PacWest Bancorp (PACW) 2007 Q1 法說會逐字稿

Good day, ladies and gentlemen and welcome to the first-quarter 2007 CapitalSource earnings conference call.

My lame is Alicia and I will be your operator for today.

At this time, all participants are in a listen-only mode.

We will conduct 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 introduce your host for today's call, Ms.

Claire Rosebush, Investor Relations associate.

Please proceed, ma'am.

Thank you, Alicia.

Good morning, everyone and thank you for joining us for the CapitalSource first-quarter 2007 earnings conference call.

With me today are John Delaney, our Chairman and Chief Executive Officer and Tom Fink, our Chief Financial Officer.

First, I want to inform you that later today we will be hosting a presentation to the Investor Relations page of our website, www.CapitalSource.com.

This call is being webcast live on our website and a recording of the call will be available beginning at approximately 12 p.m.

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 last night and 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.

Thanks, Claire and good morning, everyone.

By any measure, this was a very strong quarter for CapitalSource.

Adjusted earnings were $113.9 million or $0.63 per share for the quarter.

Asset growth was strong this quarter with $878 million of net asset growth in our commercial business.

As usual, the growth was across all of our businesses.

This quarter weighed more heavily towards Structured Finance as opposed to last quarter where it was weighed more heavily towards Healthcare Finance.

Once again, reflecting the benefits of a multi-strategy lending business.

Assets under management, a more intensely followed number these days, grew to $18.3 billion making CapitalSource one of the largest asset managers as well.

Credit improved somewhat dramatically this quarter.

Our principal credit metric, loans on non-accrual, fell by 51 basis points to 1.63% of commercial assets.

This together with improvements in delinquencies places CapitalSource in what I will call the best-in-class ZIP code with respect to credit metrics.

I remind everyone as I do each quarter that credit statistics can be lumpy of course.

Despite this comment however, we are very pleased with the credit performance as it reflects three important aspects of the business and I have made these points in the past.

First, a strong underwriting and credit culture that prevents us from chasing business.

Second, an active loan management program that aggressively identifies problems as evidenced by the fact that we are one of the only lenders that I know of who is non-accruals consistently exceed delinquencies.

Meaning almost half of our loans on non-accrual are completely current on interest and principal, but we are being very proactive in the identification of future problems.

And finally, best-in-class workout capabilities.

To my mind, CapitalSource has one of the most talented workout teams in the business and we believe we can leverage this team if and when we see further market dislocation.

On the heels of this quarter, I wanted to spend a minute redefining for you why I think CapitalSource is a singular financial services company.

Once again, we have produced an adjusted return on equity of over 20% and grew our dividends per share by 5.5% from last quarter.

This was done with low, true financial leverage and very high asset quality.

This performance speaks to three attributes of our business that are unique to us relative to any peer group for the Company.

The first aspect is stability.

CapitalSource has a diverse mix of lending investment and asset management businesses that allows us to be more disciplined and effectively allocate capital based on market opportunity.

In addition, based on our investment-grade rating, we now have a diverse source of liabilities to fund the business.

Balanced assets and balanced liabilities equals a more stable business profile.

The second attribute is quality.

Our asset quality and credit performance continues to be very strong and the return on equity for the business is exceptional.

This performance suggests the franchise that is a market leader, extraordinarily disciplined and staffed by high-quality and dedicated employees.

And finally we have a growth.

Quarter over quarter, our dividend grew by 5.5% and year over year, our dividend grew by 18%.

In addition, we remain well-positioned for strong, long-term growth, growth through our existing lending investment businesses, our asset management business and new initiatives we will likely roll out.

Stability, quality and growth all translate into a solid, stable and growing dividend clearly worthy of a premium, not a discount to market peers.

Again, we are both pleased with the quarter and very excited for our prospects across the remainder of the year.

And with that, I will let Tom drill deeper on the financial performance.

Thank you, John.

Good morning, everyone.

The first quarter was indeed an excellent one for CapitalSource.

In addition to the immediate headlines of strong adjusted return on equity, strong adjusted EPS and improved credit metrics, we also saw a very strong performance in the significant drivers of the business this quarter.

In my remarks this morning, I will walk through those significant drivers for you and give some additional color on the quarter.

But first I want to speak a little bit about funding and the execution of our funding plan for the Company.

Here, we continue to make great progress and in some respects the year-to-date period has been one of our most important from a funding perspective.

As mentioned in the release, we accomplished three very important things so far this year, each of which I would put in the strategic category.

First, we continue to demonstrate our deep access to the secured term markets.

This, for us, has never been in doubt.

However, there is no question that in the last four months or so, it has been more difficult generally speaking for issuers to get deals done.

The market is choppier.

Spreads are wider and in my opinion, investors have become more choosy as they should be about what deals from which issuers they will invest in.

Against this backdrop in April, we priced and closed our 2007-1 securitization.

This was our 11th balance sheet securitization and was an $800 million deal.

In terms of its size and structure '07-1 looked very much like our 2006-1 securitization that we completed about one year earlier.

Our '07-1 securitization was a great success.

In this choppier more selective market, our '07-1 securitization priced just three basis points wide of the '06-1 securitization for liabilities, which were about one year longer than '06-1.

In this market, that is fantastic execution.

