PacWest Bancorp (PACW) 2004 Q4 法說會逐字稿

Good day, ladies and gentlemen and welcome to the CapitalSource fourth quarter 2004 earnings conference call. My name is Steven and I'll be your coordinator for today. At this time all participants are in listen-only mode. We will facilitate a question and answer session toward the end of this conference. (Operator instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Tony Skarupa CapitalSource's Finance Director in charge of Investor Relations. Please proceed, sir.

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 webcast simultaneous on the Investor Relations session of our website, www.CapitalSource.com. Furthermore, a recording of the call will be available on the website this evening beginning at approximately 7:30 p.m. Eastern time and our press release and website provide the 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 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 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 12th, 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. Let me just lay out the road map for the call before I get started. I'm obviously starting here and I'll touch on some of the highlights for the quarter. And then I'll talk about some of the organizational changes that we've made that we've disclosed in our press release that went out a little over an hour ago. And then I'll conclude with credit, and then I'll turn the call over to Tom and Jason who will touch on some financial - - drill deeper on some of the financial information for the quarter and for the year.

We were very pleased with our numbers. We reported $.33 per share in net income for the fourth quarter and $1.06 for the full year. We consider this to be very strong performance for both the fourth quarter and for the year. The asset growth during the fourth quarter was strong at $492 million.

This strongest driver, or the main driver of this asset growth was our Healthcare business which grew from 23 percent of our portfolio at the end of the third quarter to 29 percent of our portfolio at the end of the year, which was a very significant growth of that business, very significant gain within the portfolio. And while Healthcare had particularly strong growth, our other 2 groups, Structured Finance and Corporate Finance also had very good quarters. Our Corporate Finance Group, which was reduced from about 45 percent of the portfolio at the end of the third quarter down to 40 percent, had higher than average prepayment during this quarter. So while the group had good gross originations, its' prepayment activities caused its' portfolio to not grow as significantly as its' gross originations would have indicated.

While I'm talking about the groups and while I'm talking about the Corporate Finance group in particular, I want to mention the award that was given to the group that we announced yesterday which was the "Small Lender of the Year" by a magazine called "Buyouts Magazine", which is kind of the main publication within the leverage buyout business. We are very pleased with this award and I think it's one other example of the strong franchise that they built within our Corporate Finance Group.

As we look ahead, we we see solid growth prospects in all 3 of our businesses, and there's been some changes within our businesses which I'll talk about in a minute but we see strong growth prospects in all 3 of them. We think the groups will continue to balance themselves out. We had started to talk about this in the second quarter, that Corporate Finance at the time had grown to about 47 percent of the portfolio and we expected the portfolio to balance itself out. We are clearly starting to see that now, as you can see from the portfolio allocations that we've disclosed in the press release with Corporate Finance down to 40 percent, Healthcare 29 and Structured Finance at 31 percent and we expect that to continue.

The competitive environment remains pretty up much the same as it was when we talked about in the past. We are certainly facing strong competition in all 3 of our businesses. It hasn't really changed significantly across the last few quarters. Corporate Finance still probably sees more competition on a relative basis than our other 2 businesses, which is 1 of the reasons we think the 3 groups will continue to balance themselves out.

We included in the release some organizational changes that we made, or descriptions of some of the organizational changes that we made, including several promotions. Let me give you the background on what's going and how we think this is an important development in the Company in terms of how we're positioning the business for future growth. Across the last few years we've experienced very significant organic growth across all of our businesses. and this organic growth was really driven by us creating several focused lending efforts within the 3 business groups that we have at the Company.

And in recognition of these new kind of focused groups that have emerged within the bus - - within the 3 historic businesses that we've had, we are promoting the 3 Managing Directors of the Company, Dean Graham, Joe Canterbury(sic) and Michael Szwajkowski, to Group Presidents. And beneath them we are promoting several individuals to the title of Managing Directors. Dean, Joe and Mike will increasing have more strategic responsibility in the Company charged with continuing to grow these larger platforms that they are running. They will be joining the Credit Committee for deals that are in their businesses. And so they are lifting up from the more tactical rolls they have had historically and adding a lot of strategic responsibility to their plate. And these several new Managing Directors have been created within the business groups that will have increasing P&L responsibility, and so we think we are seeding the business for additional growth.

Our Healthcare group, which has been called our Healthcare Finance Group historically, is being renamed Healthcare and Specialty Finance business to reflect some of the broader asset based lending activities that are occurring within that group that Dean has so successfully built. There's a group called Healthcare Credit Group which comprises all non-real estate lending within Healthcare, which will be run by Keith Ruben, new Managing Director. There's a HealthCare Real Estate Group which will carry out all our HealthCare real estate lending, which is run by Jim Pyzinski(ph), new Managing Director.

Business Credit Services, which is a business we've been incubating across the last year, run by Steve Cline, a new Managing Director, which is more of a generic asset based lending business. Security Alarm Lending Group, which is run by Bill Polk. This is the old SLP business that we acquired last year which has moved from the Structured Finance business into the new HealthCare & Specialty Finance business. And then finally, CapitalSource Mortgage Finance, which is run by Eric Windenhauer (ph), new Managing Director. This is our FHA / HUD processing business.

The Corporate Finance group is simply being renamed the Corporate Finance Business, Joe Kenary, the President of that business. Three regions, the Western; the Midwestern; the Eastern region, run by 3 Managing Directors, Richard Debair (ph) in the Western region, Jeff Kilray (ph) in the Midwestern region; and Inz Toomy (ph) in the Eastern region. And then finally the Structure Finance Group is being renamed the Structured Finance Business, with 2 businesses beneath it. The Real Estate Group, run by new Managing Director Chris Kelly, and then the Rediscount Group run by new Managing Director Chris Hague(ph). When I say new Managing Director, all these people have been with us for some time but they've been promoted to the title of Managing Director.

