PacWest Bancorp (PACW) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the fourth-quarter and full-year 2006 CapitalSource Inc. earnings conference call. My name is Jackie and I will be your operator for today's conference. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's 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 conference, Ms. Claire Rosebush from Investor Relations. You may proceed, Claire.

Thank you, Jackie. Good morning, everyone. Thank you for joining us for the CapitalSource fourth-quarter and full-year 2006 earnings conference call. With me today are John Delaney, our Chairman and Chief Executive Officer, and Tom Fink, our Chief Financial Officer.

This morning we posted a presentation to the Investor Relations page of our website, www.CapitalSource.com, which contains additional materials related to this conference call that we may refer to during our remarks today. Furthermore this call is being webcast live on our website and a recording of the call will be available beginning at approximately 12 PM Eastern time today. Our press release and website provide details on accessing the archived call.

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 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 press release issued this morning and in our annual report as filed with the SEC on Form 10-K. 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.

Thank you Claire. Good morning everyone. I hope you had a chance to review our earnings release issued this morning before the market opened. I'm sure you have. We had strong results in the fourth quarter capping off a very strong and very successful year for CapitalSource. Adjusted earnings were $110 million in the quarter or $0.61 per diluted share. For the full year, adjusted earnings were up 61% to $426 million. On a per diluted share basis, adjusted earnings were $2.51, up 17% from 2005.

During the quarter we grew our commercial assets by $1 billion for a total commercial asset portfolio at year end of $8.6 billion. This represents $2.6 billion in net commercial portfolio growth over 2005. An important aspect of our growth this quarter is that it was balanced. Each of our lending businesses grew including our repositioned corporate finance business. Also our growth was balanced nearly equally so between our loans and sale leaseback investments.

This quarterly growth performance and our balanced growth for the full year underscore what we have been saying about the strength of CapitalSource's direct origination platform and the opportunity we continue to see for the business.

We also have included information in our press release today about total managed assets. In addition to our core commercial finance business, we also have significant other assets under management. These include our $5.8 billion residential mortgage investment portfolio; $100 million portfolio of equity investments; and $2.4 billion of loans either managed in our CLO asset management business or managed directly on behalf of other investors.

Clearly with developments in the market there is somewhat of a blurring between the distinctions of commercial finance and asset management. CapitalSource does both and we think we have good opportunities to grow both the spread and the non-spread sources of income for the company, in a sense residing within the company is a large asset management platform that manages several different lending businesses. As such, we will continue to report our total managed assets going forward.

Turning back to the commercial finance business, which grew approximately $1 billion in the quarter to $8.6 billion at year end, market conditions continue to be competitive. We think this places a premium on the need to be careful, selective, and let's face it, patient. We are careful, selective, and patient and our strong direct origination capability provides us a key advantage here. While we had strong growth across the year, we are not solely focused on total originations in growth but more focused on high-quality originations and high-quality growth. We believe that through direct originations we will find better opportunities and will have much greater control over credit quality.

In addition, by maintaining a liquid balance sheet and maintaining a high-quality portfolio, we are very well-positioned to move very aggressively should market conditions turn. Tom will go into more detail on the quarterly and annual results, so let me focus the rest of my comments on some of the highlights for the year and also give you a sense as to our objectives for 2007.

As I said in our press release, in 2006 we accomplished many important things. First we were able to pay regular cash dividends in excess of our guidance for '06 while being at the low end of our payout ratio guidance.

Second, as I said earlier, our direct origination teams continued to find good opportunities, allowing us to grow in each of our lending businesses and produce superior results. In particular, our real estate businesses were empowered by our conversion to REIT status as evidenced by the very significant growth in our first mortgage loans year-over-year and by successfully entering the sale leaseback market, where we ended the year with over $730 million of assets.

Third, our corporate finance business was successfully repositioned as a more capital markets oriented platform, which allows us to be much more competitive in this highly liquid market.

Fourth, we are maintaining a strong credit discipline and the portfolio has performed very well. Our credit metrics have stayed within a range and have improved.

Finally and perhaps most importantly since it is the most effective way to measure relative performance in financial services, we delivered very strong risk-adjusted return on equity of 22% for the year. From a business that is largely focused on senior secured lending across a variety of businesses and employs modest financial leverage, I think this is very impressive performance and I am very proud of the Company's results.

In terms of our objectives going forward for 2007, they are fairly simple and straightforward. We plan on carefully growing our business to meet both our financial objectives and just as importantly, our credit objectives. We plan on continuing the buildout of our platform as needed to achieve both balance across the business and to maximize its effectiveness and efficiency.

We plan on maintaining a liquid and strong balance sheet to position us for opportunities in the market. We plan on continuing to diversify our funding base including pursuing more unsecured financing and securing deposit based funding to lower our cost of capital and improve our access to capital. We plan on focusing on building more long life assets which will reduce runoff. This will include expanding our already successful healthcare sale leaseback business and building businesses with similar profiles. And we plan on continuing to diversify our income away from pure spread income and into more asset management income.

