PacWest Bancorp (PACW) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen.

Thank you for your patience and welcome to the second-quarter 2007 CapitalSource earnings conference call.

My name is [Fab] and I'll be your coordinator 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 this conference.

(OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to Mr.

Dennis Oakes, Vice President of Investor Relations.

Please proceed, sir.

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

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

This call is being webcast live on our Web site and a recording of the call will be available beginning at approximately 12 noon Eastern Standard Time today.

Our press release and Web site provide details on accessing the archived call.

Additionally, we have posted a presentation to the Investor Relations page of our Web site at www.Capitalsource, which contains additional materials related to CapitalSource and the Company's performance this quarter.

I urge you to read the forward-looking statements language in our earnings release, but essentially it says 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 reports filed with the SEC.

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

I'd like now to turn the call over to CapitalSource Chairman and CEO, John Delaney.

John?

Thank you, Dennis.

Good morning, everyone.

I want to begin with a brief overview of our performance in the second quarter, but really I want to focus my remarks this morning on a review of our business in the context of the current volatility and uncertainty that we are seeing in the capital markets.

My goal is to provide a deeper understanding of our credit culture and business practices and hopefully show that these actually position us to prosper as the credit cycle turns.

In terms of operating performance, this was a business-as-usual quarter for CapitalSource.

We had strong profitability, a hallmark of the Company, with adjusted earnings of $0.68 per diluted share and an adjusted Return On Equity in excess of 22%.

Our credit metrics were very solid and in line with historic averages.

As I will explain more fully in a few moments, we had lower net commercial loan growth in the quarter of approximately $300 million, which reflects a deliberate go-slow approach that we had taken in recent months due to credit market conditions.

Trust me, we could have easily funded more loans in the second quarter, based on the volume of deals in the market, but instead, we chose to step back from the table and wait for a better market, which we believe is right around the quarter.

During the quarter, we announced the acquisition of TierOne Bank.

The integration is proceeding is planned and we currently expect to close in the fourth quarter, as previously announced.

In light of the recent volatility in the capital markets, our strategic rationale behind the TierOne acquisition should be even more evident.

All in all, we were extremely pleased with our second-quarter performance and are looking forward to the future.

Now, let me touch on the market.

Across the last two weeks, we have seen a massive repricing of risk, and deleveraging in the capital markets.

While some adjustment in the risk premium was expected, based on developments we've spoken about publicly in the past, the speed at which events unfolded and the severity of the dislocation was, in a word, amazing.

Our view of this market's impact on CapitalSource is as follows.

First, we believe we will see a significant widening of spreads in all of our target markets.

On-balance, this is an extremely positive development for a business.

Wider spreads leads to a higher Return On Equity and greater profitability for the franchise.

Those of you who know us also know that we have been predicting and preparing for this correction for some time.

In fact, CapitalSource has been built for exactly the type of market that we now see unfolding.

We strongly believe that we are about to witness the finest lending environment we have seen in five years.

We will be providing liquidity in a liquidity-tight market and getting paid to do so.

Second, wider spreads are just beginning to enter our markets.

As a result, we are being very, very prudent with respect to new lending until we believe the risk-adjusted return is appropriate, which is not yet the case.

We see no reason to aggressively lend before spreads on our lending opportunities widen.

This approach, however, has resulted in lower origination in the second quarter and will likely translate into lower originations in the second half of the year as well.

Recent events will also cause our cost of funds to go up from our traditional sources, but over time, I expect spreads to widen even more for our lending opportunities, leading to higher profitability and higher Return On Equity I just mentioned.

Finally, despite our strong liquidity, we plan on taking advantage of every opportunity to continue to add even more debt-capital to our balance sheet.

Doing so both buffers the Company against further drops or tightening of the debt markets and positions us to take advantage of the improved opportunities we believe will exist, as I said, right around the corner.

Our convertible offering was an example of this.

It was 100% insurance for us.

Like most insurance, we don't think we need it, but we wanted to have it.

Additionally, our proposed acquisition of TierOne Bank will strengthen our funding platform for those same opportunities.

Beyond providing our view of the impact of market conditions on CapitalSource, I also want to make three important points that fall under the category of abundance of clarity, and then also comment on our dividend guidance.

First, we are not a subprime lender.

The residential mortgage portfolio we have on our books is there to help optimize our REIT structure.

We have taken a decidedly low-risk approach to it.

The residential mortgage portfolio is comprised of high-quality assets, including Freddie Mac and Fannie Mae guaranteed agency securities, which constitute a majority of the portfolio, and super-prime quality home mortgage loans.

Further, we actively hedge the interest rate risk in this portfolio.

The residential mortgage portfolio on our books is about as far away from sub-prime as you can get.

At our core, CapitalSource is a diversified commercial lender diversified across a variety of industries and sectors, including healthcare, which is about 30% of our portfolio.

While certain of the businesses we are in are more subject to market flows of liquidity, such as commercial real estate and corporate lending, other businesses are truly niche businesses with exceptional risk-adjusted returns.

For example, our healthcare real estate business, healthcare credit business, and our rediscount business collectively have $4.4 billion of assets or 44% of our commercial assets, and they have less than $1 million of nonaccruals in them in total.