And we think these are important changes. They are part of what we've kind of called internally our 4 to 15 billion dollar campaign, where we are taking the business which now stands - or stood at 4.3 billion at the end of the year, and we're going to drive it, we think, across the next several years to 15 billion of assets. And that involves very significant organizational changes to manage that growth and we think we've laid the seeds for that growth. We continue to push responsibility down to the talented teams that we've built. Some of our more successful managers are lifting up and taking on more responsibility and we think we are being consistent with our desire to be a meritocracy as we build this business. So those are important changes.

And finally credit. We feel I would say particularly good about the credit performance of the business, both in terms of the fourth quarter and as we look into the year 2005. We had 2.9 million of chargeoffs this quarter related principally to one real estate transaction. The specific reserves against that - - those chargeoffs were largely taken in prior quarters. About 1.8 million of the 2.9 of chargeoffs were already provisioned against in terms of specific reserves, and we took a little over a million dollars of additional specific reserves that accounted for the rest of the chargeoff amount that occurred in the fourth quarter.

What happened with that transaction, we foreclosed upon that piece of real estate in the fourth quarter. And 1 of the reasons why our other assets grew at the end of the year, but we've since sold the asset. And so the asset has been fully resolved but we've recognized this chargeoff so that situation is behind us now. 60-day delinquencies. There was a small uptick. Nothing material is going on there. Non-accruals were down significantly. One of the reasons they were down is somewhat of an anomaly and that is that as we foreclosed upon this one piece of real estate, that loan actually went from being a loan to being a piece of real estate or REO that we have on our books, so it left the non-accrual category. But as I said, we've since sold that asset. And the additional specific reserves came in below our expectations at 1.3 million.

So as I said, we feel very good about how a few situations have resolved themselves. There's one in particular that I just went into some detail on and we feel good about how the credit book performed in the fourth quarter, and we feel good about how it looks into 2005. So that's the credit update. I've touched on the overview. These reorganizational, or these organizational changes in credit and with that, I'll turn it over to Tom Fink.

Thank you, John. And good evening, everyone.

John's already touched on the highlights of the quarter so I'll go through the results in a little more detail and provide some color on how this quarter compares to last quarter. And as you know, we held an investor conference last September where we gave detailed guidance for the rest of 2004. Jason will talk about how these results compare to that guidance and what to expect for 2005.

The fourth quarter was another strong quarter for CapitalSource capping off a very good year for the Company. The fourth quarter highlights were continued good growth in our loan portfolio and from a high level the business continued to perform as we expect and have told you about with a bias towards the positive. Digging into the details you will see slightly stronger yield in margin than forecast, better credit performance than was forecast back in September, and improvements in operating efficiencies. The result, as John has already mentioned, is fully diluted earnings per share of $.33 for the quarter compared to $.29 for the third quarter. For the year we earned $1.06 per fully diluted share.

Our portfolio finished the year at 4,274 billion up 492 million over the third quarter. That compares with growth of 482 million in the third quarter. The HealthCare Group was the largest driver of this growth for the quarter and Structured Finance had a good quarter as well. Corporate Finance, which is still our largest business, was up only slightly for the quarter as payoffs and paydowns offset good originations by that group in the quarter.

As John discussed credit quality remains good. For the quarter we took specific reserves of $2.4 million compared to $5 million in the third quarter. We also had chargeoffs of $2.9 million in connection with the real estate loan we foreclosed upon in December. I'll come back to this real estate loan in a minute when I get to the balance sheet, but as John mentioned, this real estate asset has already been sold in 2005. This chargeoff equated to 29 basis points annualized for the quarter, and of this amount $1.9 million was provided for in prior periods and $1 million was included in the specific reserve this quarter. Now that we know the final outcome of that real estate loan I can say that at 12/31 we had fully reserved for substantially all of that situation during 2004.

Our total chargeoffs for the year were 26 basis points. In terms of the rest of the credit metrics, delinquent loans were up slightly at 76 basis points, non-accruals declined to 53 basis points, largely reflecting the foreclosure and chargeoff of the real estate loan. Our total allowance for loan losses was $35.2 million or 82 basis points at year end, versus 32.6 million or 86 basis points at the end of the third quarter.

As you know specific reserves are included in that allowance and the timing of any chargeoff introduces some noise into the allowance. The decrease in the allowance as a percentage of the portfolio this quarter was due to the net change in our specific reserves during the quarter, primarily the chargeoff. The general reserve component of our allowance decreased slightly from quarter to quarter, it was approximately 70 basis points at the end of December and approximately 71 basis points at the end of September.

Yield was 11.54 percent for the quarter which was 26 basis points lower versus the third quarter but ahead of our expectations. The primary driver for this - - the quarter-over-quarter decrease in yield was that prepayment related fee income also came in 26 basis points lower than last quarter. In the fourth quarter prepayment related fee income contributed 62 basis points to yield compared to 88 basis points last quarter. However, as we've discussed before, we model approximately 50 basis points as our assumption for prepayment related fee income so this quarter was slightly ahead of expectations. For the yield -- excuse me for the year yield was 11.59 percent.

One thing to note here, you will recall that during 2004 we acquired a business called CIG International which makes deeply subordinated mezzanine loans to developers of residential real estate. Beginning in 2005 we have adopted an accounting treatment that will have the effect of back ending some of the income from this part of the portfolio. This is not at all material to the business and will not have an impact on what we think our full year results will be. However, it will have the effect of sliding a little income from the first couple of quarters until later in the year.

Another factor I'd like to touch on is the general interest rate environment and how that will - - affected us this quarter and how we expect that to affect us in a positive way going forward. As you know we are largely a floating rate lender and a floating rate borrower, and as a result of changes in short-term rates, which is prime or one month LIBOR, they will generally have some effect on the ratios such as yield and cost of funds.

During this fourth quarter, short-term rates increased for example one month LIBOR averaged 2.23 percent. This was ahead of our expectations by about 24 basis points and we saw some small benefit to yield this quarter from the rising rate environment, but not very much due to the remaining effect of floors on certain loans in the portfolio. And the small benefit we did see was offset by a small decrease in lending spreads which we had expected. However, it was worth mentioning here that with the growth in the portfolio and the rise in short-term rates that we have seen, CapitalSource's transition to an asset sensitive position so it - - so further rises in short-term rates will benefit the Company.

