PacWest Bancorp (PACW) 2004 Q2 法說會逐字稿

Good day, everyone, and welcome to the CapitalSource second quarter 2004 earnings conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the finance director, Mr Tony Skarupa. Please go ahead, sir.

Thank you, operator, and good evening. Joining us today are John Delaney, Chairman and Chief Executive Officer of CapitalSource, and Tom Fink, our Chief Financial Officer. Before I turn the call over to John I want to inform you that this call is being webcast simultaneously on the Investor Relations section of our website at www.CapitalSource.com. Furthermore, a recording of the call will be available on the website beginning at approximately 8:30pm eastern time and our press release and website provide details on accessing the archived call. Also before we begin I need to inform you that statements in this earnings call which are not historical facts may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All forward-looking statements including statements regarding future financial and operating results involve risk, uncertainties and contingencies, many of which are beyond CapitalSource's control and which may cause actual results to differ materially from anticipated results. More detailed information about these risk factors can be found in our annual report as filed with the Securities and Exchange Commission on Form 10(K) on March 12, 2004. CapitalSource is under no obligation to and we expressly disclaim any such obligation to update or alter our forward-looking statements whether as a result of new information, future events or otherwise. Now I would like to turn the call over to CapitalSource's Chairman and Chief Executive Officer, John Delaney.

Thanks, Tony, and good evening, everyone. As always we appreciate you carving out time to join us here tonight. I am pleased to report that our earnings for the first quarter were 24 cents per diluted share or $27.9 million. This is a 17% increase in our net income from the first quarter and a 4 cent increase in EPS from the first quarter. The major drivers of these positive results are strong asset growth, credit performance in line with our expectations, strong risk adjusted yields in the portfolio and improved funding costs. Let me take a moment to comment on each of these briefly. Regarding asset growth, we ended the second quarter with over $3.3 billion of funded loans, a $548 million increase from the first quarter. In the second quarter we added approximately 60 new loans on the net basis. While we view the net asset gross -- net asset growth this quarter as being particularly strong we believe our gross loan growth will remain strong in the near term. The success we are having attracting new customers is a clear reflection of a number of positive aspects of the business including the benefits of a business model that focuses on under served niches, the leadership position of our various businesses and their respective markets, the unique and valued service we offer our customers and the outstanding quality of our team in their commitment to the success of the business.

Regarding credit. We had a 3.4 million of charge offs in the second quarter which had no real P&L impact since we had already taken specific reserves against these loans in prior periods. This quarter we had a relatively small amount of specific reserves. As discussed before the credit side of the business will be lumpy but in general I view the performance of the portfolio from a credit perspective to be very strong right now. General reserves increased in line with our normal methodology. Loans on non-accrual increased by approximately $22 million, principally due to one of our first mortgage real estate loans that is involved in a active work out. Regarding yields. Both core yield and yield derived from fee income declined. A slight decline in interest income was not unexpected. Fee income declined significantly due to an unusually small amount of prepayment income which is another one of our lumpy items. Clearly the better than expected asset growth in the business is causing us to focus more intently on pricing with a view that we do in fact have more pricing power in our business . Other income, which is comprised of fees from our FHA HUD processing business, gains from equity investments and a few other things was solid this quarter at $6.9 million. Last quarter we had predicted that this number would be higher which in fact it was.

Cost of funds continued to trend down on a normalized basis. We complet -- did a second convertible debt offering and our fifth term debt securitization in the second quarter which Tom will touch on in a few minutes. Our operating expenses to average assets was flat for the quarter due to closing costs and a spike in headcount specifically related to the SLP acquisition and due to higher bonus provisions, which is a natural by product of our stronger financial performance. In general, however, we still have a very deep team that is capable of handling more volume. Someone close to the company recently made an observation that our team is built to fly an F 15 and it's still flying a single engine plane. That's probably the best explanation I can provide as to why we still need to grow into our operating expenses. Now let me touch on a few highlights from the three business groups. Corporate finance enjoyed a strong second quarter. We continue to see good opportunities in corporate finance which as most of you know is our business where we principally provide senior debt to finance middle market leverage buyouts. I will reiterate the two trends that I have noted in the past. First, LBO volume is up and this is creating more deal flow for our corporate finance group. Second, competition has also increased, but only on larger deals which is not our core market.

Once again we feel like the market niche we have targeted within the larger leveraged finance universe, specifically financing smaller LBO's, is a very defensible market position and should continue to produce good opportunities even as liquidity flows back into the market. We reached this conclusion based on three specific market dynamics. First, smaller LBOs are less strategic to the larger commercial banks and investment banks since the borrowers are less likely to need other capital markets activities which they like to cross sell. Second, originating these transactions is much more difficult since we tend to target smaller leveraged buyout firms or even non-traditional sponsors like Pledge Funds or Family Offices or things like that which typically have a much lower market profile. And finally, smaller LBOs typically require more work from an underwriting and diligence perspective. The borrowers tend to be less sophisticated and our team, particularly with the services of Capital Analytics, is very, very good at efficiently structuring and doing the more intense bottoms up diligence that is required in this part of the market. Healthcare finance continues to enjoy a strong pipeline and had a productive quarter although net asset growth was lower than in prior quarters due to higher paydowns and pay offs.

