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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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, 2004

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.)

4445 Willard Avenue, 12th Floor

Chevy Chase, MD 20815
(Address of Principal Executive Offices, Including Zip Code)

(800) 370-9431

(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 $.01 per share
  New York Stock Exchange

Securities Registered Pursuant to Section 12(g) of the Act:

None

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No þ

     As of August 1, 2004, the number of shares of the Registrant’s Common Stock, par value $.01 per share, outstanding was 117,676,568.




 

CAPITALSOURCE INC.

TABLE OF CONTENTS

             
Page

PART I
Item 1.
  Unaudited Consolidated Financial Statements        
    Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003     2  
    Consolidated Statements of Income (unaudited) for the three and six months ended June 30, 2004 and 2003     3  
    Consolidated Statement of Shareholders’ Equity (unaudited) for the six months ended June 30, 2004     4  
    Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2004 and 2003     5  
    Notes to the Unaudited Consolidated Financial Statement     6  
Item 2.
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     24  
Item 3.
  Quantitative and Qualitative Disclosures about Market Risk     38  
Item 4.
  Controls and Procedures     39  
PART II
Item 1.
  Legal Proceedings     40  
Item 2.
  Changes in Securities and Use of Proceeds     40  
Item 3.
  Defaults Upon Senior Securities     40  
Item 4.
  Submission of Matters to a Vote of Security Holders     40  
Item 5.
  Other Information     40  
Item 6.
  Exhibits and Reports on Form 8-K     40  
Signatures     41  
Index to Exhibits     42  

1


 

CAPITALSOURCE INC.

CONSOLIDATED BALANCE SHEETS

                     
June 30, December 31,
2004 2003


(Unaudited)
($ in thousands)
ASSETS
Cash and cash equivalents
  $ 171,572     $ 69,865  
Restricted cash
    54,608       79,913  
Loans:
               
 
Loans
    3,300,872       2,416,907  
 
Less deferred loan fees and discounts
    (67,905 )     (59,793 )
 
Less allowance for loan losses
    (24,775 )     (18,025 )
     
     
 
 
Loans, net
    3,208,192       2,339,089  
Investments
    42,237       39,788  
Deferred financing fees, net
    28,399       17,348  
Property and equipment, net
    10,129       8,590  
Other assets
    13,713       12,498  
     
     
 
   
Total assets
  $ 3,528,850     $ 2,567,091  
     
     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
               
 
Repurchase agreements
  $ 666     $ 8,446  
 
Credit facilities
    948,578       737,998  
 
Term debt
    1,459,655       923,208  
 
Convertible debt
    225,789        
 
Accounts payable and other liabilities
    25,666       29,466  
 
Due diligence deposits
    1,613       841  
     
     
 
   
Total liabilities
    2,661,967       1,699,959  
Shareholders’ equity:
               
 
Preferred stock (50,000,000 shares authorized; no shares outstanding)
           
 
Common stock ($0.01 par value, 500,000,000 shares authorized; 118,940,650 and 118,780,773 shares issued; 117,640,650 and 118,780,773 shares outstanding, respectively)
    1,176       1,188  
 
Additional paid-in capital
    754,773       777,766  
 
Retained earnings
    159,941       108,182  
 
Deferred compensation
    (18,843 )     (21,065 )
 
Accumulated other comprehensive (loss) income, net
    (238 )     1,061  
 
Treasury stock, at cost
    (29,926 )      
     
     
 
   
Total shareholders’ equity
    866,883       867,132  
     
     
 
   
Total liabilities and shareholders’ equity
  $ 3,528,850     $ 2,567,091  
     
     
 

See accompanying notes.

2


 

CAPITALSOURCE INC.

CONSOLIDATED STATEMENTS OF INCOME

                                   
Three Months Ended June 30, Six Months Ended June 30,


2004 2003 2004 2003




(Unaudited)
($ in thousands, except per share data)
Net interest and fee income:
                               
 
Interest
  $ 71,718     $ 40,944     $ 131,981     $ 74,037  
 
Fee income
    15,262       12,836       35,838       20,132  
     
     
     
     
 
 
Total interest and fee income
    86,980       53,780       167,819       94,169  
 
Interest expense
    16,275       10,065       29,374       17,105  
     
     
     
     
 
Net interest and fee income
    70,705       43,715       138,445       77,064  
Provision for loan losses
    5,143       2,059       12,406       4,774  
     
     
     
     
 
Net interest and fee income after provision for loan losses
    65,562       41,656       126,039       72,290  
Operating expenses:
                               
 
Compensation and benefits
    17,116       10,613       31,988       19,066  
 
Other administrative expenses
    10,442       4,417       17,851       9,123  
     
     
     
     
 
Total operating expenses
    27,558       15,030       49,839       28,189  
Other income (expense):
                               
 
Diligence deposits forfeited
    1,984       857       3,095       1,994  
 
Gain (loss) on investments
    234       964       (20 )     115  
 
Gain (loss) on derivatives
    259       (636 )     (256 )     (499 )
 
Other income
    4,454       762       4,463       1,154  
     
     
     
     
 
Total other income
    6,931       1,947       7,282       2,764  
     
     
     
     
 
Net income before income taxes
    44,935       28,573       83,482       46,865  
 
Income taxes
    17,075             31,723        
     
     
     
     
 
Net income
  $ 27,860     $ 28,573     $ 51,759     $ 46,865  
     
     
     
     
 
Net income per share:
                               
 
Basic
  $ 0.24     $ 0.29     $ 0.45     $ 0.48  
 
Diluted
  $ 0.24     $ 0.29     $ 0.44     $ 0.47  
Average shares outstanding:
                               
 
Basic
    115,770,083       98,100,029       116,274,840       98,082,562  
 
Diluted
    117,303,124       99,912,866       117,816,358       99,906,492  

See accompanying notes.

3


 

CAPITALSOURCE INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

                                                           
Accumulated
Other
Additional Comprehensive Treasury Total
Common Paid-In Retained Deferred Income Stock, Shareholders’
Stock Capital Earnings Compensation (Loss), net at cost Equity







(Unaudited)
($ in thousands)
Total shareholders’ equity as of December 31, 2003
  $ 1,188     $ 777,766     $ 108,182     $ (21,065 )   $ 1,061     $     $ 867,132  
Net income
                51,759                         51,759  
Other comprehensive income:
                                                       
 
Unrealized losses, net of tax
                            (1,299 )           (1,299 )
                                                     
 
Total comprehensive income
                                                    50,460  
Proceeds from issuance of common stock, net
          239                               239  
Stock option expense
          214                               214  
Exercise of options
    1       581                               582  
Purchase of treasury stock
    (13 )                             (29,926 )     (29,939 )
Purchase of call option, net
          (25,577 )                             (25,577 )
Restricted stock activity
          (124 )                             (124 )
Amortization of deferred stock compensation
                      2,222                   2,222  
Tax benefit on purchase of call option
          741                               741  
Tax benefit on exercise of options
          933                               933  
     
     
     
     
     
     
     
 
Total shareholders’ equity as of June 30, 2004
  $ 1,176     $ 754,773     $ 159,941     $ (18,843 )   $ (238 )   $ (29,926 )   $ 866,883  
     
     
     
     
     
     
     
 

See accompanying notes.

4


 

CAPITALSOURCE INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

                     
Six Months Ended
June 30,

2004 2003


(Unaudited)
($ in thousands)
Operating activities:
               
 
Net income
  $ 51,759     $ 46,865  
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
   
Stock option expense
    214       167  
   
Issuance of restricted stock
    76        
   
Amortization of deferred loan fees
    (20,657 )     (14,172 )
   
Provision for loan losses
    12,406       4,774  
   
Amortization of deferred financing fees
    5,833       3,422  
   
Depreciation and amortization
    932       627  
   
Benefit for deferred income taxes
    (4,362 )      
   
Amortization of deferred stock compensation
    2,222       114  
   
Loss (gain) on investments
    20       (115 )
   
Loss on derivatives
    256       499  
   
Decrease (increase) in other assets
    3,147       (85 )
   
(Decrease) increase in accounts payable and other liabilities
    (2,042 )     1,256  
   
Increase (decrease) in due diligence deposits
    772       (445 )
     
     
 
 
Cash provided by operating activities
    50,576       42,907  
Investing activities:
               
 
Decrease (increase) in restricted cash
    25,305       (34,184 )
 
Increase in loans, net
    (861,028 )     (632,264 )
 
Acquisition of investments, net
    (3,955 )     (5,782 )
 
Acquisition of property and equipment
    (2,471 )     (1,638 )
     
     
 
 
Cash used in investing activities
    (842,149 )     (673,868 )
Financing activities:
               
 
Payment of deferred financing fees
    (16,934 )     (9,682 )
 
(Repayments of) borrowings under repurchase agreements, net
    (7,780 )     90,997  
 
Borrowings on credit facilities, net
    210,580       314,701  
 
Borrowings of term debt
    765,625       371,309  
 
Repayments of term debt
    (228,516 )     (101,064 )
 
Borrowings of convertible debt
    225,000        
 
Members’ contributions, net
          71,153  
 
Distributions to members
          (27,498 )
 
Proceeds from issuance of common stock, net
    239        
 
Proceeds from exercise of options
    582       26  
 
Call option transactions, net
    (25,577 )      
 
Purchase of treasury stock
    (29,939 )      
     
     
 
 
Cash provided by financing activities
    893,280       709,942  
     
     
 
Increase in cash and cash equivalents
    101,707       78,981  
Cash and cash equivalents as of beginning of period
    69,865       49,806  
     
     
 
Cash and cash equivalents as of end of period
  $ 171,572     $ 128,787  
     
     
 

See accompanying notes.

5


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1.     Organization

      CapitalSource Inc. (“CapitalSource”), a Delaware corporation, is a commercial finance company that provides a broad array of financial products to small and medium-sized businesses. We provide the following products:

  •  Senior Secured Asset-Based Loans — loans that are underwritten based on our assessment of the client’s eligible accounts receivable and/or inventory;
 
  •  Senior Secured Cash Flow Loans — loans that are underwritten based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and maintain or increase its enterprise value during the term of the loan, thereby facilitating repayment of the principal at maturity;
 
  •  Mortgage Loans — loans that are secured by first mortgages on the property of the client;
 
  •  Term B, Second Lien, and Mezzanine Loans — loans, including subordinated mortgage loans, that come after a client’s senior loans in right of payment or upon liquidation; and
 
  •  Private Equity Co-Investments — opportunistic equity investments, typically in conjunction with lending relationships and on the same terms as other equity investors.

As of June 30, 2004, we are the parent company of the following wholly owned significant subsidiaries:

     
Entity Purpose


CapitalSource Finance LLC
  Primary operating subsidiary that conducts lending business of CapitalSource.
CapitalSource Holdings LLC
  Holding company for CapitalSource Finance LLC.
CapitalSource Funding LLC
  Single-purpose, bankruptcy-remote subsidiary established in accordance with a warehouse credit facility.
CS Funding II Depositor LLC
  Single-purpose, bankruptcy-remote subsidiary established in accordance with a warehouse credit facility.
CapitalSource Commercial Loan Trust 2003-1
  Single-purpose, bankruptcy-remote subsidiary established for issuance of term debt.
CapitalSource Commercial Loan Trust 2003-2
  Single-purpose, bankruptcy-remote subsidiary established for issuance of term debt.
CapitalSource Commercial Loan Trust 2004-1
  Single-purpose, bankruptcy-remote subsidiary established for issuance of term debt.

      On August 6, 2003, CapitalSource became the successor to CapitalSource Holdings LLC (“CapitalSource Holdings”) through a reorganization. In the reorganization, a wholly owned subsidiary of CapitalSource merged with and into CapitalSource Holdings, with CapitalSource Holdings continuing as a wholly owned subsidiary of CapitalSource. As a result of the merger, the 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 canceled.

      On August 12, 2003, we completed the sale of 23.43 million shares of 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 $262.9 million, resulting in net proceeds to

6


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

us, after payment of underwriting discounts, commissions, and other expenses of approximately $241.6 million. We did not receive any proceeds from the shares sold by the selling stockholders. The net proceeds from the initial public offering were used to repay indebtedness under our credit facilities and one of our repurchase agreements.

Note 2.     Summary of Significant Accounting Policies

     Unaudited Interim Consolidated Financial Statements Basis of Presentation

      Our interim consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“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 and eliminations, 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 included in our Annual Report on Form 10-K for the year ended December 31, 2003.

      The accompanying financial statements reflect our consolidated accounts, including all of our subsidiaries and the related consolidated results of operations with all intercompany balances and transactions eliminated in consolidation.

      Our accounting policies are described in Note 1 of our audited December 31, 2003 financial statements included in our Annual Report on Form 10-K and Note 1 of our unaudited March 31, 2004 financial statements included in our Quarterly Report on Form 10-Q. The accounting policies that management has identified as critical or complex accounting policies are described on Page 41 of this Form 10-Q under the caption Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies.

 
      Cash and Cash Equivalents

      Included in cash and cash equivalents are collections from our borrowers. We are required to remit the collections to the trustee of our credit facilities and term debt securitizations within two days of receipt. Upon transfer to the trustee, a portion of these funds will become restricted.

