order to continue to own CapitalSource Bank, the Parent Company would be required to register as a bank holding company, or BHC. If we were unsuccessful in registering as a BHC or another exception does not become available to us, our continued ownership of CapitalSource Bank would not be permissible.
The Dodd-Frank Act directs the federal banking agencies to issue regulations requiring that the parent company of any federally insured depository institution serve as a “source of financial strength” to its subsidiary depository institution. The source of strength requirement had historically applied only to BHCs and their subsidiary banks. Under the source of strength requirement, the Parent Company will be required to serve as a source of financial strength to CapitalSource Bank. The banking regulators could require the Parent Company to contribute additional capital to CapitalSource Bank or to take, or refrain from taking, other actions for the benefit of CapitalSource Bank.
The Dodd-Frank Act restricted the acquisition of control of an industrial bank by a non-financial firm. For a period of three years beginning on July 21, 2010, the Dodd-Frank Act generally prohibited the banking regulators from approving any proposed change in control of an industrial bank, such as CapitalSource Bank, if the proposed acquirer was a “commercial firm.” Although that three-year moratorium period has expired, there is no certainty that the FDIC would approve the direct or indirect acquisition of control of CapitalSource Bank by a commercial firm.
The Dodd-Frank Act requires the FRB to adopt regulations requiring increased capital requirements, minimum liquidity ratios, periodic stress testing and the establishment of board-level risk management committees for the largest banking institutions (those with assets greater than $50 billion or, in some case, greater than $10 billion), some or all of which requirements may become requirements, over time, for smaller institutions and for banking organizations not regulated by the FRB.
The Dodd-Frank Act requires the federal financial agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain “unregistered investment companies” (defined as hedge funds and private equity funds). This statutory provision is commonly referred to as the “Volcker Rule.” In December 2013, five financial regulatory agencies, including the FDIC, adopted final rules implementing the Volcker Rule (the “Final Rules"). The Final Rules prohibit banking entities from (i) engaging in short-term proprietary trading for their own accounts, or (ii) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). The Final Rules are intended to provide greater clarity with respect to the extent of those prohibitions and the related exemptions and exclusions. Each regulated entity, including the Parent Company and CapitalSource Bank, is also required to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule. The Final Rules also include certain regulatory reporting requirements. We intend to adopt the Final Rules by the mandated April 1, 2014 date and expect to be fully compliant with the Final Rules by the conformity period on July 21, 2015. We are currently analyzing the effects of the Volcker Rule.
Six financial regulatory federal agencies, including the FDIC, have proposed rules to implement the Dodd-Frank Act provisions requiring retention of credit risk by certain securitization participants through holding interests in securitization vehicles. The proposed rules would require a securitizer (or sponsor) to retain an economic interest equal to at least 5 percent of the aggregate credit risk of assets collateralizing an issuance of asset-backed securities, subject to certain exceptions for qualified residential mortgages and qualified commercial real estate mortgages, commercial loans and auto loans, which meet specified underwriting standards. Because these rules are not yet finalized or effective, the ultimate impact of these provisions on the CapitalSource Bank and the Parent Company are not known at this time. We will continue to monitor developments related to the implementation of these risk retention provisions of the Dodd-Frank Act.
Insurance of Accounts and Regulation by the FDIC
CapitalSource Bank's deposits are insured up to the maximum amounts permitted by the FDIC, currently $250,000. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. The FDIC may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against insured institutions.
On October 7, 2008, the FDIC established a Restoration Plan to return the Depositors Insurance Fund ("DIF") to its statutorily mandated minimum reserve ratio of 1.15% within five years. In 2009, the Restoration Plan was amended to extend the restoration period to seven years and Congress subsequently amended the statute to allow the FDIC up to eight years to return the DIF reserve ratio to 1.15%, absent extraordinary circumstances. To meet this reserve ratio by the end of 2016, the FDIC amended its Restoration Plan and adopted a uniform 3 basis point increase in the initial assessment rates effective January 1, 2011.
The Dodd-Frank Act establishes a minimum designated reserve ratio (“DRR”) of 1.35% of estimated insured deposits, provides discretion to the FDIC to develop a new assessment base, mandates the FDIC adopt a restoration plan should the fund balance fall below 1.35%, and authorizes payment of dividends to the industry should the fund balance exceed 1.50%. The Dodd-Frank Act requires the DRR to be achieved by September 30, 2020. On February 7, 2011, the FDIC adopted a final rule that revised the assessment base and assessment rate schedule effective April 1, 2011, and, in lieu of dividends, provides for reduced assessment

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rates once the DRR exceeds 2.00% and again at 2.50%. Assessments generally will be calculated using an insured depository institution's average assets minus average tangible equity. The initial assessment rates range between 5 basis points for a low risk institution to 35 basis points for a high risk institution, with further rate adjustments for the level of unsecured debt and brokered deposits held by an institution.
A significant increase in FDIC assessment rates would have an adverse effect on the operating expenses and results of operations of CapitalSource Bank. We cannot predict what 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.
Prompt Corrective Action
The FDIC is 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% of total assets is deemed to be “critically undercapitalized.” Subject to a narrow exception, the FDIC 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 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 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. Inadequate capital is also a basis for action, ultimately including receivership, by the FDIC.
The Basel III Capital Rules revise the prompt corrective action (“PCA”) regulations pursuant to section 38 of the Federal Deposit Insurance Act, which authorize and, under certain circumstances, require the federal banking agencies to take certain actions against banks that fail to meet their capital requirements, particularly those that are categorized as less than “adequately capitalized” (i.e., categorized as “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized”). The Basel III Capital rules revise the PCA regulations by: (1) introducing a CET1 ratio requirement at each PCA category (other than “critically undercapitalized”; (2) increasing the minimum Tier 1 capital ratio requirement for each category; and (3) eliminating the current provision that allows a bank with a composite supervisory rating of 1 to have a 3% leverage ratio and remain classified as “adequately capitalized.” The total risk-based capital ratio requirement for each PCA category remains unchanged. To qualify as “well capitalized” under the revised PCA regulations, a bank must meet the following capital ratio requirements: (1) 6.5% CET1 to risk-weighted assets; (2) 8.0% Tier 1 capital to risk-weighted assets; (3) 10.0% total capital to risk-weighted assets, and (4) 5.0% leverage ratio. The FDIC and other federal banking agencies have advised that they expect banking organizations to maintain capital ratios well above the minimum ratios necessary to be categorized as “well capitalized.”
To remain in compliance with the conditions imposed by the FDIC, CapitalSource 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 additionally requires CapitalSource Bank to have minimum Tier 1 risk-based capital ratio of 6% and Tier 1 leverage ratio of 5% in accordance with pre-Basel III Capital Rules. As of December 31, 2013, CapitalSource Bank had Tier 1 leverage, Tier 1 risked-based capital and total risk based capital ratios of 13.88%, 15.03%, and 16.29%, respectively, each in excess of the minimum percentage requirements for “well-capitalized” institutions. With regard to the Basel III Capital Rules, we are in the process of determining the impact of the new capital requirements on our capital ratios. For additional information, see Note 14, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.
Limitations on Capital Distributions
The authority of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. Additionally, Enhanced Supervisory Procedures for Newly Insured FDIC-Supervised Institutions require the FDIC’s prior non-objection to material changes to a de novo institution’s business plan which includes the payment of dividends in excess of the CapitalSource Bank’s FDIC-approved Four Year Plan. For purposes of this guidance, CapitalSource Bank is still categorized as a de novo institution. The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") prohibits a bank from making capital distributions, including dividends, if, after such transaction, the bank would be undercapitalized.
In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank and the bank's net income for its

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last three fiscal years (less any distributions to shareholders during this period). If a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with appropriate regulatory approval in an amount not exceeding the greatest of the bank's retained earnings, the bank's net income for its last fiscal year and the bank's net income for its current fiscal year. Simultaneously with the Merger with PacWest, CapitalSource Bank will pay a dividend to the Parent Company in an amount no more than CapitalSource Bank's retained earnings as of December 31, 2013.
The FDIC also has the authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.
Transactions with Affiliates
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 stock and surplus as defined by the regulators. 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.
Community Reinvestment Act
Under the Community Reinvestment Act ("CRA"), 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 CRA 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 CRA. The CRA 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 or closure 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 CRA in the past few years, CapitalSource Bank may be required to devote additional funds for investment and lending in its local community, which comprises southern and central California. CapitalSource Bank received a rating of "Outstanding" from the FDIC on its most recent CRA evaluation.
Regulatory and Criminal Enforcement Provisions
The FDIC and DBO 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. The FDIC has the authority to assess civil money penalties for a wide range of violations, which can amount to $25,000 per day, or $1.1 million per day in especially egregious cases. Federal law also establishes criminal penalties for specific violations.
Environmental Issues Associated with Real Estate Lending
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.
Privacy Standards
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

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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 consumers 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.
Anti-Money Laundering and Customer Identification
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.
Other Laws and Regulations
We are subject to many other federal statutes and regulations, such as the Equal Credit Opportunity Act, the Truth in Savings Act, the Fair Credit Reporting 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 customers, mandate the collection and reporting of certain data regarding customers, regulate marketing practices and require the safeguarding of non-public information of customers. Violations of these laws could subject us to lawsuits and could also result in administrative penalties, including, fines and reimbursements. We 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 the above-referenced laws and their implementing regulations have become more intense. Due to these heightened regulatory concerns, we may incur additional compliance costs or be required to expend additional funds for investments in our local community.
The federal government continues to evaluate possible new laws and regulations, which if enacted, could have a material impact on us, including among other things increased reporting obligations, restrictions on current lending activities, federal and state supervision and increased expenses to operate as a bank.
Regulation of Other Activities
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 and lending activities, including establishing licensing requirements in some jurisdictions;
establish the maximum interest rates, finance charges and other fees we may charge our borrowers;
govern secured transactions;
require specified information disclosures to our borrowers;
set collection, foreclosure, repossession and claims handling procedures and other trade practices;  
regulate our borrowers' insurance coverage;
prohibit discrimination in the extension of credit and administration of our loans; and
regulate the use and reporting of certain borrower information.
In addition, many of our healthcare borrowers receive significant funding from governmental sources and are subject to licensure, certification and other regulation and oversight under the applicable Medicare and Medicaid programs. These regulations and governmental oversight, both on federal and state levels, indirectly affect our business in several ways as discussed below.
Failure to comply with the applicable laws and regulation by our borrowers could result in loss of accreditation, denial of reimbursement, imposition of fines or corporate integrity agreements, suspension or decertification from federal and state health care programs, loss of license and closure of the facility.