Furthermore, in addition to the excellent pricing, the diversity of investors we saw in the '07-1 transaction confirm that the market views CapitalSource as a premier issuer of middle-market loan securitizations.

The second funding accomplishment so far this year was our substantial increase to the financial flexibility and balance sheet strength of the Company through our convertible debt exchange offer.

Basically with the exchange offer, we subordinated approximately $500 million of senior debt allowing us, if we wanted to, to increase the amount of leverage in the business by giving us the ability to issue new senior debt on that same existing asset base.

This added capacity has created the increased flexibility and balance sheet strength.

We already employ relatively modest conservative leverage in our commercial finance business.

At March 31, the total debt to equity ratio in our commercial lending segment was 3.8 times.

However, if we classify that debt into senior and subordinated debt and look at the metric that way, as a result of the exchange offer, the senior debt to subordinate capital ratio in our commercial segment was only approximately 2.2 times.

Clearly, the convertible exchange offer has created a very solid and strong capital foundation upon which we can grow the business.

As you know, we intend to increase leverage marginally in the commercial business this year to the four to five times debt to equity range we have discussed.

However, with the exchange offer, we have built the cushion to do significantly more than that if we wish to or needed to do so.

To be clear, we do not intend to max out leverage in the business, but this additional balance sheet capacity is in our opinion a very smart, prudent and strategic investment to make given the recent choppy market conditions.

Last and definitely not least from the funding side is the opening of significant access for CapitalSource to the unsecured term markets through our receipt of a second investment-grade rating.

In April, we truly became identified as an investment-grade company with both the affirmation of our rating by Fitch ratings and the receipt of a BBB- from Standard & Poor's.

With these two investment-grade ratings, we have opened up access to a new pool of capital, a new universe of investors with the unsecured term debt now becoming another way for us to fund the business.

As you know from past discussions, we have always had a focus on building a robust and diversified funding platform and to broaden that platform over time.

This new unsecured term debt capacity certainly adds to that funding diversity and I am very pleased with these accomplishments.

Now let me walk you through the significant drivers of the business this quarter so you can understand this quarter's excellent results.

The first metric we generally talk about on these calls is growth and our view of growth this quarter is very positive.

We are very pleased with all aspects of our growth this quarter, including the quantity, quality and mix of that growth.

In our core commercial lending and investment segment, net asset growth was very strong at nearly $900 million.

This was just over 10% net growth from last quarter.

Net growth in the commercial segment was led this quarter by our Structured Finance business, as John mentioned, with substantially all of that net growth being in the REIT.

However, all of our businesses grew in the quarter and we continue to enjoy the benefits of our balanced business model.

Also we saw $83 million in net growth and sale-leasebacks this quarter.

That represents a 12% net increase in sale-leasebacks versus last quarter and we are obviously pleased with that.

We continue to see strong pipelines across our businesses and while we have set out ambitious plans for 2007, we feel good about our growth prospects looking forward.

Our residential mortgage portfolio, which comprises the high-quality, prime mortgage assets we use to balance and optimize the REIT structure, was essentially flat this quarter, down $190 million.

Our managed asset portfolio, which includes the commercial portfolio and the residential portfolio I just mentioned, as well as loan balances syndicated to and managed for other lenders, three CLOs and other assets in total, was up nicely this quarter as well.

Assets under management increased $1.3 billion or 7.7% from last quarter.

As you know, our business model was built on a conservative foundation of a recurring revenue base.

That is interest and fees earned on our loans are generally recognized over the life of those loans.

As a result, we continue to benefit from past investments we have made in building the portfolio through the yield or the recurring interest in fee income that the portfolio produces and we are continuing to build that future recurring revenue base through the current period growth.

Yield was a strong positive for us this quarter focusing on the commercial lending and investment segment.

As we have discussed before, we have been using the pretax power of our REIT structure and have actively been steering the business toward a safer asset mix with expected lower spreads.

However, again this quarter, I am pleased to report that our lending spread, that is yield minus 30 day LIBOR, was ahead of our expectations.

Specifically, yield on interest earning assets was 12.44% for the quarter, up 32 basis points from last quarter's yield.

Included in that yield, we saw strong prepayment-related fee income this quarter.

Prepayment-related fees were $23 million for the quarter or 110 basis points of yield compared to $12 million or 60 basis points last quarter.

Continuing on with the positive theme, cost of funds and our borrowing spread in the commercial segment also was improved versus last quarter.

Specifically cost of funds was 6.22%, down 24 basis points from last quarter.

The largest driver of that change was lower amortization of deferred financing fees as a result of lower early repayments of liabilities during the quarter.

Leverage in the commercial segment as measured by our debt to equity ratio was essentially unchanged at March 31 at 3.8 times.

Average commercial leverage was up slightly at 3.66 times this quarter compared to 3.53 last quarter.

As you know, we have talked about modestly increasing leverage in the commercial business this year and specifically are targeting to run the business at a debt to equity ratio of 4 to 5 times.

We had good asset growth this quarter as I've already mentioned, but we have also seen very successful results from our direct investment plan so far this year.

Our success with the DRIP has been working somewhat against our leverage goal, so to achieve that objective, we will reduce our DRIP activity a little bit until we manage the business up into the 4 to 5 times debt to equity range.