Note 3.     Recently Proposed Accounting Guidance

      In March and July 2004, we entered into two series of contingent convertible debt instruments (“Contingent Convertibles”) that are convertible into 7,401,420 and 10,382,262 shares of common stock, respectively. Contingent Convertibles combine the features of contingently issuable shares with a convertible debt instrument. These instruments generally become convertible into common stock only if one or more specified events occur, such as the underlying common stock achieving a specified price target.

      Under current interpretations of Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings Per Share, issuers of Contingent Convertibles exclude the potential common shares underlying the Contingent Convertibles from the calculation of diluted net income per share until the market price or other contingency is met. When the contingency is met, generally the if-converted method is used to calculate the dilutive impact of the instrument. Under the if-converted method, the instrument is considered converted, with the resulting number of shares included in the denominator of the net income per share calculation and the interest expense, net of tax, added back to the numerator of the net income per share calculation. Under these interpretations, we did not include any of the shares issuable upon conversion of our Contingent

7


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Convertibles in our calculation of diluted net income or diluted net income per share for the three months ended March 31, 2004 or the three or six months ended June 30, 2004.

      Subsequent to our pricing of the July 2004 Contingent Convertibles, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) announced a tentative conclusion on EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings Per Share (“EITF 04-8”). The EITF tentatively concluded that Contingent Convertibles should be included in diluted net income per share computations using the if-converted method regardless of whether the market price trigger or other contingent feature has been met. The EITF has proposed that this new treatment be applied retroactively, with the result that the issuers of Contingent Convertibles would be required to restate previously reported diluted earnings per share. If approved by the FASB as proposed by the EITF, we expect the implementation of EITF 04-8 would have an impact on our net income and net income per share for the three months ended March 31, 2004 and the three and six months ended June 30, 2004 as follows:

                         
Three Months Three Months Six Months
Ended March 31, Ended June 30, Ended June 30,
2004 2004 2004



Average shares:
                       
Reported average shares — diluted
    118,731,114       117,303,124       117,816,358  
Dilutive impact of convertible debt
    1,233,570       7,401,420       4,317,495  
     
     
     
 
Pro forma average shares — diluted
    119,964,684       124,704,544       122,133,853  
     
     
     
 
Diluted net income per share:
                       
Reported diluted net income
  $ 23,899     $ 27,860     $ 51,759  
Add: interest expense on convertible debt, net of tax
    73       436       509  
     
     
     
 
Pro forma diluted net income
  $ 23,972     $ 28,296     $ 52,268  
     
     
     
 
Reported diluted net income per share
  $ 0.20     $ 0.24     $ 0.44  
     
     
     
 
Pro forma diluted net income per share
  $ 0.20     $ 0.23     $ 0.43  
     
     
     
 

      If approved by the FASB, we expect that the implementation of EITF 04-8 could potentially increase our number of diluted shares by 17,783,682 for future reporting periods. Concurrently with the issuance of our Contingent Convertibles in March 2004, we entered into a call option transaction for 7,401,420 that could potentially partially offset the possible dilutive nature of those Contingent Convertibles.

Note 4.     Allowance for Loan Losses

      Activity in the allowance for loan losses for the six months ended June 30, 2004 and 2003 was as follows:

                 
Six Months Ended
June 30,

2004 2003


($ in thousands)
Balance as of beginning of period
  $ 18,025     $ 6,688  
Provision for loan losses
    12,406       4,774  
Charge offs
    (5,656 )      
     
     
 
Balance as of end of period
  $ 24,775     $ 11,462  
     
     
 

      As of June 30, 2004 and December 31, 2003, the net principal balance of impaired loans, as defined by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, totaled $24.5 million and $15.3 million,

8


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

respectively. As of June 30, 2004 and December 31, 2003, specific reserves for the impaired loans were $0.6 million and $2.7 million, respectively. Additionally, as of June 30, 2004 and December 31, 2003, loans with an aggregate net principal balance of $32.5 million and $8.8 million, respectively, were on non-accrual status.

      For the six months ended June 30, 2004, we had no new loans that were accounted for as troubled debt restructurings as defined by SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructuring. For the year ended December 31, 2003, loans with a carrying value of $36.3 million as of December 31, 2003 were classified as troubled debt restructurings. The specific reserve for loans classified as a troubled debt restructuring was $0.5 million as of December 31, 2003.

Note 5.     Acquisition of Loan Portfolio

      In April 2004, we purchased a portfolio of loans and certain other assets of SLP Capital (“SLP”), one of the largest specialty finance companies serving the security alarm industry, for approximately $75.2 million. The assets acquired included 32 well-seasoned performing asset-based loans with an aggregate principal balance of approximately $72.0 million and a servicing platform. In conjunction with the transaction, we also originated a $17.7 million senior loan to the seller which is secured by loans not acquired by us.

      We considered SFAS No. 141, Business Combination, and EITF Issue No. 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.

Note 6.     Borrowings

      As of June 30, 2004 and December 31, 2003, we had outstanding borrowings totaling $2.6 billion and $1.7 billion, respectively. For a detailed discussion of our borrowings, see Note 8, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2003 included in our Form 10-K, as filed with the SEC on March 12, 2004.

      The following changes to our borrowings occurred during the three months ended June 30, 2004:

     Repurchase Agreements

      In June 2004, we terminated our repurchase agreement with Citigroup Global Markets Inc (“Citigroup”). All amounts outstanding under this repurchase agreement were repaid.

     Credit Facilities

      In April 2004, we amended our $115.0 million credit facility with Wachovia Capital Markets LLC (“Wachovia”) to reduce the maximum facility amount of the facility to $100.0 million. Availability under the credit facility depends on our borrowing base, which is calculated based on the outstanding principal amount of eligible loans in the credit facility combined with specified portfolio concentration criteria. In connection with the amendment, we extended the maturity to April 7, 2006 and expanded the scope of the eligibility criteria to enable us to include the assets acquired in the SLP transaction in the credit facility. Interest on borrowings under the credit facility was reduced to the commercial paper rate, plus 0.90%, which was 1.22% as of June 30, 2004.

      In April 2004, we entered into a new $400.0 million credit facility with Wachovia to finance our loans. Funding under this credit facility is obtained through a single-purpose, bankruptcy-remote subsidiary, CapitalSource Funding III LLC. The credit facility permits us to obtain financing of up to 85% of the

9


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

outstanding principal balance of commercial loans we originate and transfer to this credit facility, depending upon their current loan rating and priority of payment within the particular borrower’s capital structure and subject to certain concentration limits. As of June 30, 2004, loans with net principal balances outstanding of $370.3 million were pledged as collateral for the credit facility. Interest on borrowings under the credit facility is charged at the commercial paper rate, plus 0.90%, which was 1.22% as of June 30, 2004. This credit facility is scheduled to expire in April 2007.

      In May 2004, we amended our $700.0 million credit facility to modify specific terms, appoint Harris Nesbitt Corp. as the new administrative agent and change the lenders participating in the credit facility. Availability under the credit facility depends on our borrowing base, which is calculated based on the outstanding principal amount of eligible loans in the credit facility combined with specified portfolio concentration criteria. In connection with the amendment, the maximum advance rate under this credit facility was increased to 75% of our borrowing base. Interest on borrowings under the credit facility was reduced to the commercial paper rate, as defined by each lender, plus 0.975%, which was 1.37% as of June 30, 2004. This credit facility is scheduled to mature on May 24, 2007 and may be renewed annually at the option of our lenders.

      In June 2004, the capacity under our credit facility with Citigroup was increased to $460.0 million from $400.0 million.

     Term Debt

      In June 2004, we completed an $875.0 million term debt securitization. In conjunction with the transaction, we established a separate single purpose subsidiary, CapitalSource Commercial Loan Trust 2004-1 (“Trust 2004-1”), and contributed $875.0 million in loans, or portions thereof, to Trust 2004-1. Subject to the satisfaction of certain conditions, we remain the servicer of the loans. Simultaneously with the initial contributions, Trust 2004-1 issued $765.6 million of notes to institutional investors. One of our subsidiaries retained $109.4 million in Class E notes and 100% of the Trust’s certificates. The Class A-1, A-2, B, C, and D notes carry an interest rate of one-month LIBOR plus 0.13%, 0.33%, 0.65%, 1.00%, and 1.75%, respectively. The Class A-1 notes are expected to mature on March 20, 2006. The Class A-2, B, C, and D notes are all expected to mature on September 22, 2008. The notes are collateralized by all or portions of specific commercial loans, totaling $841.7 million as of June 30, 2004. We have treated the contribution of the loans to Trust 2004-1 and the related sale of notes by Trust 2004-1 as a financing arrangement under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). As required by the terms of Trust 2004-1, we have entered into interest rate swaps and caps to mitigate certain interest rate risk. As of June 30, 2004, total borrowings outstanding under this term debt transaction were $766.2 million.

Note 7.     Guarantor Information

      The following represents the unaudited supplemental consolidating condensed financial statements of CapitalSource Inc., which was the issuer of the convertible debt issued in March 2004, CapitalSource Holdings and CapitalSource Finance LLC (“CapitalSource Finance”), which are guarantors of the convertible debentures, and our subsidiaries that are not guarantors of the convertible debentures as of June 30, 2004 and December 31, 2003 and for the three and six months ended June 30, 2004 and 2003. CapitalSource Holdings and CapitalSource Finance have guaranteed the debentures, jointly and severally, on a senior basis. CapitalSource Finance is a wholly owned subsidiary of CapitalSource Holdings. Separate consolidated financial statements of each guarantor are not presented, as we have determined that they would not be material to investors.

10


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING BALANCE SHEET

June 30, 2004
                                             
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
CapitalSource Inc. Subsidiaries Subsidiaries Eliminations CapitalSource Inc.





(Unaudited)
($ in thousands)
ASSETS
 
Cash and cash equivalents
  $     $ 149,595     $ 21,977     $     $ 171,572  
 
Restricted cash
          18,246       36,362             54,608  
 
Loans:
                                       
   
Loans
          3,276,435       30,483       (6,046 )     3,300,872  
   
Less deferred loan fees and discounts
          484       (68,389 )           (67,905 )
   
Allowance for loan losses
                (24,775 )           (24,775 )
     
     
     
     
     
 
   
Loans, net
          3,276,919       (62,681 )     (6,046 )     3,208,192  
 
Investment in subsidiaries
    1,080,986             1,034,722       (2,115,708 )      
 
Intercompany (due to)/due from
          12,330       (12,330 )            
 
Intercompany note receivable
                28,670       (28,670 )      
 
Investments
                42,237             42,237  
 
Deferred financing fees, net
    5,636       22,696       67             28,399  
 
Property and equipment, net
          4       10,125             10,129  
 
Other assets
    7,833       1,062       4,818             13,713  
     
     
     
     
     
 
   
Total assets
  $ 1,094,455     $ 3,480,852     $ 1,103,967     $ (2,150,424 )   $ 3,528,850  
     
     
     
     
     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
                                       
 
Repurchase agreements
  $     $ 666     $     $     $ 666  
 
Credit facilities
          948,578                   948,578  
 
Term debt
          1,460,729       (1,074 )           1,459,655  
 
Convertible debt
    225,789                         225,789  
 
Accounts payable and other liabilities
    1,783       7,271       22,658       (6,046 )     25,666  
 
Intercompany note payable
          28,670             (28,670 )      
 
Due diligence deposits
          216       1,397             1,613  
     
     
     
     
     
 
 
Total liabilities
    227,572       2,446,130       22,981       (34,716 )     2,661,967  
Shareholders’ equity:
                                       
 
Preferred stock
                             
 
Common stock
    1,176                         1,176  
 
Additional paid-in capital
    754,773       678,727       815,836       (1,494,563 )     754,773  
 
Retained earnings
    159,941       356,105       265,466       (621,571 )     159,941  
 
Deferred compensation
    (18,843 )                       (18,843 )
 
Accumulated other comprehensive loss, net
    (238 )     (110 )     (316 )     426       (238 )
 
Treasury stock, at cost
    (29,926 )                       (29,926 )
     
     
     
     
     
 
   
Total shareholders’ equity
    866,883       1,034,722       1,080,986       (2,115,708 )     866,883  
     
     
     
     
     
 
   
Total liabilities and shareholders’ equity
  $ 1,094,455     $ 3,480,852     $ 1,103,967     $ (2,150,424 )   $ 3,528,850  
     
     
     
     
     
 

11


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING BALANCE SHEET

December 31, 2003
                                             
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
CapitalSource Inc. Subsidiaries Subsidiaries Eliminations CapitalSource Inc.





