PacWest Bancorp (PACW) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q2 2006 CapitalSource earnings conference call.

My name is Tony and I will be your coordinator for today.

At this time, all participants are in listen-only mode and we will conduct a question-and-answer session towards the end of this conference. (OPERATOR INSTRUCTIONS) I would now like to turn the call over to Ms. Meg Nollen, Vice President of Investor Relations.

Thank you and good morning, everyone.

Welcome to the call.

We appreciate your interest in CapitalSource.

I am very pleased to be here for my first call.

Joining me today is John Delaney, Chairman and Chief Executive Officer of CapitalSource, and Tom Fink, Chief Financial Officer.

In addition, this call is being webcast through our website, and for those of you participating through the webcast, you will be able to view an accompanying slide show this morning.

So if you have dialed in, you may want to go ahead and get in through our website at www.capitalsource.com through Investor Relations.

A recording of this call is being made and will be made available about 12:00 PM Eastern time today.

Our press release and website give you full detail on how to access that call.

And of course in accordance with the Private Securities Litigation Reform Act of 1995, certain statements made during this call which are not historical facts may be deemed forward-looking statements.

All such 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.

For more detailed information about these risk factors, please refer to this morning's press release, as well as our first-quarter 2006 10-Q and our 10-K for 2005, which are previously filed with the SEC and available on our website.

CapitalSource is under no obligation to and we expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events, or otherwise.

During the course of this call, we will be discussing certain non-GAAP financial measures that management believes are useful to investors in comparing past and present operating results.

Please refer to our website or today's earnings release for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures.

Now with the formalities out of the way, I would like to turn the call over to John Delaney, Chairman and Chief Executive Officer of CapitalSource.

John?

Thank you, Meg.

Let me start by touching on what I consider to be the four largest themes for the quarter.

First, we continue to see the clear benefits of the REIT election for our businesses that have real estate as primary collateral, which include our commercial real estate businesses, our healthcare real estate business, and our re-discount business.

Essentially, we are successfully investing the tax savings inherent in the REIT structure into our ability to go after stronger borrowers in lower leverage situations in these businesses, and that is continuing to drive very strong asset growth.

Second, we are continuing the buildout of our multiple corporate lending products, particularly our asset-based products and our deal syndication capabilities in corporate finance.

Third, the credit pipeline remains positive, which is a trend that most of you recall we have observed in the last several quarters.

Best evidence of this is the reduction in the loans on nonaccrual status, which we view as our most relevant credit statistic.

Finally, we have particularly strong momentum into the second half of the year in terms of asset growth, fee income, and credit.

As you can see from our release, adjusted earnings per diluted share were $0.51 for the quarter, which compares to $0.55 in the first quarter.

Adjusted earnings is a new metric for us since our REIT election, and a reconciliation of adjusted earnings to GAAP net income can be found in our release.

Regarding asset growth, we had the strongest net quarterly asset growth in the Company's history.

Core commercial assets grew by $776 million to $7.4 billion, which again is a reflection of the origination machine we have assembled here at CapitalSource.

Our residential mortgage investment portfolio, which is not detailed on the slide that should be in front of you right now, declined slightly to $5.5 billion.

Not all of this net asset growth had time to impact our results, however, as much of it was backended from a net portfolio growth perspective, and this is a very important point.

You can see that while the June 30 commercial loan portfolio balance was $7.2 billion -- and this does not include our sale leaseback investments -- average loans outstanding for the quarter was only $6.6 billion.

The difference of $600 million is an unusual lag that bodes very well for the third quarter, but clearly had an effect on the second-quarter results.

No surprises as it relates to portfolio composition.

In general, we see a continual shift towards lending businesses that have more of an asset orientation.

We continue to see growth in our real estate businesses, where we now have the incremental advantage, given our REIT election.

There was a slight uptick in activity in our corporate finance business, which has been enhanced by our efforts to move into slightly larger deals, leveraging our emerging syndication capabilities.

At first glance, our portfolio statistics would indicate a slight decline in our corporate finance business, but really what happened is about $190 million of loans went off our balance sheet and into our CLO as part of our asset management strategy, which is important to our syndication efforts.

In general, we continue to see a very strong pipeline across all business units in the Company.

And you can see that the pipeline continues to grow, with $35.6 billion of new transactions entering into our system during the second quarter.

And despite the growth in the pipeline, we have maintained a high level of deal selectivity.

Our deal selectivity rate was 4.6% for the quarter, which represents the number of deals closed relative to new transactions during the quarter.

The continued tightening of our deal selectivity, if you will, across the last 10 quarters reflects the continued evolution of our credit platform as we build out this business.

Finally, our credit metrics showed continued positive trends this quarter.

We were particularly pleased to see our loans on nonaccrual down 23 basis points to 2.01% of total loan portfolio.

We have said in the past that this metric to our minds is by far the most relevant credit statistic for the Company.

Impaired loans were also down slightly for the quarter, and delinquent loans were up, largely due to a larger-than-average real estate loan that is in the process of being refinanced out.

And by that I mean the borrower has a commitment letter from a major Wall Street financial institution and the deal should be closing any day.

And also due to a corporate loan that we view as an asset-based situation, so really no news there.

I want to remind everyone, however, that these statistics will move around from quarter-to-quarter, although I tend to think we have settled into somewhat of a normalized range.

The type of highly structured middle market lending we do involves some measure of credit risk, risk that we believe we understand and can manage very successfully.

But this risk will manifest itself from time to time in both problem loans that will populate these statistics and in charge-offs, where we actually had $12 million of charge-offs this quarter.

Before I turn the call over to Tom, I want to reiterate that to my mind the business is performing at or above my expectations in all material respects, and I think we have very strong momentum going into the second half of the year.

Tom?

Thank you, John.

Good morning, everyone.

We will be filing our second-quarter 10-Q this afternoon, and for the future, we plan to report our earnings concurrent with our filings going forward.

Also, because we have provided more detailed information about our results in the press release, I will try to keep my remarks brief and will focus on the main financial themes this quarter.

I encourage everyone to read the full text of the release, as we think you will find the added detail to be helpful.

The second quarter was another good quarter for CapitalSource that was ahead of our expectations for adjusted earnings and in line with our expectations for adjusted earnings per share.

The main themes I will cover today include the increase in our average equity this quarter, which decreased average leverage in our commercial lending business, and the increased share count.

I will touch on a few other factors that affect the comparability of this quarter to last so that you can see the strength underlying these results, and give some more color around borrowing spread, net finance margin, and our lower effective tax rate.

And the main message I want to deliver is that the business is performing well.

We have lots of momentum heading into the third quarter and the outlook for the second half is very strong.

As John mentioned, adjusted earnings for the second quarter were $0.51 per share, compared to $0.55 per share in the first quarter.

As we guided in last quarter's call, this is directionally what we expected, and in absolute terms, better than we expected for earnings.

I would point out that we modified our adjusted earnings definition this quarter to include non-cash equity compensation, which I think better aligns our adjusted earnings metric with the funds available for distribution metric that is out in the REIT industry.

The single largest financial theme affecting our per-share performance this quarter was our increased share count and the related average equity balance.

In mid-March, we completed an equity offering of 17.8 million shares, so we're seeing the full-quarter effect of that equity raise, if you will.

And we also issued during the quarter 1.9 million shares through our dividend reinvestment and direct share purchase plan.

These equity raises increased our average equity to 1.9, almost $2 billion, and our shares outstanding and reduced our average leverage.

As you can see, the average leverage in the commercial lending segment was 3.07 times in the second quarter compared to 3.9 times approximately in the first quarter.

This added dilution explains the lower adjusted EPS compared to the higher adjusted earnings this quarter versus last.

The ramp rate of asset growth, which John also referred to, varies from quarter-to-quarter.

In the second quarter, asset growth was on target in terms of absolute dollars, but was relatively back-end weighted instead of spread throughout the period.

As a result, ending loan balance in our commercial lending and investment segment exceeded average loans by $558 million compared to last quarter, where they were nearly the same, due to late first-quarter payoffs.

We have a powerful origination capability at CapitalSource and our current pipeline is strong.

However, the dynamics of transactions we finance sometimes lead to a lumpy closing schedule, and we certainly saw that in the second quarter.

Ramp rate has and effect in the quarterly results in a few areas, including the amount of net interest and fee income earned during the quarter, as well as operating expenses as a percentage of average assets.

The good news is that we have those assets on the book now and they have provided significant momentum into the third quarter, and this, among other reasons, is why the outlook for the second half is very strong.

Next item I want to address is yield, and in particular, the prepayment related fee income component.

Yield in the commercial lending and investment segment was lower this quarter by 12 basis points compared to last quarter, reflecting primarily a reduction of lower prepayment-related fee income.

Last quarter, prepayment-related fee income was unusually strong, so in both absolute dollar terms and in basis points of yield, prepayment-related fee income was solid this quarter, but comparatively less, demonstrating the lumpiness in the business.

Specifically, prepayment-related fees contributed $10.9 million to interest and fee income this quarter, or 63 basis points of yield.

This compares to $17.4 million, or 105 basis points of yield last quarter.

We view our core yield performance this quarter to be strong, especially in light of the significant growth in real estate related lending where we are using the pricing power enabled by the REIT structure to drive strong bottom-line results.

Operating expenses this quarter included some unusual items that are worth noting.

For the second quarter, total operating expense was $53.7 million, up from $50.6 million in the first quarter.

The significant drivers of this increase were higher stock compensation expenses, higher professional fees and higher depreciation and amortization related to our sale leaseback transaction.

Let me focus on the first two of these items.

Non-cash stock compensation was $9.8 million this quarter, up from $6.5 million last quarter.

This increase was primarily due to expenses related to new option and restricted stock grants issued in the quarter in connection with new employment agreements signed with our top two executives.

Two things I want to point out here are that, number one, due to the vesting schedule, the expense of these agreements is relatively front-end weighted; and in subsequent quarters, the changes for these agreements will not be as large.

With respect to professional fees, the quarter included a $1.4 million charge for expenses we had previously been capitalizing related to a terminated transaction we had been considering.

This offset the professional fee savings we had guided you toward last quarter.

Absent the increase in non-cash stock compensation expense and unusual item in professional fees, operating expense in dollar terms would have been lower this quarter.

Cost of funds is another area I want to touch on.

Cost of funds in the commercial lending and investment segment was up this quarter, reflecting both higher short-term interest rate environment and a slightly higher borrowing spread.

Higher short-term rates is not issue for us, as we are predominately a floating-rate lender as well.

However, with respect to our borrowing spread to LIBOR, we usually talk about that moving downward, so this quarter was a bit atypical in that our borrowing spreads increased slightly.

We have some relatively short-term phenomena occurring in our funding, and I expect to ultimately resume our downward trajectory in terms of borrowing spread.

First, there was an uptick in non-cash amortization of deferred financing fees this quarter, which directly affects borrowing spread.

Second, as we have talked about before, we are making an investment in our unsecured funding strategy.

We expect unsecured debt to be more expensive than our secured debt, especially at the outset.

However, we believe that broadening and diversifying our funding sources is worth that expense incurred.

During the quarter, we did make further progress on our unsecured strategy and expanded our unsecured credit facility to $640 million and a total of 16 participating banks.

And third, as you know, we have been waiting patiently for CapitalSource Bank, which is the name of the Utah industrial bank for which we have made an application in June of last year.

For reasons unrelated to CapitalSource, the FDIC approval process has been much slower this year, and recently the FDIC announced a six-month moratorium on industrial bank approvals.

Given that our application has been pending for over a year now, we are obviously disappointed in the FDIC's announcement.

However, we nonetheless intend to wait out the temporary moratorium, and we hope that our bank will be approved in January 2007.

This waiting has not been without some cost to the Company, however.

While we have not priced in the benefit of deposit-based funding into our projections for the business, we have been warehousing a substantial amount of loans that would constitute the bank's initial loan portfolio.

Warehouse credit facilities are relatively more expensive on a cash basis than some of our other sources of funding, for example term debt securitizations, and as a result, this waiting for the bank has added to our borrowing spread.

Due to the moratorium, we will now pursue more efficient funding for some of those warehouse loans, and this should get us back on track towards lower borrowing spreads by the end of the year.

Net finance margin, which includes interest income, fee income, operating lease income, and interest expense, was 7.99% this quarter, compared to 8.4% last quarter.

Excluding the 42 basis points of lower prepayment-related fee income, net finance margin was actually up slightly this quarter compared to last.

As you know, part of our thinking behind the REIT election was to employ lower, more competitive pricing in our real estate related lending business.

All other things being equal, we expected this to show up in a reduced pretax yield and reduced net finance margin, so I am pleased with the consistency of the net finance margin this quarter.

Finally in tax rate, our effective tax rate this quarter was 19.4%, reflecting our revised estimate of a 21% annual effective tax rate.

This is a reduction from the 22.9% annual estimate of the first quarter and is based on our revised forecast for the business, including mix of REIT and TRS activities.

Given the disparity between the tax rates of the REIT and the TRS, our projected mix of business has a significant effect on this tax rate estimate.

As a result, this is an area where we may see more volatility in the future.

However, as we aim to produce similar after-tax results in both the TRS and the REIT, this change in effective tax rate does not affect the quality of our earnings.

So in closing, the second quarter earnings were solid, with net growth on target, yet relatively back-end weighted.

We continued our momentum and the business performed well.

Adjusted earnings were ahead of our expectations for the quarter and in line on a per-share basis, providing a strong trajectory into the third quarter as we continue to grow the business.

The outlook for the second half is very strong.

We are on track to achieve our 2006 dividend goal of $1.96 per share and expect to be within our payout guidance of up to 90% of adjusted EPS.

With that, let me turn the call back over to John.

Thanks, Tom.

I just want to make a few points to sum up before we go to questions.

As I said a few minutes ago, to my mind, the business continues to perform at or above our expectations.

We believe our strategy of building a highly focused but highly balanced business is working, and I believe this will continue to drive shareholder value into the future.

Despite what I would call to be significant market liquidity, we are experiencing very strong opportunities in markets where we have inherent competitive advantages.

And one of the things I want to footnote is that the sale leaseback business, where we had good activity in the first quarter, had slight growth in the second quarter, we think is setting up very nicely in the second half of the year and we have a very strong pipeline of those transactions.

And as it relates to the second half of the year, as I said in my remarks earlier, this quarter, which I view as a very strong quarter, we actually had some lumpy items cut against us -- lower repayment fees and a bit of a lag in our average balance.

Based on what I'm seeing, I think those things will reverse in the second half of the year and I think some of these lumpy items will cut our way, both in terms of asset growth and in terms of fee income.

And those will occur while we continue to have this what I call strong credit pipeline.

So I think the business is setting up very nicely in the second half of the year and that we've had a very strong first half of the year.

We're proud of our results.

And at this point, why don't we open it up for questions?

(OPERATOR INSTRUCTIONS) Henry Coffey, Ferris, Baker Watts.

I was wondering if you could give us some more detail on the $12 million worth of charge-offs.

Sure, Henry.

The only detail I could provide, I think, without going loan by loan, which we normally don't do, is that these loans had been specifically reserved for, so they were not surprises.

As we have discussed in the past, when a loan enters into one of the -- typically the nonaccrual bucket, we will test it for whether a specific reserve is required or we have to allocate, I guess, our larger reserves.

And we do this on many of our loans.

Then when the charge-offs occurs, which is based on a variety of factors, either there has been a complete resolution of the situation or it is so clear from the performance of the credit that there will be a permanent impairment, then we'll actually take a charge-off.

And to the extent that loan has been specifically reserved for, what happens is that charge-off goes against the specific reserve and it lowers the total reserves, assuming there's not new reserves to take its place.

And that is in part what happened this quarter.

The other reason our -- I'm adding to your question here -- the other reason our reserves trended down as a percentage of the portfolio was because mix of business changed.

As I think you know, we take lower general reserves, if you will, against more assety situations.

And the portfolio is shifting toward more of an asset-based orientation, so the reserves as a percentage of the portfolio should go down, absent larger specific reserves, which has not occurred.

So that is probably the only detail I could provide with respect to that $12 million.

The $12 million is certainly not surprise.

Again, our charge-offs are somewhat lumpy.

The first quarter we had essentially no charge-offs, maybe a couple hundred thousand.

I don't even remember off the top of my head what it was.

In this quarter, it was $12 million.

We feel very good about the guidance we provided for charge-offs certainly for this year.

Could you remind me what that is?

Henry, it's Tom Fink.

We had talked about $42 million of charge-offs was our guidance for the year.

And that works out to what in terms of expected basis points about?

Well, at the time we gave it, it was around 50 basis points.

Obviously, the portfolio moves and that basis point number would move.

I am more comfortable with the $42 million number.

Then the second question, and I'll get back on the speakerphone, we will call it footnote 4.

The way you're calculating your adjusted earnings, it seems in most periods you are going to add back your provision, but not charge earnings for their charge-offs.

That seems to be -- I guess it doesn't seem like a big issue when the difference is 200,000 versus 300,000; but when it is 12 million versus zero, it seems to create kind of -- it opens up the question in terms of why is that the method and is that consistent with some other metric?

You can see where the questions could come from on that one, when the difference is this big.

And that's not new, Henry.

We did disclose (multiple speakers).

The thought there was that the adjusted earnings definition, we will add back reserves, but we will charge it with charge-offs to more reflect true cash flow business.

The determination was made at the end of the year since we had relatively large specific reserves, that the extent that we want to have a clean slate with the REIT election and kind of have an apples-to-apples comparison, it was better to have the adjusted earnings definition be more pure as it relates to problems that occur while we are a REIT.

So I would say this year we're probably in a transition as it relates to that.

But that was the thought process behind that.

Thank you.

Don Fandetti, Citigroup.

I was wondering, John, if you could give us a little more color on this large commercial real estate loan that became delinquent.

What type of property was it?

It was in our commercial real estate group, and it was kind of a combined office/retail complex.

We are at a very appropriate loan-to-value, we believe.

There were some specific issues with the property and the borrower that are probably not worth going into at this time, but it was fairly traditional down the fairway property.

It was a downtown property in the city that it was located in.

And we just are not on the same page with the borrower as it relates to the future of property, and we encouraged them to refinance us out, which they are in the process of doing.

As I said, they have a commitment letter from a major strategic Wall Street financial institution that is active in the real estate business, which probably means every Wall Street firm.

We expect that deal to close.

And it is on schedule to close, so it is just part of the business.

Okay.

Where was it located, roughly?

I tend to avoid going into kind of blow-by-blows of all the loans because there are people other than shareholders and analysts who listen to our calls, including borrowers.

I will say that it was a downtown building in one of the larger cities in America.

Was it a construction financing or what went wrong that caused you --?

I think that building has been around -- the building has been around for I would guess 50 years.

And there was -- it had a government tenant, it had retail.

It is a large building, a complicated deal.

It wasn't a land deal; it wasn't ground-up construction.

It wasn't in some remote area.

It was -- if I would have told you the deal, it's a downtown building that has been around that was reasonably stabilized with a government tenant.

So you can have problems with those kind of deals too.

So this will work itself out.

I think just to be clear -- one more time.

We have a commitment letter -- or the borrower has a commitment letter from a major Wall Street firm to refinance our loan out.

And we expect that transaction to occur in the next few weeks.

Great.

Tom, just briefly --

When I said larger than average, our average loan size is such that we have quite a spread on our loans, right?

We make loans that are $5 million.

We make loans that are $30 million or $40 million.

Sometime we make loans that are even larger than that.

This was a somewhat larger than average real estate loan, so it tends to -- I mean, with the delinquency statistics, which is probably what you're drilling in on, you really do have the law of small numbers.

And one loan can move that statistic quite a bit because it is a pretty small statistic.

I will say in my experience as an asset-based lender, I have lots and lots and lots of loans that go as delinquents that you work out of.

The delinquency statistic is -- I won't call it an inconsequential measurement of our credit performance, because you would rather have loans be current than delinquent, and it means something.

But in order of magnitude on a scale of one to ten, I would put non-accruals at a ten and I would put delinquencies at like a two.

It really doesn't mean much.

Sometimes those are delinquent because they're just past their term, and we haven't executed any kind of a new deal where (indiscernible) refinances out, but the loan could be current.

There's all kinds of reasons loans go delinquent, and I encourage you that -- I think we have been pretty clear about this point for a few years now, than that is not a relevant statistic.

Nonaccrual -- the non-accrual loans are the loans we are looking at and saying, for various reasons, we think there is a significant impairment to the situation -- and I don't mean to use the word impairment in the accounting term, but I'm just using my kind of lay language here -- that we have either taken a specific reserve against or we think it is not appropriate to accrue the interest on.

Many norms on non-accrual paying current, but we decide not to accrue them.

That is really the bucket that means something around here.

Okay.

I will just leave it there.

Thank you.

Sameer Gokhale, Bear Stearns.

I actually just wanted to revisit the point about your adjusted earnings.

The credit losses, I think you were pretty clear last quarter too that you wouldn't include those in the adjusted earnings calculation to the extent that you provided for those losses before and they were expected.

But if we were to look into '07 or once you work through the existing reserve and at some point you have to have those charge-offs reflected in your adjusted earnings numbers.

And what would you see as kind of the offset to that, once you do include those charge-offs in the adjusted earnings calculation?

Well, just so we are clear, it was only [loans] that had been reserved against at 12/31/05.

We are aware of the observation you're making, and it is factored into our view of the business.

So -- and we could have charge-offs that run through adjusted earnings this year.

It is certainly not unlikely that we would have a charge-off that we had not specifically reserved against as of 12/31.

So it may not even just be an '07 issue.

It may be an '06 issue.

So we are aware of that and we factor that into our business, and the way we have spoken about our business.

And Sameer, I would add that all of that has been obviously factored into our modeling for the business, and we're focused on the favorable growth dynamics we're seeing.

And so in terms of where is our adjusted earnings going to go, we think it is going to go up due to the very positive growth that we're seeing in the business and the other strengths we see in the business.

Okay, then is it -- on your non-accrual ratio, clearly that is the most important metric from a credit standpoint.

But if you were to look at it on a lag basis, what is the most appropriate -- how do your loans season?

Because these aren't like your traditional consumer finance loans.

So is it appropriate to lag it on a 12-month basis or two-year basis?

When you lag it there, what trends do you see there, and what does that suggest for credit quality potentially going forward?

I would say you're right that this is not a consumer business.

We describe this more as a high touch lending business, so it is hard to put general parameters on things like that.

But I would just focus on the fact that -- and we have said this now for the last few quarters -- that we have seen in the portfolio a positive credit pipeline.

We certainly had some situations that popped up last year and we have been working through those, and now you're starting to see some charge-offs related to those situations.

But we are not seeing a lot of new situations queuing up behind them.

So we look at the portfolio and we are very pleased with the performance.

We think we've settled into a nice range here.

They are going to move around a little bit, but we are very happy with the credit performance of the portfolio.

Okay, that's helpful.

Then just a last question I had is typically I think you provide a table in your presentation which shows all the credit statistics over a period of time, with your losses by different categories.

I did not see that this time around, unless I'm missing it.

Is that something you can provide?

You're talking about our standard investor presentation?

That has not been put up yet, but we will have that up on the website shortly.

Okay, great.

Thank you again.

Joel Houck, Wachovia Securities.

I guess we'll just stay on the credit theme, guys.

The $52 million increase in dollars in 60 days past due, you talked about these two transactions without identifying the names.

Can you give us a sense of how much of that increase was from these two deals?

I don't know if you mentioned that percentage in your prepared remarks or not.

I didn't mention that percentage, Joel.

I would put under the category of most if not all.

Okay.

So basically one is imminently refinance, one is a well-secured asset-based loan, and hence your comments about not worried about those resulting --.

Yes, this is not something I'm at all concerned about.

Okay.

Then in terms of the non-accrual bucket, which you guys obviously look at as more indicative of future charge-offs, is there some -- given the shift in business mix over the last couple of years, is there some sense you can talk about how many of those loans are real estate or asset-based secured at the end of June versus corporate cash flow loans, roughly?

Certainly.

I think as we have talked about in the past, I think most of it is coming from the corporate or the cash flow side of the house and much less from the real estate and the asset-based.

I think that is pretty much still the case.

Okay.

Then Tom, just quickly on the tax rate, I know you addressed it.

It sounded -- I don't want to put words in your mouth, but it sounded like the full-year tax rate might come in a little than original guidance.

Is that the case, or is it just going to be lumpy?

Yes, that is exactly what we're saying.

Last quarter, excluding -- we had a onetime write-off of net deferred tax liabilities in the first quarter.

So putting that issue aside, we had provided for taxes at a 22.9% rate.

We are now providing on an annual basis at 21%.

The actual rate is quarter is a little bit lower because there's obviously a catch-up adjustment that gets done because the first quarter was at a higher rate.

But as I tried to illustrate in my remarks, I think this is sort of an interesting issue and the number is going to move around, and it is going to move around more than it has for us historically because -- and it really depends on our forecast for the business.

Because if we have $1 of income in the REIT, generally speaking the tax is zero; if we have $1 in the TRS, generally speaking the tax rate is 38.6.

So there is pretty big swing there.

But we have to keep in mind is we are aiming for similar after-tax returns in the business.

So I can sit here and I'm relatively indifferent between growth in income -- after-tax income in the REIT and growth in after-tax income in the TRS.

So I think on a bottom-line basis, it really doesn't matter.

And the changes in the tax rate doesn't really affect the quality of the earnings of the business.

We just have some -- just interesting dynamics due to the REIT structure and it's as simple as that.

But I think the earnings quality was very high this quarter.

Thanks, Tom.

Great quarter.

Don Destino.

All of my credit questions have been answered, so let me just one last push is on lending spreads.

We keep on expecting to see lending spreads deteriorate a little bit, just generally from competition and you guys kind of lowered the return hurdle with the REIT conversion.

And yet when we strip out all the fees, it still looks like spreads for the indices are pretty stable.

Can you talk a little bit about what's going on there?

Are you at all surprised that you have been able to get the same type of spreads recently as you had, say, a year ago?

And would be prudent for us to continue to expect those spreads to tighten going forward?

I will start a little more general and then let Tom drill down.

I think it is always prudent to expect the spreads to go down.

That is how we think about the business.

I would say that we have got a very -- I will start with a very macro point, which is we have a very good business where we're focused on delivering value to our customers and the team is executing at a very high level.

So it doesn't surprise me that the team continues to exceed my expectations in terms of the spreads they can earn and the quality of the loans that they produce.

And it is a reflection, I believe, of the quality of the business, the niches that we are in, the market-leading position we have in these businesses, the fact that we do get paid premium for delivering value to our customers, and the fact that we've built a business designed to do just that.

I mean, we generally take a prudent approach in terms of our modeling of the business as it relates to all the various categories, including spreads, and generally have a view that spreads will compress as the business gets larger and the markets continue to get more liquid, which I believe they do with each passing year.

But it does not completely surprise me that the team also continues to outperform, which is what they are doing now, which is driving spreads.

So I think we share your view that it is prudent to look at a tightening spread environment.

We've said that repeatedly in the past.

But again, I think the team's doing a really good job and the business is performing at a very high level, and that is why spreads have stayed good.

Now I will let Tom comment more specifically.

I think, Don, the only other detail I would add there or color I'd add there is kind of referring back to the same kind of discussion around the tax rate.

We are using the pricing power of the REIT to grow the real estate businesses.

And we can actually target or go after lower-priced deals, be more competitive and earn the same or better after-tax return.

And that is what we're really focused on, is that bottom line.

And so as the mix of business changes, if we do more real estate and we are using more of that pricing power and we're still getting the same after-tax returns, you're going to see that show up in lower spreads, but that does not mean the business is doing worse.

In fact, it means I think we are being successful.

So we are focused on the after-tax part of the business as well.

And I'd add one other thing.

This gets to an orientation.

Our general orientation is very return focused.

We're not empire builders necessarily in terms of building a big business just to have a big business.

We're building a business that we think is highly profitable, and so we're very focused on spreads and return.

Got it.

Thank you very much.

[Damon Peller], Lehman Brothers.

Just one last question on the credit again.

With delinquencies, what percentage of the total is actually related to the real estate loan that you talked about downtown versus the other loan that you referred to?

Again, we don't make specific comments on specific loans.

I think what the answer that Joel pried out of me earlier was probably the most I can say, and there are some cautionary looks around the table already.

I will repeat that answer, because I already have said it, so there's no reason not to repeat it -- I don't think that is a problem, even though some may disagree -- is that I would put it under the category of most to all was related to those two loans.

I did make the observation earlier that the real estate loan that was in the category was above average in size.

I don't mean that to be concerning, because obviously if we have an average and we have said repeatedly we have spread in terms of the size of loans we make -- it is above average in size.

So -- and as I said in my comments, I don't think -- first of all, I don't think there is much to read into the delinquency category period.

And I don't think in light of what we have described as a real estate loan that is getting refinanced out and a corporate loan that we view as asset-backed, the fact that those two are driving the increase in that 60-day delinquencies, I would actually put that under the category of inconsequential.

Okay.

In terms of the reserve rates, the amount that is actually reserved for has gone down.

And I'm wondering is that going to be something that is sort of static, continue being a little lower, given the mix shift in loans being more secured-based and real estate-based?

I think that would be my guess or my prediction, that the allowance reserves would continue to go down as a percentage of the portfolio due to that mix issue, absolutely right.

Then a few more quick questions.

One of them on the growth in the latter part of the quarter, what caused that just jump in growth?

I think you said $600 million of growth was in the last month or the back half.

What led to that ramp up at the end versus sort of steady throughout?

We didn't get into when the growth occurred because it complicated, right?

We talk about net asset growth and the things that go into net asset growth are originations in paydowns, right?

Which the way we model the business, which is the way you model business probably, is you assume this nice, steady increase in net asset growth.

So if you have a certain net asset growth projected for the quarter, you take that amount and you divide it by 90 and that's how it grows.

But in the real world, it doesn't really happen away.

What happens is loans sometimes pay off.

A lot of our prepayments may have come really early in the quarter, or some of our gross originations may occur late in the quarter.

So without commenting into the blow-by-blow as to why the net asset growth was on average lower than where we ended up, all those factors contributed to it.

But it is a really important point -- I'm glad you brought it up, because if you go back to that slide we had, you see that in the first quarter, we ended the quarter with the same balances the average loans were for the quarter.

Which is a good dynamic in terms of that quarterly's performance, because you have those loans working all quarter.

This quarter, the average loans were $600 million lower than where we ended.

And so we would have liked to have had $600 million more to work all quarter at our net interest margin; the Company would have made a lot more money.

Now when we go into the third quarter, it kind of sets up nicely, because the assets are where we expected them to be.

We are seeing very good growth in the business.

And so I think that kind of lumpy lag, if you will, that cut against us in the second quarter is not going to really play out in the rest of the year.

I will also say in the first quarter, it played out to our benefit.

I think one other time did the average loans equal the ending balance.

But that did happen in the first quarter, and that's clearly a very good thing.

This was unusually the negative in terms of the average loans were being $600 million lower than where we ended.

We model the business a certain way, you model the business a certain way.

But in the real world, loans pay off when they decide to pay off, not when we tell them to pay off.

Then loans close what everyone gets together and closes, not when we tell them to close.

We have some say in it, but there's other parties obviously.

So you tend to see these swings around in terms of average loans.

And that was a material factor this quarter.

But again, I think the business performed very well, even with that.

And it is setting up, more importantly, very nicely into the third quarter.

The growth is very strong and it was good to see.

But maybe you could just comment on the outlook for '07 in terms of the dividend.

I know before there has been mention of $2.68, and is that still standing?

Is there any sense you can give us there?

You know, we have got a big investor conference occurring in September.

And our plan is, as we have said in the past and we try to stick with it, that that is when we give our various guidance and provide a lot more detail behind it.

So I am not trying to avoid your question.

I'm just saying that our policy has been to stick to that.

Okay.

Thanks.

Moshe Orenbuch, Credit Suisse.

Could you just talk the little bit about the reserve?

I know you don't quite have the same specific reserving methodology you used to have, but how much of the reserve is allocated to the charge-offs that you expected?

Moshe, it's Tom.

I would -- probably $37 million or so of the allowance is allocated to specific loans at this time.

Great.

Laura Kaster, Sandler O'Neill.

I don't know if this is the right way to ask it, but the decline in your reserves on a sequential quarter basis, can you tell us how much of that was due to mix shift and how much was due to the specific reserve?

I don't know if you specifically went over that.

Well, I don't know that we specifically went over that.

Just to kind of review the facts, the provision was that $11.6 million in charge-offs were $12.3 million.

And allowance is something that we report as a period end number, right?

So you're looking at the ending portfolio balance, which is up substantially.

But you can see the growth dynamics in the portfolio, which is part of the story.

And obviously taking $12 million out of the reserve for the charge-offs, but most of that being replenished by new provision.

Okay, great.

As far as your bank being delayed, John, did you say that they are going to be relooking at bank [turners] again in January?

And was that the timing that you thought yours would close or just when they're going to begin to revisit it?

I will start by saying I have learned not to comment on the timing of industrial loan corporations, so that kind of informs my answer to your question.

I am obviously joking, because I have said in the past that I expected to be approved by a certain time.

You know, I think the safest ground for us to go to on this question is to say we really don't know.

They put us a six-month moratorium on this, which I found a little odd, if you ask my own opinion.

The FDIC has decided not to process these applications for six months while they evaluate the various things being thrown around Congress.

That six months ends the end of January, which some might conclude they will get back to business and process applications, and as we have said in the past, they had no problem with our application, as best we can tell, and we had very extensive dialogue with them.

In addition, the various comments that are being made about industrial loan corporations and why they should be regulated, if you will, is probably the right word, don't really apply to us because what they are really focused on is commercial enterprises, not financial enterprises.

And CapitalSource is obviously a pure financial enterprise.

And we have obviously had that dialogue, not only with the FDIC, but we have had that with members of Congress who are spearheading some of the opposition to these ILCs.

So I would say that we are confident that we will be able to get this charter.

We're not sure when it will happen.

It is unfortunate how this has played out.

We are disappointed, obviously.

We will not be withdrawing our application.

We continue -- we believe we will stay the course because we clearly qualify for this charter, and we will see how it plays out.

But I really can't provide any insight.

I think the thing to note as it relates to the Company's performance, we did not model into our projections that we would have this charter, which we've made that comment in the past.

We thought that was the prudent tack, because even though we expected to receive it, we did not in fact have it.

And as we have learned here, you can't count on something until you actually have it.

So we did not model it in.

It did affect our spreads because we had somewhat kept assets set aside, waiting for the bank to happen, so that we would deliver a large bulk of assets into the bank when the charter was approved.

Now we thought that was the best way to optimize the bank structure.

And what that did is it meant that we did not securitize the assets, which would have been the normal course of business of the finance and accounting group.

And so they would already moved these assets into a lower-cost funding home.

So they kind of sat in our credit facilities, which is a higher cost place to finance them, for longer than they would have.

So now Tom and his team will be busy at work securitizing these assets, which will get the spreads back towards their trends of declining spreads.

So that was probably the collateral damage, if you will, of this decision, was, number one, we spent a lot of money getting ready for this application.

We have to maintain an office in Utah and a team of people, etc.

Secondly, we kept some of these assets in higher cost funding vehicles pending the bank, and now we will just have to move them.

But beyond that, I won't speculate as to when this charter could be acted upon -- or this charter application could be acted upon.

Okay, great.

Lastly most of my credit quality questions have been addressed, but can you just give us a broad overview of the competitive environment, what you're seeing in each of your business lines?

I would say that nothing has really changed from comments I have made in the past.

The corporate finance group continues to be very competitive.

There's a lot of liquidity in the market, and the way we're dealing with that is by leveraging our syndication capabilities, trying to move into larger deals.

I would make the observation that I think we're somewhat in an inverted market, which is interesting and something I would not have thought would've occurred.

By that I mean I think the middle market buyout space is actually not as attractive as some of the larger buyout space.

I think that is just a supply and demand phenomenon.

In other words, in the past, the spread you were paid and the leverage you had to lend on a middle market deal made it worth doing those deals because they are in fact riskier, and you were generally lending at lower leverage and at wider spreads.

And what has happened on the smaller end of the deal market is people are paying a lot for these businesses.

They're basically paying the same multiples for these businesses as people are paying for larger businesses, larger businesses that are much more seasoned and global etc.

And so I actually think the middle market space, the smaller end of the middle market space is a little less attractive than some of the larger middle market to larger deals.

So what we're trying to do is leverage our business and play more in the larger deal space to some extent, while preserving the good relations we have on the middle market side and continuing to do deals that require what I would call a special level of attention or expertise.

So that would be my general observation on the corporate finance group.

I think team is doing a great job.

I think our syndication team is really performing at a high level.

And I think that team has shown that it has been smart in this market.

Shifting onto the other businesses, the healthcare and specialty finance business, which has a real estate business unit and healthy in terms of healthcare real estate, that business is doing terrific.

I made the observation that the healthcare sale leaseback pipeline is quite strong, and you should expect a fair amount of activity from us in that area in the coming quarters.

The healthcare accounts receivable business continues to do great.

The business credit services business, which is the asset-based business that we are building, kind of a general asset-based business that focuses on restructurings and (indiscernible) etc., is also continuing its good growth trajectory.

And we are building a distress business within that area that is off to a great start.

So I would say all is good in healthcare and specialty finance.

Structured finance has also been significantly enabled by this REIT election.

You know, as we have looked back the activity in that business, both in terms of the commercial real estate business and the re-discount business, we have concluded that prior to this REIT election we were probably 100 basis points or so off a pretty rich vein in the market prior to the REIT election.

And by being able to lower our spreads, which we can do because we are not paying tax and we get to the same ROE, has really opened a significant opportunity for both commercial real estate and the re-discount business, and you're seeing that in these numbers.

So again, I would say all is good in structured finance as well.

So that is probably my general overview of the various businesses.

Thank you.

Bob Napoli, Piper Jaffray.

Just a question, I guess, on the growth.

I was surprised by the level of growth in the quarter and wondered what you saw that maybe accelerated growth or was it an actual acceleration in originations or was it just a slowdown in prepayments?

And I had one follow-up question.

Well, I think we certainly had some runoff during the quarter, but mostly it was due to, I would say, strengthen in originations.

Which I think we are very strong considering two things.

One, there certainly were payoffs during the quarter.

But we also had from a balance sheet reporting perspective the headwind of deconsolidating those loans held for sale.

And John made the point specifically, if you look on the surface of corporate finance, it looks like it shrank, but it actually grew a little bit because it in particular was fighting a headwind.

Then my question, what do you think led to the acceleration?

It seems like the economy maybe slowed a little bit, but you had an acceleration in growth.

Is it more effective marketing or competitive pullback?

What drove that?

I would say the asset growth is not unexpected from our perspective.

I mean, you have to remember, we have built a very large origination team here, and it is hitting on all cylinders, and this is what we've talked about in the past.

We have also allowed that origination team to actually target a new vein in the market by putting them in a position to lower their spreads and go after some what I would consider to be some stronger credit business, some larger deals, lower leverage situations.

And I think that is reflected in the number.

I don't think it is necessarily correlated to what's happening in the economy.

I think it is much more correlated to what is happening here at CapitalSource, which is us continuing to build out what I consider to be the finest middle market lending platform in the country.

We have invested significantly in origination efforts of the business.

We have made the business more competitive with the REIT election.

And I think that is what is driving these results, not any macro trends in the economy.

Is the pipeline such that the third-quarter growth looks a lot like the second quarter in the outlook for the year?

As I said, I think the second half of the year is setting up very nicely in terms of asset growth.

I made the observation that fee income looks good.

That has been a lumpy item and was up first quarter, down a little second quarter.

I think we think it is going to be up again.

And the credit [profile].

So I think the business is setting up nicely.

Last question, just on a macroeconomic environment, what is your feeling as to what is going on out in the market?

What are you seeing and where are you most concerned about the economy?

I think -- I've always had a view that CapitalSource takes much more operation risk than it does economic risk, and that is the general orientation I think of a senior, highly secured lender.

I think the observation I have on corporate finance is that we are in somewhat of an inverted market is probably the most significant observation I have about what is going on in the business world.

I think the market is highly transactional right now, which creates a lot of opportunities for a company like ours.

I think our healthcare business is in very good shape.

It is not necessarily tied to the economy, as we've spoken about in the past.

I think our commercial real estate business is very localized in terms of the risk, the economic risks it has.

And we take that into consideration.

Our rediscount business is doing very well, and we are seeing some actually interesting opportunities in that business related to the dislocation in the residential lending business.

So I don't have any broad economic concerns right now, other than some of those specific things I mentioned that reflect our guidance in the businesses.

Great.

Thank you.

Carl Drake, SunTrust Robinson Humphrey.

I was wondering if you could provide an update on the operating expense leverage.

Maybe Tom, you've talked about some metrics in the past that were continuing to benefit from scale.

Could you provide some update there?

Yes, I think that those -- we certainly will continue to benefit from growing scale of the business.

I don't think we actually mentioned it yet on the call, but our headcount, if you just look at that number, for example, was up only slightly this quarter.

We had been growing the business and the employee base and operating expenses, and we are trying to keep a very close eye on operating efficiencies in the business.

We talked about it as we announced the REIT election, that part of the other benefits of the business in terms of its scale is that we will see opportunities to use best practices in one part of the business across the other.

So I think we have a lot that we can capitalize on.

We have built a very strong origination team, as John has mentioned.

And as that portfolio of asset continues to grow, you're obviously amortizing those front-end costs over a much bigger portfolio.

And I think maybe you updated efficiency ratio or operating expense to assets or gross revenues in the past, and are there any updates there?

I don't have an update on efficiency ratios.

I think we expect our operating expenses in terms of assets to be down next quarter.

We talked about some of the unusual items this quarter.

So I would expect to see a downward trajectory.

One of the other things, just to -- I know you know this, Carl, but included in operating expenses is depreciation and amortization related to our sale leaseback investments.

That is another item that is in that category that was not there a year ago, and I think in terms of how we think about the operating part of the business, it is not something I would generally include in that.

But that is where it shows up in the income statement.

One last question.

John, when you mentioned the highly transactional nature of the middle market and the small end and the larger end, and the small end being less attractive, how would you define the small end in terms of EBITDA companies?

Are you talking about $5 million to $10 million EBITDA, or how would you segment that?

I think $5 million to $10 million is still a pretty inefficient part of the market, and I don't even consider that in this.

I mean, we do deals in that space, it's a small deal market.

I think we are seeing this inversion, if you will, is kind of down the fairway middle market, which is enterprise values kind of 75 to 250.

Okay.

So that is the area where it is inverted?

Yes, and I want to be careful with the term inverted, because the point I am making is that if you turn the clock back a few years and you look at a large buyout, the kind of buyouts that make the front page top of the Wall Street Journal versus some of the middle market stuff, what you'd see is people paying lower multiples for the middle market companies.

You would see the leverage levels being quite a bit lower.

You would see the spreads on the debt being wider.

And you would say, well, that make sense.

They are smaller companies, right?

They are riskier for a variety of reasons.

What you are seeing now is that the spread between the middle market and the large deals has compressed.

The spread -- what I mean by compressed, I mean people are paying about the same in terms of multiples of cash flow, lending them about the same.

And the spreads are still wider but not as wide.

And then when you say to yourself, okay, is that appropriate considering the risk of these middle market businesses?

And I think an added risk to these middle market businesses is the global economy, and the bigger companies are in some ways better positioned.

So that is why I think it has been a little inverted.

And if you look -- it is interesting.

We have in our asset management business that we are building, which is the CLO effort, that is the point we made the earlier, that some of the assets shifted to that, where we are essentially selling loans and also buying loans from people as part of this third party capital strategy we have.

We are getting a little insight more into the larger deal market.

And it's kind of confirmed the discipline that we have shown in our corporate finance business.

I think it is a supply and demand dynamic that is going on in the larger deal market; there are just so many large deals getting done that it is -- and the nature of those deals, with firms coming together, less of an auction.

Because in the middle market, what you have right now is someone always has to win a deal, right?

So a middle market company goes to auction, there's 30 firms that can buy it, and one person really feels like they need to win it, so it bids it up.

Whereas these larger deals, it's a smaller number of people can buy them, they tend to club up together.

And I think you get a little less of that dynamic.

So I think there are a lot of factors playing into it.

But it's kind of confirmed our view that the tack we are taking in corporate finance appears to have been the right one.

Okay, thank you.

Stephen Schulz, KBW.

Can you describe a little bit more in detail the transfer of $190 million or roughly of corporate finance loans into the special-purpose entity?

Did it have any impact on the P&L?

Did it have any impact on problem loan metrics?

I'm just curious why this CLO would be classified or deconsolidated as it kind of limits the visibility of how those loans would perform.

Sure.

Well, I will have to -- I will address your comments, Steven, but I just want to be mindful that there are actually -- the CLO is in the middle of a private placement right now, so I am limited in what I can say about it.

But basically, we had loans held for sale on the balance sheet -- identified that before.

These were loans that were acquired by the Company in connection with this asset management business that dovetails very nicely into our syndications effort.

Those were on balance sheet because during the warehouse period, we were the prime beneficiary, if you will, of the list.

But the intent was always to do an off-balance sheet securitization with respect to those assets.

Those are not going to be our assets; they belong to the CLO.

A CapitalSource subsidiary is simply the asset manager there.

The accounting standards for those loans is that they are held for sale, which means that there accounted for on a lower cost per market.

So they really didn't drive any allowance, if you will, before.

They were included in our gross loan balance that we use to develop the metrics, so now they are off-balance sheet and not part of those metrics anymore.

Does that get to most of your question?

Yes, I guess I'm just curious, if you are all -- would you intend to do more off-balance sheet financing then going forward for kind of more high-risk loans from the corporate finance business?

Let me make one further observation to what Tom said there, and he referenced this.

In terms of the loans that moved into that, they were all completely performing or they would not have qualified for the CLO.

So there were no delinquencies or impairments of any of those loans.

What we are doing with that business is we are creating essentially an asset management business where we use third party capital all the way through the equity, and we simply get paid a fee to manage the assets.

Which is a good strategy for us for holding assets that have a lower yield than we want for the equity of the company, because we can go into the CLO market and we can sell the equity at a spread that's lower than the ROE that we are targeting for this business.

And so for those assets it makes sense for us to be more of a seller of credit and earn fees.

And so for parts of the corporate finance business that could be competitive, we have to price the loans at tighter spreads than what we can earn on an after-tax basis from an ROE perspective.

At CapitalSource, it makes sense to put them in that vehicle.

So I would expect there to be more of that going on.

I don't expect there to be a wholesale shift in the corporate finance business.

I think what you'll see is CapitalSource will do little more direct originations right into those vehicles.

Again, which are vehicles where CapitalSource is -- the intent of that strategy is not to hold the credit risk and simply to get paid fees for managing the assets.

So it becomes part of a larger asset management strategy we have going on in the Company.

But I don't -- you should not expect the corporate finance business to move off-balance sheet certainly.

I think for corporate finance loans that we view having a return that is attractive to our balance sheet, we'll continue to put them on our balance sheet.

We will sell some loans into that as part of our syndication vehicle.

In other words, if we do a larger deal, we'll hold a piece, we will sell pieces of the loans to many financial institutions and we will quote sell a piece to our own kind of captively managed CLO.

Is that to imply that CapitalSource would not hold any equity in that CLO?

Yes.

Okay.

Then just back to --

It becomes a pure asset management business over time.

-- on the recognition of charge-offs, I guess there are two ways to look at adjusted earnings.

One is to try to make things apples-to-apples.

Another one is to try to get kind of a cash basis earnings that would drive your dividendable income.

And I guess from the perspective that you are trying to get to dividendable income, is it fair to say that not recognizing those charge-offs in adjusted earnings right now is kind of overstating earnings in the near term, until you get to the point where you are actually recognizing charge-offs through adjusted earnings?

I don't think that is fair to say at all, Steven.

I think the point John elaborated on this was with respect to the transition, if you will, becoming a REIT, all of those charge-offs that were not running through the adjusted earnings, those are all things that we actually have run through our EPS in prior periods; so they have already been funded, if you will, through our performance metric.

So we didn't think it made sense actually to double count them.

Okay.

And then just to clarify I guess the response you had to another question was, the detailed breakout that you used to provide of the problem loans and identified, say, three of the loans that were non-accrual and delinquent status were in structured finance, two were in corporate finance, just as examples -- you are going to update that and put that on your website?

We will have an updated investor presentation up on the website shortly, and that will include the recovery analysis that we have had before.

Absolutely.

There is nothing that you'll see there that will surprise you one way or the other.

Just my last question was excluding the non-cash equity compensation expense from the adjusted earnings, just curious was that just an oversight when you did your initial review of what you wanted to back out of adjusted earnings, or what drove the decision or kind of the decision to exclude that this quarter?

You hate to say it was an oversight, but that is probably the right terminology.

A lot of things have been happening with this REIT conversion, and coming up with the adjusted earnings definition is something we worked on towards the end of the first quarter.

Then after that, we were advised, if you will, that the better definition would conform to the NAREIT definition, which is funds available for distribution.

Which makes sense, because that is really the point of this, right?

To make sure you have coverage on your dividend.

And so we have conformed it to that based on that advice and we think that is the right decision to do, which brings up, I think, a good point.

One of the things that I think we should make the observation with respect to is kind of the coverage.

We are already showing good coverage as it relates to adjusted earnings off our dividend payout.

And we expect that to improve across the second half of the year.

We've guided towards a certain dividend, a certain flat level dividend.

And based on some of the things that are happening in the business that I commented, specifically loan balance being strong and us continuing to see good growth in that, fee income kind of likely to cut our way in the second half of the year a little more, based on some things we see, probable improvements in funding costs based on some of this unfortunate inefficiency related to keeping loans in higher cost funding vehicles, waiting for the bank, which we will fix that, you should see the coverage ratio improve pretty significantly in the second half of the year.

And that adjusted earnings definition as it relates to our dividend payout, I think you'll see at CapitalSource a very healthy kind of margin of safety relative to some other dividend-paying entities.

But that is really why we wanted that definition to be a good definition and to conform with something that is more standard in the marketplace.

All right, thanks.

I think we have time for one or two more questions.

Scott Valentin, Friedman, Billings, Ramsey.

This is actually Mike.

I just had -- all of my questions have been answered, except I just want to find out what were the specific reserves at the end of December prior to the REIT conversion?

The allocated portion of the reserve at the end of December was, I think, $33 million. $33.0 million, actually.

So about $21 million or so left of that remains.

And that was factored into the $42 million guidance for losses for this year?

Yes.

Okay, great.

That's all I had.

Eugene Chen, SuttonBrook.

Just to go back to the comment about loan growth, net asset growth being back-end loaded in the quarter, if you were to normalize for the timing of it, how much additional impact do you guess would it have been?

Sort of rough (indiscernible).

You know, it is probably $10 million of spread income.

Okay.

So $0.04 maybe.

Thanks.

A follow-up from Henry Coffey, Ferris, Baker Watts.

I was just interested in listening while you were talking about your CLO business.

Are there any -- is there anything that occurs in that transaction that would have triggered gain on sale accounting or recognition of non-cash revenue?

No, there is no real gains or losses on the sale of that.

Thank you.

I think that is all the questions.

Again, thank you for calling in and feel free to contact us with any questions.

I think Meg has something to say.

Well, I just wanted to remind everyone we sent out our recent Save the Date, and if you have not seen it, this is what it looks like.

And we will be hosting our conference on September 27th here in D.C.

So if you have not received that and are interested in attending, please give us a call in Investor Relations.

We will be around all day.

The number is 301-634-6860.

Thank you and have a great day.

Thank you for your attendance on today's conference.

This concludes your presentation.

You may now disconnect.

Good day.