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 September 30, 2009

 

Commission File No. 1-31753

 

CapitalSource Inc.

(Exact name of registrant as specified in its charter)

 

 

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)

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

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

 

As of November 2, 2009, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 323,080,476.

 

 

TABLE OF CONTENTS

 

CapitalSource Inc.

 

Consolidated Balance Sheets

 

 

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Income

 

 

See accompanying notes.

CapitalSource Inc.

 

Consolidated Statement of Shareholders’ Equity

 

 

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Cash Flows

 

 

 

See accompanying notes.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

 

CapitalSource Inc. (“CapitalSource,” and together with its subsidiaries other than CapitalSource Bank, the “Parent Company”), a Delaware corporation, is a commercial lender that, through its wholly owned subsidiary, CapitalSource Bank, provides financial products to middle market businesses and provides depository products and services in southern and central California. Prior to the formation of CapitalSource Bank, CapitalSource conducted its commercial lending business through its other subsidiaries, whereas subsequent to CapitalSource Bank’s formation, substantially all new loans have been originated at CapitalSource Bank. The Parent Company’s commercial lending activities consist primarily of satisfying existing commitments made prior to CapitalSource Bank’s formation.

 

We currently operate as three reportable segments: 1) CapitalSource Bank, 2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank segment comprises our commercial lending and banking business activities; our Other Commercial Finance segment comprises our loan portfolio and residential mortgage business activities in the Parent Company; and our Healthcare Net Lease segment comprises our direct real estate investment business activities.

 

For the three and nine months ended September 30, 2008, we presented financial results through three reportable segments: 1) Commercial Banking, 2) Healthcare Net Lease, and 3) Residential Mortgage Investment. Beginning in the first quarter of 2009, changes were made in the way management organizes financial information to make operating decisions, resulting in the activities previously reported in the Commercial Banking segment being disaggregated into the CapitalSource Bank and Other Commercial Finance segments and the results of our Residential Mortgage Investment segment being combined into the Other Commercial Finance segment. We have reclassified all comparative prior period segment information to reflect our current segments. For financial information about our segments, see Note 20, Segment Data.

 

 

Interim Consolidated Financial Statements Basis of Presentation

 

Our interim consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments 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 consolidated financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in our Form 8-K filed on July 2, 2009, which recasted the financial statements and footnotes included in our Annual Report on Form 10-K for the year ended December 31, 2008, due to the retrospective adoption of new accounting pronouncements, as filed with the Securities and Exchange Commission on March 2, 2009 (“Form 10-K”).

 

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

 

We have conducted our subsequent events review through November 4, 2009.

 

Reclassifications

 

Certain amounts in prior period consolidated financial statements have been reclassified to conform to the current period presentation, including the reclassification of noncontrolling interests.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements as of December 31, 2008, included in our Form 10-K.

 

New Accounting Pronouncements

 

The Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC” 105), Generally Accepted Accounting Principles (“GAAP”), which established the FASB Accounting Standards Codification (the “Codification” or “ASC”) as the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The Codification superseded all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification became non-authoritative. The Codification was made effective by the FASB for periods ending on or after September 15, 2009. This quarterly report reflects the guidance in the Codification.

 

In December 2007, the FASB issued guidance establishing principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. It also provided a framework for recognizing and measuring the goodwill acquired in the business combination and determined what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The effective date of adoption is for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In February 2008, the FASB issued guidance delaying the effective date of fair value measurement disclosures for all non financial assets and liabilities, except those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until years beginning after November 15, 2008. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In April 2009, the FASB issued further guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly when compared with normal market activity for the asset or liability (or similar assets or liabilities) and, further, identifying circumstances that indicate a transaction is not orderly. It applies to all assets and liabilities within the scope of accounting guidance that require or permit fair value measurements, except items cited as scope exceptions in the Codification. The guidance is effective prospectively for interim and annual reporting periods ending after June 15, 2009. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In March 2008, the FASB issued guidance related to disclosures about derivative instruments and hedging activities, which was intended to improve transparency in financial reporting by requiring enhanced disclosures of an entity’s derivative instruments and hedging activities and their effects on the entity’s financial position, financial performance, and cash flows. The guidance applies to all derivative instruments within the scope of the Derivatives and Hedging Activities Topic of the Codification. It also applies to non-derivative hedging instruments and all hedged items designated and qualifying as hedges under this topic. The effective date of adoption is the beginning of the first fiscal year beginning after November 15, 2008. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In April 2009, the FASB issued guidance to address application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. It applies to all assets acquired and liabilities assumed in a business combination that arise from contingencies that would be within the scope of existing guidance on accounting for contingencies, if not