Second, we have been very prudent with respect to our LBO lending and have no significant syndication exposure.

Many lenders are currently start with large commitments on loans they cannot sell.

CapitalSource, because of our discipline, is not in that camp.

Finally, in commercial real estate, we essentially stopped making condo loans nearly 18 months ago.

New York City market, where values have help up, is the only market where we have continued to lend.

I wanted to comment on our prior dividend guidance of $2.40 per share.

Though our original guidance was based on asset growth assumptions we will likely not achieve due to our more conservative loan orientation I just described, our results in the first half of this year have exceeded our expectation, which leads us to the conclusion that we will achieve our full-year dividend guidance.

It is important for all of our investors to understand, however, that certain variables in our financial model are in flux, both positive and negatively.

On the positive side, we will likely see an increase in asset spread, an increase in margin, and an increase in Return On Equity over time.

We will also likely see lower cost of funds once we obtain deposit-based funding.

On the negative side, we will likely see reduced short-term asset growth and increased financing costs from our traditional sources of funds.

In my judgment, these positives clearly outweigh the negatives.

Before concluding, I want to provide my views on the lessons learned from the subprime situations that we have all witnessed in the recent weeks.

In addition to exercising poor credit judgment, I believe subprime lenders made two fundamental mistakes.

First, they kept lending when the capital markets told them to slow down.

Second, they stopped accessing the term financing markets while they still could because they didn't like the execution and they thought things would get better.

I want to be very clear that we're not in the subprime business.

Therefore, we have not faced credit deterioration or any deterioration in credit quality faced by those lenders.

However, I believe these lessons are instructive for all players in the capital markets.

We are conducting ourselves accordingly in order to effectively navigate these turbulent times and take advantage of the terrific opportunities we see in our future.

With that, I will turn the call over to Tom.

Thank you, John, and good morning, everyone.

I echo John's sentiments that the second quarter's results were very strong.

They also demonstrate the value of the diversity of our business.

This morning, I will briefly review these results and highlight some of the drivers of our performance.

I also will touch on funding and liquidity, which is very important in today's market climate, as well as the recent steps we've taken to strengthen our position.

Adjusted earnings for the second quarter were $128.4 million or $0.68 per diluted share.

This was up $0.05 per share, or 8% from the last quarter, which also was a very good quarter.

Our adjusted ROE for the quarter was 22.3% and was higher than the high-teens to 20% benchmark we have set for the business, clearly a strong performance.

These bottom-one results were the function of a very solid performance in our commercial loans and lease investment portfolio, continued favorable credit experience, and significant other income.

Let me dive into each of these a little bit further.

Our yield this quarter of 12.05% in our commercial loan portfolio was a continuation of the trend we have seen in recent quarters of stronger-then-expected yields on interest-earning assets.

The average return on our lease investments, or sale leasebacks, also was strong at 10.16%, which is toward the higher end of our expected range for that part of the business.

This 12-plus% yield on interest earning assets included 77 basis points of prepayment-related fee income, or $17.3 million, which is down from last quarter's very strong 110 basis points but still ahead of our expectations.

Our commercial portfolio ended the quarter at just under $10 billion in assets, including approximately $8.9 billion of commercial loans and just over $1 billion of lease investments.

This represents approximately $530 million of net growth from the end of the first quarter, including $300 million of net loan growth and $230 million of net growth in lease investments.

While this net growth is below that of the first quarter's pace, it reflects the cautious, prudent approach in today's market that John explained.

Each of our businesses grew this quarter.

Healthcare and specialty finance had the greatest growth, followed by structured finance and then corporate finance.

The relative percentages of the commercial portfolio contributed by these businesses was essentially the same as the prior quarter, but the greater growth seen by healthcare and structured finance, which contain our real estate businesses, underscores the continuing favorable effect of last year's REIT election.

And we continue to maintain a strong senior debt orientation in the portfolio.

Credit was the second major contributor to this quarter's solid results.

For the quarter, we saw $13.6 million of charge-offs.

As a percentage of average commercial assets, annualized net charge-offs for the year-to-date period were 52 basis points and right in line with our expectations.

Delinquencies and the more important nonaccrual metric both edged up a little bit in the quarter, but you will recall, in the first quarter, we saw a significant downtick in these metrics.

So this quarter's results were neither unexpected nor concerning.

We are adequately reserved for credit losses with an allowance of 128 basis points of commercial assets, almost 2.5 times our year-to-date annualized charge-off level.

In fact, I would characterize this quarter's credit metrics as very good.

For both delinquencies and nonaccruals, we are still below the levels of last year at year-end and below the levels at this time last year.

As John has done in the past, I want to remind everyone that these metrics can be very lumpy, and we expect movements, both positively and negatively, in these statistics.

I mentioned other income as another driver of this quarter's results.

Here, the major component was realized gains and dividends received in our commercial investment portfolio.

This is the fourth quarter in a row where we have seen significant realized gains and dividends in the equity investment portfolio.

This quarter, they totaled over $17 million, and I have two things to say about that.