(Unaudited)
($ in thousands)
ASSETS
 
Cash and cash equivalents
  $     $ 37,848     $ 32,017     $     $ 69,865  
 
Restricted cash
          16,860       63,053             79,913  
 
Loans:
                                       
   
Loans
          2,400,601       27,419       (11,113 )     2,416,907  
   
Less deferred loan fees and discounts
          1,221       (61,014 )           (59,793 )
   
Allowance for loan losses
                (18,025 )           (18,025 )
     
     
     
     
     
 
   
Loans, net
          2,401,822       (51,620 )     (11,113 )     2,339,089  
 
Investment in subsidiaries
    864,073             1,030,148       (1,894,221 )      
 
Intercompany (due to)/due from
          9,727       (9,727 )            
 
Intercompany note receivable
          246,985       33,046       (280,031 )      
 
Investments
                39,788             39,788  
 
Deferred financing fees, net
          17,216       132             17,348  
 
Property and equipment, net
          5       8,585             8,590  
 
Other assets
    3,623       972       7,903             12,498  
     
     
     
     
     
 
 
Total assets
  $ 867,696     $ 2,731,435     $ 1,153,325     $ (2,185,365 )   $ 2,567,091  
     
     
     
     
     
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
                                       
 
Repurchase agreements
  $     $     $ 8,446     $     $ 8,446  
 
Credit facilities
          737,998                   737,998  
 
Term debt
          923,503       (295 )           923,208  
 
Accounts payable and other liabilities
    564       6,554       33,461       (11,113 )     29,466  
 
Intercompany note payable
          33,046       246,985       (280,031 )      
 
Due diligence deposits
          186       655             841  
     
     
     
     
     
 
 
Total liabilities
    564       1,701,287       289,252       (291,144 )     1,699,959  
Shareholders’ equity:
                                       
 
Preferred stock
    -                          
 
Common stock
    1,188                         1,188  
 
Additional paid-in capital
    777,766       799,263       701,500       (1,500,763 )     777,766  
 
Retained earnings
    108,182       230,875       161,522       (392,397 )     108,182  
 
Deferred compensation
    (21,065 )                       (21,065 )
 
Accumulated other comprehensive income, net
    1,061       10       1,051       (1,061 )     1,061  
     
     
     
     
     
 
 
Total shareholders’ equity
    867,132       1,030,148       864,073       (1,894,221 )     867,132  
     
     
     
     
     
 
 
Total liabilities and shareholders’ equity
  $ 867,696     $ 2,731,435     $ 1,153,325     $ (2,185,365 )   $ 2,567,091  
     
     
     
     
     
 

12


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF INCOME

Three Months Ended June 30, 2004
                                           
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
CapitalSource Inc. Subsidiaries Subsidiaries Eliminations CapitalSource Inc.





(Unaudited)
($ in thousands)
Net interest and fee income:
                                       
 
Interest
  $     $ 75,460     $ 1,297     $ (5,039 )   $ 71,718  
 
Fee income
          5,466       9,796             15,262  
     
     
     
     
     
 
 
Total interest and fee income
          80,926       11,093       (5,039 )     86,980  
 
Interest expense
    1,000       15,625       4,689       (5,039 )     16,275  
     
     
     
     
     
 
Net interest and fee income
    (1,000 )     65,301       6,404             70,705  
Provision for loan losses
                5,143             5,143  
     
     
     
     
     
 
Net interest and fee income after provision for loan losses
    (1,000 )     65,301       1,261             65,562  
Operating expenses:
                                       
 
Compensation and benefits
          308       16,808             17,116  
 
Other administrative expenses
    1       309       10,132             10,442  
     
     
     
     
     
 
Total operating expenses
    1       617       26,940             27,558  
Other income (expense):
                                       
 
Diligence deposits forfeited
                1,984             1,984  
 
Gain on investments
                234             234  
 
Gain (loss) on derivatives
          588       (329 )           259  
 
Other income
          3,865       589             4,454  
 
Earnings in subsidiaries
    45,936             70,577       (116,513 )      
 
Transfer pricing
          1,440       (1,440 )            
     
     
     
     
     
 
Total other income
    45,936       5,893       71,615       (116,513 )     6,931  
     
     
     
     
     
 
Net income before income taxes
    44,935       70,577       45,936       (116,513 )     44,935  
 
Income taxes
    17,075                         17,075  
     
     
     
     
     
 
Net income
  $ 27,860     $ 70,577     $ 45,936     $ (116,513 )   $ 27,860  
     
     
     
     
     
 

13


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF INCOME

Six Months Ended June 30, 2004
                                           
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
CapitalSource Inc. Subsidiaries Subsidiaries Eliminations CapitalSource Inc.





(Unaudited)
($ in thousands)
Net interest and fee income:
                                       
 
Interest
  $     $ 138,785     $ 3,357     $ (10,161 )   $ 131,981  
 
Fee income
          12,697       23,141             35,838  
     
     
     
     
     
 
 
Total interest and fee income
          151,482       26,498       (10,161 )     167,819  
 
Interest expense
    1,140       29,157       9,238       (10,161 )     29,374  
     
     
     
     
     
 
Net interest and fee income
    (1,140 )     122,325       17,260             138,445  
Provision for loan losses
                12,406             12,406  
     
     
     
     
     
 
Net interest and fee income after provision for loan losses
    (1,140 )     122,325       4,854             126,039  
Operating expenses:
                                       
 
Compensation and benefits
          602       31,386             31,988  
 
Other administrative expenses
    40       384       17,427             17,851  
     
     
     
     
     
 
Total operating expenses
    40       986       48,813             49,839  
Other income (expense):
                                       
 
Diligence deposits forfeited
                3,095             3,095  
 
Loss on investments
                (20 )           (20 )
 
(Loss) gain on derivatives
          (1,166 )     910             (256 )
 
Other income
          4,061       402             4,463  
 
Earnings in subsidiaries
    84,662             126,837       (211,499 )      
 
Transfer pricing
          2,603       (2,603 )            
     
     
     
     
     
 
Total other income
    84,662       5,498       128,621       (211,499 )     7,282  
     
     
     
     
     
 
Net income before income taxes
    83,482       126,837       84,662       (211,499 )     83,482  
 
Income taxes
    31,723                         31,723  
     
     
     
     
     
 
Net income
  $ 51,759     $ 126,837     $ 84,662     $ (211,499 )   $ 51,759  
     
     
     
     
     
 

14


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF INCOME

Three Months Ended June 30, 2003
                                   
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
Subsidiaries Subsidiaries Eliminations CapitalSource Inc.




(Unaudited)
($ in thousands)
Net interest and fee income:
                               
 
Interest
  $ 40,289     $ 1,342     $ (687 )   $ 40,944  
 
Fee income
    2,591       10,245             12,836  
     
     
     
     
 
 
Total interest and fee income
    42,880       11,587       (687 )     53,780  
 
Interest expense
    10,592       160       (687 )     10,065  
     
     
     
     
 
Net interest and fee income
    32,288       11,427             43,715  
Provision for loan losses
          2,059             2,059  
     
     
     
     
 
Net interest and fee income after provision for loan losses
    32,288       9,368             41,656  
Operating expenses:
                               
 
Compensation and benefits
    157       10,456             10,613  
 
Other administrative expenses
    112       4,305             4,417  
     
     
     
     
 
Total operating expenses
    269       14,761             15,030  
Other (expense) income:
                               
 
Diligence deposits forfeited
          857             857  
 
Gain on investments
          964             964  
 
(Loss) gain on derivatives
    (1,226 )     590             (636 )
 
Other income (expense)
    823       (61 )           762  
 
Earnings in subsidiaries
          31,616       (31,616 )      
     
     
     
     
 
Total other (expense) income
    (403 )     33,966       (31,616 )     1,947  
     
     
     
     
 
Net income before income taxes
    31,616       28,573       (31,616 )     28,573  
 
Income taxes
                       
     
     
     
     
 
Net income
  $ 31,616     $ 28,573     $ (31,616 )   $ 28,573  
     
     
     
     
 

15


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF INCOME

Six Months Ended June 30, 2003
                                   
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
Subsidiaries Subsidiaries Eliminations CapitalSource Inc.




(Unaudited)
($ in thousands)
Net interest and fee income:
                               
 
Interest
  $ 72,724     $ 2,558     $ (1,245 )   $ 74,037  
 
Fee income
    4,691       15,441             20,132  
     
     
     
     
 
 
Total interest and fee income
    77,415       17,999       (1,245 )     94,169  
 
Interest expense
    18,040       310       (1,245 )     17,105  
     
     
     
     
 
Net interest and fee income
    59,375       17,689             77,064  
Provision for loan losses
          4,774             4,774  
     
     
     
     
 
Net interest and fee income after provision for loan losses
    59,375       12,915             72,290  
Operating expenses:
                               
 
Compensation and benefits
    283       18,783             19,066  
 
Other administrative expenses
    176       8,947             9,123  
     
     
     
     
 
Total operating expenses
    459       27,730             28,189  
Other income (expense):
                               
 
Diligence deposits forfeited
          1,994             1,994  
 
Gain on investments
          115             115  
 
(Loss) gain on derivatives
    (1,032 )     533             (499 )
 
Other income
    1,142       12             1,154  
 
Earnings in subsidiaries
          59,026       (59,026 )      
     
     
     
     
 
Total other income
    110       61,680       (59,026 )     2,764  
     
     
     
     
 
Net income before income taxes
    59,026       46,865       (59,026 )     46,865  
 
Income taxes
                       
     
     
     
     
 
Net income
  $ 59,026     $ 46,865     $ (59,026 )   $ 46,865  
     
     
     
     
 

16


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF CASH FLOWS

Six Months Ended June 30, 2004
                                               
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
CapitalSource Inc. Subsidiaries Subsidiaries Eliminations CapitalSource Inc.





(Unaudited)
($ in thousands)
Operating activities:
                                       
 
Net income
  $ 51,759     $ 126,837     $ 84,662     $ (211,499 )   $ 51,759  
   
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
                                       
     
Amortization of compensatory options
    47                         47  
     
Issuance of options to third party
    167                         167  
     
Issuance of restricted stock
    76                         76  
     
Amortization of deferred loan fees
                (20,657 )           (20,657 )
     
Provision for loan losses
                12,406             12,406  
     
Amortization of deferred financing fees
    343       5,452       38             5,833  
     
Depreciation and amortization
                932             932  
     
Benefit for deferred income taxes
    (4,362 )                       (4,362 )
     
Amortization of deferred stock compensation
    2,222                         2,222  
     
(Gain) loss on investments
          (50 )     70             20  
     
Loss (gain) on derivatives
          1,168       (912 )           256  
     
Decrease in note receivable
          246,985       4,376       (251,361 )      
     
Decrease (increase) in other assets
    152       (90 )     3,085             3,147  
     
Increase (decrease) in accounts payable and other liabilities
    3,681       814       (11,605 )     5,068       (2,042 )
     
Increase in due diligence deposits
          30       742             772  
     
Net transfers with subsidiaries
    (218,411 )     (124,746 )     131,658       211,499        
     
     
     
     
     
 
 
Cash (used in) provided by operating activities
    (164,326 )     256,400       204,795       (246,293 )     50,576  
Investing activities:
                                       
 
(Increase) decrease in restricted cash
          (1,386 )     26,691             25,305  
 
(Increase) decrease in loans, net
          (876,264 )     20,304       (5,068 )     (861,028 )
 
Acquisition of investments
                (3,955 )           (3,955 )
 
Acquisition of property and equipment
                (2,471 )           (2,471 )
     
     
     
     
     
 
 
Cash (used in) provided by investing activities
          (877,650 )     40,569       (5,068 )     (842,149 )
Financing activities:
                                       
 
Payment of deferred financing fees
    (5,979 )     (10,982 )     27             (16,934 )
 
Decrease in intercompany note payable
          (4,376 )     (246,985 )     251,361        
 
Borrowings under (repayments of) repurchase agreements, net
          666       (8,446 )           (7,780 )
 
Borrowings on credit facilities, net
          210,580                   210,580  
 
Borrowings of term debt
          765,625                   765,625  
 
Repayments of term debt
          (228,516 )                 (228,516 )
 
Borrowings of convertible debt
    225,000                         225,000  
 
Proceeds from issuance of common stock, net
    239                         239  
 
Proceeds from exercise of options
    582                         582  
 
Call option transactions, net
    (25,577 )                       (25,577 )
 
Purchase of treasury stock
    (29,939 )                       (29,939 )
     
     
     
     
     
 
 
Cash provided by (used in) financing activities
    164,326       732,997       (255,404 )     251,361       893,280  
     
     
     
     
     
 
Increase (decrease) in cash and cash equivalents
          111,747       (10,040 )           101,707  
Cash and cash equivalents as of beginning of period
          37,848       32,017             69,865  
     
     
     
     
     
 
Cash and cash equivalents as of end of period
  $     $ 149,595     $ 21,977     $     $ 171,572  
     
     
     
     
     
 

17


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

CONSOLIDATING STATEMENT OF CASH FLOWS

Six Months Ended June 30, 2003
                                       
CapitalSource Holdings LLC

Combined Combined
Non-Guarantor Guarantor Consolidated
Subsidiaries Subsidiaries Eliminations CapitalSource Inc.