The reason for this transition is that we have largely worked through the effect of interest rate floors on loans in the portfolio. To make this point, as of December 31st, 2004, approximately 18 percent of our portfolio had floors that were in the money compared to 73 percent at the end of last year - - or excuse me at the end of 2003. So we are in a position that, should there be large increases in short-term rates we will benefit because we are beyond most of the floors. And, should there be large decreases in rates, we will see a small benefit because the floors will start to become active again and provide a small cushion as the rate drops. However, to be clear, we are forecasting short-term rates to rise and have included this rate forecast in our guidance for 2005 and Jason will touch on that in his remarks.

Cost of funds increased this quarter to 3.46 percent from 3 percent in the third quarter. This reflects the increase in short-term interest rates we saw over the quarter offset by efficiencies in our funding mix. Specifically we saw an average of about 53 basis points of market rate increase during the quarter offset by about 7 basis points of improved borrowing spread. For the year our cost of funds was 3.08 percent.

I think the important story in cost of funds all this year really has been the improving financing spreads we've seen due to better execution, more efficient structures and a mix of financing that included more term debt. Some of the accomplishments we have made in this area have been masked somewhat by rising rates. But if you look at our borrowing spread which we define as cost of funds minus one month LIBOR, in the first quarter of 2004 this borrowing spread was 188 basis points, and by the fourth quarter it had declined to 131 basis points highlighting the success of our funding strategies in 2004.

The next line item I want to address is leverage which we saw blip up at the end of the year due to several unusual factors appearing at the same time. As you would expect with the growth in our loan portfolio and consistent with our plan to continue growing into our leverage, our debt to equity ratio increased during this quarter. The debt to equity ratio was 3.9 times at December 31st compared to 3.4 last quarter. We had forecasted year end leverage at 3.6 times and this increase versus our expectations was due, almost exclusively, to higher than usual year end cash and restricted cash balances driven by anticipated closings at year end, and the timing of some year end loan collections.

I'll discuss this a little more when I get to the balance sheet , but this is truly a moment in time phenomena due in large part to December 31st not being a business day. And if we had not seen these year end effects, and cash were at more normal levels, leverage would have been 3.7 times or very close to our guidance.

Net interest margin was down this quarter to 8.87 percent from 9.5 percent in the third quarter. As you know we've been forecasting declines in net interest margin as a natural function of the growth of the business and how our business model would develop so this decrease was no surprise to us. In fact, net interest margin was slightly ahead of our expectations. For the year net interest margin was 9.3 percent.

Let me touch on 2 other income statement items quickly before pointing out couple things on the balance sheet. First is other income, which was up this quarter to 6.5 million from 4 million in the prior quarter. The primary driver for this income over the prior quarter was $2.8 million in net realized gains in our equity investment portfolio. These gains equated to about 1.5 cents per share on fully diluted basis . Second is operating expenses which decreased this quarter to 2.8 percent as a percentage of assets. As we continued our progress from 3 percent in the third quarter. The efficiency ratio is 29.8 percent versus 30 percent in the first quarter. Excuse me, in the third quarter.

For the year operating expenses as a percentage of assets were 3.1 percent. We continue to see growth in operating expenses in dollar terms as we continue to grow the Company. Also we saw relative increases in bonuses and other incentive compensation that is tied to our better than planned financial performance during the year, but importantly, the operating leverage we have spoken about before continues to be realized.

Finally I'll touch on a couple items on the balance sheet. First, if you look at quarter-over-quarter comparison you will see the significant increase in cash and restricted cash that I had mentioned before. To make the point, our average cash balance during the quarter was $114 million versus $206 million at year end. Our average restricted cash balance during the quarter was $163 million versus $237 million at year end.

Some of this increase in cash versus the prior quarter was expected, as we do make daily collections on many of our loans. These collections show up as cash on the balance sheet and as we expected this number would continue to grow as the portfolio grows. However cash was unusually large right at year end because of a couple of factors. First, we had anticipated certain loan closings to occur right at year end, and had prepositioned funds for that purpose. Those closings did not occur and we carried the cash over year end. Second, since we do make daily collections through lock boxes on many loans, and December 31st was not a business day, we actually had approximately 2 days worth of cash collection sitting on the balance sheet at year end.

With respect to the restricted cash, part of the increase there also was expected. This line item principally represents the reserve funds built into our term debt securitization, principal collections on loans in those securitizations, as well as cash collateral balances for Letters of Credit. We expected an increase due to the funding of the reserve fund for our 2004- 2 term securitization which closed in the fourth quarter. However, we also received significant collections on some of these loans right at year end and that increased restricted cash at year end.

Also during the quarter we issued approximately $40 million of Letters of Credit for our borrower's as part of our lending activity. This required an equivalent amount of cash collateral which also showed up in restricted cash at year end. Going forward we generally expect cash and restricted cash requirements to grow in dollar terms as our business grows, but we did have a blip at year end due to the confluence of all these factors so cash and restricted cash were unusually large at year end and this moment in time phenomenon was noticeable in our year end leverage.

My last point is, on the balance sheet is other assets which was up $28 million in the quarter largely due to 2 big factors. First is the foreclosure on the real estate loan which I mentioned earlier. We foreclosed upon this loan in the quarter, charged it off, and then recorded the net fair value amount of the real estate collateral as REO. That shows up in other assets. This was approximately $15.5 million of that increase in other assets. The other big driver relates to the Letters of Credit I just mentioned. When we issue a Letter of Credit we are required to record the fair value of our balance sheet - - our off balance sheet commitment. We do this in other assets by present valuing the income we expect to receive from these LC's over their life. In addition to being relatively large in size, approximately $40 million, the LC's that we issued in the fourth quarter were relatively long term and had fairly good fees associated with them. This calculation resulted in a $12.6 million increase in other assets.