Across the year, we will be checking off all of these objectives and we look forward to updating you on them as we go. Again, I thought it was a very successful quarter capping off a very successful year and we feel very good about the prospects for the company going forward.

With that, I'll turn the call over to Tom Fink.

Thank you John. Good morning everyone. Our earnings this quarter and for the year were, as John outlined, strong. Adjusted earnings per diluted share for the quarter was $0.61, bringing our annual adjusted EPS to $2.51 for the year, a 17% increase over adjusted earnings per diluted share last year.

The headlines for this quarter's performance include lower prepayment related fee income compared to the third quarter, which was expected; very good net growth across the business as John highlighted, although a little back-end weighted; strong core returns on the loan portfolio that is interest and fee yield excluding prepayment fee income; stable nonaccruals and significantly lower charge-offs than last quarter. We think that when viewed together with our strong yields, our credit statistics have demonstrated CapitalSource's ability to consistently generate strong risk-adjusted returns.

Similar to last quarter, we saw good below the line fee income this quarter, including $8.6 million in dividends and realized gains on equity investments.

Finally, our tax rate came in a little better than expected, driven by a slightly better mix of income in favor of the REIT. In total, our tax rate for the year was 19.4%, down from 20.8% which we had been forecasting. The fourth-quarter rate was slightly lower than that, reflecting both the lower annual effective rate and the true-up adjustment in the fourth quarter to bring the full year annual rate in line.

Let me take a few minutes this morning to focus on a couple of these areas as well as provide some additional color on our performance. The first area I want to drill into is prepayment related fee income, obviously. As you can see in our release, adjusted earnings per share were lower this quarter than in the third quarter. This was expected by us as it was primarily due to lower quarter-over-quarter prepayment related fee income.

As described in our call last time, we had a very strong and unusually large amount of prepayment related fee income in the third quarter of $26.4 million. That equated to 137 basis points of yield on our commercial interest-earning assets. By contrast this quarter, prepayment related fee income was $12 million, contributing a more normal 60 basis points to yield. In fact I would characterize the fourth quarter's prepayment related fee income as good but it obviously is a challenging quarter-over-quarter comparison.

As we have discussed several times in the past, our business model regularly produces strong but sometimes lumpy fee income. We certainly saw that in this quarter-over-quarter comparison.

The second item I'd like to focus on this morning is growth. As John described, we saw very good and very balanced net growth in our commercial lending business this quarter. I say that net growth was good because it was slightly ahead of the quarterly rate we had assumed back in September when we established guidance for the rest of '06 and 2007. And it was good in comparison to the relatively light net growth of the third quarter. I would note that while this quarter we made back some of the ground lost due to the relatively low third quarter growth, but we did not make back all of it.

I say growth this quarter is balanced because it is coming from all parts of the business. We saw each business grow and we saw growth from both lending and sale leaseback investments. For the full year, our commercial assets grew $2.6 billion including $1.9 billion of net growth in our commercial loan portfolio and over $720 million in direct real estate investments.

Direct real estate investments or sale leasebacks as we sometimes call them is one of the businesses that our REIT election has made more competitive. It is a generator of the type of long-lived assets that John mentioned. Because of the significance of our sale leaseback investments, I want to point out a few additional disclosures in our press release that I think help put the business in perspective.

First on the balance sheet, we are now breaking out for you our direct real estate investments. The second additional disclosure appears towards the end of the release in the selected financial data table. Here you will see that we are now disclosing operating expenses as a percentage of assets and efficiency ratio two ways.

The first way is what we have shown historically, and that is operating expenses as a percentage of total assets and efficiency ratio including all operating expenses, which includes the depreciation related to the sale leaseback portfolio. The second way we are showing it is to show those ratios excluding depreciation and amortization from the sale leaseback portfolio. We think that this new way using operating expenses excluding real estate depreciation is a better picture of how our business is performing from a true operating expense perspective.

The last additional disclosure I want to highlight appears at the end of the press release in a table called credit metrics by asset classification. Again due to the growing significance of the sale leaseback portfolio, we think it is helpful to see the various credit metrics expressed as both a percentage of commercial loans and as a percentage of commercial assets so it reflects the sale leaseback investments as well.

Since I am on the credit metrics, let me take a minute to make a statement here that the portfolio is performing well. And against a background of being able to earn 12% plus yields from a portfolio of over 90% senior loans, our portfolio is we think in very good shape from a risk-adjusted return perspective.

Also during the quarter we saw some improvements. Charge-offs were $12.6 million this quarter, a $10.2 million improvement from last quarter. Net charge-offs as a percentage of average commercial assets equaled 63 basis points for the quarter and 66 basis points for the year. Non-accruals as a percentage of commercial assets and as a percentage of commercial loans were stable and in fact down this quarter. As a percentage of commercial assets, non-accruals were 2.14% at year end.

In terms of other highlights, our core lending spreads in our commercial segment, that is the basic coupon component of yield less the weighted average 30-day LIBOR, was strong again this quarter, continuing the trend we saw last quarter. For the quarter, core lending spread was 4.85%, down just 8 basis points from the third quarter. We have been expecting to see lower pretax spreads due to a number of factors including the pricing power advantage as a result of our REIT structure. This quarter's core lending spread, as with last quarter's, was a bit better than our expectations.

