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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2003

Commission File No. 1-31753

CapitalSource Inc.

(800) 370-9431

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s class of common stock, as of the latest practicable date:

CAPITALSOURCE INC.
TABLE OF CONTENTS

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Item 1. Financial Statements

CapitalSource Holdings LLC
Consolidated Balance Sheets
($ in thousands)

See accompanying notes.

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CapitalSource Holdings LLC
Consolidated Statements of Income
(Unaudited)
($ in thousands, except per unit and per share data)

See accompanying notes.

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CapitalSource Holdings LLC
Consolidated Statement of Members’ Equity
(Unaudited)
($ in thousands)

See accompanying notes.

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CapitalSource Holdings LLC
Consolidated Statements of Cash Flows
(Unaudited)
($ in thousands)

See accompanying notes.

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CapitalSource Holdings LLC
Notes to the Unaudited Consolidated Financial Statements

     Note 1. Organization

CapitalSource Holdings LLC (“CapitalSource Holdings”), a limited liability company, was formed under the laws of the State of Delaware on September 7, 2000. CapitalSource Holdings is a commercial finance company that provides a broad array of financial products to businesses. CapitalSource Holdings provides financial solutions using one or more of the following products:

	•		Senior Secured Cash Flow Loans – secured by a priority lien on assets;
	•		Senior Secured Asset-Based Loans – secured by accounts receivable, inventory, equipment, real estate, and/or other assets;
	•		Mezzanine Loans – subordinated loans, or loans that exceed senior lending coverage formulas;
	•		First Mortgage Loans – non-traditional, short-term real estate loans; and
	•		Private Equity Co-Investments – opportunistic equity investment, typically in conjunction with a debt relationship and other equity investors.

CapitalSource Holdings is the parent company of the following significant subsidiaries: CapitalSource Finance LLC (“CapitalSource Finance”), CapitalSource Funding LLC (“CapitalSource Funding”), CapitalSource Acquisition Funding LLC (“CapitalSource Acquisition Funding”), CapitalSource Repo Funding LLC (“CapitalSource Repo Funding”), CapitalSource Commercial Loan Trust 2002-1 (“Trust 2002-1”), CapitalSource Commercial Loan Trust 2002-2 (“Trust 2002-2”), CapitalSource Commercial Loan Trust 2003-1 (“Trust 2003-1”), CapitalSource Analytics LLC (“CapitalSource Analytics”) and CapitalSource Mortgage Finance LLC (“CapitalSource Mortgage Finance”).

CapitalSource Finance is the primary operating subsidiary of CapitalSource Holdings and conducts the lending business of CapitalSource Holdings. CapitalSource Funding and CapitalSource Acquisition Funding purchase loans from CapitalSource Finance and pledge those loans as collateral on borrowings under the commercial paper conduit credit facilities. CapitalSource Repo Funding purchases loans from CapitalSource Finance and pledges those loans as collateral on amounts borrowed under a repurchase agreement with Wachovia Bank, National Association (“Wachovia”). Trust 2002-1, Trust 2002-2, and Trust 2003-1 are single-purpose bankruptcy remote subsidiaries established to complete asset securitizations. CapitalSource Analytics conducts underwriting and due diligence functions. CapitalSource Mortgage Finance acts as an agent for the United States Department of Housing and Urban Development for the origination and servicing of federally insured mortgage loans to healthcare providers.

CapitalSource Holdings’s operating agreement provides that it will be dissolved on or before June 28, 2007. A majority of the members have the right to dissolve CapitalSource Holdings at any time prior to a liquidity event and after June 28, 2005.

Members’ liability is limited to the capital they have contributed to CapitalSource Holdings.

Note 2. Summary of Significant Accounting Policies

Unaudited Interim Consolidated Financial Statements Basis of Presentation

Interim consolidated financial statements of CapitalSource Holdings are prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The current period’s results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim unaudited consolidated financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto for the years ended December 31, 2002 and 2001 and the period from September 7, 2000 (inception) through December 31, 2000, included in our final prospectus dated August 6, 2003, as filed with the SEC pursuant to Rule 424(b) on August 7, 2003.