(Unaudited)
($ in thousands)
Operating activities:
                               
 
Net income
  $ 59,026     $ 46,865     $ (59,026 )   $ 46,865  
   
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
                               
     
Amortization of compensatory options
          167             167  
     
Amortization of deferred loan fees
          (14,172 )           (14,172 )
     
Provision for loan losses
          4,774             4,774  
     
Amortization of deferred financing fees
    3,342       80             3,422  
     
Depreciation and amortization
    9       618             627  
     
Amortization of deferred stock compensation
          114             114  
     
Gain on investments
          (115 )           (115 )
     
Loss (gain) on derivatives
    1,032       (533 )           499  
     
Decrease in note receivable
          3,867       (3,867 )      
     
Increase in other assets
    (13 )     (72 )           (85 )
     
Increase (decrease) in accounts payable and other liabilities
    2,873       (614 )     (1,003 )     1,256  
     
Increase (decrease) in due diligence deposits
    154       (599 )           (445 )
     
Net transfers with subsidiaries
    (2,581 )     (56,445 )     59,026        
     
     
     
     
 
 
Cash provided by (used in) operating activities
    63,842       (16,065 )     (4,870 )     42,907  
Investing activities:
                               
 
Increase in restricted cash
    (840 )     (33,344 )           (34,184 )
 
(Increase) decrease in loans, net
    (668,279 )     35,012       1,003       (632,264 )
 
Acquisition of investments
          (5,782 )           (5,782 )
 
Acquisition of property and equipment
    (9 )     (1,629 )           (1,638 )
     
     
     
     
 
 
Cash used in investing activities
    (669,128 )     (5,743 )     1,003       (673,868 )
Financing activities:
                               
 
Payment of deferred financing fees
    (8,570 )     (1,112 )           (9,682 )
 
Decrease in intercompany note payable
    (3,867 )           3,867        
 
Borrowings on repurchase agreements, net
    82,233       8,764             90,997  
 
Borrowings on credit facilities, net
    314,701                   314,701  
 
Borrowings of term debt
    371,309                   371,309  
 
Repayments of term debt
    (101,064 )                 (101,064 )
 
Members’ contributions, net
          71,153             71,153  
 
Distributions to members
          (27,498 )           (27,498 )
 
Proceeds from exercise of options
          26             26  
     
     
     
     
 
 
Cash provided by financing activities
    654,742       51,333       3,867       709,942  
     
     
     
     
 
Increase in cash and cash equivalents
    49,456       29,525             78,981  
Cash and cash equivalents as of beginning of period
    40,191       9,615             49,806  
     
     
     
     
 
Cash and cash equivalents as of end of period
  $ 89,647     $ 39,140     $     $ 128,787  
     
     
     
     
 

18


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 8.     Shareholders’ Equity

     Common Stock Shares Outstanding

      Common stock activity for the six months ended June 30, 2004 was as follows:

           
Outstanding as of December 31, 2003.
    118,780,773  
 
Exercise of options
    113,577  
 
Issuance of shares under the Employee Stock Purchase Plan
    32,517  
 
Restricted stock and other stock grants, net
    13,783  
 
Repurchase of treasury stock
    (1,300,000 )
     
 
Outstanding as of June 30, 2004.
    117,640,650  
     
 

     Employee Stock Purchase Plan

      Effective with our initial public offering on August 6, 2003, our Board of Directors and stockholders adopted the CapitalSource Inc. Employee Stock Purchase Plan (“ESPP”). A total of 2.0 million shares of common stock were initially reserved for issuance under the ESPP. 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 us. The ESPP will expire upon the earliest of such time as the Board of Directors, in its discretion, chooses to terminate the ESPP, 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 ESPP. We issued 32,517 shares under the ESPP during the six months ended June 30, 2004. As of June 30, 2004, there are currently 1,908,790 shares remaining available for issuance under the ESPP.

     Equity Incentive Plan

      Effective with our initial public offering on August 6, 2003, our Board of Directors and stockholders adopted the CapitalSource Inc. Second Amended and Restated Equity Incentive Plan (successor to the Equity Incentive Plan, the “Plan”). A total of 14.0 million shares of common stock were initially 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 our 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, and our consultants and advisors awards that are linked to the performance of our common stock. As of June 30, 2004, there are currently 8,040,106 shares remaining available for issuance under the Plan.

     Restricted Stock

      Pursuant to the Plan, we have granted shares of restricted common stock to certain employees and non-employee directors of the Board of Directors, which vest over time, generally between one and five years. Of the 14.0 million shares initially authorized for awards under the Plan, up to 5.0 million shares were initially authorized to be granted in the form of restricted stock. For the six months ended June 30, 2004, we issued 56,253 shares of restricted stock at a weighted-average fair value of $22.18. For the six months ended June 30, 2004, 42,970 shares of restricted stock were forfeited. As of June 30, 2004, there are currently 3,877,967 shares of the initially authorized 5.0 million shares available for issuance as restricted stock under the Plan.

19


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 9.     Income Taxes

      The effective tax rate differed from the statutory federal corporate income tax rate for the three and six months ended June 30, 2004 and 2003 as follows:

                                 
Three Months Six Months
Ended June 30, Ended June 30,


2004 2003 2004 2003




Federal statutory rate
    35.0 %     35.0 %     35.0 %     35.0 %
State income taxes, net of federal tax benefit
    2.8       0.0       2.8       0.0  
Other(1)
    0.2       (35.0 )     0.2       (35.0 )
     
     
     
     
 
Effective tax rate
    38.0 %     0.0 %     38.0 %     0.0 %
     
     
     
     
 


(1)  After reorganizing as a “C” corporation on August 6, 2003, we provided for income taxes on the income earned from August 7, 2003 through December 31, 2003 based on a 38% effective tax rate. Prior to our reorganization as a “C” corporation on August 6, 2003, we operated as a limited liability company and all income taxes were paid by the members.

Note 10.     Comprehensive Income

      Comprehensive income for the three and six months ended June 30, 2004 and 2003 was as follows:

                                 
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




($ in thousands)
Net income
  $ 27,860     $ 28,573     $ 51,759     $ 46,865  
Unrealized (loss) gain on available for sale security, net of tax in 2004
    (1,060 )     (145 )     (1,179 )     83  
Unrealized loss on cash flow hedges, net of tax in 2004
    (32 )           (120 )      
     
     
     
     
 
Comprehensive income
  $ 26,768     $ 28,428     $ 50,460     $ 46,948  
     
     
     
     
 

20


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 11.     Net Income per Share

      The computation of basic and diluted net income per share for the three and six months ended June 30, 2004 and 2003 was as follows:

                                   
Three Months Ended June 30, Six Months Ended June 30,


2004 2003 2004 2003




Basic net income per share:
                               
Net income
  $ 27,860     $ 28,573     $ 51,759     $ 46,865  
Average shares — basic
    115,770,083       98,100,029       116,274,840       98,082,562  
Basic net income per share
  $ 0.24     $ 0.29     $ 0.45     $ 0.48  
     
     
     
     
 
Diluted net income per share:
                               
Net income
  $ 27,860     $ 28,573     $ 51,759     $ 46,865  
Average shares — basic
    115,770,083       98,100,029       116,274,840       98,082,562  
Effect of dilutive securities:
                               
 
Option shares and unvested restricted stock
    1,533,041       1,812,837       1,541,518       1,823,930  
 
Convertible debt(1)
                       
 
Call option
                       
     
     
     
     
 
Average shares — diluted
    117,303,124       99,912,866       117,816,358       99,906,492  
     
     
     
     
 
Diluted net income per share
  $ 0.24     $ 0.29     $ 0.44     $ 0.47  
     
     
     
     
 


(1)  See Note 3 for discussion of the recently proposed accounting guidance with respect to Contingent Convertibles and the potential impact of the proposed guidance on our reported diluted earnings per share.

Note 12.     Stock-Based Compensation

      We account for our stock-based compensation plan under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations. In accordance with APB 25, compensation cost is recognized for our options and restricted stock granted to employees where the exercise price is less than the market price of the underlying common stock on the date of grant. Such expense is recognized on a ratable basis over the related vesting period of the award. The effect on net income and net income per share as if we had applied the fair

21


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based compensation for the three and six months ended June 30, 2004 and 2003 was as follows:

                                   
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




Net income as reported
  $ 27,860     $ 28,573     $ 51,759     $ 46,865  
Add back: Stock-based compensation expense from options included in reported net income, net of tax in 2004
    35       103       69       142  
Deduct: Stock-based compensation expense determined under fair value-based method for all option awards, net of tax in 2004
    (477 )     (411 )     (811 )     (694 )
     
     
     
     
 
Pro forma net income
  $ 27,418     $ 28,265     $ 51,017     $ 46,313  
     
     
     
     
 
Net income per share:
                               
 
Basic — as reported
  $ 0.24     $ 0.29     $ 0.45     $ 0.48  
     
     
     
     
 
 
Basic — pro forma
  $ 0.24     $ 0.29     $ 0.44     $ 0.47  
     
     
     
     
 
 
Diluted — as reported
  $ 0.24     $ 0.29     $ 0.44     $ 0.47  
     
     
     
     
 
 
Diluted — pro forma
  $ 0.23     $ 0.28     $ 0.43     $ 0.46  
     
     
     
     
 

      The fair value of each option grant was estimated on the date of the grant using the Black-Scholes option-pricing model with weighted-average assumptions for the three and six months ended June 30, 2004 and 2003 as follows:

                                 
Three Months Ended Six Months Ended
June 30, June 30,


2004 2003 2004 2003




Dividend yield
                       
Expected volatility
    32 %     30 %     32 %     30 %
Risk-free interest rate
    3.95 %     3.02 %     3.61 %     3.02 %
Expected life
    6 years       6 years       6 years       6 years  

      The pro forma net effect of the total stock-based compensation expense determined under fair value-based method for all awards may not be representative of future disclosures because the estimated fair value of options is amortized to expense over the vesting period, and additional options may be granted in future years.

Note 13.     Commitments and Contingencies

      As of June 30, 2004, we had arranged for $74.5 million of standby letters of credit in conjunction with certain loans to our borrowers. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be responsible to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. In accordance with FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, we included the fair value of these obligations, totaling $1.4 million, in the consolidated balance sheet as of June 30, 2004.

      From time to time we are party to legal proceedings. We do not believe that currently any 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.

22


 

CAPITALSOURCE INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 14.     Subsequent Events

     Acquisition

      In July 2004, we acquired the outstanding equity of CIG International, LLC and CIG Holdings, Inc. (collectively, “CIG”), a Washington, D.C.-based specialty lender that provides mezzanine debt financing to the for-sale residential real estate development industry, for approximately $97.5 million in cash, which represents a $1.8 million premium to the estimated historical book value of CIG at the date of acquisition.

     Convertible Debt

      In July 2004, we completed an offering of $330.0 million principal amount of 3.5% senior convertible debentures due 2034 (the “Debentures”) in a private offering pursuant to Rule 144A under the Securities Act of 1933, as amended. The Debentures will also pay contingent interest, subject to certain limitations as described in the offering memorandum, beginning on July 15, 2011. The Debentures are initially convertible, subject to certain conditions, into shares of our common stock at a conversion rate of 31.4614 shares of common stock per $1,000 principal amount of Debentures, representing an initial effective conversion price of approximately $31.78 per share. The Debentures will be redeemable for cash at our option at any time on or after July 15, 2011 at a redemption price of 100% of their principal amount plus accrued interest. Holders of the Debentures will have the right to require us to repurchase some or all of their Debentures for cash on July 15, 2011; July 15, 2014; July 15, 2019; July 15, 2024 and July 15, 2029 at a price of 100% of their principal amount plus accrued interest. Holders of the Debentures will also have the right to require us to repurchase some or all of their Debentures upon certain events constituting a fundamental change. The Debentures are unsecured and unsubordinated obligations, and are guaranteed by CapitalSource Holdings and CapitalSource Finance, two of our wholly owned subsidiaries.

      We received net proceeds from the offering of approximately $321.4 million, after deducting the initial purchasers’ discounts and commissions and estimated expenses of approximately $8.6 million. We used the net proceeds from this offering to repay outstanding indebtedness under our credit facilities and for other general corporate purposes.

23


 

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

FORWARD-LOOKING STATEMENTS AND PROJECTIONS

      This Form 10-Q, including the footnotes to our unaudited consolidated financial statements included herein, contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that may cause our clients’ or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievement expressed or implied by these forward-looking statements. More detailed information about these factors is contained herein in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in our Form 10-K as filed with the Securities and Exchange Commission on March 12, 2004.

      The forward-looking statements made in this Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

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

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 financing. We conduct our business in one reportable segment through three focused lending groups:

  •  Corporate Finance, which generally provides senior and mezzanine loans principally to businesses backed by private equity sponsors;
 
  •  HealthCare Finance, which generally provides asset-based revolving lines of credit, first mortgage loans, equipment financing and other senior and mezzanine loans to a broad range of healthcare companies; and
 
  •  Structured Finance, which generally provides 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 generally range in size from $1 million to $50 million, with an average loan size as of June 30, 2004 of $6.2 million. Substantially 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. Consequently, as interest rates rise, our interest income on these loans will not increase until the contractual interest rates exceed the level of the floor. As of June 30, 2004, $2.6 billion, or 79%, of the aggregate outstanding principal amount of our loan portfolio had interest rate floors. Of this amount, $114.0 million of loans had contractual rates of interest exceeding the interest rate floor, $698.9 million of loans had contractual rates of interest at the interest rate floor, and $1.8 billion of loans had contractual rates of interest below 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, gains (losses) on the sale of

24


 

warrants and other equity interests, gains (losses) on derivatives, third-party loan servicing income, income from fee generating business and deposits forfeited by our borrowers. Our expenses consist principally of interest expense and operating expenses which include compensation and employee benefits and other administrative expenses.

      The primary driver of our results of operations and financial condition has been our significant growth since our inception on September 7, 2000. Our interest earning assets, which consist primarily of loans, grew to $3.5 billion as of June 30, 2004, an increase of 35% from $2.6 billion as of December 31, 2003, and generated a gross yield of 11.39% for the six months ended June 30, 2004.

      We have been able to manage our significant growth since inception without material adverse effects on the credit quality of our portfolio. We have established an allowance for loan losses consistent with our expectation of losses inherent in our portfolio. As of June 30, 2004, none of our loans was 60 or more days delinquent. As of June 30, 2004, loans with an aggregate net principal balance of $32.5 million were on non-accrual status.