This quarter the healthcare team was also awarded a contract to act as special servicer with respect to a portfolio of healthcare accounts receivable loans of DVI Business Credit. We were selected by the creditors of DVI Business Credit and our job will be to provide specific loan management services for a monthly monitoring fee. It is our sense that many firms were interested in this contract and that we were selected because the creditors of DVI viewed our healthcare team as the most qualified in the industry which is I think another example of the quality of the team we've built. Like healthcare, structure finance enjoys a strong pipeline and had strong net asset growth. Real estate finance continues to be a strong driver of growth in structure finance. Real estate finance under the direction of Chris Kelly, who joined us this year, has recently expanded its product offering with the acquisition of CIG International. CIG offers mezzanine loans to residential home builders. They have been actively financing this sector for over 12 years and we have worked closely with the company since 2001. We just decided to acquire the company because we believe their market focus fits well within our real estate product offering, because we are very impressed with the company's management team and their credit discipline in particular, and because their assets within the CapitalSource balance sheet will generate very strong returns. Although this deal was structured as a stock purchase the acquisition was effectively a loan portfolio purchase.

We acquired for cash approximately 47 loans with $98 million loan balance, which was a slight premium to the face amount of the loans. So let me conclude by touching on what I think are the big themes for the quarter, in particular and for the enterprise as a whole. These themes center on origination, credit and funding. Our origination efforts are proving to be more productive than we predicted. We have built a highly effective origination machine across three business groups and probably a dozen products that should continue to drive strong gross loan growth into the future. Our credit process which starts with a credit first approach to the business and is highly dependent on industry and sector focus and a detailed diligent services provided by Capital Analytics continues to deliver very strong credit out comes and very manageable credit losses. In funding of the business in an efficient manner is obviously critically important in light of these very positive trends and our finance and accounting team will continue to explore the most effective ways to finance the growth of the business. Right now our liquidity position is excellent which is the right time to explore the best path for future fundings.

So with that I will turn the call over to Tom.

Thank you, John,and good evening, everyone. We released our earning this afternoon after the market closed. I hope you have all had a chance to see the press release. The second quarter was another strong quarter for CapitalSource with the obvious highlight of very good growth in our loan portfolio. And this drove increases in the top line interest and fee income and combined with a nice pick up in other income we saw continued growth in the bottom line performance. John already touched on the highlights so in my comments today I will try to give you a little more texture on some of the drivers of our financial performance and as we go through, freshen up our guidance as it relates to some of these areas. I will also touch on some other topics including our recent financing activity and some themes related to it. In terms of loan growth our June ending portfolio was $3.3 billion, up 548 million for this quarter and up 884 million since the end of last year. Obviously this -- the business is growing well and it's ahead of our plan.

In the past we've spoken about annual loan growth levels of 1 billion to 1.2 billion per year, and based on our performance in the first half we believe that this year we will exceed those levels. And I think that we can now embrace the fact that the business can grow faster than we had previously laid out. However, I would not want you to go all the way and annualize our current quarterly growth rate. Rather we feel comfortable guiding you to the high-end of our previous range, namely a $1.2 billion annual portfolio growth rate as a good pace for the business from June 30. However, as always, growth will likely continue to be lumpy. Credit quality remained very good this quarter. John already mentioned that we recorded charge offs this quarter totaling $3.4 million or 11 basis points and that these charge offs had virtually no effect on net income since we had specifically reserved for almost all of that loss during the first quarter. Our provision for credit loss this quarter included approximately $560,000 in net -- excuse me, in new specific reserves and our allowance for loan loss to June 30th stood at $24.8 million or 75 basis points. Of this amount two basis points are the specific reserves reflecting both the decrease due to the charge offs and the small new reserves I just mentioned. And 73 basis points is our more formulaic general reserve which is up by three basis points from last quarter in line with our methodology. The next item I want to talk about tonight is yield. Yield for the first quarter, excuse me, for this quarter was 10.75%, which is lower than 12.18% we saw in the first quarter, due primarily to the relative lack of prepayment related fee activity we saw which was a big driver in the last few quarters.

Prepayment related fee activity contributed just 26 basis points to yield this quarter,versus 133 basis points last quarter. And we'd discussed before the prepayment related fees are another lumpy area of the business and that we are continuing to see that here. Putting the prepayment related fees aside we did see some reduction this quarter in yield from interest income at 8.886% down from 9.08% last quarter, and recurring fee income of 1.63% this quarter, down from 1.77% last quarter. This is consistent with the guidance we gave earlier this year for yields trending lower throughout 2004. Leverage, as you would expect with growth in the portfolio, is up this quarter with a debt to equity ratio of just over 3 times compared to 2.4 times last quarter. In the past we have spoken about modestly increasing leverage in the business to a 4 to 1 debt to equity level. 4 to 1 was never a hard limit for us but rather more of a practical output from the business model projected at slower growth levels than we are seeing currently. So based on how we now see the business we think we will get to the 4 to 1 range and above that a little sooner than we modeled earlier. And having said that we are comfortable managing the business north of the 4 to 1 level, and looking to the 4.5 to 5 to 1 range over time. Cost of funds improved this quarter to 2.74%. As discussed in the release, this was due to our funding of the growth of the business from lower cost sources, included in this are our 1.25% convertible bond financing which we closed in March, as well as some of our new credit facilities coming in at lower margins. We do model cost of funds increasing from this level, however. Part of this is due to the mix and in particular adding the 3.5% convertible bond offering that closed in July. But we also note that short-term rates are now starting to rise and are expected to continue to rise for the rest of the year.

With yield down, leverage up and some other improvements in cost of funds, net interest margin was down this quarter to 8.73%. Earlier in the year we gave guidance for net interest margin to flow down to the mid to high 8% area. We're now in that range. And going forward we model being in the mid 8% area for the rest of the year. Excluding some anticipation for modest prepayment related fee activity we would be modeling net interest margin to be in the low 8s over the next two quarters, again without prepayment related fee activity. Other income was up nicely this quarter to $6.9 million. This is due to positive variances in all the line items that comprise other income. The major improvement we saw was due to our HUD mortgage business and some new third party servicing income. The HUD mortgage business is primarily a fee based business linked to transaction activity. We closed a few large deals this quarter versus one small transaction in the first quarter. The new third party loan servicing income this quarter related to CapitalSource being retained as special servicer to the DVI loans that John mentioned earlier. We also saw fee income from the embrasure platform and other third party servicing that came with the SLP portfolio acquired earlier in the quarter.

Both of these are nice fee income sources for us and in particular the servicing of the DVI portfolio allows us to leverage our infrastructure as well as providing another validation of the skills and expertise we have in our healthcare lending group. Forfeited due diligence deposits or what we call dead deal fees is another item I would like to mention. They were up almost 80% this quarter. However, as I remind everyone, this line item represents just the gross revenue side of our work on these deals that did not close. Our cost related to the work show up in the various line items of operating expenses. So in terms of how we look at it I would say that we are very pleased with where we are in terms of other income on a year-to-date basis and slightly ahead of plan there on an annualized basis. Operating expenses were up this quarter in dollar terms but remained essentially flat at 3.4% in terms of expenses of as a percent of assets. The efficiency ratio was 35.5%. One small thing to note is that we did change the definition of efficiency ratio this quarter to also pick up other income. We think that is more reflective of our business since other income is a contributor to bottom line performance.

Operating expenses are rising in dollar terms as we continue to grow the business and add people, office space, et cetera. So we expect to continue to see operating expense increases in dollar terms for those reasons. However, we are still comfortable with the guidance we gave earlier of 3 to 3.25% in terms of operating expenses as a percentage of assets for the year. And we possibly will be cracking the 3% mark for the fourth quarter. Now let me turn to the funding side of the business. We had a busy quarter on the financing side with several good things to report. As previously announced in other press releases we completed new and amended credit facilities bringing our credit facility capacity to $1.7 billion. We are very pleased with the terms of these financings and the strong reception CapitalSource received from the bank market. We now have seven different banks involved in some form of credit facility with CapitalSource. We also completed our fifth and largest term debt securitization at $875 million. This term debt financing is one of the primary means we use to fund the business and we continue to experience very good reception in that market. The placement of the 2004-1 transaction was a success. We saw further improvement in pricing levels for this deal versus our last transaction. And again, we're very pleased with the execution of this financing. One of the things that we continue to look at in these term debt financings is the structure.

If you recall the prior transaction completed in late 2003 used a pro rata structure for the first time which had some benefits to us compared to the sequential pay structure used in earlier transaction. The structure of the 2004-1 transaction was slightly different from the last and I would say the last transaction is probably between those two types. And we'll continue to look at the structures going forward to find the right balance of leveraged structure and flexibility for us. Also on the financing side is the $330 million convertible bond transaction we closed earlier this month and mentioned in our release as a subsequent event. Like the first convertible we closed in March this was a very favorable financing for us with a 3.5% coupon fix rate for a 30 year term and 7 year first call, first put feature. As with the first convertible we did in March, the immediate use of proceeds was for us to repay borrowings under our credit facilities. However, both of these convertible bond financings provided capital that we can leverage in growing the business. One thing to note is that like most of the convertible financings done in recent years both of our convertibles included a contingent conversion feature. This feature has been the focus of some discussion in accounting circles of late and has been mentioned in a few articles in the Wall Street Journal and other places. I don't want to get too much into the weeds on it, but the Emerging Issues Task Force, or the EITF of the FASB, is proposing to change the way that diluted EPS will be calculated with respect to these contingent convertible bonds. Currently the shares underlying the convertible are not brought into the diluted share count until the stock price exceeds the contingent conversion threshold. In our case these thresholds were set at 120% of the conversion price or $36.48 and $38.14 respectively for the first and second transaction. The proposal is to require companies to use the if converted method of EPS accounting without regard to the contingencies.

That is to say, if enacted as we understand it the change would result in an increase in our diluted share count to reflect the underlying shares even though the convertible holders do not yet have the right to convert. As we understand it the proposal is currently subject to comment but if enacted as proposed would result in decrease in diluted EPS in the high single digits for us. The timing is possibly as soon as the fourth quarter and could be applied retroactively. As I said this has been the subject of a few newspaper articles and has been a question that we've received from a few people. So let me state two very important things that I will tell -- that I really tell everyone since there is no confusion about the issue. First, the proposal does not affect the convertible securities at all. It does not change their terms or their economics. And second, the proposal would not affect the net income of CapitalSource nor our cash flow. Therefore I do not expect it to have any impact on us for evaluation. All the ruling does is change the way EPS is calculated. So it does not -- so it's just a change of that metric, making it a little more complex and perhaps a little less useful.

And with that I will turn the call back to John.

Thanks, Tom, why don't we open it up for questions.

[Caller Instructions]. We'll go first to Bob Napoli with Piper Jaffray.

Good afternoon. Hey, John, I was wondering if you could talk a little bit more about credit. You had mentioned one, your nonperforming assets as a percentage. You had a -- had a pretty good dollar increase. Could you -- you mentioned a specific real estate loan. Could you talk more about, I guess, the credit quality as a whole and that loan in particular?

Well, yeah, I probably won't go into too much detail on that loan in particular because I'm not sure it's relevant. But as I said in my comments credit quality across the business we believe is very strong right now. The non accrual statistics which is what I was referring to did bump but they bumped principally because of this one real estate loan which is in work out and we have a first mortgage secured by the property. You know, and we've actually had some positive developments on the asset this week. So, I wanted to highlight that because it was a jump in the non accrual amounts but I think the important observation to make is that it's related to a first mortgage real estate loan. So you can appreciate the risk profile, those transactions there's obviously much different than in a cash flow loan. But, the larger issue is the company's credit quality which this quarter we had fairly inconsequential specific reserves relative to prior quarters and across the whole business, this is anecdotal, obviously, but we believe the portfolio is performing very well.

Okay. Just -- maybe just a followup on the sector growth and you -- you had mentioned -- can you give us the dollar amount of loans outstanding by sector, the end of the second quarter?

We can do that.

Yes.

Just one second , here.

Bob, how about I give you a percentage first then we can followup with the numbers?

Sure.

So corporate finance at the end of the quarter was 47%, healthcare finance of 22%, and structured finance is 30%.

Thanks. Thank you.

Sure, thanks, Bob.

We'll go next to Josh Steiner with Lehman Brothers. Hi, guys.

It sounds as though, actually from the breakdown you just gave that corporate finance is responsible for a lot of the growth in excessive, kind of the 1 billion, 1.2 billion organic framework you had given us originally and part of that is clearly due to the acquisitions. Do you think going forward that -- of the -- you know, to the extent there is out performance, if there is out performance beyond this 1 billion annual run rate we would continue to see that in the corporate finance division? And kind of as a second question, in terms of the acquisition outlook it seems like you are getting some nice opportunities out of the lender re-discount division. And do you think, within that area that you'd -- there are other potential good fits.

Well, the corporate finance group has kind of the quarter-over-quarter portfolio allocation from corporate finance, first quarter, second is about the same. So we haven't seen any material change in corporate finance as a percentage of the portfolio. Corporate finance has performed very well. We talked about that in earlier calls that one of the reasons the business was performing ahead of plan is growth in the corporate finance group. So that's continuing. We've said in the past and we will continue to say that we think that business is more cyclical than our other businesses and it's probably a 3 to 3.5 year on out of every 5 years and the other businesses are more consistent in terms of their growth year-over-year. And we still think that's true, we haven't seen that yet. The team has done a terrific job in getting itself entrenched in a market that's expanding. It's expanding because LBO volume is up. LBO volume is up in our part of the market in part because there's just a lot more funds focusing on smaller deals. So that's becoming a much more liquid market. There's a lot of sales from buyout fund to buyout fund which you didn't use to see in the past. So that's almost becoming a secondary market. And w're just benefiting quite significantly with the presence we have in the market and the quality of the team. But we do caution people to say that we think that growth will slow. That's one of the reasons why we are certainly not forecasting to take our current growth and annualizing it. But the other businesses, you know, are seeing good growth. Structure finance in particularly, the real estate effort we had talked about at the end of the year, talked about in our annual report how we wanted real estate to be a bigger part of the business and that group is off to a very good start and, I think, it's just really picking up steam to some extent. As far as acquisitions, we continue to look for these kind of tuck in acquisitions that might fit into our business groups. Structure finance is the most likely home for these things, in part because they have a broader mandate. And what I mean by that is that team is very good at these highly structured asset intensive products and to the extent we find more of those, they fit well within that business. That business has the most number of product offerings. Across real estate it offers about 4 products, in the lender finance business it offers now 3 products. So that business has about seven different products within the structure finance group. So that's where we are likely to see these acquisitions, which is, again, a really tuck in opportunities. We are effectively buying a portfolio of loans, we are doing credit work on every individual loan and then we are bringing on a team of people that we think can do better in our environment because they are not constrained by funding. They have more opportunities than they could as a standalone.

And then just as a follow up on the credit front. Are you seeing any kind of material differences between the different sectors in terms of corporate finance, structure finance, healthcare, where one sector is performing better than you had expected or another is slightly behind expectations or are they all kind of in line?