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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 adequate Medicare and Medicaid reimbursements to cover the actual costs of operating the facilities and providing care to patients. In addition, modifications to reimbursement payment mechanisms, statutory and regulatory changes, retroactive rate adjustments, administrative rulings, policy interpretations, payment delays, and government funding restrictions could result in payment delays or alterations in reimbursements affecting providers' cash flows with possible material adverse effect on a borrower's liquidity.
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 borrowers depend on Medicare and Medicaid reimbursements, and reductions in reimbursements, caused by modifications to reimbursement systems, payment cuts, census declines, staffing shortages, or other operational forces 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.
The impacts of Congressional healthcare reform, federal fiscal cliff impacts and related budget deficit initiatives, impacts of medicaid expansion participation by individual states where we conduct business, as well as individual state budgetary shortfalls may initiate significant reforms and alterations to the United States healthcare system, including potential material changes to the delivery of healthcare services including anticipated shifts to a higher utilization of managed care coverage, and the level of reimbursements paid to providers and the mechanisms for such payments by the government and other third party payors.
For our borrowers to remain eligible to receive reimbursements under the Medicare and Medicaid programs, the borrowers 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, life safety and operational covenants. A borrower's failure to comply with these covenants and regulations may cause the borrower 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 borrower's inability to make scheduled payments to us.
Employees
As of December 31, 2013, we employed 495 people. We believe that our relations with our employees are good.
 

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Executive Officers
Our executive officers and their ages and positions are as follows:
Name
Age
Position
James J. Pieczynski
51
Chief Executive Officer
Douglas H. (Tad) Lowrey
61
Chief Executive Officer - CapitalSource Bank
Laird M. Boulden
56
President
John A. Bogler
48
Chief Financial Officer
Mike A. Smith
47
Senior Vice President and Chief Accounting Officer
Bryan M. Corsini
52
Executive Vice President and Chief Administrative Officer - CapitalSource Bank
Christopher A. Scardelletti
44
Executive Vice President and Chief Credit Officer - CapitalSource Bank
_________________________
Biographies for our executive officers are as follows:
James J. Pieczynski, 51, has served as a director since January 2010 and as Chief Executive Officer since January 2012. Mr. Pieczynski has also served as President of CapitalSource Bank since January 2012 and as a member of the board of directors of CapitalSource Bank since January 2013. Mr. Pieczynski previously served as Co-Chief Executive Officer from January 2010 through December 2011, our President - Healthcare Real Estate Business from November 2008 until January 2010, and our Co-President - Healthcare and Specialty Finance from January 2006 until November 2008. Mr. Pieczynski received his undergraduate degree from the University of Illinois, Urbana-Champaign in 1984.
Douglas H. (Tad) Lowrey, 61, has served as Chairman of the Board of CapitalSource Bank since July 2012, and as the Chief Executive Officer of CapitalSource Bank since its formation on July 25, 2008 and served as President of CapitalSource Bank from his appointment through December 2011. 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 is an elected director of the Federal Home Loan Bank of San Francisco and the California Bankers Association. He received his undergraduate degree from Arkansas Tech University and was licensed in 1977 in the state of Arkansas as a certified public accountant.
Laird M. Boulden, 56, has served as President since October 2011 and as the Chief Lending Officer of CapitalSource Bank since January 1, 2012. Mr. Boulden previously served as the President of the Company's Corporate Finance Group from May 2011 to October 2011 and President of the Company's Corporate Asset Finance Group from February 2010 to May 2011. Before joining the Company, Mr. Boulden was co-founder of Tygris Commercial Finance where he served as President of Tygris Asset Finance from March 2008 to December 2010 and was the founder and President of RBS Asset Finance (f/k/a RBS Lombard) from October 2001 until March 2008. Mr. Boulden received his undergraduate degree from the University of South Florida in 1979.
John A. Bogler, 48, has served as Chief Financial Officer since January 2012 and as Chief Financial Officer of CapitalSource Bank since its formation on July 25, 2008. Prior to his appointment, Mr. Bogler served as Chief Financial Officer of Affinity Financial Corporation from January 2008 until July 2008. Mr. Bogler served as a financial consultant specializing in bank acquisition and de novo activities from February 2005 until January 2008. Mr. Bogler received his undergraduate degree from Missouri State University in 1988, became a certified public accountant in the state of Missouri in 1991 and became a chartered financial analyst in 1998.
Mike A. Smith, 47, has served as our Chief Accounting Officer since March 2012 and as Chief Accounting Officer of CapitalSource Bank since October 2009. Previously, Mr. Smith served as Senior Vice President, Finance of CapitalSource Bank since its formation from July 2008 until September 2009. Mr. Smith served as Chief Accounting Officer of Fremont Investment & Loan from May 2004 until July 2008. Mr. Smith received his masters and undergraduate degrees from Brigham Young University in 1992, became a certified public accountant in the state of California in 1996, became a certified management accountant in 1997 and became a chartered global management accountant in 2012.
Bryan M. Corsini, 52, has served as the Executive Vice President and Chief Administrative Officer of CapitalSource Bank since October 2011. Mr. Corsini previously served as President, Credit Administration of CapitalSource Bank from July 2008 to October 2011 and as our Chief Credit Officer from our inception in 2000 until July 2008. He received his undergraduate degree from Providence College, Rhode Island. Mr. Corsini was licensed in 1986 in the state of Connecticut as a certified public accountant.
Christopher A. Scardelletti, 44, has served as the Executive Vice President and Chief Credit Officer of CapitalSource Bank since July 2008. Previously, Mr. Scardelletti served as Director of Credit in our Lender Finance Group from March 2003 to June 2008. Mr. Scardelletti received his undergraduate degree from the University of Maryland, College Park and was licensed in 1993 in the state of Maryland as a certified public accountant.

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Other Information
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 (866) 876-8723 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, Asset / Liability Committee, Risk Committee and Nominating and Corporate Governance Committee 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 our executive officers or directors from, our Code of Business Conduct and Ethics.
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. The U.S. economy is still in the process of recovering from an economic recession, and a slow recovery may adversely 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 Related to the Pending Merger

Regulatory approvals may not be received, may take longer than expected or may impose conditions that are not presently anticipated or that could have an adverse effect on the combined company following the merger.

Before the merger and the other transactions contemplated by the Merger Agreement may be completed, the Company and PacWest must obtain approvals from the FRB, the FDIC, and the California Department of Business Oversight. Other approvals, waivers or consents from regulators may also be required. These regulators may impose conditions on the completion of the merger or the other transactions contemplated by the Merger Agreement or require changes to the terms of the merger or the other transactions contemplated by the Merger Agreement. Such conditions or changes could have the effect of delaying or preventing completion of the merger or the other transactions contemplated by the Merger Agreement or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have an adverse effect on the combined company following the merger.

Combining the two companies may be more difficult, costly or time consuming than expected and the anticipated benefits and cost savings of the merger may not be realized.

PacWest and the Company have operated and, until the completion of the merger, will continue to operate, independently. The success of the merger, including anticipated benefits and cost savings, will depend, in part, on PacWest's ability to successfully combine the businesses of PacWest and the Company. To realize these anticipated benefits and cost savings, after the completion of the merger, PacWest expects to integrate the Company's business into its own. It is possible that the integration process could result in the loss of key employees, the disruption of each company's ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company's ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits and cost savings of the merger. The loss of key employees could have an adverse effect on PacWest's financial results and the value of its common stock, and therefore on the value of the merger consideration to be received by the Company's stockholders in the merger. If PacWest experiences difficulties with the integration process, the anticipated benefits of the merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause PacWest and/or the Company to lose customers or cause customers to remove their accounts from PacWest and/or the Company and move their business to competing financial institutions. Integration efforts between the two companies will also divert management attention and resources. These integration matters could have an adverse effect on each of PacWest and the Company during this transition period and for an undetermined period after completion of the merger on the combined company. In addition, the actual cost savings of the merger could be less than anticipated.


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Termination of the Merger Agreement could negatively impact us.