      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 credit facilities, term debt, convertible debt, repurchase agreements, $511.0 million of equity capital raised from private investors, $241.6 million of equity from our initial public offering and retained earnings. The weighted average interest cost of our borrowings for the six months ended June 30, 2004 was 2.84%. All of our term debt transactions have been accounted for as on balance sheet financings with no gain or loss recorded on the transactions. As of June 30, 2004, our debt to equity ratio was 3.04x. Our ability to continue to grow depends to a large extent on our ability to continue to borrow from our lenders and our access to the debt capital markets. To the extent these markets were to suffer from prolonged disruptions, our ability to finance continued growth could be hampered. 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 have continued to make these investments. We believe our expenses generally will continue to decrease as a percentage of our average total assets as we continue to monitor our operating expenses and spread these expenses over a growing portfolio of loans. For the six months ended June 30, 2004, the ratio of our operating expenses to average total assets was 3.38%, down from 3.58% for the six months ended June 30, 2003.

     Portfolio Composition

      The schedule below shows the number of loans, average loan size, number of clients and average loan size per client by lending group as of June 30, 2004:

                                   
Number Average Loan Size
Number of Loans Average Loan Size of Clients Per Client




($ in thousands)
Composition of portfolio by lending group:
                               
 
Corporate Finance
    186     $ 8,381       89     $ 17,516  
 
HealthCare Finance
    182       4,062       140       5,280  
 
Structured Finance
    162       6,189       151       6,640  
     
             
         
Overall portfolio
    530       6,228       380       8,687  
     
             
         

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      The schedule below shows the composition of our loan portfolio by type and by lending group as of June 30, 2004 and December 31, 2003:

                                   
June 30, 2004 December 31, 2003


($ in thousands)
Composition of portfolio by loan type:
                               
 
Senior secured asset-based loans
  $ 956,676       29 %   $ 802,115       33 %
 
Senior secured cash flow loans
    1,359,584       41       832,871       35  
 
First mortgage loans
    826,114       25       677,404       28  
 
Mezzanine loans
    158,498       5       104,517       4  
     
     
     
     
 
Total
  $ 3,300,872       100 %   $ 2,416,907       100 %
     
     
     
     
 
Composition of portfolio by lending group:
                               
 
Corporate Finance
  $ 1,558,952       47 %   $ 972,105       40 %
 
HealthCare Finance
    739,260       23       656,671       27  
 
Structured Finance
    1,002,660       30       788,131       33  
     
     
     
     
 
Total
  $ 3,300,872       100 %   $ 2,416,907       100 %
     
     
     
     
 

      The schedule below shows the scheduled maturities of our loans as of June 30, 2004:

                                   
Due in Due in One
One Year to Five Due After
Or Less Years Five Years Total




($ in thousands)
Scheduled maturities by loan type:
                               
 
Senior secured asset-based loans
  $ 259,436     $ 694,875     $ 2,365     $ 956,676  
 
Senior secured cash flow loans
    162,491       1,145,372       51,721       1,359,584  
 
First mortgage loans
    149,468       675,321       1,325       826,114  
 
Mezzanine loans
    29,975       108,065       20,458       158,498  
     
     
     
     
 
Total
  $ 601,370     $ 2,623,633     $ 75,869     $ 3,300,872  
     
     
     
     
 

      The schedule below shows the dollar amount of all fixed-rate and adjustable-rate loans as of June 30, 2004:

                           
Fixed Rates Adjustable Rates Total



($ in thousands)
Composition of portfolio by loan type:
                       
 
Senior secured asset-based loans
  $ 24,442     $ 932,234     $ 956,676  
 
Senior secured cash flow loans
    24,177       1,335,407       1,359,584  
 
First mortgage loans
    18,645       807,469       826,114  
 
Mezzanine loans
    19,272       139,226       158,498  
     
     
     
 
Total
  $ 86,536     $ 3,214,336     $ 3,300,872  
     
     
     
 

      We also invest in equity interests, often in connection with a loan to a client. The equity interests include common stock, preferred stock, limited liability company interests, limited partnership interests and warrants to purchase equity instruments. As of June 30, 2004 and December 31, 2003, the carrying value of investments was $42.2 million and $39.8 million, respectively. As of June 30, 2004, investments totaling $5.7 million are carried at fair value with increases and decreases recorded in other income (expense).

      As of June 30, 2004, we are committed to contribute $13.4 million of additional capital to eight private equity funds.

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     Interest and Fee Income

      Interest and fee income represents commercial loan interest and net fee income earned from our commercial loan operations. Substantially all of our loans charge interest at variable rates that generally adjust monthly. Loans representing approximately 79% of the aggregate outstanding balance of our loan portfolio as of June 30, 2004 have interest rate floors, which protect us from an erosion of earnings in a declining interest rate environment. As interest rates rise, our interest income on loans with interest rate floors will not increase until the contractual interest rates exceed the level of the floors. Fee income includes the amortization of loan origination fees, net of the direct costs of origination, amortization of original issue discount, the amortization of the discount on loans acquired, and other fees charged to borrowers. Loan prepayments may materially affect fee income since, in the period of prepayment, the amortization of remaining net loan origination fees and discounts is accelerated and additional prepayment penalties may be assessed on the prepaid loans.

     Interest Expense

      Interest expense is the amount paid on borrowings, including the amortization of deferred financing fees. With the exception of our convertible debt, which pays a fixed rate, all of our borrowings charge interest at variable rates based on LIBOR or commercial paper rates plus a margin. As our borrowings increase and as interest rates rise, our interest expense will increase. Deferred financing fees and the costs of acquiring debt, such as commitment fees and legal fees, are amortized over the shorter of either the first call period or the contractual maturity of the borrowing. Loan prepayments may materially affect interest expense since in the period of prepayment the amortization of remaining deferred financing fees and debt acquisition costs is accelerated.

     Provision for Loan Losses

      The provision for loan losses is the periodic cost of maintaining an appropriate allowance for loan losses inherent in our portfolio. As the size of our portfolio increases, or if the credit quality of the portfolio declines, we record a provision to increase the allowance for loan losses.

     Operating Expenses

      Operating expenses include compensation and benefits, professional fees, travel, rent, insurance, depreciation and amortization, marketing and other general and administrative expenses.

     Other Income (Expense)

      Other income (expense) consists of gains (losses) on the sale of warrants and other equity interests, unrealized appreciation (depreciation) on certain equity interests, gains (losses) on derivatives, due diligence deposits forfeited, fees associated with HUD origination activities, third-party servicing income, and other miscellaneous fees not attributable to our loan operations.

     Income Taxes

      We were originally organized as a limited liability company. During the period that we were organized as a limited liability company, all income taxes were the responsibility of our individual members; therefore, our historical consolidated statements of income do not include any provision for income taxes. Since our reorganization into a “C” corporation for income tax purposes in August 2003, we are responsible for paying federal, state and local income taxes. Deferred tax liabilities and assets have been reflected in the consolidated balance sheets. Deferred tax liabilities and assets are determined based on the differences between the book value and the tax basis of particular assets and liabilities, using tax rates scheduled to be in effect for the years in which the differences are expected to reverse.

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     Segment Reporting

      Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information, requires that a public business enterprise report financial and descriptive information about its reportable operating segments including a measure of segment profit or loss, certain specific revenue and expense items, and segment assets.

      We operate as a single business segment and, therefore, this statement is not applicable. Because our clients require customized and sophisticated debt financing, we have created three lending groups to develop the industry experience required to structure loans that reflect the particular credit and security characteristics required by different types of clients. However, we manage our lending business as a whole rather than by lending group. For example:

  •  To date, our resources have been sufficient to support our lending business. We obtain resources for the benefit of the entire company and do not allocate resources to specific lending groups based on their individual or relative performance. We fund all of our loans from common funding sources.
 
  •  We have established common loan origination, credit underwriting, credit approval, and loan monitoring processes, which are used by all lending groups.
 
  •  We do not factor the identity of the lending group originating a loan into our decision as to whether to fund proposed loans. Rather, we fund every loan that is approved by our credit committee and is acceptable to our customers, and we expect this trend to continue.

RESULTS OF OPERATIONS

      Our results of operations are driven primarily by our rapid growth since inception. The most significant factors influencing our results of operations for the periods described in this section were:

  •  Significant growth in average interest earning assets;
 
  •  Increased borrowings to fund our growth;
 
  •  Increased provision for loan losses as our portfolio continues to grow and become more seasoned; and
 
  •  Increased operating expenses, consisting primarily of higher employee compensation directly related to increases in the number of employees necessary to originate and manage our loan portfolio.

Comparison of the Three Months Ended June 30, 2004 and 2003

     Interest Income

      Interest income was $71.7 million for the three months ended June 30, 2004, an increase of $30.8 million, or 75%, from $40.9 million for the three months ended June 30, 2003. The increase was due to growth in average interest earning assets of $1.5 billion, or 82%, offset by a decrease in the yield on average interest earning assets of 32 basis points.

     Fee Income

      Fee income was $15.3 million for the three months ended June 30, 2004, an increase of $2.5 million, or 20%, from $12.8 million for the three months ended June 30, 2003. The increase was due to the recognition of fee income associated with the accelerated amortization of deferred net origination fees and loan discounts and prepayment fees from loans that prepaid and the overall growth in interest earning assets.

     Interest Expense

      Interest expense was $16.3 million for the three months ended June 30, 2004, an increase of $6.2 million, or 61%, from $10.1 million for the three months ended June 30, 2003. The increase was due to an increase in average borrowings of $1.2 billion, or 97%, to fund growth in interest earning assets and an increase in our debt

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to equity ratio to 3.04x as of June 30, 2004 from 2.38x as of June 30, 2003. This increase was partially offset by a decrease in our cost of borrowings of 59 basis points to 2.74% for the three months ended June 30, 2004 from 3.33% for the three months ended June 30, 2003. This decrease was primarily the result of funding of our portfolio growth with lower cost sources of capital.

     Net Interest Margin

      Net interest margin, defined as net interest income divided by average interest earning assets, was 8.73% for the three months ended June 30, 2004, a decrease of 107 basis points from 9.80% for the three months ended June 30, 2003. The decrease in net interest margin was due to the decrease in yield from prepayment-related fee income, the effect of higher leverage, and lower yield from interest income, partially offset by the decrease in cost of funds. Net interest spread, the difference between our gross yield on interest earning assets and the total cost of our interest bearing liabilities, was 8.01% for the three months ended June 30, 2004, a decrease of 72 basis points from 8.73% for the three months ended June 30, 2003. Gross yield is the sum of interest and fee income divided by our average interest earning assets. The decrease in net interest spread is attributable to the changes in its components as described above.

      The yield and cost of interest earning assets and interest bearing liabilities for the three months ended June 30, 2004 and 2003 were as follows:

                                                   
Three Months Ended June 30,

2004 2003


($ in thousands)
Interest and Interest and
Weighted Fee Income/ Average Weighted Fee Income/ Average
Average Interest Yield/ Average Interest Yield/
Balance Expense Cost Balance Expense Cost






Interest earning assets:
                                               
 
Interest income
          $ 71,718       8.86 %           $ 40,944       9.18 %
 
Fee income
            15,262       1.89               12,836       2.88  
             
     
             
     
 
Total interest earning assets(1)
  $ 3,255,972       86,980       10.75     $ 1,789,527       53,780       12.06  
Total interest bearing liabilities(2)
    2,385,912       16,275       2.74       1,211,057       10,065       3.33  
             
     
             
     
 
Net interest spread
          $ 70,705       8.01 %           $ 43,715       8.73 %
             
     
             
     
 
Net interest margin (net yield on interest earning assets)
                    8.73 %                     9.80 %
                     
                     
 


(1)  Interest earning assets include cash, restricted cash and gross loans.
 
(2)  Interest bearing liabilities include repurchase agreements, credit facilities, term debt and convertible debt.

     Provision for Loan Losses

      The provision for loan losses increased to $5.1 million for the three months ended June 30, 2004 from $2.1 million for the three months ended June 30, 2003. The increase in the provision reflected the growth and seasoning of the portfolio. As of June 30, 2004, none of our loans was 60 or more days delinquent. As of December 31, 2003, loans with an aggregate net principal balance of $4.3 million were 60 or more days delinquent. Additionally, as of June 30, 2004 and December 31, 2003, loans with an aggregate net principal balance of $32.5 million and $8.8 million, respectively, were on non-accrual status. During the three months ended June 30, 2004 and 2003, we recorded specific reserves of $0.6 million and $0.3 million, respectively, for loans which we considered to be impaired. We consider a loan to be impaired when, based on current information, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement, including principal and scheduled interest payments. During the three months ended

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June 30, 2004, we charged off loans totaling $3.4 million. No loans were charged off during the three months ended June 30, 2003.

     Operating Expenses

      Operating expenses were $27.6 million for the three months ended June 30, 2004, an increase of $12.6 million, or 84%, from $15.0 million for the three months ended June 30, 2003. Contributing to the increase was greater employee compensation, which increased $6.5 million, or 61%. The greater employee compensation was attributable to the increase in employees to 364 as of June 30, 2004 from 239 as of June 30, 2003. A significant portion of the employee compensation comprises annual bonuses, which we accrue throughout the year. For the three months ended June 30, 2004 and 2003, bonus expense totaled $7.0 million and $4.6 million, respectively. The remaining $6.1 million increase in operating expenses for the three months ended June 30, 2004 was attributable to an increase of $2.3 million in professional fees, $0.8 million in travel and entertainment expense, $0.7 million in insurance, $0.6 million in rent, and $1.7 million in other general business expenses.