The accounting rules also require us to record an offsetting liability which we recorded in other liabilities, so this is just a $12 million increase or gross up in the balance sheet, however, I did want to explain that as part of the increase in other assets. And with that, I will turn the call over to Jason who will discuss what we expect in 2005.

Thanks, Tom.

I'm going to start my remarks by stating that we will continue to update guidance only on an annual basis which will be at our annual investor conference each fall. That said, we will make exceptions to this policy to the extent that there are substantial interest rate movements which will have an impact on earnings or if there is a material event which the business -- within the business that produces a meaningful impact on earnings. And while we are not going to be revising any of our guidance at this point, I can say that we are extremely comfortable with all the drivers of our business.

We have seen a stronger upward movement in short term interest rates since the September investor conference than the forward LIBOR curve predicted at that time, and Tom talked about that a little bit earlier. The forward curve today indicates that one month LIBOR will be approximately 60 basis points higher at year end 2005 than the market indicated in September. The net impact to CapitalSource of this upward revision is a positive 2 to 3 cents to our September guidance for 2005 of $1.42.

I also want to add that the impact of the accounting treatment of the CIG loans that Tom referred to a few minutes ago, during the whole of 2005 will be immaterial, but will have a short-term effect of reducing portfolio yield by up to 25 basis points in the first half of the year, which will be made up in the second half of the year.

Now I'll just go through the same financial metrics that we used in September in terms of giving guidance, and reflecting the 2004 actual results versus the guidance for 2004. Net originations were up approximately 3 percent over our guidance for all of 2004 at 1.86 billion versus guidance of 1.8 billion. While those numbers are very strong we continue to feel comfortable only projecting 1.5 billion of net portfolio growth for 2005.

Yield on interest earning assets at 11.54 percent for the fourth quarter and 11.6 percent for the year was ahead of full year guidance of 11.4 percent for 2004 due primarily to increases in interest rates and higher than projected prepayment fee income. We continue to project yields coming down to 11.1 percent for 2005 based on the competitive landscape for credit. Note that we model the new loans coming on the books at lower yields than the current portfolio provides.

Cost of funds for the year was 3.1 percent , slightly higher than the guidance of 3 percent due again to rate movement. Guidance for 2005 remains at 3.7 percent based on the forward LIBOR curve increasing over the year. Additionally we do not anticipate any further spread contraction to our cost of funds beyond what we are able to achieve in our very successful 2004 financings.

Net interest margin at 9.3 percent was slightly ahead of guidance for 2004 of 9.1. Based on our anticipated decrease in yield on portfolio, coupled with the rise in our cost of funds and incremental leverage, we continue to believe net interest margin will drop to 8.2 percent for 2005 consistent with our September guidance and the long-term net interest margin for the business, which we predict will be in the low 8 percent range.

Our other income came in just a few hundred thousand dollars below guidance. We remain comfortable with guidance of 40 basis points on average assets for 2005 coming from 3 revenue sources. Due diligence deposits forfeited, don't forget that has an offsetting item in our operating expense line, so that's really just an accounting line item. And fees for processing HUD loan applications for our HealthCare Real Estate borrower's. Both the due diligence deposits forfeited and these fees associated with our HealthCare Real Estate loans are relatively steady sources of income. And then our third source of income and other income equity gains have been and will continue to be lumpy quarter to quarter, but predictable over a 12-month cycle.

General reserves at 70 basis points were slightly behind guidance of 73 basis points. This is due solely to the mix of new assets shifting slightly away from our cash flow lending , which John mentioned earlier, which require higher reserves to more asset based financings to which we apply generally lower reserves based on their inherently low risk.

Specific reserves of 34 basis points for the year were less than the 40 basis points we've guided toward at our investor conference for 2004 based on taking approximately $2.5 million less in specific reserves than we budgeted for in the fourth quarter. That said, we still believe it is prudent to budget 40 basis points per annum for losses going forward.

Operating expenses to assets were - - had an actual number of 3.1 percent for the year versus guidance of 3.2 percent, and was in line and reflects continued operating efficiencies at our business - - as our business moves towards stabilization. The rate of growth in our operating expenses will continue to slow in 2005 and we are projecting a ratio of 2.7 percent operating expenses to average assets for the year which should occur in subsequential fashion coming down each quarter slightly.

Return on assets was strong for the quarter and the year at 3.7 percent and 3.6 percent respectively. We are very pleased with that. We remain cautious with our guidance of 3.3 percent as a ratio for 2005, but with a continued goal of trying to attain 3.5 percent both in '05 and on the long-term basis.

Our return on equity. We were again very pleased with the return on equity for the quarter of 16.6 percent and for the year of 14.2 percent. We are guiding that return on equity for 2005 will be consistent with a level attained in the fourth quarter of around 16.5 percent. As Tom touched on, leverage was somewhat higher than anticipated for year end. In large part due to the large cash position we carried and we continue to expect that leverage will not exceed 4.5 percent or 4.5 times equity by year end. A note on taxes. We accrued taxes for 2004 at 39.2 percent, for 2005 and forward we are assuming a 39 percent tax rate for the Company.

Finally EPS for 2004 of $1.06 was ahead of guidance of $1.02. John, Tom and I have highlighted some of the reasons for this positive variance, and obviously we are pleased with the results. Still we will not be revising the $1.42 per share earnings guidance for 2005 save for my earlier comments about the $.02 to $.03 improvement that the forward LIBOR curve implied today versus at the end of September. Please also note that, as in the past, earnings will be impacted mostly by loan growth and we have - - we expect to have subsequentially higher earnings each quarter in 2005.

With that I'll turn this call back over to John.

Okay. Thanks, Jason. I think it's the time when we open it up for questions.

(Operator instructions). Our first question comes from Michael Hodes of Goldman Sachs.