If the Merger Agreement is terminated, there may be various consequences. For example, our businesses may have been impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger. Additionally, if the merger agreement is terminated, the market price of the Company's common stock could decline to the extent that the current market price reflects a market assumption that the merger will be completed. In addition, we have incurred and will incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the Merger Agreement. If the merger is not completed, we would have to recognize these expenses without realizing the expected benefits of the transaction.

The Company and PacWest will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on PacWest or the Company as well as the combined organization. These uncertainties may impair the Company's or PacWest's ability to attract, retain and motivate key personnel until the merger is completed, and could cause customers and others that deal with the Company or PacWest to seek to change existing business relationships with the Company or PacWest. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or PacWest, the Company's business or PacWest's business could be harmed. Subject to certain exceptions, each of PacWest and the Company has agreed to operate its business in the ordinary and usual course prior to closing.
The Merger Agreement limits PacWest's and the Company's ability to pursue acquisition proposals.

The Merger Agreement prohibits the Company from initiating, soliciting, encouraging or facilitating certain third party acquisition proposals. In addition, the Merger Agreement provides that the Company must pay to PacWest a termination fee in the amount of $91 million under certain limited circumstances relating to third party acquisition transactions involving the Company. This provision might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of the Company from considering or proposing such an acquisition.

Risks Related to Our Lending Activities

Our results of operations and financial condition would be adversely affected if our allowance for loan and lease losses is not sufficient to absorb actual losses.

Experience in the financial services industry indicates that a portion of our loans in all categories of our lending business will become delinquent or impaired, and some may only be partially repaid or may never be repaid at all. Our methodology for establishing the adequacy of the allowance for loan and lease losses depends in part on subjective determinations and judgments about our borrowers' ability to repay. Despite management's efforts to estimate future losses, ultimate resolutions of individual loans may result in actual losses that are greater than our allowance. Deterioration in general economic conditions and unforeseen risks affecting customers may have an adverse effect on our borrowers' capacity to repay their obligations, whether our risk ratings or valuation analyses reflect those changing conditions. Changes in economic and market conditions may increase the risk that our allowance for loan and lease losses would become inadequate if borrowers experience economic and other conditions adverse to their businesses. Maintaining the adequacy of our allowance for loan and lease losses may require that we make significant and unanticipated increases in our provisions for loan and lease losses, which would materially affect our results of operations and capital adequacy. Recognizing that many of our loans individually represent a significant percentage of our total allowance for loan and lease losses, adverse collection experience in a relatively small number of loans could require an increase in our allowance. Federal and State regulators, as an integral part of their respective supervisory functions, periodically review a portion of our loan portfolio. The regulatory agencies may require changes to our risk ratings on loans, which could lead to an increase in the allowance for loan and lease losses, increased provisions for loan and lease losses and as appropriate, recognition of further loan charge-offs based upon their judgments, which may be different from ours. Increases in the allowance for loan and lease losses required by these regulatory agencies could have a negative effect on our results of operations and financial condition.

We may not recover all amounts that are contractually owed to us by our borrowers.

The Parent Company is dependent primarily on loan collections and the proceeds of loan sales to fund its operations. A shortfall in loan proceeds may impair our ability to fund our operations or to repay our existing debt.

When we loan money, commit to loan money or enter into a letter of credit or other contract with a counterparty, we incur credit risk. The credit quality of our portfolio can have a significant impact on our earnings. We expect to experience charge-offs and delinquencies on our loans in the future. Our clients may experience operational or financial problems or may perform below

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that which we expected when we originated a loan that, if not timely addressed, 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. Even if clients provide us with full and accurate disclosure of all material information concerning their businesses, we may misinterpret or incorrectly analyze this information. Mistakes may cause us to make loans that we otherwise would not have made or, to fund advances that we otherwise would not have funded, or result in losses on one or more of our loans. As a result, we could suffer loan losses, which could have a material adverse effect on our revenues, net income and results of operations and financial condition, to the extent the losses exceed our allowance for loan and lease losses.

The collateral securing a loan may not be sufficient to protect us if we have not properly obtained or perfected a lien on such collateral or if the collateral value does not cover the loan.

Most of our loans are secured by a lien on specified collateral of the client and we may not obtain or properly perfect our liens or the value of the collateral securing any particular loan may not protect us from suffering a partial or complete loss if the loan becomes non-performing and we move to foreclose on the collateral. In such event, we could suffer loan losses, which could have a material adverse effect on our revenue, net income, financial condition and results of operations.

In particular, leveraged 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. As of December 31, 2013, approximately 28% of the aggregate outstanding loan balance of our portfolio comprised leveraged loans. The value of the assets which we hold as collateral for these loans is typically substantially less than the amount of money we advance to a client under these loans. When a leveraged 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 or restructure the company in a way we believe would enable it to generate sufficient cash flow over time to repay our loan. Neither of these alternatives may be an available or viable option or generate enough proceeds to repay the loan. Additionally, given recent and current economic conditions, many of our leveraged loan clients have and may continue to suffer decreases in revenues and net income, 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.

Our concentration of loans to privately owned small and medium-sized companies and to a limited number of clients within particular industry or region could expose us to greater lending risk if the market sector, industry or region were to experience economic difficulties or changes in the regulatory environment.

Our portfolio consists primarily of commercial loans to small and medium-sized, privately owned businesses in a limited number of industries and regions primarily throughout the United States. In our normal course of business, we engage in lending activities with clients primarily throughout the United States. As of December 31, 2013, the single largest industry concentration in our outstanding loan balance was health care and social assistance, which represented approximately 22.2% of the outstanding loan portfolio. As of December 31, 2013, taken in the aggregate, lender finance (primarily timeshare) loans were our largest loan concentration by sector and represented approximately 16% of our loan portfolio. As of December 31, 2013, the largest loan to one borrower amounted to $83.7 million, or 1.2%, of our portfolio and the largest relationship with one borrower amounted to $104.1 million, or 1.5%, of our portfolio which was comprised of multiple loans.

Apart from the borrower industry concentrations, loans secured by real estate represented approximately 43% of our outstanding loan portfolio as of December 31, 2013. Within this area, the largest property type concentration was the multifamily category, comprising approximately 23% of total loans and 10% of loans secured by real estate. The largest geographical concentration was in California, comprising approximately 21% of total loans and 9% of loans secured by real estate.

If any particular industry or geographic region were to experience economic difficulties, the overall timing and amount of collections on our loans to clients operating in those industries or geographic regions may differ from what we expected, which could have a material adverse impact on our financial condition or results of operations.

Additionally, compared to larger, publicly owned firms, privately owned small and medium-sized companies generally have 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 that are able to access a broader array of credit sources. The concentration of our portfolio in loans to these types of clients could amplify these risks.

Further, there is generally no publicly available information about the small and medium-sized privately owned companies to which we lend. Therefore, we underwrite our loans based on detailed financial information and projections provided to us by our clients and we must rely on our clients and the due diligence efforts of our employees to obtain the information relevant to

16




making our credit decisions. We 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.

We are in a competitive business and may not be able to take advantage of attractive opportunities.

Our markets are competitive and characterized by varying competitive factors. We compete with a large number of companies, including:

commercial banks and thrifts;
specialty and commercial finance companies;
private investment funds;
insurance companies; and
investment banks.

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 on deposits if banks or other competitors 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 depositors or 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 increase, which could change the characteristics of our loan portfolio as well as cause our anticipated return on our existing loans to vary.

Risks Impacting Funding our Operations

Our ability to operate our business depends on our ability to raise sufficient deposits and in some cases other sources of funding.

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 have greater financial resources;
as a California state-chartered 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; and
depositors’ negative views of the Company could cause those 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. If the ability of CapitalSource Bank to attract and retain suitable levels of deposits weakens, it would have a negative impact on our business, financial condition, results of operations and the market price of our common stock.

In addition, given the short average maturity of CapitalSource Bank's deposits relative 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 our solvency.

Aside from deposit funding, CapitalSource Bank may obtain back-up liquidity from the Parent Company pursuant to the $150.0 million revolving credit facility it has established with the Parent Company. The Parent Company may not have or maintain sufficient liquidity, in which case CapitalSource Bank may not be able to draw on the $150.0 million revolving credit facility.

CapitalSource Bank has borrowing facilities established with the FHLB SF and the FRB. Our access to borrowing from FHLB SF may be materially impacted should Congress alter or dissolve the Federal Home Loan Bank system. Our access to the FRB primary credit program may be materially impacted should the FRB modify its credit program and limit CapitalSource Bank's access to the program. The ability to borrow from each of the FHLB SF and the FRB is dependent upon the value of collateral pledged to these entities. These lenders could reduce the borrowing capacity of CapitalSource Bank, eliminate certain types of

17




eligible collateral or could otherwise modify or even terminate their respective loan programs. Such changes or termination could have an adverse affect on our liquidity and profitability.

Our commitments to lend additional amounts to existing clients exceed our resources available to fund these commitments.

As of December 31, 2013, we had $1.1 billion of unfunded commitments to extend credit to our clients, of which $1.0 billion were commitments of CapitalSource Bank and $28.0 million were commitments of the Parent Company. Due to their nature, we cannot 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 funding, the collateral's satisfaction of eligibility requirements, our clients' ability to meet specified preconditions to borrowing, including compliance with the loan agreements, and/or our discretion pursuant to the terms of the loan agreements. In other cases, however, there are no such prerequisites to future funding by us, and our clients may draw on these unfunded commitments at any time. Clients may seek to draw on our unfunded commitments to improve their cash positions. We expect that these unfunded commitments will continue to exceed the Parent Company's available funds. Our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract and lender liability for us and irreparably damage our reputation in the marketplace, which would have a material adverse effect on our ability to continue to operate our business.