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

acquired or assumed in a business combination, except for assets or liabilities arising from contingencies that are outside this scope of this new guidance. This guidance is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In April 2009, the FASB amended its guidance on other-than-temporary impairment for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. The additional guidance does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. It is effective for interim and annual reporting periods ending after June 15, 2009. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In April 2009, the FASB amended its guidance on the fair value of financial instruments to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This also amended existing guidance on interim financial reporting to require those disclosures in summarized financial information at interim reporting periods. This guidance is effective for interim reporting periods ending after June 15, 2009. We adopted this guidance, and it did not have a material impact on our consolidated financial statements. For additional information about fair value of our financial instruments, see Note 19, Fair Value Measurements.

 

In May 2009, the FASB issued guidance establishing principles and requirements for subsequent events accounting and disclosure, setting forth general principles of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance does not apply to subsequent events or transactions that are within the scope of other applicable GAAP that provide specific guidance on the accounting treatment for subsequent events or transactions. This is effective prospectively for interim or annual financial periods ending after June 15, 2009. We adopted this guidance, and it did not have a material impact on our consolidated financial statements.

 

In June 2009, the FASB amended its guidance on the accounting for transfers and servicing of financial assets and extinguishments of liabilities and established additional disclosures about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It applies to all entities and eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets. This guidance is effective as of the beginning of our first annual reporting period that begins after November 15, 2009 for all transfers occurring subsequent to the adoption date. We will adopt this guidance on January 1, 2010, and have not completed our assessment of the impact of its adoption on our consolidated financial statements.

 

In June 2009, the FASB issued new guidance changing how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This requires enhanced disclosures about variable interest entities that will provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. This guidance also requires ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. It does not change the existing scope for accounting and assessment of variable interest entities, however it adds entities previously considered qualifying special-purpose entities, as the concept of these entities was eliminated. This guidance is effective for our first annual reporting period that begins after November 15, 2009. We will adopt this guidance on January 1, 2010, and have not completed our assessment of the impact of its adoption on our consolidated financial statements.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

In May 2008, the FASB issued guidance clarifying the requirements for accounting for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) and specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. The guidance applies to convertible debt instruments that, by their stated terms, may be settled in cash (or other assets) upon conversion, including partial cash settlement, unless the embedded conversion option is required to be separately accounted for as a derivative under the Derivatives and Hedge Accounting Topic of the Codification. This guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and requires retroactive application for all periods presented in the consolidated financial statements.

 

In December 2007, the FASB issued guidance, which establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. The guidance also amends certain consolidation procedures for consistency with the requirements of the Consolidation Topic of the Codification. The effective date for application of this guidance is the beginning of the first fiscal year beginning after December 15, 2008.

 

On January 1, 2009, we applied this guidance to our convertible debt and non-controlling interests retrospectively. The adoption of this guidance affected financial statement line items for the periods presented below as follows:

 

Consolidated Balance Sheets

 

 

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Consolidated Statements of Income

 

 

 

 

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

 

Consolidated Statements of Cash Flows

 

 

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

As of September 30, 2009 and December 31, 2008, our cash and cash equivalents and restricted cash balances were as follows:

 

 

 

 

 

In February 2006, we purchased beneficial interests in special purpose entities (“SPEs”) that acquired and securitized pools of adjustable rate, prime residential mortgage loans. These beneficial interests are subordinate to other interests issued by the SPEs that are held by third parties. We determined that the SPEs were variable interest entities designed to create and pass along risks related to the credit performance of the underlying residential mortgage loan portfolio.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

We concluded that we were the primary beneficiary of the SPEs as we expected that our subordinated interests would absorb a majority of the expected losses related to these risks. As a result, we consolidated the assets and liabilities of such entities for financial statement purposes. In so doing, we also determined that the SPEs’ interest in the underlying mortgage loans constituted, for accounting purposes, receivables secured by underlying mortgage loans. Since initial consolidation, there has been no change to our assessment of the nature of the risks associated with the SPEs, and no events have occurred that would give rise to reconsidering our conclusion that we are the primary beneficiary of the SPEs or that the SPEs are variable interest entities.