Hi. Good afternoon, guys. 3 somewhat related questions. First, just on the Corporate Finance loan growth in the quarter of 9 million, I understand part of the pressure came from higher prepayments, yet at the same time it seemed like the prepayment contribution to the - - that finance income was light. I was hoping maybe you could give us a little more color on that. And then secondly, in HealthCare and Specialty Finance, there was a 38 percent sequential increase in loans.

Could you give us a feel for maybe the average size the loans that you were putting on in HealthCare? You know, was there something that's special that happened in the fourth quarter? And then lastly, you know, if asset growth were to prove a little faster than the 1.5 billion net that you're talking about, could you give us a feel for at what level of leverage you would contemplate raising equity? Thanks.

Okay. Thanks, Michael.

The first question relates to the fact that Corporate Finance had kind of inconsequential net asset growth, and that the repayment fees were actually down relative to the third quarter. The fact that that may be inconsistent. And I think you're right, on its face it's inconsistent. The Corporate Finance Group actually had reasonably good gross originations. They did have high prepayment, so if you were to kind of chart the Corporate Finance group's quarter relative to prior quarters it wasn't their best quarter in terms of gross originations, but it certainly wasn't their worst. It was kind of an average quarter. They did have high prepayment penalties - - or high prepayment fees - - I'm sorry high prepayments that did not produce high prepayment fees , and the reason for that quite frankly has to do with when loans prepay.

When we negotiate these loans, we try to do a couple things. Number one we try to insert yield maintenance for a period of time. We are not always successful in obtaining that, and to the extent we do, it's generally the first of the year. And then you typically have a prepayment fee scheme that goes something like 3, 2, 1; 4, 2, 1, all kinds of negotiated amounts where the borrower has to pay us a certain fee depending upon when the loans prepay.

In the case of the prepayments in the Corporate Finance Group this quarter, we unfortunately had a lot of good customers prepay their loans and the loans had been on the books for some time. So you both didn't have a high prepayment fee, nor did you have a significant acceleration of the commitment fee. Because that's the other thing that happens when a loan prepays early. Not only do you typically get a higher prepayment fee, but you also have not taken into income most of the commitment fees. So all of that kind of accelerates.

So it's one of those situations where you had reasonably good prepayments and not particularly high prepayment fees. And you all I can say is there's some lumpiness on these things. We've had quarters like the first quarter of '04, where we actually had very high prepayment related fees and it was average to below average prepayment volume because we had one loan that had yield maintenance and it had a very large fee associated with it. So that's really the only answer to that question. I wouldn't read anything into it in terms of trends. It wouldn't surprise me if in the next few quarters we have some very high prepayment fees without particularly high prepayment dollars, so that will move around a little bit.

As far as the HealthCare Group, the HealthCare Group did have very strong asset growth. You asked did they have some large loans. They did actually have in this quarter some larger loans that helped kind of drive that asset growth. One loan in particular has a little bit of a bridge component associated with it, and it will have some prepayments on that loan in the first quarter. So that did occur in the HealthCare Group.

And the third question was level of leverage where we we would consider raising equity. I don't think we have a, you know, a firm answer to that question at this time. I mean, we always evaluate our capital structure based on capital that's available to us, not wanting to put too much leverage on the business. But also being very, you know, protective and jealous of the equity and wanting to have high returns. So I don't think we have an answer at this point as to at what leverage we would raise additional equity, other than in general we've kind of guided people towards leverage of 4.5 to 1.

Alright. Thanks a lot. Appreciate it.

Thanks, Michael.

And our next question comes from Josh Steiner of Lehman Brothers.

Hi, guys. Congratulations on a good quarter. Just, first a clarification question. John, did I hear you say earlier that you had moved the Alarm Security Business out of the Structured Finance segment into the HealthCare and Specialty Finance segment?

Yes. But that occurred in '05, so the '04 numbers that you're seeing, the Security Alarm Finance business is in the Structured Finance numbers. So that 31 percent Structured Finance includes Security Alarm and the 29 percent HealthCare does not include Security Alarm.

And is that - - how large is that?

It's a little - - you know, it's a little over $100 million so it's not all that significant.

Okay. And then, just in terms of loan growth in general, you know, you guys grew by almost 500 million this quarter. If I remember correctly, historically you've said that the first quarter - - I think it was the first quarter and the fourth quarter were seasonally a little bit stronger than the second and the third, because I think Corporate Finance tends to slow down a little in the summer. But just wondering, you know, with the 1.5 billion guidance and, you know, almost a third of that coming in, you know, the fourth quarter on kind of a run-rate basis, do you think we're going to see kind of more pronounced seasonality going forward and that's sort of how we get to the 1.5?

No. There's no - - you know, we look hard to try to find trends with the hope that if we discover them, they will tell us something about the future. And we haven't seen any real - - I mean, is we see some trends in terms of growth of the different businesses, but I think those - - we find them because we are searching so hard for them. They are really not that material. So I don't think the reason we are forecasting a 1.5 billion is based on any view of seasonality of the business.

I think, you know, once again we are in a credit business. We think we have to be very prudent about driving asset growth. All the asset growth has to meet our standards, both in terms of credit and pricing. And you know we don't have a complete ability, obviously, to predict prepayments. Nor do we have a complete ability to predict our growth. I mean, our pipeline is very strong and continues to be stronger with each passing quarter. So it's stronger now than it was the quarter before. So there are plenty of good things going on, but I think at this point we're not really, you know, comfortable guiding towards more than a 1.5 billion.

Josh, this is Jason. I might just add also that, as John mentioned, there was one large HealthCare loan some of which will come off in the first quarter and some of which will come off in the second quarter. That was sort of bridge in nature as John described it. And so that was part of the impetus for the increased - - slight increase in the originations in the fourth quarter over what we had given guidance for in the September conference. So I don't think that you can take any kind of, sort of, going forward take away from that on the metrics.

Okay. Thank you. And then just as a final question. Could you guys just comment a little bit about what you're seeing in terms of valuations in the small and middle market LBL?