Credit was a significant positive this quarter.

As John mentioned, all the standard credit-related statistics improved both in percentage terms and in absolute dollar terms.

In addition to the improvement in non-accruals, charge-offs were lower this quarter.

Annualized charge-offs were $10.2 million or 47 basis points of average assets compared to $12.6 million or 63 basis points last quarter.

Other income was also strong this quarter as well, continuing the trend that we have seen for the last few quarters.

On an adjusted earnings basis, other income was $14 million this quarter driven by $6.2 million in realized equity gains and dividends, a very strong number.

We continue to see a very positive contribution from this non-spread income, which is driven by our equity investments, HUD business and fees related to asset management platforms that we are developing.

The last metric I want to talk about is taxes.

Our effective tax rate for the quarter is 19.5% reflecting our current estimate for the full year.

This is higher than our initial thoughts for this year reflecting a combination of a higher tax rate assumption in the TRS and our estimate that the tax REIT subsidiary will be more profitable and earn a greater portion of the income this year.

For example, the significant prepayment fee income I mentioned that we earned this quarter was mostly realized on loans that had been in the taxable REIT subsidiary and we are very pleased to have the income of course, but are expecting to see the 19.5% tax rate this year due to things like that.

And with that, I will turn the call back to John Delaney for questions.

Thanks, Tom.

It is probably that time when we open the call up for questions from those of you out there.

(OPERATOR INSTRUCTIONS).

Bob Napoli, Piper Jaffray.

Good morning.

Nice quarter.

Good solid trends.

A question on the DRIP because I would like to see that leverage go up a little bit too, how do you slow -- how quickly can you slow that down and how do you do that?

Well there is a couple of different parts to it, Bob, but basically the most significant component has been in what is called a waiver where people are asked to invest relatively large amounts of money and that is completely at the discretion of the Company.

So I think we will accept fewer of those waivers.

On the expense side, the expense leverage, I know you guys are very focused on managing that expense line and getting the efficiency out of that.

The one item was a little bit above my model was the expenses this quarter.

Were the expenses -- I just wondered is there anything unusual in there and what is the outlook for recognizing that efficiency as you grow?

I don't think there is anything unusual in there.

Most of the comp expense in total and most of the increase this quarter was driven by compensation-related items, which, as you know, we have had a -- really throughout last year and certainly into this year a strong focus on headcount and managing headcount.

During the periods of 2003, 2004, 2005, the Company grew its employee base at a rapid rate and we have seen less growth from that.

So based on all of those efforts, we are certainly expecting operating expenses in general and compensation as well to decrease as a percentage of assets.

So we feel very confident in our view that operating expenses as a percentage of assets are going to decrease.

Last question on the credit quality, obviously very good this quarter.

What are you guys seeing as part -- as a forward look on credit and what is your feel on the US economy in the areas that you serve today?

Well Bob, let me spend more attention on that credit as it relates to our portfolio because I don't think we are seeing anything incredibly unique in the economy that is worth commenting on that is much different than anyone else's.

Obviously we're looking at the housing situation carefully.

And one of the things we did was lower our exposure as we talked about in the past to some of the residential construction sector and the condos sector, which is an area we are very concerned about.

But in general, the portfolio, as these statistics reflect, is performing very well and myself and the team have about a 14-year track record of delivering well above standard credit performance and I expect that to continue.

When I look at the portfolio and I know the portfolio well as does the rest of the team, we expect that to continue.

That is probably the best thing I can say.

The portfolio is performing better than it had been.

The statistics reflect that.

I think we've specifically steered this portfolio towards a more stable profile, made it more assety, made it more secured.

I think other in the markets have taken perhaps a different tact, but we made the decision to try to make this a very predictable, very stable portfolio and we have been able to do that and I think these statistics support that.

And so we feel great about the credit performance of the Company.

I think this quarter was clearly a shining quarter in that capacity and we expect good performance to continue.

So I can't comment intelligently about the economy because we are not necessarily seeing anything that is overly concerning other than watching the housing sector carefully.

Again, I think our real estate team had the right answer there, which is to steer the portfolio away from a lot of condo concentration because I think that is still a scary place to be.

But in general, I think things are performing very well.

Thank you.

Carl Drake, SunTrust Robinson Humphrey.

Good morning.

Thank you.

John, could you address the growth a little bit by segment?

It seemed like you mentioned Structured Finance had a lot more growth than last quarter and maybe specifically within Structured Finance if that was the parts of real estate or REIT discount business, where the growth came from there?

We say this a lot.

We use the word lumpy a lot and we do see lumpy growth across the different businesses and again the way we run the business is from a bottoms-up perspective.

Meaning these different businesses have credit standards and pricing standards and as opportunities come in, if they clear the standards, both the credit and the pricing standards, we originate the loan and the portfolio kind of steers itself around the opportunities that exist.

We do see the business move around a little bit based on normal kind of lumpiness of closing deals, but also based on opportunities in the business.

As you identified, Structured Finance does have two businesses.

It has of course a real estate business and a rediscount business.

The growth was balanced across those two businesses.

Rediscount is actually doing very well.

That is a terrific business for us and it has always been a great business and the person who runs it, Chris Hague, has done a beautiful job building that business, working obviously with Mike Szwajkowski, the President of the Structured Finance business and I think we're seeing very good trends in the rediscount business.