And a final noteworthy element of our performance this quarter was the significant returns we saw on our equity investment portfolio. These appear below the line in other income and we had strong performance here last quarter as well as again this quarter. Of our $15 million of other income this quarter, $8.6 million was the result of dividends and realized gains on this equity portfolio.

As you know, we frequently make small equity co-investments in connection with our corporate finance businesses' lending activities. This portfolio provides a meaningful source of income. We are also hopeful of seeing additional gains from this portfolio in 2007 as well.

Away from these headline items, let me touch on a few additional areas for the quarter. The first of these is operating expenses, which were up a bit this quarter. Operating expenses excluding direct real estate depreciation as a percentage of assets increased from 2.36% in the prior quarter to 2.43% this quarter. While compensation expense was relatively stable quarter-over-quarter, non-compensation expenses including professional fees inched up during the quarter. We are confident that there are further operating efficiencies to be gained in the business and expect to see progress in 2007.

The second topic is funding and leverage. Cost of funds was up this quarter primarily as a result of deferred fee amortization and a higher cost mix of funding. We did close a significant financing, our $1.3 billion real estate securitization, toward the end of December. This was our first real estate only securitization from our REIT balance sheet and was a very attractive financing on a number of levels including cost, advance rate, and the existence of a five-year replenishment feature that essentially locks in these low-cost liabilities for a longer period of time.

I would view the cost of funds in the fourth quarter as higher than normal and would expect it to be lower as we start 2007. However we are consciously continuing to expand our sources of funding this year and expect to do more in the unsecured markets. This is a more expensive source of financing than we obtained in our securitizations, but we think the additional flexibility it brings to the company is worth it.

In terms of leverage, we ended the year at roughly 3.8 times in the commercial portfolio. That is the debt to equity ratio. This is a very conservative leverage level and we have talked about a prudent level for the firm at this stage to be in the 4 to 5 times range. One of our objectives this year is to try to consistently run the business in that 4 to 5 times range.

And with that update on the fourth quarter, I'll now turn the call back over to John.

Thank you Tom. I think it is that time when we open it up for questions.

(OPERATOR INSTRUCTIONS) Laura Kaster, Sandler O'Neill.

Can you just give us an update on your deposit funding? You know, an update on whether or not you might be amenable to acquiring a thrift?

Sure, let me restate a few points we've made in the past on deposit funding and then kind of tie-in to where we are today. The first comment I want to make is that we think deposit funding is very important to us. We think it will materially lower our cost of funds, allow us over time to add more leverage to the business in a prudent way, and we think it will open up avenues for business expansion by allowing us to fund certain asset classes such as more asset-based lending that don't fit as nicely into our principal funding source now, which is secured funding and fit ideally in a bank balance sheet.

So we view deposit based funding as a very high priority for the company and it is something that if we were to have it as part of our business, I think it would add significant value to the shareholders. So just so we are clear on that, that is our position.

As you know, we filed for an ILC a while ago at this point and we were subject to a moratorium. That moratorium as it relates to financial firms was effectively lifted at the end of January and we continue to pursue that path. I believe what I've in the past is that we are open to all avenues to obtain deposit based funding because we think it is important and we think it is something the shareholders should embrace. As you would expect, we look at all alternatives and we weigh the pros and cons of each and we hope that constant analysis will lead us towards the right answer as to what we should do.

I am not trying to avoid your question but trying to give the most appropriate answer I can.

Okay, that's cool. So is it a possibility or a probability that we could see a resolution to this in calendar '07?

Yes, I would put it into the category of possibility and probability.

I appreciate your candor.

I am trying to answer it as directly as I can. I've clearly made the point again and I'll make it again it is important to us. We think it makes perfect sense and there's a variety of options available to us. As you'd expect we sit around and we look at them and we analyze them and we try to figure out what's the right answer. We believe we will and probably in '06 -- I'm sorry, '07. We thought we were going to figure it out in '06 but a little moratorium got imposed.

That's fair. On your recovery analysis, I know you don't have that slide, but of the 17 loans at the third quarter that were unresolved, there were six in asset-based foreign cash flow, and seven in mortgage. Any change to those categorizations?

We have these data in the release. I think we might have shown it -- (multiple speakers).

We've changed the presentation a little bit. It's up on the website. I don't think there's been any material change in the recovery statistics as we've talked about them before.

Okay. Any change, John, in your outlook for a payout of your dividends as far as -- the 80 to 95%? Can you give us an update on how you are thinking (multiple speakers)?

Our standard answer on these things, Laura, is that we give guidance once a year and we only update and do those kind of things once a year. As our General Counsel is staring at me as I give the right answer here. So we are kind of a once-a-year guidance place. As I said in my comments we plan on running our business to meet our objectives for this year.

Okay, so no real change to the guidance you gave us for '07.

As I said, we only comment on guidance once a year is the form answer for the company but as I said, we plan on running our business to achieve our objectives for this year.

Great, thank you.

Bob Napoli, Piper Jaffray.