The accompanying financial statements reflect the consolidated accounts of CapitalSource Holdings, including all of its subsidiaries and the related consolidated results of operations with all significant intercompany balances eliminated.

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New Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 requires a guarantor to recognize a liability at the inception of the guarantee for the fair value of the obligation undertaken in issuing the guarantee and include more detailed disclosure with respect to guarantees. The types of contracts we enter into that meet the scope of this interpretation are standby letters of credit on behalf of borrowers. FIN 45 is effective for the guarantees issued or modified after December 31, 2002. The adoption of this accounting pronouncement is not expected to have a material effect on our consolidated financial statements.

In January 2003, FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. FIN 46 also requires disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest.

The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003 and to existing entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of this accounting pronouncement is not expected to have a material effect on our consolidated financial statements.

Note 3. Allowance for Loan Losses

Activity in the allowance for loan losses for the six months ended June 30, 2003 and 2002 was as follows:

As of June 30, 2003 impaired loans totaled $7.6 million. Specific reserves for the impaired loans were $0.3 million. As of December 31, 2002, there were no impaired loans.

As of June 30, 2003, three loans totaling $33.8 million were classified as troubled debt restructurings. As of December 31, 2002, there were no loans classified as troubled debt restructurings.

Note 4. Acquisition

On March 3, 2003, we purchased assets from another financial institution for a purchase price of approximately $174.8 million. The assets acquired included 55 loans with an aggregate principal balance of approximately $188.5 million. The loans comprised a well-seasoned portfolio and had a weighted average remaining life of approximately 14 months at acquisition. Additionally, we purchased furniture and equipment from the seller, assumed the seller’s office lease of 3,792 square feet located in a suburb of Dallas, and added nine former employees of the seller who were responsible for managing the acquired assets, including five auditors, three loan officers and a development officer. The office lease has been renegotiated and extended through June 26, 2006 at a monthly rental expense of approximately $7,500.

We considered Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combination, and EITF 98-3, Determining Whether a Non monetary Transaction Involves Receipt of Productive Assets or of a Business, to determine if the assets acquired constituted a business. Since all but a de minimis amount of the fair value of the transferred set of activities and assets is represented by a single tangible asset, the loan portfolio, the concentration of value in the single asset is an indicator that an asset rather than a business was purchased. Therefore, we have accounted for the acquisition of loans in accordance with SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, expensing the costs associated with the acquisition.

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Note 5. Borrowings

Commercial Paper Conduit Credit Facility

In February 2003, CapitalSource Holdings established a $135.0 million commercial paper conduit facility with Wachovia Securities, Inc., concurrently with the purchase of a portfolio of assets from anther financial institution. Funding under this facility is obtained through a single-purpose, bankruptcy-remote subsidiary, CapitalSource Acquisition Funding. This facility does not permit us to pledge additional collateral without the lender’s consent, but we may continue to draw, repay, and redraw funds thereunder. The credit facility is scheduled to terminate on February 27, 2004. Specific commercial loans are pledged as collateral for this facility. During April and May 2003, we reduced the maximum facility amount of the commercial paper conduit facility to $115.0 million. As of June 30, 2003, the outstanding balance of this commercial paper conduit facility was $73.6 million.

Repurchase Obligations

CapitalSource Holdings has sold full and partial loans and interests in Class D notes from its asset securitization transactions under repurchase agreements. Repurchase agreements are short-term financings, in which CapitalSource Holdings sells loans to a third party and CapitalSource Holdings has an obligation to repurchase the loans on a future date. During the time that the third party holds all or a portion of the loan, it is entitled to any interest paid by the borrower on the portion of the loan held by the third party. Interest is paid to the counterparty based on the amount of the loans sold. These repurchase agreements provide that the purchaser may mark the loans down to fair market value at any time and require CapitalSource Holdings to satisfy a margin call or repurchase the loan. Assets sold under repurchase agreements are included on the consolidated balance sheet as loans.

In January 2003, CapitalSource Holdings entered into a repurchase agreement with Nomura Credit & Capital Inc. (“Nomura”). The stated borrowing rate for the repurchase agreement is LIBOR plus 300 basis points. CapitalSource Holdings sold interest in one loan totaling $9.0 million to Nomura as of June 30, 2003. The Nomura repurchase agreement is scheduled to terminate on January 31, 2004. As of June 30, 2003, the outstanding balance of the Nomura repurchase agreement was $8.8 million.