They have been very active.

We like the business, we think it is a good place to play in this current credit cycle.

There is a little less focus on the business.

It is a very secure business.

We haven't had -- if I misspeak here, Tom, correct me, but we haven't had any losses in that business I don't believe.

So it is a great business and that was balanced with of course the real estate business.

The commercial real estate business, we have tried to diversify it and be in all the commercial real estate food groups.

Again, kind of going back to my earlier comment about not emphasizing kind of the residential or condo product.

So the growth this quarter was more heavily weighed towards Structured Finance.

I wouldn't read anything into that.

I think the business just had a good quarter.

The Healthcare business is becoming a little more lumpy as we are increasingly pursuing sale-leaseback transactions, which tend to be larger.

We have a very nice pipeline of opportunities there and we actually have some very large and interesting and we think significant healthcare real estate deals that we are working on that we will be talking about in the next few quarters.

So I expect Healthcare real estate to be a good performer for the rest of the year.

The Corporate Finance group continues to do a very, very admirable job in a very competitive market.

In general, we have lowered our hold sizes in that business.

We are more of a syndication player in that market.

We are seeing growth in that business, but modest growth, which is exactly what we want to see.

We still want to be an active participant in the market.

We still want to serve our customers well, but we want to be careful and I think we have done that.

The credit performance in the Corporate Finance group has improved as well.

So I think all the businesses -- I'm kind of expanding your question here a little bit in talking about our three businesses, but I think they are all performing exactly the way we want them to be actually and I am expecting good news from them through the rest of the year.

That's very helpful.

In terms of the healthcare REIT, you talked about a possible spin-off, could you address that?

Yes, there is clearly a significant if you will arbitrage opportunity there in terms of how that business would be valued as a standalone versus how it is valued within CapitalSource and I think what we are assessing is the right way to take advantage of that for the benefit of our shareholders.

We love the business and we think we have got a terrific team running the business and we have got a very good pipeline for that business.

So the question is is there a better way to fund the business?

Is there some structure we can come up with to take advantage of the fact that REITs in those sectors trade at almost half the dividend yield we do.

There is a lot of value there that we should be focused on creating for our shareholders.

I think we will ultimately figure out what the right answer is there, but we are working on it because we don't want to make just a short-term decision and give up long-term benefits for our shareholders.

So we are working through that.

But there is opportunity there and we should be talking about things soon there.

Good, good.

Tom, on the funding side, this lower spread over LIBOR, is that something you think is sustainable?

I mean I know you expanded different avenues of funding.

You had it looked like a little bit of a benefit from lower repayments or early repayments on liabilities.

Go ahead.

Sorry.

I would just say it looked like a little bit of a benefit due to maybe some prepayments that lowered the deferred amortization.

I wasn't sure if that could reverse or if maybe some of these new initiatives -- this is just a lower spread going forward?

Well you are right.

I mean the amortization of deferred financing fees or the change in that was the biggest driver of that reduction in cost of funds.

Generally speaking, we model or forecast a LIBOR plus 100-ish cost of funds for the business, which would include averaging if you will the lumpiness of that deferred fee amortization plus our expectation that we will increase the amount of unsecured debt in the capital structure, which comes at a slightly higher spread.

Okay.

And then the ILC, I imagine that is something you are still addressing given some of the more restrictive conditions there?

That's correct.

Okay.

Last question on the tax rate, would that be a level tax rate for the rest of the year, this 19 --?

Yes.

Exactly.

The way we provide for income taxes there is based on our annual assessment, which has to do with the, as I mentioned, the tax rate expectation for the taxable REIT subsidiary and also the split of income in the business between what is in the TRS and what is in the REIT.

So that reflects our full-year expectation.

We have in the past, and I would remind everyone again, that is an area that is going to be a little bit more volatile for us as a REIT just given on how -- as the business unfolds.

If we have a little bit more growth in the REIT, that number could be lower.

If we have a little bit more growth in the TRS, that number could be higher.

Okay.

Thanks.

Nice quarter.

Thanks.

Sameer Gokhale, Keefe, Bruyette & Woods.

Hi, good morning.

Just had a question on the loan growth again.

I know you went into some detail and gave some color on that, but if you look at the Healthcare and Specialty Finance segment again, just wanted to drill down a little bit.

If you strip out the growth from the real estate, the direct real estate investment, it looks like there was very modest growth in the loan -- in the Healthcare and Specialty Finance loans.

So was there -- I know you said growth could be lumpy, but was there anything unusual there as far as prepayment activities in the Specialty Finance versus the Healthcare business or on the comparative front, etc.

that led to kind of the very modest growth there?

Sure.

As John mentioned, I wouldn't read anything really into the ups or downs from quarter to quarter of one group versus the other.

I mean that is really the benefit for us of having this balanced business model.

But Sameer, you are exactly right.

Most of the growth -- the net growth I should say in the Healthcare business was due to the net growth in the sale-leasebacks.

The large prepayment fee income was attributable primarily to loans that paid off in the Healthcare business, so they bore the brunt this quarter of the prepayment activity, but again I really wouldn't read anything into the quarter-to-quarter changes there.

Okay.

That clarification is very helpful, Tom.

Thank you.

And then the other thing I wanted to ask also was as it relates to the healthcare REIT spin-off and discussions about that, I mean maybe this is just overly simplistic, but couldn't you just accomplish the same goal by reporting the Healthcare segment separately so that you still retain maybe commonalities in the origination and servicing platform, but then you don't have to go through the time and expense of actually doing the complete spin of the business.

Yes or not even doing a complete spin or selling a small piece of the business and holding the rest.

So there is a whole variety of options we are looking at.

But if I could go back to the Healthcare question, the other thing I want to make the point is the pipeline for the healthcare non-real estate business is actually quite good.

Again, not to overplay this, but thinking about a diverse franchise for a balanced business model or a multi-strategy lending platform, whatever you want to call it, the Healthcare business had a lot of payoffs this quarter, which drove very good fee income, which is all good.

And the fact that it didn't grow really didn't matter because other businesses grew and next quarter, it may be the opposite story where we may see flat growth in corporate finance and good prepayment income and some equity gains associated with sales that are occurring in that portfolio, etc.

and the Healthcare Specialty Finance business may see very good growth.

So it really is all working as we had planned it to work and the point I am really trying to make here is that it really does allow us to run a very disciplined business.

And I think these credit stats reflect that.

There is real value to that.

It's hard to build an integrated platform like this.

Right.

It seems --.

(multiple speakers) more value there.

It seems like there is a bit of an actual hedge with higher prepayments, but then you picked up the fees and vice versa.

So the other thing I wanted to ask was also in the syndication activity in the Corporate Finance business.

Can you quantify that for us in terms of volumes of maybe syndication activity last quarter versus this quarter perhaps?

Yes, and let me just follow up on the prior question because I think it is an important point.

The other thing about originations is there is no there acceleration of income associated with us originating loans.

Meaning we don't take any deal fees that are accelerated upon closing a loan.

So if we don't have strong originations in the business, it doesn't really affect that quarter.

Again, the point I am trying to make there is this is a very good recurring revenue model.

Our earnings in a particular quarter are not overly affected by originations in any particular business.

Syndication activity -- I know we moved up in the league tables in that business from 13 to about 10 in middle-market syndications and in those league tables, there is some major financial institutions that break out their middle-market syndications.

You know, Merrill Lynch and people like that.

So the businesses -- our syndication trends are very positive.

I unfortunately don't have the number, but Tom in his large book here has the number that he is pointing to, so I'll turn it over to him.

Waving frantically.

Right.

Yes, syndication volume or the balance that is syndicated to other lenders increased about 21% last -- over the quarter, it was $1.9 billion at the end of the year and it was $2.3 billion at March 31.

Okay.

That's really helpful.

Thank you very much.

Joel Houck, Wachovia Securities.

All right.

Thanks, good morning.

A question I guess back on credit quality, what happened this quarter specifically.

Were loans secured via refinance or did the underlying borrowers or credits get better and what -- if you can tell us kind of what segments they were in, those loans that got better, either went off of delinquency or off a non-accrual?

I'm not sure we want to go into the gory details, Joel, about what segments they were in other than, at this point, our average loan size is not that large, so there's a number of things going in and out is actually a decent quarter.

I would say that we had all of the above.

Meaning we had loans pay off in those categories.

We had loans fix themselves and historically the way it has worked here is if a loan has been "repaired", it actually stays in those categories for some time because we want to make sure it is actually repaired.

So we have set up some standards internally where we want to see a certain amount of performance on a loan before we actually say, yes, this thing is now really working again.

But it was all those things.

It was payoffs, it was loans being "repaired" if you will and being seasoned as it relates to repair.

So that is the one point I want to make.

We just don't -- just because of business -- let's say we are financing a piece of real estate and it is out of whack on its debt service coverage.

If it fixes for one quarter for some reason, we want to see some sustained performance before it will actually move out of the category.

Tom, I don't know what you want to add there.

No, I think that's right.

It is all of the above.

Okay.

And then I guess in terms of forward-looking comments, I mean you guys have always said the business is going to run at a certain level of non-accruals.

It looks like you are below that this quarter.

Is there anything structurally that has changed in terms of mix that would cause you to change your forecast or should we still think about kind of 2% non-accrual as kind of the long-term number that you will kind of revolve around?

Yes, I think that is the right stance for us to have.

I think that -- because we do say -- we do make the observation and I will make it -- I have made it when the numbers have gone up and it is fair to make it when the numbers go down, which business is lumpy and sometimes you can have a $30 million loan that really doesn't have much of a risk of loss, but we don't want to increase the exposure we put in non-accrual even if it is current.

That could swing the numbers back up again.

So I think as it relates to non-accruals, what I have said in the past was 2% to 3% is what I said.

Sorry, sorry.

Which doesn't mean we are not delighted with this performance nor are we saying that we expect them to go up.

I am just saying that they are lumpy and they move around.

The other thing that happened this quarter because there is a lot of variables.

As I said, loans paying off, loans being repaired, but the absence of significant new loans entering the category is also an important variable.

Right, okay.

And an unrelated question on the third-party assets that you guys made, can you talk about -- a little bit about what those are, the type of returns you get off of those assets and then maybe what the growth prospects are in terms of growth of off-balance sheet assets?

I don't know if we have -- do we have --?

We haven't really given specific guidance, Joel, about the returns if you will there.

I mean the managed for third parties includes the syndicated loan balances, which I mentioned are now $2.3 billion.

Then we have three CLOs that we are managing.

One that is complete; two that are ramping.

There is about $600 million in assets there.

We have some other assets, equity investments and also some other debt investments that we manage on behalf of other investors.

Is it fair to say those businesses are very high ROE businesses because they don't consume a lot of capital?

Yes, yes.

I mean my definition of an asset management business is a business you have no capital in, right?

If you have got half the capital in it, that it is really not an asset management business.

Right.

So if you want to really talk -- the reason asset managers get very high multiples, right, is that they have good recurring revenue models and they don't have risk.

If you have a lot of capital in the business, it doesn't really meet that definition of not having risk, right?

So when we talk about asset management business, we're talking about things where we don't really have capital exposure as it relates to.

And I think as we go forward, that is how we are going to view our asset management business, really building businesses that leverages franchise where we are using third-party capital for really two reasons.

One, to enter a sector where that capital is a better match for the asset as opposed to our balance sheet and then secondly, just to take advantage of the fact that we're originating a lot of assets that people want and we want to manage our holds, which we have been very good at, but we might as well take other pieces of these transactions and manage them for investors and get fees.

But I think when we talk about asset management business, we're going to hold to the definition of it's a recurring revenue business and we don't have significant capital at risk.

Yes, no, that's a good strategy.

I am just trying to get a sense for potential size a couple years down the road.

I think that we have -- we don't want to go into too many things, but we have several things we are working on that I think we will be talking about this year that will be reasonably significant increases in this area for us.

Okay.

And then kind of lastly, I know you touched on the Corporate Finance business.

Spreads are still tight.

I know you guys don't do buyouts, but one of your competitors today cited kind of reduced buyout levels for its earnings [management], so I'm just kind of wondering what your overall thought process is on corporate finance.

Looks like you are doing more syndications.

Is there any sense that you guys could become more active on the senior side in that business this year?

I think we're fairly active.

I mean positioning the platform with the syndication capability we have now has made us much more competitive and enabled us to go after larger deals.

The buyout activity -- it moves around and there was some backup in the business, but we are not seeing anything that is telling -- would tell us that we are going to do more or less than we think in that business.

We manage that business -- it is a tough time to be in that business.

There's a tremendous amount of liquidity.

Multiples are high.

People are paying high prices for businesses.

Covenant structures have loosened, etc.

So again, we have got other things to do at the Company, so I think the two people who run that business, Dan Duffy and [Jeff Kilroy], have done a great job and they have been very disciplined and we have actually seen a very positive credit pipeline in that business in terms of the business that we have done.

The credit profile looks actually really good in that business right now.

So I think we feel very good about the way that business is handling the current market environment.

We continue to build up the franchise.

We're moving up in the league tables and I think we are playing the business smart.

A few years ago, it was a different strategy.

Right?

It was opportunistic.

The wind was at our back and we aggressively went after deals and had larger hold sizes.

Today, I think you want to take a different tact in that business.

Okay.

Thanks, guys.

Don Fandetti, Citigroup.

Good morning.

John, just wanted to get your thoughts on sort of these larger leverage loan deals.

Obviously you guys have a great franchise in the CLO market.

Any thoughts about getting much more aggressive in that?

I guess you are doing some of that in your third-party business.

Yes, we mostly do that in our third-party business.

And what are your thoughts on that market versus middle-market?

Well I think we can play in that business and make the returns we want to make, so that is why we do it in a third-party business.

That is probably the headline comment.

In our CLOs, we can sell the equity for 30%, 40% less on a pretax basis than the pretax ROE we have targeted for our business.

So I think -- but again, it is my judgment that our third-party managed business will perform significantly better than average because of the depth of our credit culture here because even though we are doing it on behalf of other investors, they still have the benefit of this credit machine that we have built.

I think our peer group is generally one or two people at a desk kind of waving in loans.

So it is a different orientation that we bring to that business, so I expect that business to perform well for us.

But in terms of the larger deals with spreads that you can earn on those deals, it is really better for us to do that as an asset management business and I don't see any significant change.

And I think what will happen is in some ways it will always be that way because when that market backs up then the big buyouts kind of stop for a while.

You see what I mean?

So it is not like the big buyouts will ever come our way if you will for the kind of returns we want to generate.

Okay.

That's all I had.

Thank you.

Henry Coffey, Ferris, Baker, Watts.

Good morning, everyone.

Strong quarter.

First off, John, we don't think about you as lumpy.

We think about you guys as kind of lean and athletic.

You are referring to other members of the management team.

Right, everyone but you.

That's right.

No, excellent quarter.

And the stock market is reacting accordingly.

A couple of things.

First, on the healthcare REIT, obviously if you are asking for votes, we'd personally prefer to see you just keep it inside the Company so we all can get a great yield with very, very low risk.

If we were to try to separate that out from your core business, can you give us some sense of what kind of existing funding costs it gets and what kind of servicing or management fee we should put on that to get a sense of what the operating overhead of that unit would be as a standalone beast?

Since we can't really answer that question, I will defer it to Tom.

Excellent.

Henry, I mean I think it's important that we not get too far ahead of ourselves with respect to this.

Right.

I mean obviously this is an intriguing notion for us and we are looking at it and as we've already talked about in this call, there are probably several different ways to go about it.

Right.

I think we need to finish our review here and figure out what we're going to do and then talk to people about what it looks like because we really haven't decided at this point.

And the thing to remember is the management team and Board own 40% of the Company, so when we make this decision, it is going to be thoroughly vetted for the absolute best interest of the CapitalSource shareholders.

We don't question that.

The other thing is on the Structured Finance side, could you give us a little more detail on that portfolio in terms of your current exposure to both residential and condo construction lending, as well as whatever you have in the subprime portfolio?

The business has no direct subprime exposure.

It has got some rediscount lines to people that play in the residential space, but really in a different part of the space.

It's hard money lending, right?

Yes and it is very small.

So CapitalSource really has no exposure to the things that are getting --.

But what is that in terms of either a dollar or percentage or something, some relative measure of the hard money portfolio?

It's about $100 million.

So pretty inconsequential.

And it is for loans that are all performing very well and they are rated very highly.

What has been smart about our real estate team is they have balanced out the business.

There have been a lot of opportunities in the condo space and we look at them selectively and from time to time, we will do one.

But we are in general pretty scared of that business right now.

So they have really focused on other what we will call food groups.

I don't think we have the real estate breakdown right now in front of us, so we can get that -- we have published that before and I think at a conference we did recently, we might have disclosed it.

So if that is the case, we will just pull that down and send it to you.

But it is a fairly balanced portfolio.

The other question in the Structured Finance business, there has been a lot of change and disruption in the timeshare business and I was wondering whether that was a -- and I know you have a small timeshare unit.

I wonder whether you have been doing anything there either on the acquisition front or was that a meaningful part of the growth or is this just a --?

We have a resort finance business broadly defined, which does include timeshare.

The timeshare business -- there are really two aspects to it.

There is a receivable finance business, which is essentially the rediscount of a pool of consumer loans, which is a terrific business and the team that runs that business has been it for a while and we haven't had any losses in the business.

And then we have a real estate-related business, a real estate aspect to the business that is principally focused on not pure play timeshare, but rings like fractional etc.

Again, that has had a very good performance for us and we like the business.

We think it is a niche business that you need relationships and expertise.

We have got a very good team and again, we haven't had any losses in that business and I don't think we have any loans in any of the problem loan categories in that business.

So it has been -- it is part of our business, we like it, but again we don't grow it just to grow, we grow it based on good opportunities.

I am just trying to figure out in the Structured Finance group what aspect of rediscount lending was the source of the growth.

I think -- the way we think about rediscount is -- timeshare -- real estate rediscount and consumer rediscount.

I think we saw growth -- I don't have the numbers in front of me, but my recollection is that all three of those buckets had growth this quarter.

I can't recall which one of those three buckets had more growth than the other.

Thank you.

Excellent quarter.

I appreciate it.

Thanks, Henry.

Scot Valentin, Friedman, Billings, Ramsey.

Thanks for taking my question.

I wanted to focus on just the capital structure of the Company.

You mentioned dialing back at your program to slow down the equity build and I was just curious if we look 12 months from now, how would you see the capital structure form between unsecured debt and maybe equity capital and maybe talk about -- there have been some I guess in some people's models maybe the capital raised during the year because of the growth of the balance sheet.

I guess it sounds like that is off the table now.

Well I couldn't really comment on timing of future offerings, if any, but I mean just generally speaking, we have spoken about for really a couple of years about 4 to 5 times leverage debt to equity, total debt to equity in our commercial segment as being the right ZIP code for us to manage the business.

That is clearly not the maximum amount of leverage we could put on the asset base, but we think it's a prudent level given our desire to have the conservative balance sheet with lots of balance sheet strength in it.

So as a result of that, we do want to move our debt to equity ratio in the commercial segment up this year.

It was 3.8 at the end of the first quarter.

I would like to see it at 5.

-- excuse me -- 4.5 times by the end of the year.

If we can manage it in the 4 to 5 times range, hovering around 4.5, 4.6, I think that, based on our composition of assets and our composition of funding today, the right place for us to be.

So that will tell you how much of that capital structure if you will is equity.

For the debt component, we would like to increase the percentage of unsecured debt in the capital structure.

Right now, the only unsecured debt we have is these convertibles, most of which are now subordinated.

Some trust preferred, which is also subordinated and our unsecured credit facility, which is a senior piece of paper.

So we would like to complement that by adding some unsecured debt.

I wouldn't -- the way I kind of think about is how much of our capital is coming from the secured markets and I think we would like to work that number down to sort of 50% in the commercial segment over time.

Hopefully that answers the question for you.

It does.

Thank you very much.

Moshe Orenbuch, Credit Suisse First Boston.

I was just wondering if -- to amplify a little bit on the credit quality question, one of the things that we have thought about for a while is your ability to get rid of problem assets within that loss severity, your target of loss severity.

Could you talk a little bit about dispositions and how that ran in the quarter?

In disposition selling loans?

Right.

Because I think one of the big concerns is if you have a 2% or 3% problem assets, but can get rid of them at 15% severity, it is not that big a loss factor.

If it is 50%, then it's obviously much higher.

Yes.

Well in terms of recovery this quarter, we don't have the recovery statistics here, but the recoveries on the loans that left the category this quarter were I think 100%.

So it shouldn't move those statistics down; it should move them up.

It is really interesting you bring that up because we spent some time on that.

We think we can be much more proactive about selling assets actually in these problem loan categories as opposed to working them out.

And we generally approach (inaudible) problem loans, we want to work them out and get 100% recoveries and that has generally been our orientation and we have had very good recovery of 93 -- recovery percentage 93%.

So the -- should we get loans out as soon as they go in those quarters and take a five point discount and not have them ever enter the problem loan categories?

That might be a smarter answer for our shareholders as opposed to our normal tact, which is they'll sit in the problem loan categories for three quarters and we will try to them out to get 100% because we're looking at the economic impact, not the optical impact.

So I think that's one of the things the team has -- the team has really done a great job and the person who runs the business, Mike Keller, deserves a lot of credit for the credit stats and the continued performance because of the proactive way he has handled our workout.

That is one of the things he wants to do is be more proactive about selling the assets and clearly, we are going to sell them at what we think is a good economic outcome for us.

That may even lead towards better credit statistics over time if you will because we haven't employed that as much in the past as we probably should have.

Thank you.

Darrin Peller, Lehman Brothers.

Thanks.

Last quarter, you guys discussed -- there was approximately four companies that you were making loans to in the subprime space.

Just wanted to know -- and last quarter, you mentioned they were holding up pretty well, just the status of those companies and how those loans are shaping up.

Sure.

It's four companies.

They are in -- they are not -- you could call them in the subprime space if you broadly define it, but what they really are is true loan-to-value lenders.

They are lending on the value of the underlying real estate to people with a very difficult credit profile.

And so in many ways, it is a much safer profile than what is the headline subprime business, which a third of that business was 80/20 loans, meaning 100% loan-to-value and they weren't confirming people's incomes, so they really didn't have a credit approach to the business.

Whereas if someone approaches a loan and says I'm going to loan at 70%, 80% what I really think a house is worth and I don't really care if you can pay it because I've got good collateral coverage.

At least that is a credit approach to the business.

And then we rediscount these people at 80% to 85%, so our exposure is 50 -- I think it is blended 55% loan-to-value against the home prices.

And those four companies we have, again which is only $100 million of our portfolio, are all performing very well and are highly rated in our loan system and if I had my way, I would do more business with them.

So it is a complete nonevent for us.

Great.

Real quick, can you also comment on the pipeline for sale-leaseback activity?

It saw nice growth this quarter, linked quarter, but it seems like a lot of it is still lagging from some deals you had last year.

Yes, it's a lumpy business.

The pipeline is good and they are generally bigger deals and so they have much more M&A dynamics around them.

So things fall out or get delayed for a variety of reasons.

We are also actively working on a few new asset classes that we think could be very good opportunities for our balance sheet in net lease assets and they are not traditional asset classes like just going and buying big-box retailers and leasing them back, but it is things that are a little more I think create a value-add higher barriers to entry that we will be talking about.

Thank you.

Sure.

David Hochstim, Bear Stearns.

Thanks.

I wonder if you could talk a little bit more about competition and pricing and is there anything we can glean from the payoffs in this quarter in terms of what competitors are offering your customers?

David, most of the -- most of the payoffs we have typically are the business being sold and that still remains the largest categories of payoffs for us.

We generally don't -- there is -- this is a business with decent frictional costs, as you can see by prepayment fees.

So people are typically not taking out to get a 50 basis point lower rate.

They are typically taking out because some major event is happening, they are buying another company or they have grown so much and they just haven't cleaned up the debt or because they sell their business and we do play in a transactional marketplace.

One of the things we are trying to do with our sale-leaseback business and other net leased assets we will enter is increase the duration of our assets and I think we will be able to do that over time.

Okay and in terms of price competition, was it any worse in the first quarter then the fourth?

No, it has been stable.

Okay.

Thanks.

So I think we will take one more question.

Henry Coffey, Ferris, Baker, Watts.

Yes, Tom, I was going to ask you another question that you can't answer.

No, I'm sorry.

If you look at your borrowing costs and obviously matched it up against asset classes, you're funding costs against secured real estate, is that all that different than your funding costs against the general portfolio or against other classes of loans such as healthcare receivables?

I think generally not, Henry.

On a secured basis, there is not very much difference and unsecured costs more a little bit than the secured, but I don't think we are seeing really very much difference because we have such a diverse portfolio and that really counts a lot in the --.

So a blended rate is the most accurate rate for both aspects of the business?

At this point, I would say so, yes.

And all the talk of a healthcare REIT, that obviously -- well I am asking you the question would that include the assets of your -- say your factoring group or your unsecured lending or would it just be the secured assets?

I think to the extent we did anything, it would be a pure play sale-leaseback, our equity business.

Thank you very much.

Okay.

Again, thank you, everyone, for calling in and we would be happy to answer any other questions that we can off-line and we look forward to reporting in about three months.

Thanks again.

Ladies and gentlemen, thank you for joining today's presentation.

This concludes the conference and you may now disconnect.

Good day.