John and Tom, I am not sure -- the dividend payout this year, the $2.40, have you decided if that is going to be a flat dividend or if it is going to be an increasing dividend through the year?

Bob, we will be announcing our dividend soon and so I think it is prudent until we announce our dividend, which our first-quarter dividend announcement will be coming up very shortly, I think we will reserve any comments on the dividend until then. And in fact we are announcing it next week, so you'll see the dividend announcement.

Okay, within your rediscount business you do some lending to the mortgage companies. Can you give any update on your exposure and your feeling for that, the size of that portfolio and your exposure?

Yes, the vast majority of our mortgage rediscount lending to mortgage companies is commercial mortgage companies. Let me be fairly specific on this point because there's obviously a fair amount of discussion going on right now about this industry and this sector. CapitalSource as you know, Bob, has a rediscount finance business and what that means is we go to other lenders and we provide them these highly structured loans that they use to finance their business. And our security is their underlying loans and oftentimes other forms of collateral support, etc.

It tends to be -- it is a midmarket focused business and to the extent we finance mortgage companies, the majority of our activities is with commercial mortgage companies. We do have four loans to companies that would be considered in the subprime business and the total balance on those loans is roughly $120 million.

These are four highly structured loans to companies that I would consider to be in the hard money end of subprime, meaning they are making loans not necessarily the way the large originators make loans principally based on FICOs, but they make loans based on a very hard underlying analysis of the collateral and they are typically making loans that have 60% to 70% advance rates and CapitalSource is providing 80% to 90% advance rates on a rediscount basis.

In that portfolio are blended what we believe loan to value is about 57% give or take and the companies are performing well. They are highly rated. While they've had some deterioration in their underlying business, it is not even close to having any effect on the quality of our loans to these companies.

So just so we are clear, CapitalSource is not a subprime originator. We are not in the subprime business. We have very small exposure on a rediscount basis to four customers that we think are actually doing very well and considering the type of subprime they are in, which is the more hard money aspect, we think they're actually very well-positioned. So it is not a factor for us.

Thank you and last question. You did build your reserve more than we thought this quarter. Looking at the mix of loans, it looks like the reserve ratio might have trended down a little bit. The corporate finance came down slightly as a percentage of the total. I'm just wondering if you could talk about why the reserve went up as much as it did and kind of your outlook for credit into the early part of 2007?

Our outlook for credit remains unchanged from the comments we've been making for some time which is we feel like the business is performing well from a credit perspective. Our general reserve, which is what you are referring to is built based on a variety of factors including mix of business and I think that is all we generally say about that. But I think my first comment is the most important, which we feel good about how the business is performing from a credit perspective and we expect that to continue.

And also, Bob, just to point out -- you are right in terms of how we build reserves. Mix of business is very important. I think the cash flow piece of the portfolio actually increased both in dollars but also in percent of the portfolio over the quarter. So that would have driven part of that increase in mix.

Thank you.

(OPERATOR INSTRUCTIONS) Carl Drake, SunTrust Robinson Humphrey.

I wanted to ask about the overall pipeline of assets and also if you could give an update on the pipeline for direct real estate transactions as well as other long-lived products you alluded to in your opening comments.

Sure Carl. The pipeline for the business remains very strong. The pipeline continues to grow. We are seeing good opportunities across the business. As I said in my opening comments, while we expect very good asset growth this year, kind of our theme for the year is being -- and as it has been the past -- being careful, selective and patient. So while we are seeing many good opportunities which is a benefit of the direct origination platform, we think we are being careful in terms of which opportunities we are booking and the pipeline remains strong.

I think the pipeline -- I would not say is balanced between direct real estate and loans. It is still more heavily weighted in loans as you'd expect because the direct real estate side specifically in the form of sale leasebacks is a new business for us.

But we are routinely pursuing what I would characterize as fairly large portfolios in the sale leaseback business, so what you should see there is kind of some more lumpiness in terms of how those deals come on. They don't come on quite as neatly as the lending business, where you tend to be booking a certain number of loans per week at this point, whereas sale leaseback portfolios tend to be larger. They tend to be cross collateralized pools of multiple properties. They tend to come on in larger chunks.

So, John, you're not updating the pipeline that you've updated in the past?

I don't think we actually included that slide this time, Carl. That is not with any particular point other than our pipeline of deals I would say has increased. We feel very good about the pipeline in the business.

I think we're making some tweaks to our presentation and that slide is not in there for any reason. Do we have the numbers? (multiple speakers) We can get you that number, Carl, but don't read anything into the fact that it's not in there.

Okay, great. Just one more question on the asset management business. Could you provide some color in terms of the activities you might go into besides senior cash flow lending and the CLO? What -- would you expand industry sectors or perhaps equity?

I think one of the first things we want to do is we will be organizing a vehicle to do more deeper parts of our cash flow lending business, specifically mezzanine and things like that. We think that makes sense to be an off balance sheet vehicle because there's a little more volatility in those assets and we think it would empower the corporate finance business if you will to be able to do one-stop shops on these LBOs. And we think the mezzanine is better suited in an externally managed vehicle. So that is one of the first things we are focused on and we will be talking about that more in the future, but we've done a fair amount of work and it looks like a very good opportunity for us.

In terms of the growth that you could have from the off balance sheet assets, do you have any comments there?

It could be significant including taking pieces of our business and putting in them in those vehicles. So I think there's a lot of ways for us to pursue growth in that area. One way is that we've got new strategies that we will be pursuing like more corporate mezzanines, which would then potentially lead to more equity. But also by taking discrete pieces of our business and saying perhaps they would be better off positioned in an externally advised vehicle.

(multiple speakers) We have about eight different strategies in the company now some of which fit ideally in the balance sheet; some of which could over time fit better in externally managed vehicles. So I think we will look at both new opportunities for new asset classes and we've got several of those we're looking at. And then the opportunity could exist for us to take parts of our business and create more value for the shareholders by putting them in externally advised vehicles.

Okay, great. Thanks for the update.

Sameer Gokhale, KBW.

I know, John, you had talked about not updating guidance, but I just wanted to get a better sense for how we should be thinking about charge-offs. I thought your previous guidance for '06 was about $40 million and I think looking at the numbers for the year you came in at about $48 million or so if I'm not mistaken. So as we look into calendar year '07, I think the previous guidance was for $50 million. It seems as the portfolio increases charge-offs you'd reasonably increase as well. So how much visibility do you have also into those charge-offs for '07 at this point in time?

We have some visibility into charge-offs, obviously because we are on top of the portfolio. We know what's going on. There's certain situations in the portfolio that we know are problems and we know will lead to charge-offs and in fact there are loans that even when they pursue a long workout strategy and we have significant allocated reserves against them, we have policies that kind of force charge-offs as the loans sit in a workout category even when the final result is not yet known.

So what I mean by that is charge-offs -- our general policy towards charge-off is when a loss occurs we take the charge-off or if a loss is certain we take a charge-off. Or if a loan just sits around in a workout category long enough, we start taking charge-offs based on policies. Because we have a view that if it sits there long enough even though the result is not certain and even though we have allocated reserves against the assets that we have marketed appropriately, the likelihood of recoveries goes down as that loan sits in workout so the prudent thing to do is to start charging it off on a regular basis.

So for all of those type of loans, we have good visibility to those charge-offs, meaning we have some loans sitting on our books right now that have allocated reserves on them that are in workout. If things were to turn, we would be effectively releasing those allocated reserves. If they were to stay in workout there'd be a process where charge-offs would occur automatically, if you will.

So we have visibility into those things. There are surprises though however like in the third quarter we had a loan that was a surprise. It deteriorated very quickly. There was some question about should we have known earlier based on the borrower's giving us better information, and the charge-off occurred very quickly. So that stuff always happens, but to a large extent we have very good visibility into it.

The other comment, let me just be clear on the guidance thing. It is our policy and I say this all the time, we comment on guidance once a year. We don't comment on it again so I don't want -- I want to make sure you understand where my comment comes from.

No, that is absolutely fair. The other thing was can you update us on the specific reserves that you had at the end of the year? Loans that you had specifically reserved for I think at the end of '05 you excluded from your adjusted EPS calculation?

Yes, that is about $54 million of the reserves. Excuse me, it was $37 million of the reserves, of the allowance total would be allocated to loans.

These are specific reserves?

(multiple speakers) Allocated and specific, we use those terms interchangeably.

Okay, then just my last question, one of -- there's a company that recently went public also that focuses primarily on these cash flow loans, senior secured loans. It seems like their portfolio looks like it has loans that would be rated kind of in the B type loan category or BB type, mostly B type loans, B rated loans. If you were to look at your senior secured cash flow loan portfolio, would you care to provide a similar type of rating to those loans on an equivalent basis so we could compare the credit quality?

I think it's about the same. Just generally grouped around the B area I would say.

I would say interpreting or making an assumption about who you are referring to, you should -- the corporate finance business is substantially similar.

Okay, that's helpful. Thank you very much.

Don Fandetti, Citigroup.

John, the REIT structure has worked pretty well for you. Would you folks ever consider an LLC or is that the REI really works well because of your legacy lending business?

I think at this point the REIT is working very well. I think there's nothing that indicates that we should make a change. We always look at these things as part of our job to maximize shareholder value and position the business to create as much value as possible. And so should we determine that something like that would do that, we would do it. So it is all about that at the end the day. I think our determination at this point is that the structure we have now is appropriate.

Okay, great. That's all I had.

Joel Houck, Wachovia.

I was just kind of wondering if maybe Tom could maybe put a little more color on the margin as it plays out in '07. It seems like we modeled the prepayment accurately but margins still came in below and it sounds more like just a strategic decision to put some more permanent kind of longer-term debt in place. And I'm wondering does that mean that the margin is closer to 7 in '07 or 750 or how should we think about that?

Right, well a couple of things, Joel. You're right, obviously the decrease, the expected decrease in prepayment related fee income would go through the net finance margin. I think when you say margin you're asking about net finance margin?

Right.