In March 2003, CapitalSource Holdings entered into a repurchase agreement with Wachovia. The stated borrowing rate for the repurchase agreement with Wachovia is LIBOR plus 250 basis points. CapitalSource Holdings sold interest in six separate loans totaling $51.3 million and its interest in the Class D notes of the 2002-2 and 2003-1 securitizations totaling $58.2 million as of June 30, 2003. The Wachovia repurchase agreement is scheduled to terminate on September 20, 2003. As of June 30, 2003, the outstanding balance of the Wachovia repurchase agreement obligation was $82.2 million.

Asset Securitization Transactions

In April 2003, we completed a $371.3 million asset securitization. As of June 30, 2003, total amounts outstanding under the asset securitization were $361.3 million. In conjunction with the transaction, we established Trust 2003-1, a single-purpose bankruptcy-remote subsidiary, and contributed $450.1 million in loans (or portions thereof) to Trust 2003-1. Simultaneously with the initial contribution, Trust 2003-1 issued $258.8 million of Class A notes, $67.5 million of Class B notes, and $45.0 million of Class C notes to institutional investors. We retained $33.8 million of Class D notes and $45.0 million of Class E notes. The notes are backed by all or portions of specific commercial loans. The Class A, B, and C notes are expected to mature on November 20, 2005, July 20, 2006, and March 20, 2007, respectively. This transaction was accounted for as a financing.

Note 6. Members’ Equity

From September 7, 2000 (inception) through August 30, 2002, there were three classes of interests in CapitalSource Holdings: preferred interests, common interests and employee units. On August 30, 2002, CapitalSource Holdings completed a recapitalization, pursuant to which all preferred interests and employee units were converted into common interests (“Units”). The recapitalization transferred ownership interests from the preferred interest holders to the holders of common interests and employee units, eliminated certain preferred return provisions to the preferred interest holders, and reduced the aggregate capital commitments of the members from $542.4 million to $511.0 million.

During the six months ended June 30, 2003, members contributed their remaining committed capital of $71.2 million.

During the six months ended June 30, 2003, distributions of $27.4 million were paid to members.

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Note 7. Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) relates to the unrealized gain (loss) on available-for-sale security for the three and six months ended June 30, 2003 and 2002 was as follows ($ in thousands):

Comprehensive income for the three and six months ended June 30, 2003 was $28,428 and $46,948, respectively. Comprehensive income for the three and six months ended June 30, 2002 equaled net income.

Note 8. Net Income per Unit

The computation of basic and diluted net income per unit for the three and six months ended June 30, 2003 and 2002 was as follows ($ in thousands, except per unit data):

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Note 9. Employee Incentive Plan

Stock-Based Compensation

CapitalSource Holdings accounts for its stock-based compensation plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The following table illustrates the effect on net income and net income per unit if CapitalSource had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation ($ in thousands, except per unit data):

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

Note 10. Subsequent Events

Reorganization as a “C” Corporation

On August 6, 2003, CapitalSource Inc. (“CapitalSource”) became the successor to CapitalSource Holdings through a reorganization. CapitalSource is a Delaware corporation that is subject to taxation as a corporation for federal and state income tax purposes. CapitalSource Holdings, by contrast, was a Delaware limited liability company taxable as a partnership for federal income tax purposes.

In the reorganization, a wholly owned subsidiary of CapitalSource merged with and into CapitalSource Holdings, with CapitalSource Holdings continuing as the surviving company. In the merger, the existing holders of units of membership interest in CapitalSource Holdings received, on a one-for-one basis, shares of CapitalSource common stock in exchange for their units, and the shares of CapitalSource common stock owned by CapitalSource Holdings were cancelled. Subsequent to the merger, CapitalSource Holdings became a wholly owned subsidiary of CapitalSource.