 

We recorded mortgage-related receivables, as well as the principal amount of related debt obligations incurred by the SPEs to fund these receivables, in our consolidated balance sheets as of September 30, 2009 and December 31, 2008. The carrying amounts of the assets and liabilities of the SPEs reported in our consolidated balance sheet as of September 30, 2009, were $1.5 billion for both assets and liabilities. We are restricted from pledging or exchanging the assets held by the SPEs. Cash flows from these underlying residential mortgage loans are designated to pay off the related liabilities. Recourse is limited to the assets held in the SPE and does not extend to the general credit of CapitalSource. As a result, our economic exposure is limited to the beneficial interests we purchased in the respective securitization trusts. Our initial economic exposure related to these beneficial interests was approximately $109.1 million at the time of their purchase. This exposure has since decreased to approximately $3.5 million as of September 30, 2009, primarily as a result of recorded charge offs and reserves.

 

Recognized mortgage-related receivables are, in economic substance, mortgage loans. Such mortgage loans are all prime, hybrid adjustable-rate loans. At acquisition, the mortgage loans that back our mortgage-related receivables had a weighted average loan-to-value ratio of 73% and a weighted average Fair Isaac & Co. (“FICO”) score of 737.

 

As of September 30, 2009 and December 31, 2008, the carrying amount of our residential mortgage-related receivables, net, including accrued interest, the allowance for loan losses, and the balance of unamortized purchase discounts, was $1.5 billion and $1.8 billion, respectively. As of September 30, 2009 and December 31, 2008, approximately 97% and 95%, respectively, of mortgage-related receivables were financed with permanent term debt in the amounts of $1.5 billion and $1.7 billion, respectively, and were recognized by us through the consolidation of SPEs. This term debt was recorded as a component of term debt in our consolidated balance sheets.

 

As of September 30, 2009 and December 31, 2008, mortgage-related receivables, whose underlying mortgage loans are 90 or more days past due or were in the process of foreclosure were as follows:

 

 

 

 

During the three and nine months ended September 30, 2009, the carrying value of foreclosed assets increased by $1.5 million and $0.3 million, respectively. As of September 30, 2009 and December 31, 2008, the carrying values of the foreclosed assets were $7.6 million and $7.3 million, respectively.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The activity in the allowance for loan losses on mortgage-related receivables for the nine months ended September 30, 2009 and 2008, was as follows:

 

 

During the three and nine months ended September 30, 2009, we recognized interest income on our mortgage-related receivables of $18.3 million and $59.4 million, respectively, as a component of interest income on loans in the consolidated statements of income. For the three and nine months ended September 30, 2008, we recognized interest income on our mortgage-related receivables of $23.1 million and $72.1 million, respectively, as a component of interest income on loans in the consolidated statements of income.

 

 

As of September 30, 2009 and December 31, 2008, our total commercial loan portfolio had an outstanding balance of $9.4 billion and $10.9 billion, respectively. Included in these amounts were loans held for investment, loans held for sale, a commercial real estate participation interest (“the “A” Participation Interest”), and related interest and fee receivables (collectively, “Commercial Lending Assets”). As of September 30, 2009 and December 31, 2008, interest and fee receivables totaled $102.8 million and $93.3 million, respectively.

 

Commercial Real Estate “A” Participation Interest

 

As of September 30, 2009, the carrying value of the “A” Participation Interest was $714.2 million, representing our share of a $3.6 billion pool of commercial real estate loans and related assets, net of a remaining purchase discount of $18.8 million.

 

The activity with respect to the “A” Participation Interest for the period from December 31, 2008 to September 30, 2009 was as follows ($ in thousands):

 

 

During the three and nine months ended September 30, 2009, we recognized $10.7 million and $35.3 million, respectively, in interest income on the “A” Participation Interest.

 

The “A” Participation Interest is reported at the outstanding principal balance less the associated discount. Interest income on the “A” Participation Interest is accrued as earned and recorded as a component of interest income on loans in our consolidated statements of income. The discount is accreted into interest income over the estimated life of the instrument using the interest method.

 

The “A” Participation Interest is governed by a participation agreement that is structured to minimize our exposure to credit risk. We have pari passu rights in the underlying loans pursuant to which we receive 70% of all borrower principal repayments from the underlying loans and properties. In addition, under the participation agreement, iStar FM Loans, LLC, the holder of the “B” Participation Interest, assumed all future funding obligations with respect to the loans underlying the participation agreement. Accordingly, although the holder

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

of the “B” Participation Interest continues to increase its percentage of the overall funding of the underlying loans, we continue to receive 70% of all borrower repayments. Thus, the structure of the “A” Participation Interest accelerates the paydown of the “A” Participation Interest, relative to the paydown of the overall underlying portfolio of assets. This accelerated paydown serves to reduce our exposure to credit risk. Additionally, the “A” Participation Interest is structured so that we do not have loan and property-level risk. We receive payments based on the cash flows of the entire underlying pool of assets and not any one asset in particular. Therefore, we will incur a loss only if the portfolio, as a whole, fails to repay at least to the extent of the “A” Participation Interest balance.

 

As of September 30, 2009, no allowance for loan losses was deemed necessary with respect to the “A” Participation Interest.

 

Loans Held for Sale

 

Loans held for sale are recorded at the lower of cost or fair value in our consolidated balance sheets. During the three and nine months ended September 30, 2009, we recognized a net pre-tax loss of $7.7 million and $10.7 million, respectively, on the sale of loans. During the three and nine months ended September 30, 2008, we recognized net pre-tax losses of $27,000 and net pre-tax gains of $2.6 million, respectively, on the sale of loans.

 

During the three and nine months ended September 30, 2009, loans held for investment with a carrying amount of $55.8 million and $130.8 million, respectively, were transferred to loans held for sale based on management’s intent with respect to the loans, resulting in no losses in the three month period and $11.4 million in losses for the nine months due to valuation adjustments.

 

Loans Held for Investment

 

Loans held for investment are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts received or premiums paid on purchased loans. We maintain an allowance for loan losses for loans held for investment, which is calculated based on management’s estimate of incurred loan losses inherent in our loan portfolio as of the balance sheet date. Activity in the allowance for loan losses related to our loans held for investment for the nine months ended September 30, 2009 and 2008, respectively, was as follows:

 

 

As of September 30, 2009 and December 31, 2008, the principal balances of contractually delinquent loans, non-accrual loans and impaired loans were as follows:

 

 

 

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the original loan agreement. In this regard, impaired loans include loans where we expect to encounter a significant delay in the collection of, and/or shortfall in the amount of contractual payments due to us. As of September 30, 2009 and December 31, 2008, we had $727.7 million and $359.3 million of impaired loans, respectively, with allocated reserves of $91.4 million and $87.4 million, respectively. As of September 30, 2009 and December 31, 2008, we had $579.0 million and $333.0 million, respectively, of loans that we assessed as impaired and for which we did not record any allocated reserves based upon our belief that it is probable that we ultimately will collect all principal amounts due.

 

The average balances of impaired loans during the three and nine months ended September 30, 2009 were $1.2 billion and $1.0 billion, respectively, and were $581.2 million and $457.3 million, respectively, during the three and nine months ended September 30, 2008. The total amounts of interest income that were recognized on impaired loans during the three and nine months ended September 30, 2009 were $10.8 million and $25.4 million, respectively and were $9.4 million and $22.9 million, respectively, during the three and nine months ended September 30, 2008. The amounts of cash basis interest income that were recognized on impaired loans during the three and nine months ended September 30, 2009 were $3.7 million and $9.7 million, respectively, and were $7.8 million and $15.9 million, respectively, during the three and nine months ended September 30, 2008. If the non-accrual loans had performed in accordance with their original terms, interest income would have been increased by $33.7 million and $85.6 million, respectively, for the three and nine months ended September 30, 2009, and $12.8 million and $31.8 million, respectively, for the three and nine months ended September 30, 2008.

 

During the three and nine months ended September 30, 2009, loans with an aggregate carrying value of $427.7 million and $795.1 million, respectively, as of their respective restructuring dates, were involved in troubled debt restructurings. As of September 30, 2009 and December 31, 2008, the balance of loans that had been restructured in troubled debt restructurings were $650.7 million and $381.4 million, respectively. Additionally, loans involved in these troubled debt restructurings are assessed as impaired, generally for a period of at least one year following the restructuring. A loan that has been involved in a troubled debt restructuring might no longer be assessed as impaired one year subsequent to the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. The allocated reserves for loans that were involved in troubled debt restructurings were $25.8 million and $48.0 million, as of September 30, 2009 and December 31, 2008, respectively.

 

Foreclosed Assets

 

Real Estate Owned

 

When we foreclose on real estate assets that collateralized a loan, we record the assets at their estimated fair value at the time of foreclosure. Upon foreclosure and through liquidation, we evaluate the asset’s fair value as compared to the loan’s carrying amount and record a charge off when the carrying amount of the loan exceeds fair

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

value. Subsequent valuation adjustments are recorded as a valuation allowance which are recorded as a component of other (expense) income, net in our consolidated statements of income. We estimate fair value at the asset’s liquidation value, based on market conditions, less estimated costs to sell such asset.

 

As of September 30, 2009 and December 31, 2008, we had $67.1 million and $84.4 million, respectively, of real estate owned (“REO”), which was recorded in other assets in our consolidated balance sheets. Activity in REO for the three and nine months ended September 30, 2009 and 2008 was as follows:

 

 

During the three and nine months ended September 30, 2009, we recognized a gain of $1.5 million and a loss of $0.3 million, respectively, on the sales of REO as a component of other income (expense) in the consolidated statements of income. For the three and nine months ended September 30, 2008, we recognized gains of $45,000 and $0.4 million, respectively, on the sale of REO as a component of other income (expense) in the consolidated statements of income.

 

Other Foreclosed Assets

 

When we foreclose on a borrower whose underlying collateral consists of loans, we record the acquired loans at the estimated fair value at the time of foreclosure. As of September 30, 2009, we had $109.7 million of loans acquired through foreclosure, which were recorded in loans held for investment in our consolidated balance sheets. As of December 31, 2008, there were no loans acquired as a result of foreclosure.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

Investment Securities, Available-for-Sale

 

As of September 30, 2009 and December 31, 2008, our investment securities, available-for-sale were as follows:

 

 

Included in investment securities, available-for-sale, were discount notes issued by Fannie Mae, Freddie Mac and the FHLB (“Agency discount notes”), callable notes issued by Fannie Mae, Freddie Mac, the FHLB and Federal Farm Credit Bank (“Agency callable notes”), bonds issued by the FHLB (“Agency debt”), commercial and residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (“Agency MBS”), commercial and residential mortgage-backed securities issued by non-government agencies (“Non-agency MBS”), corporate debt, an investment in a subordinated note of a collateralized loan obligation and an equity security. CapitalSource Bank pledged to the FHLB of San Francisco (“FHLB SF”) and FRB investment securities, available-for-sale with an estimated fair value of $656.7 million and $19.3 million, respectively, as sources of borrowing capacity as of September 30, 2009.

 

During the three and nine months ended September 30, 2009, we sold investment securities, available-for-sale for $28.4 million and $46.5 million, respectively, recognizing net pre-tax gains of $63,000 and $0.5 million, respectively. We did not sell any of these investments during the three and nine months ended September 30, 2008.

 

During the three and nine months ended September 30, 2008, we recorded other-than-temporary impairments in the fair value of our Non-agency MBS of $1.4 million and $4.1 million, respectively, as a component of gain (loss) on residential mortgage investment portfolio in the consolidated statements of income. We did not incur any such other-than-temporary impairments in the fair value of our Non-agency MBS during the three and nine months ended September 30, 2009. Additionally, we recorded no other-than- temporary impairment during the three months ended September 30, 2009, and $11.7 million during the nine months ended September 30, 2009, related to corporate debt, as a component of loss on investments, net in the consolidated statements of income. During the three and nine months ended September 30, 2008, we did not record any other-than-temporary impairment related to corporate debt. During the three and nine months ended September 30, 2009, we recorded other-than-temporary impairments in the fair value of the collateralized loan obligation of $0.4 million and $1.8 million, respectively, as a component of loss on investments, net in the consolidated statements of income. During the three and nine months ended September 30, 2008, we recorded other-than-temporary impairments in the fair value of the collateralized loan obligation of $0.8 million for both periods, as a component of loss on investments, net in the consolidated statements of income.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

During the three and nine months ended September 30, 2009, we recognized $6.9 million and $0.5 million, respectively, of net unrealized after-tax gains, related to our available-for-sale investment securities, as a component of accumulated other comprehensive income, net in our consolidated balance sheets.

 

As of September 30, 2009 and December 31, 2008, the gross unrealized losses and fair value of investment securities, available-for-sale, that were in an unrealized loss position, were as follows:

 

 

We do not believe that any unrealized losses greater than 12 months in our available-for-sale portfolio as of September 30, 2009 and December 31, 2008 represent an other-than-temporary impairment. These losses are related to an equity security and are attributable to fluctuations in its market price due to current market conditions.

 

Investment Securities, Held-to-Maturity

 

As of September 30, 2009 and December 31, 2008, the amortized cost of investment securities, held-to-maturity, was $250.2 million and $14.4 million, respectively and consisted of AAA-rated commercial mortgage-backed securities. In addition, CapitalSource Bank pledged to the FHLB SF and FRB investment securities, held-to-maturity, with an amortized cost of $74.5 million and $170.2 million, respectively, and estimated fair value of $76.6 million and $182.2 million, respectively, as sources of borrowing capacity as of September 30, 2009.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Contractual Maturities

 

As of September 30, 2009, the contractual maturities of our investment securities, available-for-sale, and investment securities, held-to-maturity, were as follows:

 

 

 

 

Other Investments

 

As of September 30, 2009 and December 31, 2008, our other investments were as follows:

 

 

During the three and nine months ended September 30, 2009, we sold other investments for $10.6 million and $23.2 million, respectively, recognizing a net pre-tax gain of $0.7 million and a net pre-tax loss of $2.4 million, respectively. For the three and nine months ended September 30, 2008, we sold other investments for $12.1 million and $22.2 million, respectively, recognizing a net pre-tax loss of $0.3 million and a net pre-tax gain of $4.6 million, respectively. During the three and nine months ended September 30, 2009, we recorded other-than-temporary impairments of $6.8 million and $11.4 million, respectively, relating to our investments carried at cost. During the three and nine months ended September 30, 2008, we recorded other-than-temporary impairments of $30.8 million and $40.0 million, respectively, relating to our investments carried at cost.

 

Residential Mortgage-Backed Securities

 

Prior to the second quarter of 2009, we invested in residential mortgage-backed securities that were issued and guaranteed by Fannie Mae or Freddie Mac (“Agency RMBS”), which were included in the line item “mortgage-backed securities pledged, trading” in the audited consolidated balance sheets as of December 31, 2008. All our Agency RMBS were collateralized by adjustable rate residential mortgage loans, including hybrid adjustable rate mortgage loans.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

During the first quarter of 2009, we sold all of our Agency RMBS and unwound all of the related derivatives remaining in our residential mortgage investment portfolio, realizing a gain of $15.3 million as a component of (loss) gain on residential mortgage investment portfolio in the consolidated statements of income.

 

 

The following represents the supplemental consolidating condensed financial information of CapitalSource Inc. As discussed in Note 13, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2008 included in our Form 10-K and Note 11, Borrowings, in these financial statements, CapitalSource Inc. is the issuer of our “2014 Senior Secured Notes,” as defined in Note 11, Borrowings, as well as our Senior Debentures and Subordinated Debentures (together, the “Debentures”). CapitalSource Finance LLC (“CapitalSource Finance”) is a guarantor of our 2014 Senior Secured Notes and the Debentures, and our subsidiaries that are not guarantors of the 2014 Senior Secured Notes or the Debentures, as of September 30, 2009 and December 31, 2008 and for the three and nine months ended September 30, 2009 and 2008. CapitalSource Finance, a 100% owned indirect subsidiary of CapitalSource Inc., has guaranteed our 2014 Senior Secured Notes and the Senior Debentures, fully and unconditionally, on a senior basis. CapitalSource Finance also has guaranteed the Subordinated Debentures, fully and unconditionally, on a senior subordinate basis. Separate consolidated financial statements of the guarantor are not presented, as we have determined that they would not be material to investors.

 

CapitalSource Inc.

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Consolidating Balance Sheet
September 30, 2009