So that explains most of the decrease this quarter. A couple other points, when we do sale leaseback investments, this is consistent with what we've talked about in terms of things in the REIT versus the way we used to look at the business historically there's a lot more pricing power there on a pretax basis. And so it's not a yield per se but the equivalent if you will in the sale leaseback portfolio is obviously less than what we are earning on an unlevered basis on the loan portfolio, which blends both REIT loan and taxable loan.

In terms of long term, we have obviously increased the amount of subordinated debt on the balance sheet. We viewed there'd be particularly good opportunities there in the trust preferred market and I would look for that to increase a little bit this year. Also to the extent we do additional unsecured, which is part of our plan, I think the spreads there would be higher than what we see on our secured financings.

Okay and maybe in terms of strategic question, everyone has been talking about how much more competitive corporate middle market has been. You guys deemphasized that a couple years ago. Now it looks like there was a little stronger growth. Exactly what is kind of driving that and what is your thinking in terms of how the landscape may play out in '07? Do you think spreads are widening? Will you be able to put on more growth in that segment?

So far our spreads have been better. Since our September investor conference, our spreads have come in better than what we had been forecasting. So I feel at this point good that on the asset side we're not going to see much deterioration relative to our forecast there. So I feel good about that. I think part of it if you just look at the absolute level, the net finance margin -- again it is a pre-tax number so a lot of it will depend on REIT originations versus originations in our taxable REIT subsidiary.

I think on the funding side there's potentially some advantages for us. Clearly a deposit based funding would be a cheaper source of funding for us, which we've not baked in any of those synergies into our forecast as of yet.

Let me add just a little more on that, Joel. In terms of how the corporate finance business, we have repositioned it as we've spoken about towards a more capital markets platform where we originate and syndicate and hold a piece of the loan, which gives us opportunities to enhance our spread, which has made that business more competitive and has allowed us to look at more opportunities.

We remain however, very careful and cautious in that business because of what is going on. And I don't think we have a firm view when spreads will widen. I think everyone can agree that spreads will widen when credit worsens. None of us know exactly when that will happen. I have said all along and I maintain this view today that I think CapitalSource is very well-positioned now that will be on balance a good event for us and what we have been focused on is positioning the balance sheet and the platform so that when that happens we can get more aggressive.

So while we're growing our business at a nice pace, we're looking at enormous opportunities in order to make that happen. There's a chance that things could break. I'm not sure when they will and then I think our ability to do business will only increase.

All we can do at this point is position ourselves for that and that's why looking at things like deposit based funding, which over time can lower the cost of funds and allow us to access a different form of capital and other things that Tom is doing is with a goal of positioning us towards that.

Okay, thanks.

Henry Coffey, Ferris Baker.

A couple of questions. First, Tom, on the lease portfolio, now that you're giving us the data obviously simply adding A plus B and dividing by 2 doesn't get the average number right. So I was wondering if you could give me some sense of what the actual sort of blended yields on that portfolio would be if we had a precise average balance to work with?

On a cash -- or on a GAAP return basis it is in excess of 10%. Just to give you a couple of numbers because these things -- we did close a lot of sale leasebacks in the fourth quarter. On a monthly run rate basis, if you will, you can think about that -- .

What's the end of period yield if we had precise data?

Well currently I will tell that our operating lease income on a monthly run rate basis is about $6.4 million and the depreciation is about $2 million.

Okay, and I will build it from there. The other question there -- I don't know how you address this but obviously the industrial loan bank would be a great add for the company. When the moratorium was dropped in January there was an American Banker reporter that was speculating that with all manners of conviction that your application was first on the list. Can you give us any read where you are in that process and I don't know how much you can comment on given the complexity of that.

I think in the past we've said we feel like we're high on the list based on the process we're gone through. We've never seen the list and so I don't know if we can say that we are first, but what we have said is that we've worked through the vast majority of the steps that are required to obtain approval and that the application was in its final stages in Washington. We have had a fair amount of dialogue back and forth in those final stages. So whether that puts us first on the list or second or top decile, we don't know for sure other than to think we were -- other than to say we were very close.

John, is that a process that will happen when they call you up or is that a process where you have some insight into when something is likely to close?

I think it is fair to say that the process, which kind of ended somewhat abruptly in the final stages, has been restarted in the final stages. So that is probably -- my ability to speculate on when we obtain our ILC can best be described as awful, so --.

Did you say Disneyland or Washington?

Right, so I've gotten out of the business of speculating on when we will obtain our ILC.

Finally a small item. Your net charge-offs in dollars for the quarter was --?

$11 million.

So you have got -- you've always had a portion of the net charge-offs that you don't take against adjusted earnings because you basically reserved against them at the end of '05.

That's right.

What's left in that category?

I think we've pretty much worked through all of that.

So when we're looking at this number in '07, it is likely net charge-offs will pretty much equal whatever is in the line item?

Yes. It will become -- I don't want use this to imply anything, but it will become more of a pure representation. It was our view that we did not want to double count, which is why in the transition we did it the way we did. We said that it will move towards a point where the charge-offs lower adjusted earnings. They are not charged against previously reserved things, as you've followed pretty carefully, Henry. So it will look very pure this year I think.

Excellent. Thank you very much. Good quarter.

Darrin Peller, Lehman Brothers.

Tom, if you could just help me understand -- it may just be my own understanding or misunderstanding, but the share counts in the adjusted part of the press release shows the diluted at 181 for the adjusted number and 178 for GAAP. You mentioned non managing member units of 2.5 million. Can you explain what that is exactly?

Yes, that goes all the back to the beginning of '06 when we did our first sale leaseback transactions of the down REITs. So those -- part of the consideration there were units that are convertible into the company stock.

The seller at the time -- one of the ways we're able to win that transaction is because we could offer stock, which is something they were interested in. Someone we had done business with for a while and knew us and so we offered -- I like to say shorthand that we offered him stock in exchange for his assets. It doesn't quite work that way from a REIT perspective. It is the down REIT units, but that is effectively what that is.

That's right. I remember now. Second question is on the leverage ratio, the debt to equity ratio, you said I think it's 378 now. What level would it be -- you said 4 to 5 times is sort of the target. What level would it be when you think you would need to actually raise again? Would it be somewhere in the middle of that 4, 5 range or would you wait for the high end?

I would say it all depends. It depends on a number of factors, sort of where we are in development of our funding platform, opportunities we see in the market. One of the things I think you are aware of is we do have a dividend reinvestment plan and direct investment plan, which has been active really ongoing every month since it started and we do keep that active. So that helps also defer the need to actually go into the market in a large way and raise equity.

(multiple speakers) I think the other thing is I think it is fair to say there is a lot of noise in the credit related equity markets that is unrelated to us but does have a negative effect and we obviously look at that stuff when we make decisions about raising equity. So I think that is fair thing to say.

All right. Fine. Last question on the prepayments, should we be expecting -- I think you said in guidance last year something about a 50 basis point contribution going forward. Is that a fair assumption for '07?

That is the assumption we are using. Obviously 2006 was at a much higher level than that, but that is our best estimate at this time.

All right, thanks.

Scott Scher, Clovis Capital.

John, quick question. Now that you are breaking out the direct real estate investments, can you talk about how you think you will fund those over time and how that might be different than your current funding?

Yes, I think I'll let Tom give a more complete answer, but those assets would be ideally funded with unsecured funding I think is one way to think about it. We also have the ability to get good secured execution against them, which is what we have done in the interim and we funded them with kind of interim secured financing. And there's really depending upon -- there's really three sources we could look to. We could look to unsecured to fund them. We could look to secured. We could also look at things like HUD financings, which are fairly attractive actually.

So I think Tom is in the process of evaluating those things. Now we funded them on an interim basis with secured financing. Tom, I don't know what you add to that.

I think that is right. I think we have a number of solutions if you will to bring to bear to the question of how to fund that portfolio, and I would expect it to be really a mix of all of that. Clearly HUD financing would be highly attractive to the company. We have part of the business, CapitalSource Mortgage Finance, which that is what they do, arrange HUD financing for owners of these types of properties. So we would certainly like to avail ourselves of that.

I would imagine that we would keep a large percentage of these unencumbered and therefore you could think about unsecured funding them. I think there are a variety of secured financing options from straight mortgages to things we could do with a nice, large, diversified portfolio like we have.

Presumably all of that funding is somewhat cheaper than your average, right?

Well the unsecured would not necessarily. I think our incremental, our marginal spread on unsecured would be higher than our average cost of funding.

So what I was trying to work out is you took two steps without the third. You showed the assets. You talked about a monthly operating lease income. You talked about a monthly DNA but you didn't talk about a monthly finance cost which would allow you to if you wanted to back into an FFO isolation on these assets. And then if one wanted to talk about what these values assets might be valued like in the current marketplace and compare them to comparable assets, that seem to trade at 4% yields I think, one might be able to do that.

So you might use a cost of funding on this of what would be if I wanted to play those number a 6? Kind of a 10 on the gross income and a 6% cost of funding?

Yes, I think that's in the ballpark. As John mentioned, we are working on finalizing our strategy and I would think there would be a mix of things but that on an average basis is probably about right.

Scott, we have looked at what you are addressing, which is the level of where healthcare REITs trade relative to where we trade. And we will look at that portfolio and make decisions about what is in the best interests of the shareholders as it relates to that over time. I think one of the reasons we probably didn't break it out this quarter is we have a fairly sizable portfolio at this point and we expect it to get larger. I think we have funded it on an interim basis in a way to allow us to sit back and evaluate these various options and not lock ourselves into anything.

So it is funded in a way right now which is not the way we would fund it long-term, meaning a short-term secured funding that has a higher spread than we would like but gives us flexibility to do things with the assets. We are trying to figure out -- we look at this asset and we say okay, let's assume it is going to grow X percent this year, what is that really worth as a business? What is the best way to fund it to maximize that value?

Second question when you talked about breaking out and doing an off-balance sheet vehicle for managed assets, then you said there was a possibility to move some CapitalSource divisions into that, can you just give some clarity as to what divisions would fit and what their relative size of them is?

Why don't we -- I'll give you one example which is what we're talking about already, which is we could look at that portfolio of assets and if we felt like it was a stand-alone business, which we do, and we felt like we could obtain more shareholder value by having that be externally advised business or just raising capital for that separately as part of our business, that is a good example.

Thank you.

A follow-up with Bob Napoli, Piper Jaffray.

Tom, on the bank, if you did get the ILC in the current yield environment, yield curve environment, what kind of savings would you get today do you estimate on your cost of funds?

I would say the brokered deposits, which is what the ILC would be using, are on average for a reasonable portfolio and duration of deposits slightly more than LIBOR. So that will give you an idea. We basically could reduce on the margins at least 60 basis points of cost of funds.

When you guys had talked about this and maybe you're not going to say anything about it today but you had an idea of essentially what assets -- you had assets prepared to move into that ILC and can you -- are you doing anything like that today? Can you quantify how much deposit funding you think if you did get approved you would utilize?

Sure. The assets would come from our taxable REIT subsidiary. We did our last securitization there back in September, so we've been building a portfolio of assets from there and it would be I would say close to or around $1 billion in size.

Okay, and just listening today, John, to your discussions about the asset management business, it sounds like maybe you have accelerated your thoughts in that regards somewhat from your analysts day.

No, I think we have been -- I think if you go back we have been talking about this consistently. I think it is probably a hotter topic now, so maybe people focus on it more, but I think we view it as really two opportunities. One, new lines of business or new strategies that complement the platform, that leverage the platform, but are better funded in a vehicle that has perhaps a different cost of capital or perhaps as investors want it as a monoline business. So that is continuing and ongoing and has not accelerated at all.

Then there is this notion of certain parts of our business like the health care sale leaseback portfolio that perhaps could be in the shareholders best interest to raise capital for that separately and we're looking at that. I think that the last question pulled that answer out a little more, but that thinking has been going on for some time. There is also a materiality question which is you want make sure the portfolio is large enough to be meaningful. You don't want to just do things because they sound good, but they actually need to make a difference.

So I think to the extent they've accelerated they've just accelerated because the asset growth has continued to accelerate, so it becomes more meaningful. Do you see what I mean? Like we had this notion before but I would have answered the question differently six months ago because we had a lot less assets and it would not have been a meaningful thing for us to even consider at the time.

The healthcare REIT is a good example. We have some information we present in our investor presentation where we compared our business broken down by the types of things we do versus the market comparables, if you will. There on an '07 dividend yield basis the median of that group is about a 5.5% dividend yield.

Some much tighter.

Some much tighter and we talked about back in September that at the time we had I think the fourth or fifth largest healthcare REIT with inside of CapitalSource today which is only going to get bigger.

Okay, any update on Europe and is it -- I know it's relatively small but are you having --?

No. I think it is proceeding exactly as we had hoped. They are building their team, which is important. Their portfolio is growing according to their plan. The credits have performed very well, so I would consider it right on track. But that is another example of potentially a business that might be better capitalized separately, for example. So we're looking at all these things but then there's a scale question about how big does that need to be before you do something like that?

How big is Europe now in assets?

$200 million or so?

Yes, just north of $200 million.

(multiple speakers) The thing to also mention about Europe we are really working hard to build a direct origination business there, so I think that is actually very important. So I want to make sure that observation is made. In other words it is becoming a real business.

So to date you have kind of -- you haven't directly originated the majority of what is on the balance sheet there?

No, the point I was making is that our approach over there is to actually build a business for the long term. In other words get originators, put in process in place, run it like a real business.

Essentially a CapitalSource business in Europe?

That's right.

Recreate your platforms?

That's right. (multiple speakers) And listen, the thing to remember is very similar to the situation going on here, but unlike CapitalSource, where we started in a credit tight environment we're starting this European effort in a credit rich environment. So all that argues for is more patience and more prudence. Build your systems, build your team, be careful about the deals you do. Don't make any mistakes early and position the business for the long term which is I believe what we're doing.

Just while your outlook for credit is I think the same as it was last quarter, you did sound a little bit more cautious on the economy and maybe the competitive environment together with the economy. Am I reading that right?

I don't think so. I don't necessarily -- my comments are less about the economy and more about just liquidity in the markets. Clearly you have to raise a question about what will happen in housing next year and what effect that will have on the economy if you're prudent and if you look at what's going with the lenders and you look at what that will do for liquidity in that market and what that could do to housing prices.

That is a bit of a double-dip if you will from what people thought, I think. So that is probably the only thing that raises a question I think as it relates to our business we feel very confident that we are reasonably insulated from these things. No one is completely insulated from things but we feel like we're in a very good position. But my comments are more about liquidity and while we expect to grow this business substantially this year, if credit were to break I think we could even grow it more. I think that is more of the thrust of my comments.

And looking at your portfolio and the operations of those companies, you see -- you see a decent economy broadly speaking?

We see nothing in our portfolio right now that would indicate any change from comments we've made in the past.

Thank you.

Felice Gelman, SuNOVA Capital.

Actually my question has been answered.

No other questions?

I am thinking, I'm thinking but I will have to think a little harder and then call you back. Thanks.

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