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Initial Public Offering

On August 12, 2003, we closed the sale of 23.43 million shares of our common stock in our initial public offering. Of this amount, a total of 18.13 million shares were sold by us and 5.3 million shares were sold by selling stockholders. The closing included 2.13 million shares of common stock sold by us pursuant to the exercise of the underwriters’ over-allotment option. The initial public offering price was $14.50 per share. The aggregate sale price for all of the shares we sold was approximately $263 million resulting in estimated net proceeds to us, after payment of underwriting discounts and commissions but before other offering costs, of approximately $247 million. We did not receive any proceeds from the shares sold by the selling stockholders.

We used the net proceeds from the initial public offering to repay indebtedness under our commercial paper conduit credit facilities and one of our repurchase agreements:

	•		We used approximately $28.2 million of the net proceeds from the initial public offering to repay all of the outstanding indebtedness under our $115 million commercial paper conduit credit facility with Wachovia Securities, Inc.
	•		We used $141.0 million of the net proceeds from the initial public offering to repay the outstanding indebtedness under our primary $700 million commercial paper conduit credit facility with five commercial banks, for which Wachovia Securities, Inc. serves as the administrative agent.
	•		We used $45.7 million of the net proceeds from the initial public offering to repay the outstanding indebtedness under our repurchase agreement with Wachovia Bank, National Association.

We will use additional borrowing capacity created by the repayments under these credit facilities and repurchase agreement to fund newly originated and existing loans in our portfolio as the need arises. We retained the remaining $32.1 million of the net proceeds from the initial public offering primarily to fund newly originated and existing loans in our portfolio as well as general business purposes including payment of other offering costs.

CapitalSource common stock trades on The New York Stock Exchange under the symbol “CSE.”

Distribution

On August 1, 2003, we made a cash distribution of $5.2 million to the members of CapitalSource Holdings to cover taxes payable on our estimated taxable income passed through to them for the period from June 30, 2003 through August 6, 2003.

Employee Stock Purchase Plan

Effective with CapitalSource’s initial public offering on August 6, 2003, the Board of Directors and stockholders of CapitalSource adopted the CapitalSource Inc. Employee Stock Purchase Plan. A total of 2.0 million shares of common stock are reserved for issuance under the plan. Such shares of common stock may be authorized but unissued shares of common stock, treasury shares or shares of common stock purchased on the open market by CapitalSource. The plan will expire upon the earliest of such time as the Board, in its discretion, chooses to terminate the plan, when all of the shares of common stock have been issued under the plan or upon the expiration of ten years from the effective date of the plan.

Equity Incentive Plan

Effective with CapitalSource’s initial public offering on August 6, 2003, the Board of Directors and stockholders of CapitalSource adopted the CapitalSource Inc. Second Amended and Restated Equity Incentive Plan (the “Plan”). A total of 14.0 million shares of common stock are reserved for issuance under the Plan. The Plan will expire on the earliest of (1) the date as of which the Board of Directors, in it sole discretion, determines that the Plan shall terminate, (2) following certain corporate transactions such as a merger or sale of CapitalSource Inc.’s assets if the Plan is not assumed by the surviving entity, (3) at such time as all shares of common stock that may be available for purchase under the Plan have been issued or (4) ten years after the effective date of the Plan. The Plan is intended to give eligible employees, members of the Board of Directors, consultants and advisors of CapitalSource Inc. and its affiliates awards that are linked to the performance of CapitalSource Inc.’s common stock.

Repurchase Obligation

In August 2003, we entered into a $300 million credit facility with an affiliate of Credit Suisse First Boston LLC to finance healthcare mortgage loans. This facility will allow us to sell mortgage loans that we originate to the buyer for a purchase price equal to 70% of the outstanding principal balance of those mortgage loans, and we will have the obligation to repurchase the loans no later than 18 months after the sale. Our obligation to repurchase loans may be accelerated if an event of default under one or more of our purchased mortgage loans occurs and under certain other conditions, such as breach of our representations or

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warranties under the credit facility documents. During the time a mortgage loan is owned by the buyer, we will pay the buyer an annual rate of LIBOR plus 1.25% of the purchase price for the mortgage loan applied to the amount advanced to us on the mortgage loan. The facility expires in July 2008, and at that time we will be required to repurchase any mortgage loans not previously repurchased. In addition, any time prior to expiration of the facility, the buyer may give notice of its intention to terminate the facility and require us to repurchase all mortgage loans not earlier repurchased on the date which is 364 days from such notice of termination.