      Due to the increase in operating expenses as described above, operating expenses as a percentage of average total assets increased to 3.40% for the three months ended June 30, 2004 from 3.37% for the three months ended June 30, 2003. Our efficiency ratio, which represents operating expenses as a percentage of our net interest and fee income and other income, increased to 35.5% for the three months ended June 30, 2004 from 32.9% for the three months ended June 30, 2003.

     Other Income

      Other income was $6.9 million for the three months ended June 30, 2004, an increase of $5.0 million, or 263%, from $1.9 million for the three months ended June 30, 2003. The increase in other income was the result of a $2.7 million increase in income generated by our mortgage finance subsidiary to $3.4 million for the three months ended June 30, 2004 from $0.7 million for the three months ended June 30, 2003, a $1.1 million increase in diligence deposits forfeited to $2.0 million for the three months ended June 30, 2004 from $0.9 million for the three months ended June 30, 2003, an addition of $1.1 million of third-party loan servicing income in the second quarter 2004, and a $0.9 million increase in gain on derivatives to $0.3 million for the three months ended June 30, 2004 from $(0.6) million for the three months ended June 30, 2003. Partially offsetting the increase in other income was a $0.7 million decrease in gain on investments to $0.2 million for the three months ended June 30, 2004 compared with $0.9 million for the three months ended June 30, 2003.

     Income Taxes

      We provided for income taxes on the income earned subsequent to August 7, 2003 based on a 38% effective tax rate. Prior to our reorganization as a “C” corporation on August 6, 2003, we operated as a limited liability company and all income taxes were paid by the members. At the reorganization date, we recorded a $4.0 million net deferred tax asset and corresponding deferred tax benefit which lowered the effective tax rate. Our effective tax rate for the three months ended June 30, 2004 and 2003 was 38% and 0%, respectively.

Comparison of the Six Months Ended June 30, 2004 and 2003

     Interest Income

      Interest income was $132.0 million for the six months ended June 30, 2004, an increase of $58.0 million, or 78%, from $74.0 million for the six months ended June 30, 2003. The increase was due to growth in average interest earning assets of $1.4 billion, or 87%, offset by a decrease in the yield on average interest earning assets of 45 basis points.

     Fee Income

      Fee income was $35.8 million for the six months ended June 30, 2004, an increase of $15.7 million, or 78%, from $20.1 million for the six months ended June 30, 2003. The increase was due to the recognition of

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fee income associated with the accelerated amortization of deferred net origination fees and loan discounts and prepayment fees from loans that prepaid and the overall growth in interest earning assets.

     Interest Expense

      Interest expense was $29.4 million for the six months ended June 30, 2004, an increase of $12.3 million, or 72%, from $17.1 million for the six months ended June 30, 2003. The increase was due to an increase in average borrowings of $1.1 billion, or 102%, to fund growth in interest earning assets and an increase in our debt to equity ratio to 3.04x as of June 30, 2004 from 2.38x as of June 30, 2003. This increase was partially offset by a decrease in our cost of borrowings of 51 basis points to 2.84% for the six months ended June 30, 2004 from 3.35% for the six months ended June 30, 2003. This decrease was primarily the result of funding our portfolio growth with lower cost sources of capital.

     Net Interest Margin

      Net interest margin, defined as net interest income divided by average interest earning assets, was 9.40% for the six months ended June 30, 2004, a decrease of 39 basis points from 9.79% for the six months ended June 30, 2003. The decrease in net interest margin was due to the decrease in prepayment-related fee income, lower yield from interest income, and the effect of higher leverage, partially offset by the decrease in cost of funds. Net interest spread, the difference between our gross yield on interest earning assets and the total cost of our interest bearing liabilities, was 8.55% for the six months ended June 30, 2004, a decrease of 7 basis points from 8.62% for the six months ended June 30, 2003. Gross yield is the sum of interest and fee income divided by our average interest earning assets. The decrease in net interest spread is attributable to the changes in its components as described above.

      The yield and cost of interest earning assets and interest bearing liabilities for the six months ended June 30, 2004 and 2003 were as follows:

                                                   
Six Months Ended June 30,

2004 2003


($ in thousands)
Interest and Interest and
Weighted Fee Income/ Average Weighted Fee Income/ Average
Average Interest Yield/ Average Interest Yield/
Balance Expense Cost Balance Expense Cost






Interest earning assets:
                                               
 
Interest income
          $ 131,981       8.96 %           $ 74,037       9.41 %
 
Fee income
            35,838       2.43               20,132       2.56  
             
     
             
     
 
Total interest earning assets(1)
  $ 2,962,201       167,819       11.39     $ 1,587,317       94,169       11.97  
Total interest bearing liabilities(2)
    2,081,201       29,374       2.84       1,028,204       17,105       3.35  
             
     
             
     
 
Net interest spread
          $ 138,445       8.55 %           $ 77,064       8.62 %
             
     
             
     
 
Net interest margin (net yield on interest earning assets)
                    9.40 %                     9.79 %
                     
                     
 


(1)  Interest earning assets include cash, restricted cash and gross loans.
 
(2)  Interest bearing liabilities include repurchase agreements, credit facilities, term debt and convertible debt.

     Provision for Loan Losses

      The provision for loan losses increased to $12.4 million for the six months ended June 30, 2004 from $4.8 million for the six months ended June 30, 2003. The increase in the provision reflected the growth and seasoning of the portfolio. As of June 30, 2004, none of our loans was 60 or more days delinquent. As of

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December 31, 2003, loans with an aggregate net principal balance of $4.3 million were 60 or more days delinquent. Additionally, as of June 30, 2004 and December 31, 2003, loans with an aggregate net principal balance of $32.5 million and $8.8 million, respectively, were on non-accrual status. During the six months ended June 30, 2004 and 2003, we recorded specific reserves of $3.7 million and $0.3 million, respectively, for loans which we considered to be impaired. We consider a loan to be impaired when, based on current information, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement, including principal and scheduled interest payments. During the six months ended June 30, 2004, we charged off loans totaling $5.7 million. No loans were charged off during the six months ended June 30, 2003.

     Operating Expenses

      Operating expenses were $49.8 million for the six months ended June 30, 2004, an increase of $21.6 million, or 77%, from $28.2 million for the six months ended June 30, 2003. Contributing to the increase was greater employee compensation, which increased $12.9 million, or 68%. The greater employee compensation was attributable to the increase in employees to 364 as of June 30, 2004 from 239 as of June 30, 2003. A significant portion of the employee compensation comprises annual bonuses, which we accrue throughout the year. For the six months ended June 30, 2004 and 2003, bonus expense totaled $12.5 million and $8.6 million, respectively. The remaining $8.7 million increase in operating expenses for the six months ended June 30, 2004 was attributable to an increase of $3.1 million in professional fees, $1.4 million in insurance, $1.3 million in travel and entertainment expenses, $1.1 million in rent, and $1.8 million in other general business expenses.

      Operating expenses as a percentage of average total assets decreased to 3.38% for the six months ended June 30, 2004 from 3.58% for the six months ended June 30, 2003. Our efficiency ratio, which represents operating expenses as a percentage of our net interest and fee income and other income, decreased to 34.2% for the six months ended June 30, 2004 from 35.3% for the six months ended June 30, 2003.

     Other Income

      Other income was $7.3 million for the six months ended June 30, 2004, an increase of $4.5 million, or 161%, from $2.8 million for the six months ended June 30, 2003. The increase in other income was the result of a $2.6 million increase in income generated by our mortgage finance subsidiary to $3.6 million for the three months ended June 30, 2004 from $1.0 million for the six months ended June 30, 2003, a $1.1 million increase in diligence deposits forfeited to $3.1 million for the six months ended June 30, 2004 from $2.0 million for the six months ended June 30, 2003, an addition of $1.1 million of third-party loan servicing income in the second quarter 2004, and a $0.2 million decrease in loss on derivatives. Partially offsetting the increase in other income was a $0.1 million decrease in income from investments.

     Income Taxes

      We provided for income taxes on the income earned subsequent to August 7, 2003 based on a 38% effective tax rate. Prior to our reorganization as a “C” corporation on August 6, 2003, we operated as a limited liability company and all income taxes were paid by the members. At the reorganization date, we recorded a $4.0 million net deferred tax asset and corresponding deferred tax benefit which lowered the effective tax rate. Our effective tax rate for the six months ended June 30, 2004 and 2003 was 38% and 0%, respectively.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

     Cash and Cash Equivalents

      As of June 30, 2004 and December 31, 2003, we had $171.6 million and $69.9 million, respectively, in cash and cash equivalents. The increase in cash as of June 30, 2004 was largely attributable to significant loan collections at the end of June 2004. We invest cash on hand in short-term liquid investments. Our objective is to maintain a low cash balance to avoid negative arbitrage. We generally fund new loan originations and growth in revolving loan balances using advances under our credit facilities.

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      We had $54.6 million and $79.9 million of restricted cash as of June 30, 2004 and December 31, 2003, respectively. The restricted cash represents interest collections on loans collateralizing our credit facilities, collateral for letters of credit issued for the benefit of clients, principal and interest collections on loans collateralizing our term debt, and client holdbacks and escrows. Interest rate swap payments, interest payable and servicing fees are deducted from the monthly interest collections funded by loans collateralizing our credit facilities and term debt, and the remaining restricted cash is returned to us and becomes unrestricted at that time.

     Asset Quality and Allowance for Loan Losses

      As of June 30, 2004, none of our loans was 60 or more days delinquent. As of December 31, 2003, loans with an aggregate net principal balance of $4.3 million were 60 or more days delinquent. As of June 30, 2004 and December 31, 2003, loans with an aggregate net principal balance of $32.5 million and $8.8 million, respectively, were on non-accrual status. As of June 30, 2004 and December 31, 2003, the net principal balance of impaired loans, as defined by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, totaled $24.5 million and $15.3 million, respectively. As of June 30, 2004 and December 31, 2003 specific reserves for the impaired loans were $0.6 million and $2.7 million, respectively. For the six months ended June 30, 2004, we had no loans that were classified as troubled debt restructurings as defined by SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings. For the year ended December 31, 2003, loans with a carrying value of $36.3 million as of December 31, 2003 were classified as troubled debt restructurings.

      We have provided an allowance for loan losses to cover estimated losses inherent in the loan portfolio. Our allowance for loan losses as of June 30, 2004 and December 31, 2003 was $24.8 million and $18.0 million, respectively. These amounts equate to 0.75% of loans as of both June 30, 2004 and December 31, 2003. As of June 30, 2004 and December 31, 2003, $0.6 million and $2.7 million, respectively, of allowance for loan losses related to specific reserves. During the six months ended June 30, 2004, we charged off loans totaling $5.7 million. Middle market lending involves a certain degree of credit risk which we believe will result in credit losses in our portfolio.

      Activity in the allowance for loan losses for the six months ended June 30, 2004 and 2003 was as follows:

                 
Six Months Ended
June 30,

2004 2003


($ in thousands)
Balance as of beginning of period
  $ 18,025     $ 6,688  
Provision for loan losses
    12,406       4,774  
Charge offs
    (5,656 )      
     
     
 
Balance as of end of period
  $ 24,775     $ 11,462  
     
     
 

     Investments

      As of June 30, 2004 and December 31, 2003, we had $42.2 million and $39.8 million, respectively, in investments. This increase resulted from $15.4 million in additional investments, offset by $10.6 million from sales of investments and return of capital and the recognition of $2.4 million in unrealized losses on our investments.

     Borrowings and Liquidity

      As of June 30, 2004 and December 31, 2003, we had outstanding borrowings totaling $2.6 billion and $1.7 billion, respectively. Borrowings under our various credit facilities, term debt, convertible debt and repurchase agreements have supported our loan growth. For a detailed discussion of our borrowings, see Note 8, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2003 included in our Form 10-K, as filed with the SEC on March 12, 2004 and Note 4, Borrowings, in our unaudited consolidated financial statements for the three and six months ended June 30, 2004.

33


 

      As of June 30, 2004, our funding sources, maximum facility amounts, amounts outstanding, and unused available commitments, subject to certain minimum equity requirements and other covenants and conditions, were as follows:

                         
Maximum Amounts Unused
Funding Source Facility Amount Outstanding(1) Capacity




($ in thousands)
Repurchase agreements(2)
  $ 300,000     $ 666     $ 300,000  
Credit facilities
    1,660,000       948,578       711,422  
Term debt(3)
    2,065,075       1,459,655        
Convertible debt(3)
    225,000       225,789        
             
     
 
Total
          $ 2,634,688     $ 1,011,422  
             
     
 


(1)  Amounts outstanding include accrued interest and interest rate swaps.
 
(2)  Amounts outstanding include borrowings under repurchase obligations that have no maximum facility amount.
 
(3)  Our term and convertible debt are one-time fundings without providing any ability for us to draw down additional amounts.

      The following changes to our borrowings have occurred since March 31, 2004:

     Repurchase Agreements

      During the three months ended June 30, 2004, we terminated our repurchase agreement with Citigroup Global Markets Inc (“Citigroup”). All amounts outstanding under this repurchase agreement were repaid.