Well, they are going up. That I think everyone in this room and this building here would agree with. I - - you know I think that - - And that's one of the things that, when we talk about our Corporate Finance Group potentially having a slower year in '05 than they did in '04, it's not because there's not an a abundance of opportunities because LBL volume continues to be up. I think when you - - again coming up to this award which we are quite proud of because the Buyouts Magazine is the leading trade magazine for the leveraged buyout business. We were awarded "Small Lender of the Year" which is really lenders who are making loans more than $150 million to the LBL world. We were the number 1 according to them.

So we're seeing plenty of opportunities. So it's just a question of will we be - - will the buyout funds push us to a zone of discomfort? And that's less related to pricing and i'ts more related to leverage. And acquisition multiples are - - have moved up, and our buyout fund clients, you know, do what you'd expect them to, which is to 1, if you continue to finance a similar percentage of the capital structure that we have historically. And, you know, we move to a point, but there's a point where we don't go past. So I - - you know, I think volume is up. I think multiples are up for now, and, you know, we'll see how long that continues.

Great. Thank you.

Sure.

And our next question comes from Joel Houck from Wachovia.

Thanks. Good evening. I'm wondering if you might talk about, you know, the product mix shift in '05 and how much of that is in the margin and presumably the yield compression in terms of your forecast?

Could you repeat the question, Joel? I'm sorry.

I'm just wondering, you know, the product mix - - directionally you've kind of given guidance for Corporate Finance to kind of trend down and the other 2 businesses to move up. I'm wondering, you know, is that the - - how much of that is related to the yield compression in your '05 forecast? Is that all of it? Because it didn't seem like you guys are 20 basis points ahead in '04 your margin guidance that you sent out in September.

Yeah. I think, you know, our guidance for '05 is, you know, we want to be prudent. We know it's a more competitive environment and we don't have a crystal ball as to where we will be able to price transactions, things like fees - - prepayment fees are a little harder to predict.

The mix of business isn't causing I mean our HealthCare and Specialty Finance Business is our highest yielding business. And, you know, it's got a very attractive risk profile. Which makes it a very good business obviously, but the fact that that business grew relative to the core finance group won't have any material effect on yields in the business.

So I think your question was, does the mix of business - - with the change in the mix of the business - - or the balancing of the portfolio that we're forecasting for '05 cause us to, you know, project or forecast low or unleveraged yields? And that's really not the reason we're doing it. We're doing it for other reasons based on just - -you know, our view of a growing franchise, the fact that there's a lot of liquidity in the market, recognizing that things have to be more competitive, that we'd rather compete a little bit on price because we have some flexibility to do that as opposed to compete on credit obviously. So it's more a reflection of just being prudent around those- - that assumption, than it is based on any change in the mix of business.

Okay. I got it.

And then can you update us on how the syndication business is going and where those fees would show up in terms of the income statement ?

Yeah. I'll turn the second half of that over to Tom. I'll talk a little bit about the business.

The business is going very well. I think increasingly CapitalSource is viewed as a very good place to go to get high-quality loans. And we want to do more syndications particularly in businesses like this business credit services business that we are getting into, that we think is an important initiative. Which is little more of a generic asset based lending business, which we think we have good skills with respect to. But we also think could produce business for some of the other groups in the Company.

And that's the business where the spreads have historically been a little tighter and I think we will use syndication as a tool to help manage our yields more effectively in that business. We may be selling off more in that business than in some of our other businesses. But you know, I think we're looking at '05 as a year where we will really get more active in the syndication market. You know, generally with us selling more than buying but using it as- - we certainly is have the people who can do it and the income recognition really depends on how you do it and I'll let Tom touch on that.

Sure. Joel, it really does depend on how you do it, as John said. I think almost everything that we have done historically has been what I would call true syndication, where the other lender that we're bringing into the situation really comes in as a co-lender. So if there's any differential in the yield of what they bought versus what we retained, that would come in over the life of the loan just like things normally do.

If things were documented as a participation, meaning we just sell an interest in our loan, depending on the specific facts and circumstances there, you could have some facts that were - - where you would result in a gain on sale with sort of a front loading of that income. We've not seen any situations to date where we've had that issue in terms of the large gain on sale in connection with participation. But I think most of what our groups are doing and oriented around is really going after the true syndication, so I think your question is really not an issue for us.

Okay. That's helpful. Then just lastly, the 15 billion dollar goal. I mean, I appreciate it's just a goal at this point. But what rough time frame do you guys see that happening? And one would suspect that that might contemplate some larger size acquisitions over the next several years?

We really don't know when it will happen, obviously. It won't happen this year, I can assure you of that. So I think we can all agree with that. And it won't happen next year. You know, I think that it - - that goal, I mean, is - - what we're trying to do is we are seeing significant growth in all of our businesses. The teams are executing very well. And managing the growth is a big part of our job.

And so, you know, when we focus and look internally about how do we scale the business? How do we maintain the credit quality? How do we maintain the customer service? Part of this reorganization , if you will, or these series of promotions, these organizational developments that I spoke of, is really a way to help us manage the growth, push down more responsibility to some of the high quality people we have in the firm, allow some of the people who've done a great job to lift up and do more things in the firm. And so the 4 to 15 is symbolic in some ways of where we are going and how we have to take that seriously from a management and operating perspective. But it also reflects, I think, our view that the businesses we are in now have that type of organic growth opportunities. That we don't have to look outside the businesses we are in.

As you go through the list of businesses as we've now broken them out we've got several businesses in this Company. I'ts become much more than these 3 group. The 3 groups have done a great job building businesses within the businesses. So there's lots of avenues for growth. So I think that 15 billion can be achieved with the businesses we are in now. There may be some tuck in acquisitions. We may find some things on the acquisition front that are particularly attractive and things we were not aware of and maybe different than what we're doing now. I don't know of anything like that. I don't see anything like that. Everything we see on the acquisition front is relatively small. It's modest and it tucks into things that we're doing. So I think it's still an organic growth story, Joel.

You guys have done a great job executing. Thanks.

Thank you.