Fluctuating interest rates could adversely affect our net interest margins.

We raise short-term deposits at prevailing rates in our local retail consumer 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 prevailing interest rates are below many of the rate floors in our loans, 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 Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk Management.

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. Additionally, changes in interest rates could adversely influence the growth rate of loans and deposits and the quality of our loan portfolio.

Risks Related to Our Operations

We are subject to extensive government regulation and supervision, which limit our flexibility and could result in adverse actions by regulatory agencies against us.

We are subject to extensive federal and state regulation and supervision that govern, limit or otherwise affect almost all aspects of our operations. Such regulation and supervision is intended primarily to protect customers, depositors and the FDIC Deposit Insurance Fund - not our shareholders. The laws and regulations to which we are subject, among other matters, establish minimum capital requirements, limit the business activities we can conduct, prohibit various business practices, limit the dividends or distributions CapitalSource Bank can pay, establish reporting requirements, require approvals or consent for many types of transactions or business changes, and establish standards for financial and managerial safety and soundness. Our state and federal regulators periodically conduct examinations of our business, including examination of our compliance with laws and regulations as well as the safety and soundness of our banking operations. Failure to comply with laws, regulations or policies pursuant to which we operate, or any regulatory order to which we are or may become subject, even if unintentional or inadvertent, could result in adverse actions by regulatory agencies against us. Such actions could result in higher capital requirements, higher deposit insurance premiums, additional limitations on our activities, civil monetary penalties and fines or, ultimately, termination of deposit insurance, or appointment of the FDIC as conservator or receiver for CapitalSource Bank. See the Supervision and Regulation section of Item 1, Business, above and, Item 8, Financial Statements and Supplementary Data, including Note 14, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

Changes in laws and regulations, including the enactment of the Dodd-Frank Act, may have a material effect on our operations.

We are currently facing increased regulation and supervision of our industry as a result of the financial crisis in the banking and financial markets. In addition, federal and state legislatures and regulatory agencies continually review banking laws, regulations and policies for possible changes for other reasons, including perceived needs for improvements in the provision of

18




financial services, the elimination of inappropriate practices or a strengthening of risk management practices. 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 companies not subject to banking regulations to offer competing financial services and products, among other things, which may have a material adverse effect on our business, financial condition, results of operations or reputation.
The Dodd-Frank Act imposes a number of significant regulatory and compliance changes in the banking and financial services industry. Many provisions of the Dodd-Frank Act must be implemented by regulations yet to be adopted by various government agencies. These regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that may impact us. Certain provisions of the Dodd-Frank Act and implementing regulations that may have a material effect on our business are noted below.
The Dodd-Frank Act required a study regarding the continued exemption of industrial banks from the Bank Holding Company Act of 1956, as amended, or BHC Act. As a state-chartered industrial bank, CapitalSource Bank is currently exempt from the definition of “bank” under the BHC Act. The required study, which has been completed by the General Accounting Office, did not state a definitive conclusion on this question but did report that the Treasury Department and the Federal Reserve Board believe that the current exemption poses risks to the financial system. If the current exemption is eliminated, in order to continue to own CapitalSource Bank, the Parent Company would be required to register as a bank holding company, or BHC. If we were unsuccessful in registering as a BHC or another exception does not become available to us, our continued ownership of CapitalSource Bank would not be permissible.
The Dodd-Frank Act directs the federal banking agencies to issue regulations requiring that the parent company of any federally insured depository institution serve as a “source of financial strength” to its subsidiary depository institution. The source of strength requirement had historically applied only to BHCs and their subsidiary banks. Under the source of strength requirement, the Parent Company will be required to serve as a source of financial strength to CapitalSource Bank. The banking regulators could require the Parent Company to contribute additional capital to CapitalSource Bank or to take, or refrain from taking, other actions for the benefit of CapitalSource Bank.
The Dodd-Frank Act restricted the acquisition of control of an industrial bank by a non-financial firm. For a period of three years beginning on July 21, 2010, the Dodd-Frank Act generally prohibited the banking regulators from approving any proposed change in control of an industrial bank, such as CapitalSource Bank, if the proposed acquirer was a “commercial firm.” Although that three-year moratorium period has expired, there is no certainty that the FDIC would approve the direct or indirect acquisition of control of CapitalSource Bank by a commercial firm.
The Dodd-Frank Act requires the FRB to adopt regulations requiring increased capital requirements, minimum liquidity ratios, periodic stress testing and the establishment of board-level risk management committees for the largest banking institutions (those with assets greater than $50 billion or, in some case, greater than $10 billion), some or all of which requirements may become requirements, over time, for smaller institutions and for banking organizations not regulated by the FRB.
The Dodd-Frank Act requires the federal financial agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain “unregistered investment companies” (defined as hedge funds and private equity funds). This statutory provision is commonly referred to as the “Volcker Rule.” In December 2013, five financial regulatory agencies, including the FDIC, adopted final rules implementing the Volcker Rule (the “Final Rules”). The Final Rules prohibit banking entities from (i) engaging in short-term proprietary trading for their own accounts, or (ii) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). The Final Rules are intended to provide greater clarity with respect to the extent of those prohibitions and the related exemptions and exclusions. Each regulated entity, including the Parent Company and CapitalSource Bank, is also required to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule. The Final Rules also include certain regulatory reporting requirements. We intend to adopt the Final Rules by the mandated April 1, 2014 date and expect to be fully compliant with the Final Rules by the conformity period on July 21, 2015. We are currently analyzing the impact of the Final Rule.
Six financial regulatory federal agencies, including the FDIC, have proposed rules to implement the Dodd-Frank Act provisions requiring retention of credit risk by certain securitization participants through holding interests in securitization vehicles. The proposed rules would require a securitizer (or sponsor) to retain an economic interest equal to at least 5 percent of the aggregate credit risk of assets collateralizing an issuance of asset-backed securities, subject to certain exceptions for qualified residential mortgages and qualified commercial real estate mortgages, commercial loans and auto loans, which meet specified underwriting standards. Because these rules are not yet finalized or effective, the ultimate effect of these provisions on the CapitalSource Bank and the Parent Company are not known at this time. We will continue to monitor developments related to the implementation of these risk retention provisions of the Dodd-Frank Act.


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These rules and regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that could increase our compliance costs and materially adversely affect our business, operations, financial results and the price of our common stock.

Federal bank regulators have adopted increased capital standards for banking organizations, including under the Basel III framework, which may have a material effect on our operations.

We are required to satisfy minimum regulatory capital standards. On December 16, 2010, the Basel Committee on Banking Supervision announced an international agreement among member country bank regulatory authorities to a heightened set of capital and liquidity standards, referred to as Basel III, for banking organizations around the world. On July 9, 2013, the federal banking agencies issued final rules (the “Basel III Capital Rules”), which will become effective on January 1, 2015 (subject to phase-in periods for certain provisions), establishing a new comprehensive capital framework for U.S. banking organizations. The Basel III Capital Rules revise the definitions and components of regulatory capital, expand the scope of the deductions from and adjustments to capital, expand the number of risk-weighting categories and assign higher risk weights to certain assets and make other changes that affect the calculation of regulatory capital ratios. The Basel III Capital Rules also implement certain provisions of the Dodd-Frank Act, including the requirements to remove references to credit ratings from the federal agencies’ rules. These changes and other regulatory initiatives in the United States in the wake of the financial crisis, including provisions of the Dodd-Frank Act, are expected to result in higher regulatory capital standards and expectations for banking organizations.

The Basel III Capital Rules (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”) and related regulatory capital ratio of CET1 to risk-weighted assets, (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain revised requirements, and (iii) require that most deductions from and adjustments to capital be made to CET1 rather than to the other components of capital.

Under the Basel III Capital Rules, the minimum capital ratios as of January 1, 2015, will be: (1) 4.5% CET1 to risk-weighted assets; (2) 6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1 capital) to risk-weighted assets; (3) 8.0% total capital (i.e., Tier 1 capital plus Tier 2 capital ) to risk-weighted assets; and (4) 4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (i.e., the “leverage ratio”). The Basel III Capital Rules also limit a banking organization’s ability to pay dividends, repurchase shares or pay discretionary bonus if a banking organization does not have a “capital conservation buffer,” comprised of CET1 capital, in an amount greater than 2.5% CET1 of risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements.

In addition, the Basel III Capital Rules revise the prompt corrective action (“PCA”) regulations pursuant to section 38 of the Federal Deposit Insurance Act, which authorize and, under certain circumstances, require the federal banking agencies to take certain actions against banks that fail to meet their capital requirements, particularly those that are categorized as less than “adequately capitalized” (i.e., categorized as “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized”). The Basel III Capital rules revise the PCA regulations by: (1) introducing a CET1 ratio requirement at each PCA category (other than “critically undercapitalized”; (2) increasing the minimum Tier 1 capital ratio requirement for each category; and (3) eliminating the current provision that allows a bank with a composite supervisory rating of 1 to have a 3% leverage ratio and remain classified as “adequately capitalized.” The total risk-based capital ratio requirement for each PCA category remains unchanged. To qualify as “well capitalized” under the revised PCA regulations, a bank must meet the following capital ratio requirements: (1) 6.5% CET1 to risk-weighted assets; (2) 8.0% Tier 1 capital to risk-weighted assets; (3) 10.0% total capital to risk-weighted assets, and (4) 5.0% leverage ratio. The FDIC and other federal banking agencies have advised that they expect banking organizations to maintain capital ratios well above the minimum ratios necessary to be categorized as “well capitalized.”

We are in the process of determining the impact of the new capital requirements on our capital ratios.

In general, however, increased regulatory capital and liquidity standards, or changes in the manner in which such standards are implemented, could adversely affect our financial results. We will continue to monitor developments relating to the implementation of the Basel III Capital Rules, the issuance of any additional capital and liquidity requirements and their potential impact on our operations.

We face risks in connection with our strategic undertakings and new businesses, products or services.

If appropriate opportunities present themselves, we may engage in strategic activities, which could include acquisitions, joint ventures, or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.


20




In order to finance future strategic undertakings, we might obtain additional equity or debt financing. Such financing might not be available on terms favorable to us, or at all. If obtained, equity financing could be dilutive and the incurrence of debt and contingent liabilities could have material adverse effect on our business, results of operations and financial condition.

Our ability to execute strategic activities successfully will depend on a variety of factors. These factors likely will vary on the nature of the activity but may include our success in integrating the operations, services, products, personnel and systems of an acquired company into our business, operating effectively with any partner with whom we elect to do business, retaining key employees, achieving anticipated synergies, meeting expectations and otherwise realizing the undertaking's anticipated benefits. Our ability to address these matters successfully cannot be assured. In addition, our strategic efforts may divert resources or management's attention from ongoing business operations and may subject us to additional regulatory scrutiny. If we do not successfully execute a strategic undertaking, it could adversely affect our business, financial condition, results of operations, reputation and growth prospects. In addition, if we were able to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations.
In addition, from time to time, we may develop and grow new lines of business or offer new products and services, within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.

Our risk management framework may not be effective in mitigating risks and/or losses to us.

We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, operational, financial, interest rate, legal and regulatory, compliance, strategic, reputation, fiduciary, and general economic risks. Our framework also includes financial or other modeling methodologies, which involves management assumptions and judgment. There is no assurance that our risk management framework will be effective under all circumstances or that it will adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially adversely affected. We may also be subject to potentially adverse regulatory consequences.

The change of control rules under Section 382 of the Internal Revenue Code may limit our ability to use net operating loss carryovers and other tax attributes to reduce future tax payments or our willingness to issue equity.

We have net operating loss carryforwards for federal and state income tax purposes that can be utilized to offset future taxable income. If we were to undergo a change in ownership of more than 50% of our capital stock over a three-year period as measured under Section 382 of the Internal Revenue Code, our ability to utilize our net operating loss carryforwards, certain built-in losses and other tax attributes recognized in years after the ownership change generally would be limited. The annual limit would equal the product of the applicable long term tax exempt rate and the value of the relevant taxable entity's capital stock immediately before the ownership change. These change of ownership rules generally focus on ownership changes involving stockholders owning directly or indirectly 5% or more (the "5-Percent Shareholders") of a company's outstanding stock, including certain public groups of stockholders as set forth under Section 382, and those arising from new stock issuances and other equity transactions, which may limit our willingness and ability to issue new equity. The determination of whether an ownership change occurs is complex and not entirely within our control. No assurance can be given as to whether we have undergone, or in the future will undergo, an ownership change under Section 382 of the Internal Revenue Code.

In July 2013, the Board of Directors adopted a tax benefit preservation plan which was designed to preserve the net operating loss carryforwards and other tax attributes of the Company. The plan is intended to discourage persons from becoming 5-Percent Shareholders and existing 5-Percent Shareholders from increasing their beneficial ownership of shares.


21




We are subject to claims and litigation which could adversely affect our cash flows, financial condition and results of operations, or cause significant reputational harm to us.

We may be involved, from time to time, in litigation pertaining to our lending activities. If such claims and legal actions, whether founded or unfounded, are not resolved in a manner favorable to us they may result in significant financial liability. Although we establish accruals for legal matters according to accounting requirements, the amount of loss ultimately incurred in relation to those matters may be substantially higher than the amounts accrued. Substantial legal liability could adversely affect our business, financial condition or results of operations or cause significant reputational harm, which could seriously harm our business.

Our systems may experience an interruption or breach in security which could subject us to increased operating costs as well as litigation and other liabilities.

We rely on the computer and telephone systems and network infrastructure that 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 and telephone 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 break-ins and other disruptions would jeopardize the security of information stored in and transmitted through our 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 business transactions with 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.
Our controls and procedures may fail or be circumvented.

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, results of operations and common stock price, and could potentially subject us to litigation.

Risks Related to Income Taxes

The Company and its subsidiaries are subject to examinations and challenges by taxing authorities.

In the normal course of business, the Company and its subsidiaries are routinely subjected to examinations and challenges from federal and state taxing authorities regarding tax positions taken by the Company and the determination of the amount of tax due. These examinations may relate to income, franchise, gross receipts, payroll, property, sales and use, or other tax returns filed, or not filed, by the Company. The challenges made by taxing authorities may result in adjustments to the amount of taxes due, and may result in the imposition of penalties and interest. If any such challenges are not resolved in the Company's favor, they could have a material adverse effect on the Company's financial condition, results of operations, and liquidity.


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The Company and its subsidiaries are subject to changes in federal and state tax laws and changes in interpretation of existing laws.

The Company's financial performance is impacted by federal and state tax laws. Given the current economic and political environment, and ongoing budgetary pressures, the enactment of new federal or state tax legislation may occur. The enactment of such legislation, or changes in the interpretation of existing law, including provisions impacting income tax rates, apportionment, consolidation or combination, income, expenses, and credits, may have a material adverse effect on the Company's financial condition, results of operations, and liquidity.

Risks Related to Our Common Stock

We may not pay dividends on our common stock.

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, regulatory stress tests, economic conditions, tax considerations, and other factors. If we change our dividend policy, our common stock price could be adversely affected.

Some provisions of Delaware law and our certificate of incorporation and bylaws as well as certain banking laws may deter third parties from acquiring us.

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 66 2/3% of the shares held by all other shareholders that are eligible to vote on the matter.

Federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, which could inhibit a business combination and adversely affect the market price of our common stock.

These laws and 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.

ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
PROPERTIES
We lease office space in Los Angeles, California and Chevy Chase, Maryland, a suburb of Washington, D.C., under long-term operating leases. We also maintain smaller offices under operating leases in Arizona, California, Colorado, Connecticut, Georgia, Florida, Illinois, Massachusetts, Missouri, New York, North Carolina, Pennsylvania, Tennessee, Texas and Utah. We believe our leased facilities are adequate for us to conduct our business.
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.
MINE SAFETY DISCLOSURES
Not applicable.

23





PART II

ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Price Range of Common Stock
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 2013 and 2012 were as follows:
 
High
Low
2013:
 
 
Fourth Quarter
$
14.72

$
12.98

Third Quarter
13.23

11.37

Second Quarter
12.26

8.85

First Quarter
9.86

8.03

2012:
 

 

Fourth Quarter
$
8.15

$
7.26

Third Quarter
7.93

6.56

Second Quarter
6.99

5.96

First Quarter
7.26

6.30


On February 26, 2014, the last reported sale price of our common stock on the NYSE was $14.41 per share.
Holders
As of February 26, 2014, there were 384 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, and each such broker or clearing agency is included as one record holder. American Stock Transfer & Trust Company serves as transfer agent for our shares of common stock.
Dividend Policy
For the years ended December 31, 2013 and 2012, we declared and paid dividends as follows:
 
Dividends Declared and Paid per Share
 
2013
 
2012
Fourth Quarter
$
0.01

 
$
0.51

Third Quarter
0.01

 
0.01

Second Quarter
0.01

 
0.01

First Quarter
0.01

 
0.01

Total dividends declared and paid
$
0.04

 
$
0.54


For shareholders who held our shares for the entire year, the dividends declared and paid in 2013 and 2012 were classified for tax reporting purposes as dividend income.
Our Board of Directors (the "Board"), 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, and other factors. Per the Merger Agreement, our dividend is limited to $0.01 per share per quarter.

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Purchases of Equity Securities by the Issuer and Affiliated Purchasers
A summary of our common stock share repurchases for the three months ended December 31, 2013, was as follows:
 
Total Number of Shares Purchased(1)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(2)
 
Maximum Number of Shares (or Approximate Dollar Value) that May Yet be Purchased Under the Plans(2)
October 1 - October 31, 2013
22,206

 
$
12.89

 

 
 

November 1 - November 30, 2013
33,588

 
13.45

 

 
 

December 1 - December 31, 2013
102,741

 
14.16

 

 
 

Total
158,535

 
$
13.83

 

 
$

_________________________
(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 our Third Amended and Restated Equity Incentive Plan.
(2)
In December 2010, our Board authorized the repurchase of $150.0 million of our common stock over a period of up to 2 years. Subsequently, an additional $635.0 million was also authorized during the same period. In October 2012, the Board extended the program to include the period through December 31, 2013 and reset the authorization at $250.0 million. Collectively, we refer to these authorizations as the “Stock Repurchase Program.” All shares repurchased under the Stock Repurchase Program were retired upon settlement. As a result of entering into the Merger Agreement, the Stock Repurchase Program was suspended as of July 23, 2013. The Stock Repurchase Program was terminated as of December 31, 2013.

Performance Graph
The following graph compares the performance of our common stock during the five-year period beginning on December 31, 2008 to December 31, 2013, 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, 2008, assuming all dividends were reinvested. Historical stock performance during this period may not be indicative of future stock performance.

25




Comparison of Cumulative Total Return
Source: SNL Financial LC, Charlottesville, VA
Company/Index
 
Base Period 12/31/08
 
Year Ended December 31,
 
2009
 
2010
 
2011
 
2012
 
2013
CapitalSource Inc.
$
100

 
$
87.1

 
$
156.9

 
$
149.0

 
$
180.8

 
$
344.1

S&P 500 Index
100

 
126.5

 
145.5

 
148.6

 
172.4

 
228.2

S&P 500 Financials Index
100

 
117.2

 
131.4

 
109.0

 
140.4

 
190.5

 

26




ITEM 6.
SELECTED FINANCIAL DATA
You should read the data set forth below in conjunction with our audited 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, 2013. We derived our selected consolidated financial data as of and for the five years ended December 31, 2013, from our audited consolidated financial statements, which have been audited by Ernst & Young LLP, an independent registered public accounting firm.
 
Year Ended December 31,
 
2013
 
2012
 
2011
 
2010
 
2009
 
($ in thousands, except per share and share data)
Results of operations:
 
 
 
 
 
 
 
 
 
Interest income
$
447,476

 
$
468,214

 
$
510,390

 
$
639,641

 
$
871,946

Interest expense
74,088

 
79,407

 
150,010

 
232,096

 
427,312

Net interest income
373,388

 
388,807

 
360,380

 
407,545

 
444,634

Provision for loan and lease losses
20,531

 
39,442

 
92,985

 
307,080

 
845,986

Net interest income (loss) after provision for loan and lease losses
352,857

 
349,365

 
267,395

 
100,465

 
(401,352
)
Non-interest income
82,550

 
49,846

 
92,694

 
71,662

 
(8,667
)
Non-interest expense
189,078

 
193,682

 
375,170

 
333,451

 
364,511

Net income (loss) from continuing operations before income taxes
246,329

 
205,529

 
(15,081
)
 
(161,324
)
 
(774,530
)
Income tax expense (benefit) (1)
82,037

 
(285,081
)
 
36,942

 
(20,802
)
 
136,314

Net income (loss) from continuing operations
164,292

 
490,610

 
(52,023
)
 
(140,522
)
 
(910,844
)
Net income from discontinued operations, net of taxes

 

 

 
9,489

 
49,868

Gain (loss) from sale of discontinued operations, net of taxes

 

 

 
21,696

 
(8,071
)
Net income (loss)
164,292

 
490,610

 
(52,023
)
 
(109,337
)
 
(869,047
)
Net loss attributable to noncontrolling interests

 

 

 
(83
)
 
(28
)
Net income (loss) attributable to CapitalSource Inc.
$
164,292

 
$
490,610

 
$
(52,023
)
 
$
(109,254
)
 
$
(869,019
)
Basic income (loss) per share:
 
 
 

 
 

 
 

 
 

From continuing operations
$
0.84

 
$
2.19

 
$
(0.17
)
 
$
(0.44
)
 
$
(2.97
)
From discontinued operations

 

 

 
0.10

 
0.14

Attributable to CapitalSource Inc.
$
0.84

 
$
2.19

 
$
(0.17
)
 
$
(0.34
)
 
$
(2.84
)
Diluted income (loss) per share:
 
 
 

 
 

 
 

 
 

From continuing operations
$
0.82

 
$
2.13

 
$
(0.17
)
 
$
(0.44
)
 
$
(2.97
)
From discontinued operations

 

 

 
0.10

 
0.14

Attributable to CapitalSource Inc.
$
0.82

 
$
2.13

 
$
(0.17
)
 
$
(0.34
)
 
$
(2.84
)
Average shares outstanding:
 
 
 

 
 

 
 

 
 

Basic
195,189,983

 
223,928,583

 
302,998,615

 
320,836,867

 
306,417,394

Diluted
200,451,899

 
230,154,989

 
302,998,615

 
320,836,867

 
306,417,394

Cash dividends declared per share
$
0.04

 
$
0.54

 
$
0.04

 
$
0.04

 
$
0.04

Dividend payout ratio attributable to CapitalSource Inc.
0.05

 
0.25

 
(0.24
)
 
(0.12
)
 
(0.01
)
________________________
(1)
We provided for income tax expense (benefit) on the consolidated income earned or loss incurred based on effective tax rates of 33.3%, (138.7)%, (245)%, 12.9%, and (17.6)% in 2013, 2012, 2011, 2010 and 2009, respectively.

27




 
 
Year Ended December 31,
 
2013
 
2012
 
2011
 
2010
 
2009
 
($ in thousands)
Balance sheet data:
 
 
 
 
 
 
 
 
 
Investment securities, available-for-sale
$
870,482

 
$
1,079,025

 
$
1,188,002

 
$
1,522,911

 
$
960,591

Investment securities, held-to-maturity
74,369

 
108,233

 
111,706

 
184,473

 
242,078

Commercial real estate “A” Participation Interest, net

 

 

 

 
530,560

Total loans(1)
6,663,969

 
6,044,676

 
5,729,537

 
5,922,650

 
7,549,215

Assets of discontinued operations, held for sale

 

 

 

 
624,650

Total assets
8,905,490

 
8,549,005

 
8,300,068

 
9,445,407

 
12,261,050

Deposits
6,127,690

 
5,579,270

 
5,124,995

 
4,621,273

 
4,483,879

Credit facilities

 

 

 
67,508

 
542,781

Term debt

 
177,188

 
309,394

 
979,254

 
2,956,536

Other borrowings
1,037,156

 
1,005,738

 
1,015,099

 
1,375,884

 
1,204,074

Total borrowings
1,037,156

 
1,182,926

 
1,324,493

 
2,422,646

 
4,703,391

Liabilities of discontinued operations

 

 

 

 
363,293

Total shareholders' equity
1,636,627

 
1,625,172

 
1,575,146

 
2,053,942

 
2,183,259

Total loan commitments
8,028,407

 
7,448,235

 
7,558,327

 
8,592,968

 
11,600,297

Average outstanding loan size
3,511

 
3,643

 
3,779

 
4,538

 
7,720

Average balance of loans(2)
6,369,520

 
6,013,799

 
5,816,760

 
7,375,775

 
9,028,580

Employees as of year end
495

 
543

 
564

 
625

 
665

________________________
(1)
Includes loans held for sale and loans held for investment, net of deferred loan fees and discounts and the allowance for loan and lease losses.
(2)
Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

28




 
 
Year Ended December 31,
 
2013
 
2012
 
2011
 
2010
 
2009
Performance ratios:
 
 
 
 
 
 
 
 
 
Return on average assets:
 
 
 
 
 
 
 
 
 
Income (loss) from continuing operations
1.90
%
 
5.80
%
 
(0.58
)%
 
(1.36
)%
 
(6.41
)%
Net income (loss)
1.90
%
 
5.80
%
 
(0.58
)%
 
(1.06
)%
 
(5.69
)%
Return on average equity:
 
 
 
 
 

 
 

 
 

Income (loss) from continuing operations
10.41
%
 
30.25
%
 
(2.64
)%
 
(6.97
)%
 
(43.86
)%
Net income (loss)
10.41
%
 
30.25
%
 
(2.64
)%
 
(5.42
)%
 
(31.96
)%
Yield on average interest-earning assets(1)
5.79
%
 
6.16
%
 
6.28
 %
 
6.65
 %
 
6.42
 %
Cost of funds(1)
1.07
%
 
1.19
%
 
2.23
 %
 
2.90
 %
 
3.60
 %
Net interest margin(1)
4.83
%
 
5.12
%
 
4.43
 %
 
4.24
 %
 
3.27
 %
Operating expenses as a percentage of average total assets(2)
1.96
%
 
2.21
%
 
2.37
 %
 
2.15
 %
 
1.91
 %
Core lending spread(1)
6.33
%
 
6.77
%
 
7.67
 %
 
7.51
 %
 
7.41
 %
Efficiency ratio(3)
38.44
%
 
43.50
%
 
47.18
 %
 
46.41
 %
 
62.39
 %
Credit quality ratios(4):
 
 
 
 
 

 
 

 
 

Loans 30-89 days contractually delinquent as a percentage of average loans (as of year end)
0.03
%
 
0.39
%
 
0.21
 %
 
0.44
 %
 
3.33
 %
Loans 90 or more days delinquent as a percentage of average loans (as of year end)
0.41
%
 
0.66
%
 
1.61
 %
 
5.03
 %
 
5.50
 %
Loans on non-accrual status as a percentage of average loans (as of year end)
1.49
%
 
1.98
%
 
4.72
 %
 
10.99
 %
 
12.89
 %
Impaired loans as a percentage of average loans (as of year end)
1.49
%
 
3.32
%
 
7.15
 %
 
14.65
 %
 
15.10
 %
Net charge offs (as a percentage of average loans)
0.27
%
 
1.27
%
 
4.62
 %
 
5.78
 %
 
7.30
 %
Allowance for loan and lease losses as a percentage of loans receivable (as of year end)
1.78
%
 
1.91
%
 
2.67
 %
 
5.35
 %
 
7.08
 %
Capital and leverage ratios:
 
 
 
 
 

 
 

 
 

Average equity to average assets(1)
18.25
%
 
19.18
%
 
22.01
 %
 
19.49
 %
 
14.61
 %
Equity to total assets (as of year end)(1)
18.38
%
 
19.01
%
 
18.98
 %
 
21.75
 %
 
17.93
 %
________________________
(1)
Ratios calculated based on continuing operations.
(2)
Operating expenses included compensation and benefits, professional fees, occupancy expense, FDIC fees and assessments, general depreciation and amortization and other administrative expenses.
(3)
Efficiency ratio is defined as operating expense divided by net interest and non-interest income, less leased equipment depreciation.
(4)
Credit ratios calculated based on average gross loans, which excludes deferred loan fees and discounts and the allowance for loan and lease losses.