     Credit Facilities

      In April 2004, we amended our $115.0 million credit facility with Wachovia to reduce the maximum facility amount of the facility to $100.0 million. Availability under the facility depends on our borrowing base, which is calculated based on the outstanding principal amount of eligible loans in the facility combined with specified portfolio concentration criteria. In connection with the amendment, the maximum advance rate under this facility was increased to 80% of our borrowing base. In addition, we extended the maturity to April 7, 2006 and gained the ability to pledge certain types of new loans to the facility. Interest on borrowings under the facility was reduced to the commercial paper rate plus 0.90%.

      In April 2004, we entered into a new $400.0 million credit facility with Wachovia to finance our loans. Funding under this facility is obtained through a single-purpose, bankruptcy-remote subsidiary, CapitalSource Funding III LLC. The credit facility permits us to obtain financing of up to 85% of the outstanding principal balance of commercial loans we originate and transfer to this facility, depending upon their current loan rating and priority of payment within the particular borrower’s capital structure and subject to certain concentration limits. Interest on borrowings under the facility is charged at the commercial paper rate, plus 0.90%. This credit facility is scheduled to expire in April 2007.

      In May 2004, we amended our $700.0 million credit facility to modify specific terms, appoint Harris Nesbitt Corp. as the new administrative agent and change the lenders participating in the facility. Availability under the facility depends on our borrowing base, which is calculated based on the outstanding principal amount of eligible loans in the facility combined with specified portfolio concentration criteria. In connection with the amendment, the maximum advance rate under this facility was increased to 75% of our borrowing base. Interest on borrowings under the facility was reduced to the commercial paper rate, as defined by each lender, plus 0.975%. This credit facility is scheduled to mature on May 24, 2007 and may be renewed annually at the option of our lenders.

      In June 2004, the capacity under our credit facility with Citigroup was increased to $460.0 million from $400.0 million.

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     Convertible Debt

      In July 2004, we completed an offering of $330.0 million principal amount of 3.5% senior convertible debentures due 2034 (the “Debentures”) in a private offering pursuant to Rule 144A under the Securities Act of 1933, as amended. The Debentures will also pay contingent interest, subject to certain limitations as described in the offering memorandum, beginning on July 15, 2011. The Debentures are initially convertible, subject to certain conditions, into shares of our common stock at a conversion rate of 31.4614 shares of common stock per $1,000 principal amount of Debentures, representing an initial effective conversion price of approximately $31.78 per share. The Debentures will be redeemable for cash at our option at any time on or after July 15, 2011 at a redemption price of 100% of their principal amount plus accrued interest. Holders of the Debentures will have the right to require us to repurchase some or all of their Debentures for cash on July 15, 2011; July 15, 2014; July 15, 2019; July 15, 2024 and July 15, 2029 at a price of 100% of their principal amount plus accrued interest. Holders of the Debentures will also have the right to require us to repurchase some or all of their Debentures upon certain events constituting a fundamental change. As discussed in Note 6, Borrowings, of our unaudited consolidated financial statements for the three and six months ended June 30, 2004, the Debentures are unsecured and unsubordinated obligations, and are guaranteed by two of our wholly owned subsidiaries.

      We have agreed to file a shelf registration statement with respect to the resale of the Debentures and the common stock issuable upon the conversion of the Debentures with the Securities and Exchange Commission within 90 days from the initial issuance of the Debentures. We will use our best efforts to cause the shelf registration statement to be declared effective no later than 180 days after the initial issuance of the Debentures. In the event that these conditions are not met, we are obligated to pay liquidated damages to the holders of the Debentures.

     Term Debt

      In June 2004, we completed an $875.0 million term debt securitization. In conjunction with the transaction, we established a separate single purpose subsidiary, CapitalSource Commercial Loan Trust 2004-1 (“Trust 2004-1”), and contributed $875.0 million in loans, or portions thereof, to Trust 2004-1. Subject to the satisfaction of certain conditions, we remain servicer of the loans. Simultaneously with the initial contributions, Trust 2004-1 issued $765.6 million of notes to institutional investors. One of our subsidiaries retained $109.4 million in Class E notes and 100% of the Trust’s certificates. The Class A-1, A-2, B, C, and D notes carry an interest rate of one-month LIBOR plus 0.13%, 0.33%, 0.65%, 1.00%, and 1.75%, respectively. The Class A-1 notes are expected to mature on March 20, 2006. The Class A-2, B, C, and D notes are all expected to mature on September 22, 2008. The notes are collateralized by all or portions of specific commercial loans, totaling $841.7 million as of June 30, 2004. We have treated the contribution of the loans to Trust 2004-1 and the related sale of notes by Trust 2004-1 as a financing arrangement under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS No. 140”). As required by the terms of Trust 2004-1, we have entered into interest rate swaps and/ or caps to mitigate certain interest rate risk. As of June 30, 2004, total borrowings outstanding under this term debt transaction were $766.2 million.

      While we view the general structure, leverage and pricing we obtained on this securitization as favorable compared to our previous term debt transactions, the rating agencies imposed limitations on our ability to modify the loans contributed to Trust 2004-1. Concurrently with the imposition of these new limitations, we were also given more flexibility to repurchase modified loans out of Trust 2004-1. Under these new limitations, if we modify a loan in specific ways enumerated in the documents governing Trust 2004-1 and do not repurchase the loan, the modification triggers provisions that would reduce the cash flow from Trust 2004-1 to us as holder of the equity in Trust 2004-1. Because the nature of our loans often requires us to make modifications to them, we expect to exercise our repurchase rights prior to any reduction in cash flow occurring. Consequently, Trust 2004-1 may pay down more rapidly than our other term securitizations.

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     Other Liquidity

      Additional liquidity is provided by our cash flow from operations. For the six months ended June 30, 2004 and 2003 and the year ended December 31, 2003, we generated cash flow from operations of $50.6 million, $42.9 million and $86.8 million, respectively.

      Proceeds from our equity offerings, borrowings on our credit facilities, the issuance of asset-backed notes in our term debt transactions and the issuance of convertible debt provide cash from financing activities. For the six months ended June 30, 2004 and 2003 and the year ended December 31, 2003, we generated cash flow from financing activities of $893.3 million, $709.9 million and $1.3 billion, respectively.

      Investing activities primarily relate to loan origination. For the six months ended June 30, 2004 and 2003 and the year ended December 31, 2003, we used cash in investing activities of $842.1 million, $673.9 million and $1.3 billion, respectively.

      As of June 30, 2004, the amount of our unfunded commitments to extend credit to our clients exceeded our unused funding sources and unrestricted cash by $275.1 million. Our requirement to fund unfunded commitments generally is based on our clients’ ability to provide additional collateral to secure the requested additional fundings, the additional collateral’s satisfaction of eligibility requirements and our clients’ ability to meet certain other preconditions to borrowing. Provided our clients’ additional collateral meets all of the eligibility requirements of our funding sources, we believe that we have sufficient funding capacity to meet short-term needs related to unfunded commitments. If we do not have sufficient funding capacity to satisfy these commitments, our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract liability for us and damage our reputation in the marketplace, which could have a material adverse effect on our business.

      We expect cash from operations, other sources of capital, including additional borrowings on existing and future credit facilities and term debt, to be adequate to support our projected needs for funding our existing loan commitments in the short-term. For the long term, the growth rate of our portfolio and other assets will determine our requirement for additional capital. Continuing to grow our portfolio at the accelerated rate at which it has been growing will require us to raise significant amounts of capital. In addition to continuing to access the secured debt market, we also will explore additional capital market financings should we determine that our growth rate requires us to raise additional capital. This could include the general unsecured debt markets, equity-related securities such as convertible debt or the issuance of common equity. To date in 2004, we have completed two convertible debt offerings which provided us with significant additional liquidity to fund our growth. We cannot assure you, however, that we will have access to any of these funding sources in the future.

     Off Balance Sheet Risk

      Depending on the legal structure of the transaction, term debt transactions may either be accounted for as off balance sheet with a gain or loss on the sale recorded in the statement of income or accounted for as on balance sheet financings. The term debt transactions we completed in May 2002, October 2002, April 2003, November 2003, and June 2004 were all recorded as on balance sheet financings.

      We are subject to off balance sheet risk in the normal course of business primarily from commitments to extend credit. As of June 30, 2004 and December 31, 2003, we had unfunded commitments to extend credit to our clients of $1.5 billion and $1.3 billion, respectively. These commitments are subject to the same underwriting and ongoing portfolio maintenance as the on balance sheet financial instruments we hold.

      We use interest rate swap agreements to hedge fixed-rate and prime rate loans pledged as collateral for our term debt. Our interest rate swap agreements modify our exposure to interest rate risk by converting fixed-rate and prime rate loans to a 30-day LIBOR rate. We enter into interest rate swaps to offset the basis swaps required by our term debt. Additionally, we use interest rate cap agreements to hedge loans with embedded interest rate caps that are pledged as collateral for our term debt. Our interest rate hedging activities partially protect us from the risk that interest collected under fixed-rate and prime rate loans will not be sufficient to service the interest due under the 30-day LIBOR-based term debt. The fair market values of the interest rate

36


 

swap agreements were $(0.9) million and $(1.9) million as of June 30, 2004 and December 31, 2003, respectively. The fair value of the interest rate cap agreements was not significant as of June 30, 2004 and December 31, 2003.

      We are required to enter into interest rate swaps if we have more than $50.0 million of fixed-rate loans collateralizing our multi-bank credit facility. As of June 30, 2004, we had $41.5 million of fixed-rate loans collateralizing the facility. Therefore, as of June 30, 2004, we were not required to enter into fixed-rate interest rate swaps. We may make additional fixed rate loans in the future, which could require us to enter into new interest rate swap agreements.

      For a detailed discussion of our derivatives and off balance sheet financial instruments, see Note 16, Derivatives and Off Balance Sheet Financial Instruments, in our audited consolidated financial statements for the year ended December 31, 2003 included in our Form 10-K, as filed with the SEC on March 12, 2004 and Qualitative and Quantitative Disclosures About Market Risk below.

CRITICAL ACCOUNTING POLICIES

      Our consolidated financial statements are based on the selection and application of critical accounting policies, many of which require management to make estimates and assumptions. The following describes the areas in which judgments are made by our management in the application of our accounting policies that significantly affect our financial condition and results of operations.

     Income Recognition

      Interest and fee income is recorded on an accrual basis to the extent that such amounts are expected to be collected. For amortizing term loans, original issue discounts and loan fees (net of direct costs of origination) are amortized into fee income using a method that approximates the effective interest method over the contractual life of the loan. For revolving lines of credit and non-amortizing term loans, original issue discounts and loan fees (net of direct costs of origination) are amortized into fee income using the straight-line method over the contractual life of the loan. Fees due at maturity are recorded over the contractual life of the loan in accordance with our policy to the extent that such amounts are expected to be collected.

      If a loan is 90 days or more past due, or we expect that the borrower will not be able to service its debt and other obligations, we will place the loan on non-accrual status. When a loan is placed on non-accrual status, interest and fees previously recognized as income but not yet paid is reversed and the recognition of interest and fee income on that loan will stop until factors indicating doubtful collection no longer exist and the loan has been brought current. We will make exceptions to this policy if the loan is well secured and in the process of collection.

      Loan origination fees are deferred and amortized as adjustments to the related loan’s yield over the contractual life of the loan. In certain loan arrangements, we receive warrants or other equity interests from the client as additional origination fees. The clients granting these interests typically are not publicly traded companies. We record the equity interests received at estimated fair value as determined using various valuation models which attempt to estimate the underlying value of the associated entity. These models are then applied to our ownership share factoring in any discounts for transfer restrictions or other terms which impact the value. Any resulting discount on the loan from recordation of warrant and other equity instruments are accreted into income over the term of the loan. If our estimates of value of the equity interests received are not accurate, our income would be misstated.

     Allowance for Loan Loss

      Our allowance for loan losses reflects the aggregate amount of our reserves we have recorded for the loans in our portfolio. Using a proprietary loan reserve matrix, we assign a reserve factor to each loan in the portfolio.

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The reserve factor assigned dictates the percentage of the total outstanding loan balance that we reserve. The actual determination of a given loan’s reserve factor is a function of three elements:

  •  the type of loan, for example, whether the loan is underwritten based on the borrower’s assets, real estate or cash flow;
 
  •  whether the loan is senior or subordinated; and
 
  •  the internal credit rating assigned to the loan.

      For example, riskier types of loans, such as cash flow loans, are assigned higher reserve factors than less risky loans such as asset-based loans. Further, a subordinate loan would generally have a higher reserve factor than a senior loan, and loans with lower internal credit ratings would be assigned reserve factors higher than those with higher internal credit ratings.

      We evaluate the internal credit ratings assigned to loans monthly to reflect the current credit risk of the borrower. The reserve factors are primarily based on historical industry loss statistics adjusted for our own credit experience and economic conditions.

      We also establish specific allowances for loan losses for impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loan’s expected cash flow, the loan’s estimated market price or the estimated fair value of the underlying collateral. We charge off loans against the allowance when realization from the sale of the collateral or the enforcement of guarantees does not exceed the outstanding loan amount. As of June 30, 2004, we maintained a specific allowance for loan losses of $0.6 million.

      If our internal credit ratings, reserve factors, or specific allowances for loan losses are not accurate, our assets would be misstated.