Our next question comes from Matt Vetto of Smith Barney.

Hi. Good afternoon. Couple questions. First on the expense front. Could you talk a little bit about sort of other expense line hasn't seen a lot of growth in the last couple of quarters. You know, is that sustainable as you do a little bit of the restructuring you talked about, is there a big comp impact as you think about that? I guess sort of back of the envelope math maybe cost per average employees may be up about 8 percent. I mean, are you getting more competition for your producers? How do you think about the head count growth you are going to see? Just a little more about how you think about the total expense picture.

And then secondly, Tom, could you repeat? I'm sorry can you walk through again that accounting change that's gonna result in a little bit of yield pressure in the first half? And I guess recovering in the second half?

Sure. Why don't I answer the second one first.

That's fine. We'll go in reverse order. You answer that. Jason will touch on the expense question, and I'll comment a little bit on compensation. So, I think you had 3 questions there, Matt.

Okay. Yes. Just getting back to the CIG item I mentioned. We acquired this business in July and we're now starting to grow this business, make new loans there. As we're looking at those loans and really the accounting treatment for - - accounting for real estate loans is you have to look at the loans. And these are deeply subordinated loans and determine what the level of equity is in the transaction.

We are very happy with this business and how it's performing and I think the accounting treatment that we're adopting is really just to back end the fee. So it's more about timing than the overall economics. Does that help you, Matt?

So is it - - I guess maybe the question is what's the impetus to go back and revisit the treatment?

It's not to go back and revisit. It's how we are treating really the portion of the loans, you know, going forward. The new - - especially the new loans that are being created, that some of them will have more of a back end economic return than will be more straight forward loan like return.

Okay.

As I said before, I don't think it's at all material to the business.

What this business has, it's a granular pool of deeply subordinated loans that have high yields, mid 20s. And as you know, because we've talked about it in the past Matt, this is a Company we financed for several years, really liked the team, knew the loans very well, bought the portfolio and the business is off to a good start. What happens is if you're deep in the capital structure, which these are, depending upon the status of the project because these are all vertical and horizontal residential developments, you can - - you either can treat it as a loan if it's far enough along.

If it's early in the project, you treat it as equity, basically, even though it's a loan. So the portfolio we purchased, the vast majority of the loans were pretty far along in the project, so they were all, you know, treated as loans. But some the new loans we're making in particular, you know, the better accounting treatment is to treat them as equity early on even though they are booked as loans. And then as the projects - - when it becomes obvious that the project is successful, then you start treating it like a loan. I mean that's sort of a layman's description but that's really what happens.

When John talks about us treating it as equity, we talk about treating it as equity from an income recognition statement only.

Right.

So what it will do is we are going to have more back ended income in that business. You know, so it's -- I'm not saying it's a conservative treatment, because it's probably the right treatment, but it tends to move income back as opposed to certainly accelerating it.

Okay. That's helpful.

And we were basically treating it on an accrual basis over the anticipated life or the contractual life. Okay?

Okay. Great.

The second question that you had asked was growth in other expense where with the line items other administrative expenses. As you can see, they have been running somewhere around a third of the cost of running the business. And the largest component of that, because all of the comp related including restricted stock and options runs through comp and benes, is rent. And then you have other - -either traditional expenses, sales, travel, T&E, et cetera, but by far the largest is rent.

We basically have established for ourselves, I think, all of the beach heads including in our Chevy Chase office for growth out for at least the next year, and hopefully in the next several years based on the amount of square footage that we have aggregated and that we are paying rent on today. So I certainly don't see that number going up as a percent of total expenses, Matt, and actually it might come down a little bit on a ratio basis, but not on material basis.

John, did you want to touch on compensation?

Yeah. All I was going to say to Matt is, and I think we talked about this in the past, but we have a bonus accrual methodology that we employ in the Company. It's effectively a waterfall that we look at the performance of the business, the fees, the interest in fees, less interest expense, less fixed overhead comes up with this kind of pre capital, pre bonus contribution. And then we run that through a waterfall where it's first initially allocated to the capital to hit a certain targeted ROE, then it's allocated to the employee bonus pool to build that up to a certain kind of what we consider to be a minimum acceptable level, and then there's a sharing percentage beyond that depending on how the business goes. So what definitely happens here, is that if we do better as a company from an ROE perspective, we share obviously a bulk of that with the capital, but we also share some of that with the employee bonus pool.

So you will see the - - if you had an apples to apples, which we haven't really had here because we are constantly hiring people in the mix of employees are changing, but if you actually had an apples to apples, you know, year 1 400 people all being the same, year 2 400 people them all being the same and year 2 is a lot better financially than year 1, you'll pay out higher bonus as you'd expect. And it's tied very directly to this performance of the Company. So this was a good year. I think our original forecast was like $.92 or something and we came at $1.06. And so we did what we should do, which was to share a fair amount of that with our employees because they did a terrific job. And we allocated that to the bonus pool. So that's why you see comp go up, comp for employee. And it al- - you know, it also - - in some ways we forecast operating efficiency ratio and operating expenses to assets which we want to hit, but to some extent we'd actually like to come in a little higher than that because that will mean the Company did quite a bit better. So I think we've done a reasonably good job, more work to do, but a reasonably good job in trying to create good alignment there.

Would you expect any sort of change to that picture all else equal from any any of the restructuring you talked to today?

No. No. No. These organizational developments. There's no new people. It's really about responsibility, authority, things like that. It's taking these 3 Managing Directors who have built 3 great businesses, lifting them up a little bit obviously they still run their 3 businesses. They are Presidents now. They are on the Credit Committee and we want to get them more involved in some of the strategic aspects of the business so they continue to drive business.

And then we're taking this group of 8 or 9 people beneath them who have done a great job, and they are gonna kind of be in some ways where these Managing Directors were a few years ago and have more P&L responsibility and, you know, I bet they'll build bigger businesses. So it's just what you do when, you know, a business is growing, so it's not going to have any real significant comp effects.