Commercial Paper Conduit Credit Facility

In September 2003, we entered into a $400 million credit facility with an affiliate of Citigroup Global Markets Inc. to finance our loans. This credit facility permits us to obtain financing of up to 75% of the outstanding principal balance of commercial loans we originate. During the time a commercial loan is subject to the credit facility, our borrowing rate is equal to an annual rate of LIBOR plus 1.00% applied to the amount advanced to us on the commercial loan. The credit facility has an initial term of 364 days and will be renewable by mutual agreement with our lender.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The information contained in this section should be read in conjunction with our unaudited consolidated financial statements and related notes.

Overview

We are a specialized commercial finance company providing loans to small and medium-sized businesses. Our goal is to be the lender of choice for small and medium-sized businesses with annual revenues ranging from $5 million to $250 million that require customized and sophisticated debt financings. We conduct our business in one reportable segment through three focused lending groups:

	•		Corporate Finance, which provides senior and mezzanine loans principally to businesses backed by private equity sponsors;
	•		HealthCare Finance, which provides asset-based revolving lines of credit, mortgage, and other secured loans to a broad range of healthcare companies; and
	•		Structured Finance, which specializes in asset-based lending to finance companies and commercial real estate owners.

We offer a range of senior secured asset-based loans, first mortgage loans, senior-secured cash flow loans and mezzanine loans to our clients. Our loans generally mature in two to five years and range in size from $1 million to $50 million. Virtually all of our loans require monthly interest payments at floating rates. In many cases, our loans provide for interest rate floors that help us maintain our yields when interest rates are low or declining. As of June 30, 2003, $1.2 billion, or 69%, of the aggregate outstanding principal amount of our loan portfolio had interest rate floors. Of this amount, $1.1 billion were paying interest at the interest rate floor.

Our revenue consists of interest and fees from our loans and, to a lesser extent, other income which includes unrealized appreciation (depreciation) on certain equity interests and gains (losses) on the sale of warrants and other equity interests. Our expenses consist of interest expense and operating expenses which include compensation and benefits and other administrative expenses.

The primary driver of our results of operations and financial condition has been our significant growth since inception on September 7, 2000. Our interest earning assets, which consist primarily of loans, grew from $1.2 billion to $1.9 billion, or 58%, from December 31, 2002 to June 30, 2003 and generated a gross yield of 11.97% for the six months ended June 30, 2003.

Our growth has not adversely affected the credit quality of our portfolio. We have not recorded a loan charge off since inception. As of June 30, 2003, one of our first mortgage loans for which we are not the agent was 60 or more days delinquent. As of that date, the approximate outstanding principal amount of the loan was $4.8 million and the delinquent amount was less than $0.1 million. We expect to experience credit losses at some point in the future and have established an allowance for loan losses consistent with our expectation of losses inherent in our portfolio.

Like all lenders our business depends on our access to external sources of financing and the cost of such funding. Since inception, we have funded our business through a combination of commercial paper conduit credit facilities, asset securitization transactions, repurchase agreements, $511.0 million of equity capital raised from private investors and retained earnings. The interest cost of our borrowings for the six months ended June 30, 2003 was 3.35%. All of our asset securitization transactions have been accounted for as on balance sheet financings with no gain or loss recorded on the transactions. As of June 30, 2003, our debt to equity ratio was 2.38x. We believe that our capital structure and access to additional funding sources provides us with the flexibility to continue to grow our assets as we pursue attractive lending opportunities.

We accelerated our investments in our staffing and other operational assets during our first years in operation and, as a result, we believe our expenses will continue to decrease as a percentage of our average total assets as we continue to carefully control our operating expenses and spread these expenses over a growing portfolio of loans. For instance, in the six months ended June 30, 2003, the ratio of our operating expenses to average total assets was 3.58%, down from 4.75% for the six months ended June 30, 2002. We will continue to focus on carefully controlling our operating expenses. If we are successful, our margins will improve in future periods as our expenses are spread over a growing portfolio of loans.

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Portfolio Composition

The schedule below shows the average size of our loans by lending group and by client as of June 30, 2003:

The schedule below shows the composition of our loan portfolio by type and by lending group as of dates shown: