PacWest Bancorp (PACW) 2004 Q3 法說會逐字稿

Good day everyone and welcome to the CapitalSource third quarter 2004 earnings conference call. (Operator Instructions) At this time for opening remarks and introductions, I would like to turn the call over to the Finance Director, Mr. Tony Skarupa.

Thank you and good evening. Joining us today are John Delaney, Chairman and Chief Executive Officer of CapitalSource, Jason Fish our President 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 web cast 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 8:30 p.m. Eastern time and our press release and website provide details on accessing the archive call.

Also before we begin I need to inform you that statements in this 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 risks uncertainties and contingencies, many of which are beyond CapitalSource's control and which may cause actual results to differ materially from anticipated results. More details about these risk factors can be found in our annual report 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. Good afternoon everyone. Our comments this afternoon will focus more on the specific performance this quarter as opposed to broad comments about the business, since we recently had an investor conference where we covered a lot of details about how the different business units in the Company are performing.

So I'll start with the highlights. As most of you know we earned $0.29 per share in the third quarter, we grew our loan portfolio by $482 million to approximately $3.8 billion, and all three groups had very solid growth, and in fact the growth this quarter was more balanced than what we had seen in prior quarters. In the past we had spoken about how the Corporate Finance had become a larger part of the business on a relative basis, and we had said that this quarter we expected the portfolio to start balancing itself out, and in fact that happened. The Corporate Finance group at the end of the quarter was 45 percent of the portfolio as compared to 47 percent of the portfolio which is where it was at the end of the second quarter. So we're starting to see some of that balancing that we had predicted. Yields were very strong this quarter both in terms of core yield and yield from fee income, and Jason will drill down deeper on the yields in a few minutes. Our operating expenses came in right on plan, and the environment for all three of the business groups remains the same as it was a few weeks ago at our investor conference -- again where we spent a fair amount of detail talking about these three groups. All three groups continue to see very good opportunities. With each passing quarter the groups are seeing more and more opportunities and all three groups continue to be more selective.

Moving on to credit, the credit performance of the company continues to be very strong and in line with our expectations. We had no charge-offs in the third quarter but we did add $5 million of specific reserves. The guidance on specific reserves for the rest of the year remains unchanged from what we advised at the investor conference, which means we expect specific reserves in the fourth quarter based on what we know now to be at or less than $2.5 million. Put another way, we were aware of the $5 million of specific reserves for this quarter when we gave our detailed guidance a few weeks ago.

The 60-day delinquency category was up this quarter, but in reality it wasn't up as much as the numbers would indicate. A loan that had gone on non-accrual last quarter which we aggressively and proactively put on non-accrual before in fact it went 60 days delinquent, slid into the 60 day category this quarter, and that was actually most of the 60 day category, so that's not really a new situation, that's something we were aware of last quarter.

A second loan that went into the 60 day delinquent category and also went into the non-accrual category was actually resolved yesterday, so as of today that loan is no longer in either the 60 day delinquent category or the non-accrual category, and then there were a few loans that we purchased from CIG -- as most of you know we purchased a business the beginning of July called CIG International which is a mezzanine lending business focused on the home building business. We purchased several loans from that company that we knew were troubled loans. We purchased those loans at a discount, that discount doesn't actually appear in our reserves it's just that we carry the loan at a significant discount to the face amount. We expect to resolve those loans at that discount amount but we knew those loans would go into non-accrual and 60-day delinquent as soon as we purchased them, so really there was no change in the 60-day delinquent category from last quarter. Non-accruals is really the same story. There was the one loan I already spoke of that slid into the non-accrual category but that's been resolved and then there were a few loans in the CIG situation. So the credit story at the Company remains quite strong.

Other significant events to comment on is probably our bond deal which we announced earlier and closed today as we had indicated this deal had the best terms we had ever achieved. There was less equity or less subordinate capital required by CapitalSource in the deal and the spreads were much tighter than on any of our prior deals. Which I think reflects a few things, clearly there is an increased acceptance of our Company in the secured debt markets, in fact we're probably the leading issuer of middle market securitizations in the markets right now, and obviously the second thing it reflects is the quality of our credits. Our earlier deals have performed very well, much better than anyone's expectations, and the rating agencies obviously do loan-by-loan analysis and so I think this improved structure and tighter spreads clearly reflects the credit performance of the Company. And the liquidity of the Company right now is the best it's ever been.

So the key takeaway from the quarter we had solid asset growth, which we see continuing in line with the asset growth guidance we provided at our investor conference. We had strong yields again reflecting our strategic focus and very good execution capabilities, and credit remained right in line with plan. The bottom line performance was ahead of our expectations this quarter driven principally by stronger yields than we had expected. So with that, I'll turn the call over to Jason who can drill down a little deeper on the financial performance.

Thank you John. John talked about two financial metrics which are the loan growth for the quarter and the credit quality and the components of that which I will leave as is and then if there are any follow up questions you can ask on those. In terms of the yield, yield was up this quarter to 11.8 percent which is 96 basis points higher than the 10.84 percent we saw in the second quarter. This increase was due to a number of factors, the greatest of which was pre-payment related fee income which contributed 88 basis points to yield this quarter versus 26 basis points last quarter.

We've discussed before that pre-payment related income is going to vary from quarter-to-quarter, it is not consistent like our core yield is, however as we said last quarter the 26 basis points we received last quarter in pre-payment fee income was unusually low. The 88 basis points we see this quarter is about -- it's within the range of what we expect to see, a little bit on the high side. We also saw some increase in our core yield this quarter, primarily due to upward rate movements, and that was comprised of yield from interest income of 9.07 percent up from 8.94 percent last quarter and an increase in recurring fee income of about 20 basis points. Leverage as you would expect grew with the loan portfolio.

Our debt to equity ratio increased from 3 times debt to equity at the end of the second quarter to 3.4 time debt to equity at the end of this quarter. This is fully in line with expectations. We expect to see leverage continue to grow in the future, and as we discussed in detail at the investor conference we are comfortable managing the business up to as much as 4.5 to 1 leverage in the near term, but we won't expect to see that for the next several quarters.

The cost of funds for the quarter was 3 percent, up 26 basis points from 2.74 percent in the prior quarter. This reflects the continuing rise in short term rates that we've seen quarter-over-quarter. Tom is going to talk about the recent term debt securitization that John alluded to where we raised slightly over $1 billion, where we actually saw much more enhanced or better pricing, tighter to the curb pricing than we've seen in the past. So the cost of funds reflection really is just the market and our acceptance in the market continues to grow.

Net interest margin for the quarter was up nicely to 9.5 percent and for the nine months ended September 30 was at 9.47 percent, so about consistent. Our previous guidance which we reiterate for 2004 for net interest margin is at 9.1 percent and we continue to look at net interest margin forecast for 2005 of 8.2 percent. We continue to expect that yields will trend down slightly over time not so much because of the rising rate environment, but because of the competitive environment that we're in.

In terms of other income, it was down this quarter to $4 million compared to $6.9 million in the quarter. This difference is mainly the result of negative timing variances in the line items that comprise other income. The largest impact we saw was due to our HUD mortgage business which had a particularly strong second quarter. Again the other income line was in line with expectations for the year. I'd also like to add that the other income will continue to be an ongoing source of regular income for us as we talked about in the investor conference.

Operating expenses were up slightly quarter-over-quarter to $28.5 million from $27.6 million, but decreased as a percentage of average assets from 3.4 percent to 3.0 percent in the quarter. The efficiency ratio was 30 percent this quarter -- or 30.1, versus 30.5 in the second quarter. So the operating leverage we've spoken of taking place is starting to occur and we had a dramatic impact on that in this quarter.

With that I'm going to turn the mike over to Tom Fink who will talk about our term debt securitizations and some other accounting and finance matters.

Good evening everyone. Both John and Jason touched on the term debt deal which we closed today, and obviously at CapitalSource we're very excited about it, it was a very significant transaction for us and by every measure a great success. I think most people saw the press release earlier in the week, so I'll just touch on the highlights. Obviously it was our largest transaction, the amount of loans involved in the transaction was just over $1.1 billion. We raised just over $1 billion of term debt. The size, the quality and really the diversity of the pooled support of capital structure for the financing which will be very efficient for us. We achieved a 90 percent -- just over 90 percent advance rate, which is our highest ever and therefore our lowest amount of retained equity, and actually the dollar amount of equity invested, if you will, in this securitization is actually smaller than the dollar amount in the prior transaction which was a smaller deal, so that's a big step forward for us. Also, the triple A rated notes on this transaction were a bigger percentage than we had seen in prior deals, again due to the nature of the pool, the size the quality and the diversification within that pool. We raised just under $800 million of triple A rated debt.

We saw a very strong and broad demand for our bonds, including a good percentage of demand coming from new investors, new to CapitalSource investors, so we're very pleased to see our investor base broadening for our term debt securitization and I think it really speaks to the maturity of middle market loans as being very good collateral for these securitizations, but also probably more to CapitalSource recognized as being a very good underwriter and originator and manager of these types of loan. And we feel we've become really the premier issuer in the market for middle market loans.

We saw significant improvements in the pricing in our spreads across all classes of the notes, which combined with the improved capital structure resulted in a 10 basis point improvement on the deal versus the deal we did four months ago. Our initial weighted average spread to LIBOR was 34 basis points on this transaction versus 44 on the prior deal, so very attractive, very efficient cost of funds for us.

I said at our investor conference last month that we believe we have deep access to the secured debt market and I think the execution of this transaction really shows that. With that I'll turn it back to John.

Okay, I think it's time for us to open up for questions.

(Operator Instructions) Michael Hodes, Goldman Sachs.

Hi, good afternoon guys. A couple quick questions for you. First, just regarding the pre-payment related fees, I was wondering if you could put that in perspective, I think you guys say in general that roughly 20 percent of your loans run off in the course of a year. If that's true it implies that the pre-payment penalties are roughly 4 to 5 percent of the face value of the loans. I was wondering if you could help contextualize that first, and then secondly just regarding the trend in the non-accruals, if we were to look at that on more of a lag basis, it does seem like a pretty pronounced ramp. I know a lot of this has to do with loans that you have collateral against that you're not so concerned about in terms of a charge-off, but maybe you could refresh us in terms of the vintage trajectory and with that your comment about the specific reserve, I just want to make sure I follow it. The $5 million specific provision that you took this quarter I assume will surface in charge-offs either next quarter or the quarter after and your comment about a $2.5 million -- I don't know if that's a specific reserve or specific provision, if you could just clarify what that is, what you were referring to there.

Sure Michael. I'll answer the second half of your question, around the specific reserves and non-accruals etc and then I'll let Jason and Tom respond to the first half of your question if that's okay.

Right.

The last part of your question centered on the $5 million of specific reserves and the comment about the $2.5 million of specific reserves in the fourth quarter. We had, as you know, provided guidance in our investor conference a few weeks ago that indicated that the total specific reserves we were advising people to model for, for the rest of 2004 was $7.5 million. And we -- the point I was making is we still feel very comfortable with that number. We took $5 million this quarter, which wasn't a surprise to us because when we gave the $7.5 million of guidance we knew we would be taking about $5 million this quarter, and we still feel comfortable that fourth quarter will come at or potentially below and potentially zero, $2.5 million. So that's really where that was coming from. We had advised about $7.5 million for the rest of the year, we took $5 million this quarter which is what we knew we would be taking when we gave the $7.5 million guidance, and so we feel comfortable saying that the fourth quarter will be at $2.5 million or below. So that's that part of the question.

In terms of when the specific reserves will translate into charge-offs, it's a very loan specific analysis. In the past we have seen the charge-offs follow specific reserves within one or two quarters. And I'm not sure that will happen with these specific reserves necessarily. One of these deals, in particular, is going into what I would consider to be kind of a longer workout phase and it may take some time before that specific reserve becomes a charge-off and maybe that specific reserve may never become a charge-off, but we feel it's prudent to take that at this point. So normally you'd see the charge-offs come within one or two quarters after the specific reserve is taken but that's not always the case, depending upon the nature of the workout and the nature of the charge-offs. So that was, I think, answering your question around the specific reserves.

The second part of your question was focused on the non-accruals, the trends in non-accruals. What really happened this quarter is that one -- in addition to a CIG loan that when we purchased it we know it would go -- it's actually two CIG loans, when we purchased them we knew they would go right into the non-accrual category, which is why we purchased those loans at a discount. They were problem loans at CIG, and we knew we were buying into the problem, and we priced the loan accordingly, and they immediately went right into the non-accrual category at CapitalSource.

So other than those situations we have one loan, a real estate loan, that slid into the non-accrual and slid into the 60-day delinquent category in the third quarter. So that loan was both 60 day delinquent and in non-accrual at the end of the third quarter. That loan has since been resolved and so as of today that loan is actually not in those categories, and so the non-accrual category is back to where it was at the end of the second quarter. And that same dynamic in the 60-day delinquent loan it slid in, that was kind of the comment I was making there.

In terms of our guidance around specific reserves, which was as you know, 40 basis points, we derived that based on our view of what those specific reserves charge-offs will be for '04, and we created kind of a hypothetical static pool that looked back two and a half years starting June 30 of this year. And so the number that we used, in other words, the numerator, if you will, included $7.5 million for the rest of the year, of which we've already taken $5 million, and we think we'll take another $2.5 million or less. That's where that 40 basis points comes from. And we still feel very confident based on our view of how the portfolio is performing and the credits within the portfolio etcetera, we still fee very comfortable that that 40 basis point number is a good number, based on what we know now, going into '05. So before I turn it over to Jason to talk about the pre-payment fees, let me ask you if I've answered all of those kind of credit related questions.

You did, thank you very much.

So Jason, you want to-and Michael's question was around-

Yes, I've got that. Michael, just to repeat for everybody on the phone, Michael had asked about the pre-payment related fees, can we give any color on that, and he had indicated that we had indicated that we thought we'd see about 20 percent payoff a year, does that reflect 4-5 points of prepayment fees coming in per loan, or on a dollar weighted basis, is that right Michael?

Yes, they did seem a little large when you look at them relative to what the runoff would likely be, and I'm not sure if there's a big payment in there, or it's more just the acceleration of upfront fees.

Right. Well, you've just touched on-the two components of prepayment related fees are, the acceleration of unamortized discount, or unaccreted-in discount, and then additional prepayment fees on top of that. Now, we've never broken that out before, but those are the two component parts. And it is very hard actually to come to any specific conclusions about what is happening in terms of the dollar volume of the prepayments. Because some loans will prepay with no additional prepayment fees, or very de minimus ones. And on the other hand, a loan will also have, if it pays off after a year, could have 4 years of acceleration of their deferred fees that had been anticipated to come in over the 5 years. So, this is not meant to be a non-answer, Michael, but I think that's it's fair to say that it's tough to draw a conclusion as to whether, number one, we saw a dramatic number of prepayments, which we didn't, they were more or less in line. But also whether or not we had large specific additional fees related to that, or these were just loans that had paid off earlier in their cycle than we had anticipated. I just want to add to that that in the investor conference, just to reiterate for anybody who was not on the phone, or at the meeting, that we gave guidance on a going forward basis that we would anticipate approximately 50 basis points per annum coming from prepayment fees. And so when I said that 88 basis points for the quarter was on the high side, but within the range, that was the context in which I was saying that.

Joshua Steiner (ph), Lehman Brothers.

John you mentioned that Corporate Finance stood at 45 percent of the business at the end of the quarter. Could we get the same numbers for Healthcare and for Structured? And then, just going forward, thinking back a couple of quarters ago, I think you had mentioned that in your view corporate finance went through these kind of 5 year cycles where you had a 3 or 3.5 year period of growth, and then a year, a year and a half kind of staying on the sidelines. And I think you had mentioned that you were kind of getting to the point where you were kind of coming out of that 3-year, 3.5-year cycle. So I guess the question is, going forward, should we expect real estate and structured to remain kind of a third or so of the growth going forward?

Sure. Let me give you the specifics on the-I'll answer the question by starting with your specific question which is, what was the portfolio breakdown between the other groups. And I can give you the percentages and the numbers if that's useful, Josh. Corporate Finance was 45 percent of the portfolio or about $1.7 billion. Structured Finance was 32 percent of the portfolio, or $1.195 billion, and Healthcare Finance was 23 percent of the portfolio or $888 million. Those are the specific breakdowns by percent and by dollar amounts. We do think that the Corporate Finance group is more cyclical than the other businesses, and we've said in the past that anecdotally we think it may be a business where you have 3-3.5 good years out of every 5-year cycle. And I don't think we're at the point now where we're predicting the end of that cycle. And it's not completely binary where it's on and then off, it's more active and of course less active, is really the dynamics of the business. You know, modeling of the business going forward, we have been more conservative with respect to the originations in Corporate Finance. Recognizing that in fact we may be approaching a time when the business is slower, which we think would be quickly followed by probably a very good time to be in the business. And that's why we want to be disciplined and sit on the sidelines a little bit more for that 1-1.5 years where it's slower so that we can get back in aggressively when the business turns. And we think we may be approaching that. And we've modeled that into our business going forward, which is one of the reasons why we projected the business, that net asset growth lower in 2005 than it did in fact, or will in fact have 2004. And so clearly the other businesses, Structured Finance and Healthcare Finance will continue to grow. We think those businesses are less cyclical. We think they can grow year in and year out. There's several different products within each of those businesses to balance them out and allow them to be consistent growers. And so I think what you'll see is more of this balancing concept that I talked about, which we talked about specifically last quarter, and I think the quarter before I said my sense was it would start to happen and I think I said last quarter that I thought it would happen this quarter, and in fact it did happen this quarter, where we started to see Corporate Finance become a smaller part. It's still the largest business, but smaller on a relative basis compared to where it was in the past. That slack will be taken up by Healthcare and Structured, which are looking at actually very good pipelines right now. So I would bet on that balancing continuing-it won't be dramatic, you won't see Corporate Finance go from 45 percent to 35 percent in any given quarter, but it'll be kind of a 1 or 2 percentage point movement that we've seen this quarter.

Great, and if I could just ask one quick follow-up. The tax rate this quarter was a little bit higher than normal, and you had mentioned it in your release, and I think you said that going forward you expect that to come back down. Could you just kind of explain that real quickly and expectations for what that should be going forward?

Sure, I can get that for you. Very simply we had been providing for income taxes at 38.5 (ph) percent tax rate, and when we made our final filing for our 2003 tax we saw that our actual taxes were higher than what we had provided for, so very simply had a catch up adjustment in the third quarter with those 2003 taxes and also we changed our estimate of taxes going forward, and we're now providing for taxes at a 39.2 percent annual rate. So the net effect of that in the third quarter is you have a catch up of about 41 percent effective rate in the third quarter which equates to a 39.2 percent rate year-to-date, and we're expecting income taxes to be 39.2 percent going forward.

Bob Napoli, Piper Jaffray.

Two questions, one on the, I was wondering if you could comment a little further on yields, I think the net interest income margin came in a little higher than you had thought for this quarter, and you kind of suggested you're reviewing next year-thinking about your guidance for next year which I think was an 8.2 percent margin for 2005. I was wondering if specifically you were able to tell what was driving the margins to stay at a higher level, I guess, than what you had anticipated.

Well the major driver I would say is that we had the higher prepayments. If you look quarter over quarter-

I mean excluding the prepayments. That part was obvious. I think the net interest income had gone up and-

Well some of it is also having to do with rates rising. We had substantially seen the effect of the interest rate floors, that would have had a near term negative impact on our margins, basically been removed earlier in the year, and then we actually have, because we are under-levered and we're funding a quarter of our business effectively with equity, as rates rise we actually have a positive impact from rate movements northward. And I think you'll continue to see that. So in terms of the impact on the core earnings, I think what you'll see in terms of the positives are as rates rise you'll see a modest, positive increase in our net interest margin, to the extent that-the other thing that I think actually had an impact this quarter was the CIG portfolio coming on, which was a higher yielding portfolio. The reason why we have not projected that we're going to maintain at these levels for the balance of the year is that the incremental loans that come on in subsequent quarters will come on more where we've seen loans come on as newly originated as opposed to acquired loans. So I think those are your major factors.

Are you also seeing less pressure than you had modeled in the yields you're able to get in the market?

I would say we have not seen any increment to competition, I don't know if John, you want to add anything to that.

No, it's a fairly-the competitive environment is fairly consistent with what it's been all year. We're not seeing new entrants continue to come into the business. I think a number of them entered in the last 18 months, and that's kind of stopped at this point. So I don't think you should interpret anything as it relates to yields, and correlate it to competition. I don't' think that's happening.

Last question. I just wonder if you can comment on the converts and whether or not we're going to see additional shares in the fourth quarter with the new convert accounting.

Yes, I think maybe for background for everyone else on the call, as you may know, the FAS (ph) we recently adopted, the emerging issue, task force proposal or accounting treatment for contingent convertible, both of our convertibles are contingent convertibles, and the proposal as we discussed on our last call, is basically that you eliminate the contingent EPS accounting and require the use of the 'if converted' method of accounting. There's also another alternate method of EPS accounting called the Treasury Stock method that's available if you have what's called a par settlement or a net share settlement feature in your convertibles. Both of our convertibles have this feature. So if CapitalSource were to make the election to, upon conversion of the bonds, to repay the principle amount in cash and any premium amount in shares or cash, we would qualify for this Treasury Stock method. We've been looking at that, we've determined that we're going to make that election with respect to our first convertible, we're studying making that election with respect to our second.

Joel Houck, Wachovia Securities.

Thanks, good evening. I want to ask about the term debt deal that you guys just did in the, you're increasing your advance rates, how much of that is a function of, you know, the rating indices look at this, and how much is it the change in mix in this deal versus last one, and how much is it the good performance as the old pool seasons, and can you give us a little more color on that?

I would say it's really dual part-some of all of the above. It's a larger pool, it's a more diverse pool, so that in and of itself supports a higher advance rate, the way these deals are structured, and just for the sake of everyone's benefit, when we do put these deals together, we do submit our loans to the agencies and they come up with their own credit quality assessments and recovery rate assessments. As I say, that's one factor, certainly, and I would also say that the agencies are continuing to evolve their criteria with respect to the financing, so they fine tune things, we're getting some of the benefit of that as well. And then of course, the good track record we've had is, I think, starting to count for something is the financing as well.

Yes, the investor community I think has really appreciated how well our prior deals have performed, because they really have. They model these things in a variety of different ways, and by almost any measurement or metric they would use, we've exceeded expectations. So, I think that's made our paper quite in demand in these deals, which, that's the reason why the spreads have gotten so tight.

Okay, and if I could kind of add on with respect to the spread, what-in our guidance for 3 percent cost of funds this year and 3.7 percent next year, did you assume any spread compression in term debt deals as time went on, or no spread compression.

No, we did not. And I think our guidance for increasing cost of funds is really just a reflection of what we think is going to happen with short-term rates, and really has been happening with short-term rates. But we do not model in any additional compression, if you will of spreads for these deals.

And one of the other reasons we do that, at least, is we want to be prudent and conservative because there is-these are market deals, so depending upon the condition of the capital markets, spreads can move around. If our deals continue to do well-there was a little wind at our back on this deal, it is a good secure debt market right now, so we-there's some benefit of that reflected in the numbers I think. But to your point I think we were reasonably conservative about the spreads going forward.

Okay, and then on the yield part, can you give us a sense for how the dynamic between higher yields because of higher rates offsets perhaps yield compression because of competitive issues. Is that a-it looks like you guys are doing quite well so far on that front, actually gaining some ground. Is it possible that you guys wouldn't lose ground well into '05?

Let me try to restate your question Joel. Are you saying what's the interaction between our yield projections as it relates to a rising rate environment and then the dynamics of the competitive environment?

Yes, how do those two things interact, and then how does that tie into your guidance as you outlaid at your conference, yes.

Well, when we gave guidance, and I'll let Tom chime in more specifically, but when we gave guidance we assumed rates going up. Which we talked about. We just looked at where the curve was. But we also assumed that based on the larger enterprise and the competitive environment that we would be originating loans at a tighter spread. So the guidance reflects those two assumptions, rising base rate and a tightening spread over that base rate based on our desire to be prudent and conservative about how we model the business going forward. Do you want to add anything Tom?

No, that's exactly right. I think if we look at how we did this quarter relative to our forecast I think our yields were a little bit stronger than we had been forecasting, so we're just very pleased with the performance this quarter.

Matt Vetto with Smith Barney.

Two questions, one is, on the on the comp expense line I was wondering -- it looks like if you try to come up with a sort of cost per employee and sort of pick up a little bit, is there anything to read into that. Is there any sort of opportunistic comp accrual given the higher prepay fees in the quarter, and what should we expect to see on the headcount line going forward. And then the second thing is just, it looks like on the balance sheet you saw a little bit of a tick up in the 'Other Assets' line, just wondering what's going on there.

I'll answer the first part of your question and I'll let Tom answer the second part. Matt, we, I think we might have touched on this before, but we have a bonus accrual system that is guided, it's not a hard and fast rule, but it's guided by the performance of the company, the return on equity that the business produces, so to some extent we have a waterfall that looks at achieving a certain hurdle, or target, and then sharing excess earnings between the capital and the bonus pool. It's quite complicated actually, so I won't go through the details on the call, but I think you were right on in your interpretation, and that is, when the business performs better, our bonus accrual is higher. And so when you see a higher return on equity in CapitalSource, you'll see the business actually become a little less efficient because we're accruing a higher bonus pool. You know we think a system like that does two things, it increases our ability to deliver a consistent and predictable return on the equity, or put another way, a consistent and predictable earnings stream, and it also creates good alignments between the employees and the shareholders.

Does it say anything about the mix of employees you're adding at this point?

No, I think that I wouldn't go there in the analysis. It's much more the concept I just discussed.

Okay, and then in terms of other assets, you're right other assets were up almost $16, $15.8 million dollars quarter-over quarter. More than half of that was due to things related to the CIG acquisition. As part of the acquisition we have about $4 million of goodwill and intangibles. And then the result is about $3.8 million of real estate owned that we acquired in connection with that. So that explains most of that variance there. And then the other items were just normal things, we pay our D&O premium for example, and that increases prepaid expense, and things like that.

(Operator instructions). Steven Schulz (ph), KBW.

Could you just give a little more color on the operating expenses as a percent of assets. I know you had kind of guided to the 3 percent, to 3 1/4 percent range, and you dropped down just a little bit below the range. Is there anything in particular that you could point to in terms of the operating leverage that helped you out there?

Well, the operating leverage is very simple. We just have a growing asset base, and we expect that to continue so we don't expect our operating expenses to increase at the same rate, so we expect to see those efficiencies and the operating expense ratio as a percentage of assets to come down. There's always some noise in there, but directionally that's what's happening, and we think, this quarter we saw some things like professional fees were down because we had fees related to the acquisition in the prior quarter, you know, a number of factors like that. There's timing differences and travel, and what have you. We're very comfortable with the guidance.

You had mentioned that the CIG portfolio addition had an affect on the asset yield. And given that CIG had a little bit more of a mezzanine focus, can you just run over the portfolio breakdown by mezzanine percentage and senior cash flow percentage, and senior asset base percentage.

Sure, in terms of the mix, if you will, of the portfolio by type, we did see mezzanine increase a little bit. The portfolio is still very, very highly senior oriented, 94 percent senior secured debt. Mezzanine increased form the last quarter from 5 percent to 6 percent, so a small increase, but that was driven largely by the CIG, acquisition of CIG. Our cash flow loans, senior secured cash flow loans which were 41 percent of the portfolio last quarter are now 40 percent, so they decreased a little bit in terms of the mix. Our first mortgages on real estate is up 27 percent from 25 percent, and our asset based loans are 27 percent, down from 29.

Michael Jones (ph), Chartwell.

Just on this loan, it resolved post the end of the quarter, can you give an idea what the magnitude of that is, and if the provision was, with the non-accrual was 1.16, what would it have been without that loan?

The loan, it actually wasn't resolved Michael, before the end of the quarter, it was resolved after.

Right, I understand.

Okay, I just wanted to make sure. It was about $6.5 million.

Michael, just to add, that would take it down to very consistent with what it was previous quarter.

about (8)?

Yeah, right around there.

The only difference would be those CIG--

Those two tiny CIG loans.

And it was resolved at a breakeven or a profit, or how?

Par.

Gentlemen we have no further questions in our queue at this time, I'll turn the conference back to you for any closing remarks.

Tom's got one detail about when our fourth quarter numbers are coming out, so I'll let him finish with that. But I will thank you all for calling in and reiterate that the guidance we provided in our investor conference, we still feel very good about. So with that, Tom?

Sure, just one minor housekeeping item. Thank you everyone for participating and we look forward to speaking to you again probably in mid-February when we will release our full year results. This is a little later than we-

The Sarbanes-Oxley requirements I think make us a little more conservative about when we'll have our numbers complete this year. Thank you.

This does conclude our conference call.