From a credit perspective I think the business is in line or ahead of expectation. I think the portfolio is performing very well. And I think that's a, you know, a result of our credit process which obviously we think is very strong with the way we do things, dual track underwriting, having Capital Analytics involved in every deal. I think our credit issues in general, you know, have fallen into 2 categories. Either we miss something in underwriting and that's probably the largest category of credit problems we've have, which is -- which means we run this great credit process but we make mistakes. You can point to things that we made -- that we did in underwriting or things that we should have focused on in underwriting that we didn't do. And then the other reason we've had credit issues is kind of material changes in a borrowers conditions that we could not have predicted. We haven't seen any kind of credit trends that would relate to directional movements in any of these markets at this point which is the way it should be. If you are a senior lender, you know, you should not take a lot of market risk in the underwriting of loans. You should really be taking company specific kind of operational risk and so I would say that the credit issues we've seen have been very specific to borrowers, that you can't draw any specific conclusions about them as relates to trends in the economy or trends in any of these businesses. It generally falls down to capital source missing something in underwriting which we are very capable of doing seeing as we've done it several times. Or something negative happening to a company that we could not have predicted. And based on all the information we had at the time we would make the loan again. It hasn't been any trends in the business. So kind of a long winded answer to your question. We are not seeing any trends. The portfolio is performing well. And our problems are kind of specific borrower issues.

Okay. Thank you.

We'll take our next question today from Don Destino with JMP Securities.

Hey, guys. John, you answered a couple of my questions. In terms of leverage, I think on the road show you talked about 4 times leverage, but I think hinted that-- that that's not necessarily a ceiling. Now you are talking about 4.5 to 5 times. Is it just that the growth has been a little better and you think you are going to be able to get to that level? Is it that the execution you are getting in the fixed income markets is that much better and you just think that creditors are going to allow you to run at that level? And then the quick followup is, as I run you at 4 to 5 times leverage and the return on capital that falls out of my model, I don't see you ever really needing to raise primary capital again. Is that -- is that a realistic long-term expectations?

There's three questions there. Let me take the first two and Tom will probably take the last one. The 4 times advise that we gave on leverage, for lack of a better word, was based on us running a model which is similar to the model you ran, Don, that said we are going to grow the business a certain amount per year and it would get to a certain point in 5 years and we would retain earnings across those 5 years. And when you did the math, the business never leveraged itself more than 4 to 1. And because growth is accelerated it's exactly as you concluded. We will probably leverage the business more than 4 to 1. Because it hasn't -- if we get to a certain asset level sooner than we thought we don't have the benefit of the retained earnings. So that's what really causes the business to leverage faster. I think our ability to access the debt markets and lever this business more than 4 to 1. There's two ways -- there's two types of debt we have in the business right now. Right? We have secured debt which some in the form of our credit facilities and our securitization and then we have unsecured debt which right now is in the form of convertible -- the two convertible debt offerings that we've done. I think those two things in combination give us the comfort that we can lever more than 4 to 1. I don't think we necessarily sit here and say that we can lever more than 4 to 1 comfortably just through the secured markets. To get to more than 4 to 1 we need the combination of the unsecured debt in there. Because for all effective purposes that we would care about the unsecured debt, whether it's a form of a convertible transaction or just an unsecured debt offering, is effectively equity in that we can leverage it with the secured debt. So the fact that we have over 500 million of unsecured debt now really implies that we have over $200 billion of additional funding capacity off that unsecured debt issuance. So it's those things in combination, the secured debt, which is the credit facility and securitizations, and then the unsecured debt make us comfortable getting above 4 to 1. I don't know if we would answer that if you just were to pose the question can you get above 4 to 1in the secured markets? I think I would say I think we can but I wouldn't be confident saying it right now just because the way those programs work and the fact that the company needs more scale and more diversity to really maximize leverage in the secured markets. I don't know if you would add anything to that, Tom.

No, I think that's right. And I think, you know, the real -- you know, the third part of the question you're asking is, would the company ever need more primary capital. I think, you know, the real answer to external capital is a function of time and growth rate, as we've been talking about, and how fast does the business grow and how much time do we have to, you know, retain and reinvest the earnings of the company. Obviously the two converts raised additional growth capital for us and as John mentioned it's capital that we can leverage just like it is equity. So I think we've got ample liquidity now and we'll look at all of our options and see where we go.

Do you mind if I have a quick followup?

Sure.

As you -- as this business gets to be 5 and eventually $10 billion, John, or Tom, do you see this as an investment grade type business? As you look at the unsecured debt markets, do you think that you can get the granularity and keep the credit and the profitability to be an investment grade company?

I will answer it quickly and then Tom will chime in. We think it should be now, in a way. We think the rating agencies, who do great work in general, we think they over weigh how long you've been in business. And obviously for a CapitalSource, which we've been around for 4 years, that's something no matter how much we talk to them about it, or show the metrics of our business which if you line it up against investment grade companies we're actually quite compelling and in some ways we win in every category. You know, returns, leverage, the kind of things you might look at if you were just walking into a situation and didn't know how long the company was around, we do very well on those things. But the age that we've been in business and the scale of the enterprise in general are two things that we just have to kind of grow into. I mean, we haven't asked for the rating and so we don't know the answer to your question. But I think John is right on paper the company looks very good but you can do the analysis like we've done and the things that are really correlated with ratings are age and size and they are what they are.