That's great. Thanks.

Sure.

Our next question comes from Tony Lisa of Westfield Capital.

Hi, guys.

Hi, Tony.

Tom, I was wondering if you could just maybe on the net interest margin, you know, bunch of things moving around. And in some of the other commentary you quantified the, you know, what -- which item caused which directional change in basis points, either up and down. And I was wondering if you could do it for net interest margin? .

You know, Tony, we haven't really I don't think broken that out specifically by component. I mean, directionally things are obvious and the most important of those is that we're continuing to grow into the leverage of the business. So just by growth and increasing leverage, we're adding interest expense, and that just mathematically reduces net interest margin. Having said that, we have seen --.

So I mean you can stop at that and if you can maybe just give me, you know, when you say the majority, is it 75 percent of that move from leverage?

No. We really haven't broken it out. We don't have that for you. But I think all those components are part of it. And it is, you know, it does move around quite a bit because you've got yield, especially now that we're in a more e dynamic interest rate environment. Yield has been moving and also our cost of funds.

Right. Great.

Tony, one thing I might add to that is that, you know, when we - - and we talked about this in the September investor conference . We project 50 basis points per annum for prepayment fees. And we certainly have some better than that in 2004, but that in no way allows us to predict any better than 50 basis points per annum in prepayment fees so that's also a component of that.

Sure. Sure. I was wondering if I could just ask one question and, you know, sort of preface it by saying obviously shareholder, obviously love what you guys are doing with the business, I'm just wondering if you could comment on the recent insider selling? And my question is, not are you going to continue to do it? Obviously you've built this business over a long period of time and that's something as a shareholder I should expect you to do.

I'm just wondering are these periodic sales or do you guys happen to be on a program we're going to to see this you know, equal amounts on a regular basis?

We put in place a program which I think we disclosed when we did it. And, you know, you can track how far we are into the program, and then it will be done.

Okay. I guess I apologize, John. I must have missed it.

That's fine. We did a press release in early January.

Okay. Okay.

That's fine.

Thanks very much. Great quarter.

Thanks, Tony.

Tony, just to clarify with the press release said is that we had an organized 10B5 program for both John and myself. And in both cases selling out of trust and not out of our personal holdings.

So is that something that will -- does that have a definitive time frame on it?

It has a definitive number of shares to it and a definitive time period , too, I think.

And prices too.

Thank you very much.

Thank you, Tony.

Our next question comes from Steven Schulz of KBW.

Hi. thanks, guys. Just to follow up a little more on the margin particularly on the funding side. I believe Tom, you had mentioned that you didn't expect to see much further benefit on the funding side from a spread perspective. And you had kind of quantified that, you know, there was about 7 basis points improvement in the fourth quarter on and, you know, a little bit more than 40 basis points, I guess, over the second and third quarter. Can you kind of walk us through? I mean, you did do I guess a billion dollar asset backed deal. And, you know, can you walk us through kind of your - - what's leading to that expectation of no further spread improvement on the funding?

Yeah. I think actually it was Jason who made the comment.

Oh, I'm sorry.

You know, I think it's - - I mean, we'll see how things unfold. It is, like a lot of things, here getting a little more complex in that last year we did some fixed rate funding with the 2 convertibles, so as rates move, you know, we definitely will see some improvement in our cost of funds just by having those fixed rate instruments out there.

I think part of Jason's comment was really, you know, thinking about, you know, some of our funding strategies for this year. Which we will continue to fund the business largely in the secured markets with term debt securitizations. Those have performed very well for us and, in fact, one of the rating agencies who rates those fixed, which, actually just upgraded just yesterday 2 of our oldest deals, so those are performing very well and I think we'll go back to that market.

We have credit facilities. There are various negotiated margins with respect to those credit facilities and then the other thing we talked about in our September conference is that, you know, we are going to look to try to diversify our funding sources which would mean heading a little bit more in the direction of some unsecured funding which is not inexpensive. It actually costs more than our secured funding does, but I think it would be a very strong move for us to do that given our growth plans for the Company and really build a very broad and diverse set of funding sources.

We did that in 2004 and I think we'd look to do that this year. So at this point it's a little bit hard to predict it based on where interest rates are going to to go and the changing mix of these facilities. But I think the point Jason tried to make is we saw tremendous improvement this year, we're not sort of holding out for you as we forecast the business you're going to see that ame kind of improvement. We've gotten a lot of bang for our buck, so to speak, and we think we'll maintain a lot of that efficiency but a number of things are in play including timing of transactions and what have you.

All right. Great. Thank you very much.

Our next question comes from Craig Moore of Fulcrum.

Yeah, hi. Good evening. Just a quick overview question for John, more of a high level question. Has anything changed in terms of outlook from business owners that you guys talked to in the small / middle market for '05 since maybe 6 months ago or last summer any improvement or deterioration in what they are looking for out of the economy this year? Thanks.

No. I mean, I think that, you know, we spent some time thinking about trends in our business, looking at our portfolio which is pretty large at this point. And in terms of business owners, I mean, talk briefly - - quickly about HealthCare. It's a big part of our business. I think most of our HealthCare operators feel pretty good. The reimbursement environment is stable. Nothing on the hor izon that's particularly concerning to any subsections of HealthCare.

You know, I think in our Corporate Finance Group we have seen things tied to the high end consumer continue to do well, and things tied more to the modest end of the consumer spectrum, you know, not do quite as well. You know, so people who are in - - run businesses that are effected maybe by those trends I think will reflect those views. I think in terms of companies selling to businesses, I think they are feeling a little more bullish about things based on what we're seeing in the portfolio. You know, so I think those are really the only observations. I wouldn't say people are bearish. I wouldn't consider them overly bullish either. I think people think it's a pretty stable environment right now.

Okay. Thanks.

(Operator instructions).

Okay. Well, it doesn't sound like there's any more questions. Operator, are there any more questions?

There are no further questions, sir.

Good. Okay. Thank you, everyone for carving out the time to join us this evening.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a good day.