     Valuation of Investments

      With respect to investments in publicly traded equity interests, we use quoted market values to value investments. With respect to investments in privately held equity interests, each investment is valued using industry valuation benchmarks, and then the value is assigned a discount reflecting the illiquid nature of the investment, as well as our minority, non-control position. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the pricing indicated by the external event will be used to corroborate our private equity valuation. Securities that are traded in the over-the-counter market or on a stock exchange generally will be valued at the prevailing bid price on the valuation date. Because of the inherent uncertainty of determining the fair value of investments that do not have a readily ascertainable market value, the fair value of our investments may differ significantly from the values that would have been used had a ready market existed for the investments, and the differences could be material.

     Term Debt Transactions

      Periodically, we transfer pools of loans to special purpose entities for use in term debt transactions. These on balance sheet term debt transactions comprise a significant source of our overall funding, with the face amount of the outstanding loans assumed by third parties totaling $1.7 billion and $1.1 billion as of June 30, 2004 and December 31, 2003, respectively. Transfers of loans have not met the requirements of SFAS No. 140 for sales treatment and are, therefore, treated as secured borrowings, with the transferred loans remaining in investments and the related liability recorded in borrowings. If our judgments as to whether the term debt transactions met the requirements for on balance sheet financing were not appropriate, the accounting would be materially different with gains or losses recorded on the transfer of loans.

38


 

Item 3:     Quantitative and Qualitative Disclosures about Market Risk

      Except as described below, there have been no material changes to our exposures to market risk since December 31, 2003. These exposures are discussed in detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Quantitative and Qualitative Disclosures About Market Risk section. In addition, for a detailed discussion of our derivatives and off balance sheet financial instruments, see Note 16, Derivatives and Off Balance Sheet Financial Instruments, in our audited consolidated financial statements for the year ended December 31, 2003 included in our Form 10-K, as filed with the SEC on March 12, 2004.

     Equity Price Risk

      The debentures we issued in March 2004 are initially convertible into our common stock at a conversion price of $30.40 per share, subject to adjustment upon the occurrence of specified events. At the initial conversion price, each $1,000 of principal of the debentures is convertible into 39.8952 shares of our common stock, subject to adjustment upon the occurrence of specified events. Holders of the debentures may convert their debentures prior to maturity only if: (1) the price of our common stock reaches $36.48 during specified periods of time, (2) specified corporate transactions occur, (3) the debentures have been called for redemption, or (4) the trading price of the debentures falls below a certain threshold.

      In addition, in the event of a significant change in our corporate ownership or structure, the holders may require us to repurchase all or any portion of their debentures for 100% of the principal amount.

      Concurrently with our sale of the debentures, we entered into two separate call option transactions with an affiliate of one of the initial purchasers, in each case covering the same number of shares as into which the debentures are initially convertible. In one transaction, we purchased a call option at a strike price equal to the initial conversion price of the debentures. This option expires on March 15, 2009 and requires physical settlement. We intend to exercise this call option from time to time as necessary to acquire shares that we may be required to deliver upon receipt of a notice of conversion of the debentures. In the second transaction, we sold warrants to one of the initial purchasers for the purchase of up to 7.4 million of our common shares at a strike price of approximately $40.30 per share. The warrants expire at various dates from March 2009 through June 2009 and must be settled in net shares. The net effect of entering into the call option and warrant transactions was to minimize potential dilution as a result of the conversion of the debentures by increasing the effective conversion price of the debentures to a 75% premium over the March 15, 2004 closing price of our common stock. The call option and warrant transactions were net settled at a net cost of approximately $25.6 million, which we paid from the proceeds of our sale of the debentures and is included as a net reduction in shareholders’ equity in the consolidated balance sheet.

      The debentures we issued in July 2004 are initially convertible into our common stock at a conversion price of $31.78 per share, subject to adjustment upon the occurrence of specified events. At the initial conversion price, each $1,000 of principal of the debentures is convertible into 31.4614 shares of our common stock, subject to adjustment upon the occurrence of specified events. Holders of the debentures may convert their debentures prior to maturity only if: (1) the price of our common stock reaches specified thresholds, (2) the trading price of the debentures falls below a specified threshold, (3) the debentures have been called for redemption, or (4) specified corporate transactions occur, each as described in the offering memorandum.

      In addition, in the event of a significant change in our corporate ownership or structure, the holders may require us to repurchase all or any portion of their debentures for 100% of the principal amount.

Item 4:     Controls and Procedures

      As of June 30, 2004, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure and controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to CapitalSource (including our consolidated subsidiaries) that is required to be disclosed in our Exchange Act reports filed with the Securities and Exchange Commission and in ensuring that such information is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. There have been no significant changes in our internal controls or, to our knowledge, in other factors that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II.     OTHER INFORMATION

 
Item 1:      Legal Proceedings

      None

 
Item 2:      Changes in Securities and Use of Proceeds

      A summary of our repurchases of shares of our common stock for the three months ended June 30, 2004 was as follows:

                                   
Shares Purchased Maximum
Average as Part of Number of Shares
Total Number Price Publicly that May Yet be
of Shares Paid per Announced Plans Purchased Under
Purchased Share or Programs the Plans




April 1 – April 30, 2004.
                       
May 1 – May 30, 2004.
    9,470 (1)   $ 21.92              
June 1 – June 30, 2004.
                       
     
     
                 
 
Total
    9,470     $ 21.92                  
     
     
                 


(1)  Shares acquired as payment by employees of applicable statutory minimum withholding taxes owed upon vesting of restricted stock granted under the Equity Incentive Plan.
 
Item 3:      Defaults Upon Senior Securities

      None

 
Item 4:      Submission of Matters to a Vote of Security Holders

      At the Registrant’s Annual Meeting of Stockholders held on April 28, 2004, the following matters were submitted to a vote of the stockholders of the Registrant:

PROPOSAL I

      Election of nominees to the Board of Directors of the Registrant for a term that ends at the 2007 Annual Meeting:

                 
Shares Voted in Favor Shares Withheld


Andrew B. Fremder
    89,670,092       2,788,374  
Tully M. Friedman
    91,027,496       1,430,970  
Paul R. Wood
    89,349,992       3,108,474  
 
Item 5:      Other Information

      None

 
Item 6:      Exhibits and Reports on Form 8-K

      (a) Exhibits

      The Index to Exhibits attached hereto is incorporated herein by reference.

      (b) Reports on Form 8-K

      During the second quarter of the fiscal year ended June 30, 2004, the registrant filed the following reports on Form 8-K:

      On June 30, 2004, we filed a report on Form 8-K relating to a press release issued to report our intention to issue a new series of senior convertible debentures due 2034 and a press release announcing the sale of the debentures.

40


 

SIGNATURES

      Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

     
Date: August 13, 2004   /s/ JOHN K. DELANEY


John K. Delaney
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
 
Date: August 13, 2004   /s/ THOMAS A. FINK


Thomas A. Fink
Chief Financial Officer
(Principal Financial Officer)
 
Date: August 13, 2004   /s/ JAMES M. MOZINGO


James M. Mozingo
Chief Accounting Officer
(Principal Accounting Officer)

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INDEX TO EXHIBITS

         
Exhibit
No. Description


  3.1     Amended and Restated Certificate of Incorporation (incorporated by reference to the same-numbered exhibit to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).
  3.2     Amended and Restated Bylaws (incorporated by reference to the same-numbered exhibit to the registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).
  4.1     Form of Certificate of Common Stock of CapitalSource Inc. (incorporated by reference to the same-numbered exhibit to the registrant’s Registration Statement on Form S-1 (Reg. No. 333-106076)).
  4.2     Indenture dated as of May 16, 2002, by and between CapitalSource Commercial Loan Trust 2002-1, as Issuer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee (incorporated by reference to the same-numbered exhibit to the registrant’s Registration Statement on Form S-1 (Reg. No. 333-106076)).
  4.3     Indenture dated as of October 30, 2002, by and between CapitalSource Commercial Loan Trust 2002-2, as Issuer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee (incorporated by reference to the same-numbered exhibit to the registrant’s Registration Statement on Form S-1 (Reg. No. 333-106076)).
  4.4     Indenture dated as of April 17, 2003, by and between CapitalSource Commercial Loan Trust 2003-1, as Issuer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee (incorporated by reference to the same-numbered exhibit to the registrant’s Registration Statement on Form S-1 (Reg. No. 333-106076)).
  4.5     Indenture dated as of September 17, 2003, between CapitalSource Funding II Trust and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee (incorporated by reference to the same-numbered exhibit to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003).
  4.6     Indenture dated as of November 25, 2003, by and between CapitalSource Commercial Loan Trust 2003-2, as Issuer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee (incorporated by reference to the same-numbered exhibit to the registrant’s Registration Statement on Form S-1 (Reg. No. 333-112002)).
  4.7     Indenture dated as of March 19, 2004, by and among CapitalSource Inc., as Issuer, U.S. Bank National Association, as Trustee, and CapitalSource Holdings LLC and CapitalSource Finance LLC, as Guarantors, including form of Senior Convertible Debenture Due 2034 (incorporated by reference to the same-numbered exhibit to the registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004).
  4.8     Indenture dated as of June 22, 2004, by and among CapitalSource Commercial Loan Trust 2004-1, as Issuer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee.†
  10.8.5     Amendment No. 5 to Loan Certificate and Servicing Agreement, dated as of April 8, 2004.†
  10.14.1 .1   First Amendment to the Sale and Servicing Agreement, dated as of April 8, 2004, among CapitalSource Funding II Trust, as Issuer, and CS Funding II Depositor LLC, as Depositor, and CapitalSource Finance LLC, as Loan Originator and Servicer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee, Collateral Custodian and Backup Servicer.†
  10.14.1 .2   Second Amendment to the Sale and Servicing Agreement, dated as of April 15, 2004, among CapitalSource Funding II Trust, as Issuer, and CS Funding II Depositor LLC, as Depositor, and CapitalSource Finance LLC, as Loan Originator and Servicer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee, Collateral Custodian and Backup Servicer.†

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Exhibit
No. Description


  10.14.1 .3   Third Amendment to the Sale and Servicing Agreement, dated as of June 29, 2004, among CapitalSource Funding II Trust, as Issuer, and CS Funding II Depositor LLC, as Depositor, and CapitalSource Finance LLC, as Loan Originator and Servicer, and Wells Fargo Bank Minnesota, National Association, as Indenture Trustee, Collateral Custodian and Backup Servicer.†
  10.14.3 .1   First Amendment to the Note Purchase Agreement, dated as of April 8, 2004, among CapitalSource Funding II Trust, as Issuer, CS Funding II Depositor LLC, as Depositor, CapitalSource Finance LLC, as Loan Originator, and Citigroup Global Markets Realty Corp., as Purchaser.†
  10.14.3 .2   Second Amendment to the Note Purchase Agreement, dated as of April 15, 2004, among CapitalSource Funding II Trust, as Issuer, CS Funding II Depositor LLC, as Depositor, CapitalSource Finance LLC, as Loan Originator, and Citigroup Global Markets Realty Corp., as Purchaser.†
  10.14.3 .3   Third Amendment to the Note Purchase Agreement, dated as of May 21, 2004, among CapitalSource Funding II Trust, as Issuer, CS Funding II Depositor LLC, as Depositor, CapitalSource Finance LLC, as Loan Originator, and Citigroup Global Markets Realty Corp., as Purchaser.†
  10.14.3 .4   Fourth Amendment to the Note Purchase Agreement, dated as of June 29, 2004, among CapitalSource Funding II Trust, as Issuer, CS Funding II Depositor LLC, as Depositor, CapitalSource Finance LLC, as Loan Originator, and Citigroup Global Markets Realty Corp., as Purchaser.†
  10.24     Fourth Amended and Restated Loan Certificate and Servicing Agreement, dated as of May 28, 2004, by and among CapitalSource Funding LLC, as Seller, CapitalSource Finance LLC, as Originator and Servicer, each of the Purchasers and Purchaser Agents from time to time party thereto, Harris Nesbitt Corp., as Administrative Agent, and Wells Fargo Bank, National Association, as Backup Servicer and Collateral Custodian.†
  10.25     Sale and Servicing Agreement, dated as of April 20, 2004, by and among CapitalSource Funding III LLC, as Seller, CapitalSource Finance LLC, as Originator and Servicer, Variable Funding Capital Corporation and each other Commercial Paper Conduit from time to time party thereto, as Conduit Purchasers, Wachovia Bank, National Association, as Swingline Purchaser, Wachovia Capital Markets, LLC, as Administrative Agent and as VFCC Agent, each other Purchaser Agent from time to time party thereto, as Additional Agents, and Wells Fargo Bank, National Association, as Backup Servicer and as Collateral Custodian.†
  10.25.1     Amendment No. 1 to Sale and Servicing Agreement, dated as of May 28, 2004.†
  10.26     Sale and Servicing Agreement, dated as of June 22, 2004, by and among CapitalSource Commercial Loan Trust 2004-1, as the Issuer, CapitalSource Commercial Loan, LLC, 2004-1, as the Trust Depositor, CapitalSource Finance LLC, as the Originator and the Servicer, and Wells Fargo Bank Minnesota, National Association, as the Indenture Trustee and as the Backup Servicer.†
  31.1     Certificate of Chairman and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
  31.2     Certificate of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.†
  32     Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.†


†  Filed herewith.

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