Thank you very much.

And our next question today comes from Joel Houck with Wachovia.

Thanks, good evening. This is kind of a question related to the near term growth in corporate finance. Should you expect to see perhaps a maybe an increase in the general reserves as those loans obviously have a different or higher risk profile than the other two businesses.

Well, I think that's one reason you see the allowance ticking up a little bit. 73 basis points now, I think it was 70, I'm talking about the general reserve part of the allowance before. And that's really due to our methodology which reflects the mix of business, reflects the migrations and all those thing. So I think, yes, you are already seeing that.

Okay. And not to beat credit to death but one would assume the 22 million increase in non accrual in those specific reserves were taken given a first mortgage position you expect little or no loss out of that transaction?

It's a reasonable assumption, you know, and as you go through work out on something like that you figure out if your view of the first mortgage is still sufficient. But an initial reaction on a first mortgage is that , hey, unless you -- it was a galactic miss, you shouldn't have high losses, so.

Right, but then there are like legal curve balls that you guys are seeing in terms of, you know, one of these might be in bankruptcy, there's nothing out of the ordinary?

There is nothing out of the ordinary, obviously as a senior lender you think if you exercise your rights they -- you ought to be able to foreclose in a day. The courts and borrowers sometimes disagree with that so there's always a legal process in these things that is inherently unpredictable. Right? It's jurisdictional specific and judge specific and it's stuff like that, how foreclosure works. You know, I don't want to say that there's nothing unusual. My initial reaction would be there's nothing unusual but these legal processes can take on lifes of their own.

Okay. And then maybe you could talk a little bit about the due diligence on the CIAG transaction. I'm specifically interested in what if any they had in terms of spec loans and how, if they did, you guys got comfortable with that -- with those types of loans.

Well, we had been financing CIG for several years. We, at different points in time, were the senior lender to the company, we had been kind of a B loan with the company. The company had a significant amount of equity in the business, about -- almost half the capital structure of that company was in a form of subordinated capital which was actually put in mezzanine but it was really equity because it was ahead of us or behind us depending on how you are looking at it. And under the borrowing base mechanism that we had with CIG for the last several years we were effectively approving every loan that went into our borrowing base. So the team and the loan officer in particular who managed this loan, Brad Donaldson , who is an important person in our structure finance group on the loan administration side, had been effectively approving all these loans as they came in. So I will start my answer to the question by saying we knew the company really well. Knew the management team, really liked them, John Abbott and Bruce Levin who really ran the business are here with us and we are very happy about that. So one of the things that I think was important, you know, because as you know our credit standards are pretty high and this was one of the those situations where we new every loan. We did much more extensive due diligence because when we were approving the loan as part of a volume base we were not necessarily doing property visits because we had a significant discount on all the loans but when we actually went to buy the portfolio the team did property visits and things like that. There is a fair amount of development related stuff in their portfolio. What they do is they work with developers who are experienced and kind of, I wouldn't say small, but kind of on the smaller end of mid-size to mid-size. They typically have an urban focus, although in the past few years they've done some things out in the suburbs and they are typically providing that stretch of capital above the senior loan to help the developer finance the project. And what they underwrite to is the margins on the project which is very important, because that's a big part, in addition to the equity that's in the deal, the excess margin which can be derived through a very good land purchase or trends in the market with respect to home prices, et cetera. They do a lot of work in underwriting that. And they have a lot of repeat business from customers they've done business with before. So the company's had, you know, a remarkably good kind of credit performance considering the business they are in which is higher margin, mezzanine financing. But we knew the company very well.

Okay, thanks, John.

And we'll go now to Moshe Orenbuch from CSFB.

Thanks a lot. I think three months ago on the first quarter call you talked about the proliferation of some of the BDCs and others kind of getting into the business and your thoughts on the competitive environment, what they might or might not do, any change on that as you kind of look out now?

No, there really hasn't much change. I mean, the BDC,you know, the wind's out of the sail there a little bit, I guess. We weren't all that focused on those being competitors of ours because we thought and continued to think that to the extent those transactions get done that those people will be very smart but more passive lenders to the middle market, in other words participating in the syndicated part of the market and things like that. And our view isn't changed at all on that. I wouldn't say there's been any material change in the competitive landscape since we chatted last. There's definitely people getting into business. We haven't seen much competition down in our parts of the market in part because I think it's harder to get into our businesses. I mean, we have, you know, 375 people now out there finding these loans, structuring these loans, it's a much more high touch lending practice and I tend to think a lot of people who get into the business are letting at more of a passive Asset Management strategy. You know, which is probably, you know, not word for word but basically the same thing I said last quarter. And so nothing has really changed.

Thanks.

And for our next question we'll go to Michael Hodes with Goldman Sachs.

This is actually Greg Reagan. Quick question, most of mine have been answered but can you just comment on the severity of the loss and actually comment if it was tied to National Waste Services bankruptcy?

You are talking as to the charge off?

Yes, I'm sorry, on the charge off,

Yes, it was approximately $3.4 million. We had a specific reserve established for that loan of about 3.2 million. So it was not that loan you're referring to.

It was not? Okay. All right, thank you.

Sure.

[Caller Instructions]. We'll go now to Bob Napoli with Piper Jaffray.