29





ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
CapitalSource Inc., a Delaware corporation, is a commercial lender that provides financial products to small and middle market businesses nationwide and provides depository products and services to consumers in southern and central California, primarily through our wholly owned subsidiary, CapitalSource Bank (the "Bank"). References to we, us, the Company or CapitalSource refer to CapitalSource Inc. together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references to the Parent Company refer to CapitalSource Inc. and its subsidiaries other than the Bank.
We offer a broad range of specialized senior secured, commercial loan products to small and middle-market businesses, and we offer our loan products on a nationwide basis. With a deposit gathering platform based in southern and central California, we believe our business model is well positioned to deliver a broad range of customized financial solutions to borrowers.
As of December 31, 2013, we had total assets of $8.9 billion, total loans of $6.8 billion, total deposits of $6.1 billion and stockholders' equity of $1.6 billion.
Our corporate headquarters is located in Los Angeles, California, and we have 21 retail bank branches located in southern and central California. Our loan origination efforts are conducted nationwide with key offices located in Chevy Chase, Maryland, Los Angeles, California, Denver, Colorado, Chicago, Illinois, and New York, New York. We also maintain a number of smaller lending offices throughout the country.
For the years ended December 31, 2013, 2012 and 2011, we operated as two reportable segments: the Bank and Other Commercial Finance. The Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. For additional information, see Note 20, Segment Data.
Results of Operations
Consolidated
The significant factors influencing our consolidated results of operations for the year ended December 31, 2013, compared to the year ended December 31, 2012 include an increase in net income tax expense, a decrease in interest income, offset by an increase in non-interest income and a decrease in loan and lease loss provision. Consolidated income tax expense (benefit) for the year ended December 31, 2013 and 2012 was $82.0 million and $(285.1) million, respectively. The $367.1 million increase in income tax expense was primarily the result of the release of the deferred tax valuation allowance during the year ended December 31, 2012. Interest income decreased from $468.2 million during year ended December 31, 2012 to $447.5 million during the year ended December 31, 2013 due to lower yields on both our loan portfolio and investment securities available-for-sale portfolio. Non-interest income increased during the year ended December 31, 2013 primarily due to gains on investments arising from the sale of investment securities. The loan and lease loss provision decreased from $39.4 million for the year ended December 31, 2012 to $20.5 million for the year ended December 31, 2013 due to an improvement in our overall portfolio credit profile with reserve releases related to loans at the Parent Company.

30





For the years ended December 31, 2013, 2012 and 2011, our consolidated average balances and the resulting average interest yields and rates were as follows:
 
2013
 
2012
 
2011
 
Average Balance
 
Interest Income / (Expense)
 
Yield / Rate
 
Average Balance
 
Interest Income / (Expense)
 
Yield / Rate
 
Average Balance
 
Interest Income / (Expense)
 
Yield / Rate
 
($ in thousands)
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
263,771

 
$
648

 
0.25
%
 
$
372,581

 
$
1,304

 
0.35
%
 
$
809,946

 
$
2,195

 
0.27
%
Investment securities
1,067,571

 
30,242

 
2.83
%
 
1,247,084

 
38,230

 
3.07
%
 
1,562,768

 
55,524

 
3.55
%
Loans(1)
6,369,520

 
415,375

 
6.52
%
 
5,952,699

 
428,397

 
7.20
%
 
5,732,172

 
452,607

 
7.90
%
Other assets
29,542

 
1,211

 
4.10
%
 
25,978

 
283

 
1.01
%
 
23,742

 
64

 
0.27
%
Total interest-earning assets
$
7,730,404

 
$
447,476

 
5.79
%
 
$
7,598,342

 
$
468,214

 
6.16
%
 
$
8,128,628

 
$
510,390

 
6.28
%
Interest-bearing liabilities:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Deposits
$
5,870,561

 
$
51,941

 
0.88
%
 
$
5,400,247

 
$
51,035

 
0.95
%
 
$
4,808,141

 
$
53,609

 
1.11
%
Other borrowings
1,051,639

 
22,147

 
2.11
%
 
1,253,237

 
28,372

 
2.26
%
 
1,911,613

 
96,401

 
5.04
%
Total interest-bearing liabilities
$
6,922,200

 
$
74,088

 
1.07
%
 
$
6,653,484

 
$
79,407

 
1.19
%
 
$
6,719,754

 
$
150,010

 
2.23
%
Net interest income/spread(2)
 

 
$
373,388

 
4.72
%
 
 

 
$
388,807

 
4.97
%
 
 

 
$
360,380

 
4.05
%
Net interest margin
 
 
 
 
4.83
%
 
 
 
 
 
5.12
%
 
 
 
 
 
4.43
%
_______________________
(1)
Average loan balances are net of deferred fees and discounts on loans. Non-accrual loans have been included in the average loan balances for the purpose of this analysis.
(2)
Net interest income is defined as the difference between total interest income and total interest expense which is calculated on a continuing operations basis. Net yield on interest-earning assets is defined as net interest-earnings divided by average total interest-earning assets.

For the years ended December 31, 2013 and 2012, changes in interest income, interest expense and net interest income as a result of changes in volume, changes in interest rates or both were as follows:
 
2013 Compared to 2012
 
2012 Compared to 2011
 
Due to Change in:(1)
 
Net Change
 
Due to Change in:(1)
 
Net Change
 
Rate
 
Volume
 
 
Rate
 
Volume
 
 
($ in thousands)
(Decrease) increase in interest income:
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
(336
)
 
(321
)
 
(657
)
 
518

 
(1,409
)
 
(891
)
Investment securities, available-for-sale
(2,717
)
 
(5,204
)
 
(7,921
)
 
(865
)
 
(8,553
)
 
(9,418
)
Investment securities, held-to-maturity
(288
)
 
220

 
(68
)
 
(5,709
)
 
(2,166
)
 
(7,875
)
Loans
(41,816
)
 
28,794

 
(13,022
)
 
(41,156
)
 
16,946

 
(24,210
)
Other assets
911

 
17

 
928

 
207

 
13

 
220

Total (decrease) increase in interest income
(44,246
)
 
23,506

 
(20,740
)
 
(47,005
)
 
4,831

 
(42,174
)
(Decrease) increase in interest expense:
 
 
 
 
 
 
 
 
 
 
 
Deposits
(3,374
)
 
4,282

 
908

 
(8,726
)
 
6,153

 
(2,573
)
Credit facilities

 

 

 
(1,783
)
 
(1,783
)
 
(3,566
)
Long-term debt
2,555

 
(6,172
)
 
(3,617
)
 
(18,360
)
 
(18,154
)
 
(36,514
)
Other borrowings
(2,495
)
 
(115
)
 
(2,610
)
 
(19,806
)
 
(8,143
)
 
(27,949
)
Total decrease in interest expense
$
(3,314
)
 
$
(2,005
)
 
$
(5,319
)
 
$
(48,675
)
 
$
(21,927
)
 
$
(70,602
)
Net increase (decrease) in net interest income
$
(40,932
)
 
$
25,511

 
$
(15,421
)
 
$
1,670

 
$
26,758

 
$
28,428

_________________
(1)
The change in interest due to both volume and rates has been allocated in proportion to the relationship of the absolute dollar amounts of the change in each.

31





Our consolidated operating results for the year ended December 31, 2013, compared to the year ended December 31, 2012, and for the year ended December 31, 2012, compared to the year ended December 31, 2011, were as follows:
 
Year Ended December 31,
 
2013 vs. 2012 % Change
 
2012 vs. 2011 % Change
 
2013
 
2012
 
2011
 
 
($ in thousands)
 
 
 
 
Interest income
$
447,476

 
$
468,214

 
$
510,390

 
(4.4
)%
 
(8.3
)%
Interest expense
74,088

 
79,407

 
150,010

 
(6.7
)%
 
(47.1
)%
Provision for loan and lease losses
20,531

 
39,442

 
92,985

 
(47.9
)%
 
(57.6
)%
Non-interest income
82,550

 
49,846

 
92,694

 
65.6
 %
 
(46.2
)%
Non-interest expense
189,078

 
193,682

 
375,170

 
(2.4
)%
 
(48.4
)%
Income tax expense (benefit)
82,037

 
(285,081
)
 
36,942

 
128.8
 %
 
(871.7
)%
Net income (loss)
164,292

 
490,610

 
(52,023
)
 
(66.5
)%
 
1,043.1
 %

Income Taxes
We provide for income taxes as a “C” corporation on income earned from operations. We are subject to federal, foreign, state and local taxation in various jurisdictions.
Periodic reviews of the carrying amount of deferred tax assets are made to determine if a valuation allowance is necessary. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. All evidence, both positive and negative, is evaluated when making this determination. Items considered in this analysis include the ability to carry back losses to recoup taxes previously paid, the reversal of temporary differences, tax planning strategies, historical financial performance, expectations of future earnings and the length of statutory carryforward periods. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences.
In 2009, we established a valuation allowance against a substantial portion of our net deferred tax assets where we determined that there was significant negative evidence with respect to our ability to realize such assets. Negative evidence we considered in making this determination included the history of operating losses and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of December 31, 2013 and 2012, the valuation allowance was $152.0 million and $128.6 million, respectively.
During 2012, we reversed $358.1 million of the valuation allowance, and such reversal was recorded as a benefit in our income tax expenses. Each of the deferred tax assets was evaluated based on our evaluation of the available positive and negative evidence with respect to our ability to realize the deferred tax asset, including considering their associated character and jurisdiction. The decision to reverse a large portion of the valuation allowance was based on our evaluation of all positive and negative evidence. A cumulative loss position, such as we had for the previous three-year period ended December 31, 2011, is generally considered significant negative evidence in assessing the realizability of a deferred tax asset. However, significant positive evidence had developed which overcame this negative evidence such that, during the year ended December 31, 2012, management determined that it is more likely than not that a portion of the deferred tax asset will be realized. This determination was made not based upon a single event or occurrence, but based upon the accumulation of all positive and negative evidence including recent trends in our earnings and taxable income. Other positive evidence included the projection of future taxable income based on a recent history of positive earnings at the Bank, improved asset performance trends, substantial decline in the Parent Company's operations and assets, and one-time losses included in the three-year cumulative pre-tax loss (i.e., debt extinguishment loss). Additionally, we are no longer in a cumulative pre-tax loss position since the end of 2012.
A valuation allowance of $152.0 million remains in effect as of December 31, 2013 with respect to deferred tax assets where we believe sufficient evidence does not exist at this time to support a reduction in the allowance. It is more likely than not that these deferred tax assets subject to a valuation allowance will not be realized primarily due to their character and/or the expiration of the carryforward periods.
2013 vs. 2012. Consolidated income tax expense for the year ended December 31, 2013 was $82.0 million, compared to an income tax benefit of $(285.1) million for the year ended December 31, 2012. The income tax expense of $82.0 million for the year ended December 31, 2013 was primarily due to the tax on pre-tax book income offset by the resolution of the 2006-2008 audit and the sale of capital assets. The income tax benefit of $(285.1) million for the year ended December 31, 2012 was primarily due to the release of valuation allowance.
2012 vs. 2011. Consolidated income tax benefit for the year ended December 31, 2012 was $(285.1) million, compared to income tax expense of $36.9 million for the year ended December 31, 2011. The income tax benefit of $(285.1) million for the

32




year ended December 31, 2012 was primarily due to the release of the valuation allowance. The tax expense of $36.9 million for the year ended December 31, 2011 was primarily due to the decrease in the net deferred tax assets of one of our corporate entities.
Comparison of the Years Ended December 31, 2013, 2012 and 2011
Certain amounts in the prior year's audited consolidated financial statements have been reclassified to conform to the current year presentation, including modifying the presentation of our audited consolidated statements of operations to include the caption of total operating expenses and the new line item of other administrative expenses being split apart from other non-interest expense. Accordingly, the reclassifications have been appropriately reflected throughout our audited consolidated financial statements. The discussion that follows differentiates our results of operations between our segments.

CapitalSource Bank Segment
Our CapitalSource Bank operating results for the year ended December 31, 2013, compared to December 31, 2012, and for the year ended December 31, 2012, compared to December 31, 2011, were as follows:
 
Year Ended December 31,
 
2013 vs. 2012 % Change
 
2012 vs. 2011 % Change
 
2013
 
2012
 
2011
 
 
($ in thousands)
 
 
 
 
Interest income
$
418,885

 
$
393,083

 
$
368,964

 
6.6
 %
 
6.5
 %
Interest expense
62,685

 
62,096

 
62,802

 
0.9
 %
 
(1.1
)%
Provision for loan and lease losses
16,866

 
16,192

 
27,539

 
4.2
 %
 
(41.2
)%
Non-interest income
66,184

 
60,495

 
41,697

 
9.4
 %
 
45.1
 %
Non-interest expense
168,249

 
168,569

 
149,710

 
(0.2
)%
 
12.6
 %
Income tax expense
96,593

 
84,054

 
57,996

 
14.9
 %
 
44.9
 %
Net income
140,676

 
122,667

 
112,614

 
14.7
 %
 
8.9
 %

Interest Income
2013 vs. 2012. Total interest income increased to $418.9 million for the year ended December 31, 2013 from $393.1 million for the year ended December 31, 2012, with an average yield on interest-earning assets of 5.72% and 5.90%, respectively. During the years ended December 31, 2013 and 2012, interest income on loans was $390.9 million and $359.2 million, respectively, yielding 6.41% and 7.01% on average loan balances of $6.1 billion and $5.1 billion, respectively. The 60 basis point decrease in loan yield is due to a 46 basis point decrease from lower loan and lease yields, a 17 basis point decrease due to amortization of premiums on purchased loans, a 15 basis point decrease due to the amortization of deferred loan fees, offset by a 15 basis point increase due to changes in prepayment speeds on loans, a 3 basis point increase due to changes in non-accrual interest and other factors.
Included in the lower loan yield analysis above, interest income of $4.7 million and $8.8 million during the years ended December 31, 2013 and 2012, respectively, was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.08% and 0.17%, respectively. During the years ended December 31, 2013 and 2012, $0.4 million and $1.4 million of interest was collected on loans previously on non-accrual status and recognized in interest income, respectively.
During the years ended December 31, 2013 and 2012, interest income from our investments, including available-for-sale and held-to-maturity securities, was $26.4 million and $32.4 million, yielding 2.53% and 2.65% on average balances of $1.0 billion and $1.2 billion, respectively. The average balances of investment securities available-for-sale and held-to-maturity decreased as a result of sales and maturities of securities which we did not fully replace due to loan growth and associated liquidity needs. The investment yield change is primarily due to a 36 basis point decrease resulting from relatively higher yielding securities paying down, purchasing new securities at lower yields and adjustable rate bonds' coupons resetting lower, offset by an 8 basis point increase resulting from accelerated discount amortization of a held-to-maturity commercial mortgage-backed security ("CMBS") from its prepayment and a 16 basis point increase due to lower premium amortization attributable to slower projected prepayment speeds on our available-for-sale MBS. As a result, total interest income on investments decreased $6.0 million attributed to a $5.9 million and $0.1 million decrease in interest income from available-for-sale securities and held-to-maturity securities, respectively.
During the year ended December 31, 2013, we purchased $117.6 million of investment securities, available-for-sale and $47.9 million of held-to-maturity securities, while $318.8 million and $35.5 million of principal repayments and sales were made on our investment securities, available-for-sale and held-to-maturity, respectively. During the year ended December 31, 2012, we

33




purchased $287.1 million of investment securities, available-for-sale and no investment securities, held-to-maturity while $385.3 million and $5.1 million, respectively, of principal repayments were received.
During the years ended December 31, 2013 and 2012, interest income on cash and cash equivalents was $0.4 million and $1.2 million, respectively, yielding 0.29% and 0.40% on average balances of $150.1 million and $294.2 million, respectively.
2012 vs. 2011. Total interest income increased to $393.1 million for the year ended December 31, 2012 from $369.0 million for the year ended December 31, 2011, with an average yield on interest-earning assets of 5.90% for the year ended December 31, 2012 compared to 6.13% for the year ended December 31, 2011. During the years ended December 31, 2012 and 2011, interest income on loans was $359.2 million and $319.5 million, respectively, yielding 7.01% on average loan balances of $5.1 billion and $4.1 billion, respectively. Interest income of $15.7 million was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.38% during the year ended December 31, 2011. In addition, $0.1 million of interest income was not recognized for loans on non-accrual status during the year ended December 31, 2011.
During the years ended December 31, 2012 and 2011, interest income from our investments, including available-for-sale and held-to-maturity securities, was $32.4 million and $48.4 million, yielding 2.65% and 3.14% on average balances of $1.2 billion and $1.5 billion, respectively. The average balances of investment securities available-for-sale and held-to-maturity decreased as a result of principal paydowns and maturities of securities which we did not fully replace due to loan growth and associated liquidity needs. Additionally, the overall yield of the portfolio decreased in the declining interest rate environment experienced in 2012. As a result, during the year ended December 31, 2012, total interest income on investments decreased $16.0 million attributed to an $8.1 million decrease in interest income from available-for-sale securities and a $7.9 million decrease in interest income from held-to-maturity securities.
During the year ended December 31, 2011, we purchased $591.9 million of investment securities, available-for-sale, and $10.6 million of investment securities, held-to-maturity, while $702.9 million and $92.6 million of principal repayments were received, respectively.
During the years ended December 31, 2012 and 2011, interest income on cash and cash equivalents was $1.2 million and $1.1 million, yielding 0.40% and 0.35% on average balances of $294.2 million and $306.2 million, respectively.

Interest Expense