Just a followup on maybe a little bit more color on, you know, where you are seeing the strongest growth opportunities, if you can drill down a little bit more. On the healthcare sector, in particular, John, it's a business that you know better than anybody I know. It's still -- it's kind of been flat for a couple quarters, flattish relative to the other sectors and wondered if you could talk about the growth potential of that sector relative to the other sectors and if it's going to be dwarfed by the opportunities you see in other areas, or is there something that would make that sector become a much bigger percentage over time?

You know, I don't think it's been dwarfed. I mean, I just think the healthcare business is -- a couple thing are going on. Number one it's inherently a business that grows at a slower pace because a lot of the loans are small. The other thing that's happening in the healthcare business they have had a lot of prepayments and paydowns and that's a reflection, I think, of the quality of the loans they've done. A lot of them have paid off sooner than expected and it's generated very high fees. Our healthcare business is by far our highest yielding business. So the contribution of the healthcare business to the company is not reflected by its asset kind of contribution, if you know what I mean. So, you know, it's a very material and important part of our business as material and as important as the other businesses. They just get there a different way right now. But I still think over time, you know, you'll -- we'll see good growth in that business and the corporate finance group, which is probably a little more cyclical, I would think the spread would narrow, it hasn't happened yet, but I do remain of the view that that will occur. If you look at the healthcare groups growth it's -- on a quarter-over-quarter basis it's still growing at a faster rate than healthcare financial partners are growing, for example. So, I think the team there is clearly doing everything they should be doing. It's a competitive market, the deals tend to be small and they've had the, some would say, the benefit of lots of prepayment activity which has driven very high fees and has made the yields in that business higher than the other groups. So on a risk adjusted basis it's, you know, you would say it's the best business, their yields are high and the credits have performed great and there's a lot of turnover in the assets, so.

Do you expect that over time that you would -- that as you use a little bit more leverage and continue to diversify funding sources and maybe start moving up in loan size, in healthcare and in some of the other sectors that kind of a natural progression that we should expect to see.

Yeah, I mean, I think you will see that, you will see that, I think, in part because the company is a better known company in the debt markets and we can do business with people that we couldn't do business with in the past. In part we do have some pricing power and we use it a little bit to go up market and get some big deals. But we think the part of the market that we are in is really the best part of the market and we want to stay focused on that part of the market. That's where -- you know, the reason I can say that we haven't had as much competition or new competition as you might have thought is because we are in these parts of the market that are tougher to get into and they are smaller deals. So we think it's quite valuable to be in that part of the market. And we think we've got a real machine that can originate a lot of deals and close them efficiently in that part of the market. So, while we will from time to time, our healthcare team, for example, is closing a $120 million deal that they are syndicating and selling off to a few other lenders, for example. And that's an example. That was an important deal for us to win and we did. And our syndication capabilities have been significantly enhanced. The gentlemen who ran our Chicago office in corporate finance has recently moved over to do syndication full time because that's become a full-time job at the company and he did that same job at Heller GE prior to joining us, Dan Duffy. So we think that we can do things like that, go after larger deals and syndicate down the risk to the hold level that we want and that's the way we are getting into larger markets. I think the question we are asking ourselves and we've got some things we are working on, is the healthcare team is a very experienced team and what else can we have them do in the company in terms of other products that might have similar -- similar orientation that the healthcare team has in their core business. So that's one of the things we are kind of working on in terms of, how do we take this very talented team and have they do more in the company in addition to the healthcare business.

Thanks, John.

Well go now to [inaudible] Hefren(ph) with Delaware Investments. Mr Hefren, your line is open, please go ahead, sir.

Thank you. Just a couple of questions. First in terms of the charge offs this quarter, did you say what the loss severity was?

I may not have. We had a -- it was a $3.4 million charge off, one loan that really drove that about 3.2 million, and I think it had about a $4.2 million balance.

If I could add, the story is a little more complicated than that and I don't want to leave you with one data point.

They always are.

What is was there are two pieces to the loan. There was a receivable loan and a term loan. And the company was in the retail industry and wasn't doing well. And it was in a work out with us. And a hedge fund approached us about buying the receivable loan which we sold them. And infusing additional capital into the business which they did, in consideration of us taking a 4.2 or $4.3 million term loan and converting it into preferred stock, which we did. And we wrote -- but that transaction was happening kind of on the saddle if you will of the first quarter and second quarter. So at the end of the first quarter we had written off 75% of that loan through a specific reserve and then when the -- by the time -- by the end of April I think is when it finally all got documented we now own 4. something million of preferred stock which we are carrying at about $1 million net amount. So the severity is not as high as the 3.4 versus 4.4 because it was a larger revolver that was larger than the term loan that we effectively sold at par as part of this work out.

Okay.

I didn't want you to think it was a 75% loss severity, it was actually lower than that. We thought that the revolver which was secured by inventory principally would have been a tough potential work out. It was worth, even though we are getting pushed back in the capital structure, we thought net/net this was the right answer.

Okay, that's fair. Second question is in terms of the $22 million real estate non accrual, you talked earlier about the types of mistakes you make, whether they are underwriting misses or material change in borrower condition. Which of those two things was this?

Underwriting miss.

Can you talk a little bit about what the miss was?

It's related to the sponsor. So I'd rather not go into specific details about it. But you can make mistakes in underwriting real estate a couple different ways. You can do business with a bad sponsor, or developer, whatever you want to call them. You can do -- you can miss your market comps or you can miss the cash flows. Those are probable the three big buckets, I'm sure I'm missing something that you can miss in real estate, the cash-flow, the market or the people. It's the latter for us.

Okay. Does it cause you to go back and sort of --?

Yes, and figure out what we did wrong? Yes.

And look at other loans in the portfolio sort of similar size and structure and make sure you are not making the same mistake.

Yes, it does and actually there's a specific procedure we put in place that didn't exist prior to this deal that we've now implemented.

Okay.

Again, I can't go into too much detail because of the nature of the situation.

I understand. And the third question is sort of philosophical, looking at the leverage question, maybe from the other perspective which is really should you be growing as quickly as you're growing? And, yes, the loans are available, and, sure, you can make the loans. But, you know, sometimes it's assign of maturity that you sort of stick to the original plan and is this a company that should be heading to 5 times leverage this early in the maturity process in terms of the loan portfolio.

It's a really good question and we've actually kind of looked at it a little differently and the question is, we are growing faster than we thought, should we be much tougher on pricing. That's kind of the response we've had to this.

Right.

And I think we've had that response because your question, which is can we manage the growth from an operational and credit perspective, we feel pretty darn comfortable we can do that, which is one of the reasons why our operating expenses as a percentage of assets have not met our expectations. And we really do believe that we've got that part of the business, you know, in as good shape as it's ever been in terms of our ability to process these deals and things like that. It's much more, you know, should we be -- we've seen a little erosion in price, and clearly as the company gets bigger and lower cost capita, we've been a little more flexible on a few deals on pricing, can we back up on that a little bit? And maybe that's a better answer.

Can I extend the question because isn't there the potential -- isn't pricing the sort of clumsy mechanism for controlling portfolio growth because it exposes you to adverse selection?

No.

Maybe people who would pay you a higher than quote market price?

What it's really, I think, happened with us a little bit is, you know, if you looked at kind of -- there's been clearly a desirous part of building these businesses is to be a little more aggressive on a few transactions, you see what I mean on pricing and that's what we're saying maybe we don't not have to do that, we have such good deal flow, maybe we don't -- it's more that, you see what I mean? It's more an expansion of the core business which has proven into things that are a little more competitive, a little larger that is affecting pricing as opposed to -- so there will be no adverse flexing because we are getting all the same deals we've always seen.

Okay. Can you give us a limit on leverage.

I don't think we can give you a limit on leverage. no.

To me that seems like a fairly material change then in terms of now versus presentations where there was leverage guidance and it seems to me we are sort of having a 5 to 1 with no potential limit and one of the stories was, one of aspects of the story was the conservative posture of the balance sheet. It seems to me you are opening the door to just about anything now.

I don't think that's actually what we've said.

I think that's, as I'm interpreting what you just said, I think that's taking what I was guiding people towards a little too far.

I don't want to get into an argument with you. I have my notes from presentations that say equity 4 to 1 long-term and that's where I am getting kind of confused.

Right. Well, as we tried to layout, I mean, when we modeled the business earlier and ran all of our projections at slower growth models it was hard to get the business to go over 4 to 1 because it just didn't throw off -- it was throwing off so much in terms of income. And now growing the business a little bit faster, you don't have time for that to compound so the leverage makes up the difference. And I, when I said we see ourselves going to 4.5, maybe to 5 over time, I mean I really meant over time. I am not saying we are going there this year or maybe next year, just trying to reset a little bit the longer term potential.

And I think, you know, it depends how you view these convertible offerings that we've done. If you view them as equity we are not going to go over 4 to 1. Right. If you view them as debt we will. That's kind of where I think the action is in this discussion.

If you are successful they will be equity and if you have difficulty they will be debt.

That's right. And so we think they are equity so I would come back to you and say, we probably haven't changed. I am not trying to be cute about it.

No, no, I think that's fair. Thank you very much.

I think that's where the action is, it's in this kind of 550, is it equity or is it debt. You know, I think the recent accounting changes have said that most people view it as equity so you think you ought to view it as equity which is hard to argue. These things are offered by the equity capital markets of the investment banks.

Yep, very fair, thank you for your time.

Sure.

We'll take our next question from Jupeng Lee with (inaudible).

Yes, I just want to make sure, the 4.5 and 5 times leverage, do you refer to secured debt leverage?

Yes, that's all -- in that definition it's credit facilities, it's securitizations and it's a convertible debt.

So when you say 4.5 and 5 times, you include the convert as debt?

Yes, yes, we do.

Okay. If excluding the convert, if you treat convert as equity.

Then we're still back door --.

You are targeting 4 times leverage.

Yes, yes.

Okay. Thanks.

And that does conclude our question and answer session. I will turn the call back to you, Mr Skarupa, for any closing remarks, sir.

Well, thank you very much. That concludes our second quarter call. We appreciate everyone participating. Thank you.

Thanks.

And once again, ladies and gentlemen, we appreciate your participation. This does conclude the conference. You may disconnect at this time.