First, the equity gains this quarter are further validation of what we have long said about this part of the business.

Very simply, we expected this investment portfolio to produce gains, and it has.

While the level of quarterly gains is not predictable, they are predictable across time and a very positive part of our business.

Second, one of the gains this quarter, a $3.2 million gain on a preferred stock investment, was in effect a recovery against the prior charge-off.

While technically not accounted for as such, we received this preferred stock in connection with a prior loan restructuring and workout.

At the time we received the preferred stock, we wrote it down by the level of the charge-off.

This economically resulted in a 100% recovery of the loan loss in that situation.

Netting this recovery into our charge-offs this quarter would have put us at $10.4 million of net charge-offs or 44 basis points annualized of average commercial assets.

Now, let me finish by going deeper into what is currently the most significant issue for finance companies in today's market, funding and liquidity.

If you have followed CapitalSource for any amount of time, you've heard us talk about low leverage and funding.

In addition to all the great things going on in the lending and asset side of our business, we are also very focused on and extremely conservative about our capital structure and liquidity.

To review, in our commercial business, we have focused on low leverage and have been targeting a modest 4 to 5 times debt-to-equity ratio as a very prudent level of leverage for our largely senior debt assets.

This quarter, we ended with 4.03 times leverage, which is at the low end of that range.

When you consider the specific components of our capital structure, our leverage is even lower, pro forma for a recent subordinated convertible, at less than 2 times when measured on a debt to subordinated capital ratio.

With respect to funding in our commercial business, we have similarly been cautious and prudent.

We have focused on committed funding, closely matched funding, and broad, diversified funding.

By choosing this path, we have knowingly reduced the amount of leverage we could have achieved, but having a strong, solid funding platform is critical to having a successful long-term business.

We have certainly seen many recent examples of the downside of too much leverage and CapitalSource aims to stay well away from that.

The repurchase agreement financing you see on our balance sheet is used only for our Fannie and Freddie guaranteed securities that we have hedged.

Turning back to our Commercial segment, it is important to note that our committed credit facilities, both secured and unsecured, are not subject to mark-to-market adjustments or margin calls.

Furthermore, we enjoy strong relationships with many banks who provide this debt financing with us and respect us as a high-quality shop and a leader in what we do.

We have a first-class reputation in the term securitization markets, who know us as a premier middle-market loan originator and manager.

These investors like our strong credit orientation to the business and our complete control of the entire credit process, from direct origination to underwriting, where we have more and better resources in the process, to our experience in expert loan management and our leading middle-market syndication and sales capability.

We highly value our investment-grade ratings, which give us access to corporate debt markets.

We're on the path to obtaining deposit-based funding without merger agreement with TierOne Bank and our ILC application.

Despite a position of relative strength, we took additional steps this past quarter and in July to further bolster our funding and liquidity.

These steps included closing additional secured credit facilities, expanding our main unsecured credit facility to just over $1 billion, and closing on the $250 million convertible debt issuance earlier in the week.

As John said upfront, the capital markets are turbulent at the moment, but in many respects, CapitalSource has been built for these conditions.

We think the market conditions ahead should be very positive for our business, and we feel confident about entering this period in a position of strength.

Dennis, we are now ready for questions.

Thank you, Tom.

Since we know there are a number of callers on the line today, we request that each individual ask no more than one question and one follow-up.

Operator, we are ready now for the first question.

(OPERATOR INSTRUCTIONS).

Bob Napoli, Piper Jaffray.

Thank you.

Good morning.

A question -- my first question and then I have a follow-up -- is if you could talk about, as you put it, the credit pipeline.

What are you seeing within your portfolio and the economy in general maybe as by going through the credit pipeline?

Sure.

Thanks, Bob.

The credit pipeline remains -- to use a word we've used to frequently -- stable.

You know, we've seen very good credit stats the last two quarters.

I think the last two quarters, our credit stats have been better than they've been since '05, you know, which reflects, I think, the fact that we've been saying it's a stable credit pipeline starting in '06 and I would say nothing's really changed now in the portfolio.

So you know, I don't think I could make any comments that would indicate that there's any changes that we expect to our credit performance.

Obviously, as you know, and I feel obligated to say this, these things are lumpy and they move, around both positively and negatively.

One loan could move stats 20, 30, 40 basis points even.

So you know, you have to -- I have to qualify every comment by saying that.

But there's certainly nothing that we're seeing that concerns us with respect to the credit pipeline.

Okay.

My follow-up question is on the TierOne acquisition.

They do have a healthy and a large, I guess is maybe is a better term, residential construction portfolio and own some real estate.

You know, that market sector I think has become more difficult even since that transaction was announced.

I just wondered what your comfort level is with that acquisition in that portfolio and their assets in particular.

Sure.

As we indicated when we announced the acquisition of TierOne, we did very significant diligence with respect to their loan portfolio, which is our expertise, as you know.

We had a view that the balance sheet we would be acquiring, recognizing that we did look at the loans in the portfolio and we did have a view about reserves against the loan portfolio, etc., that the balance sheet that we would be acquiring would be appropriate and would perform pursuant to our expectations.

We've been in very close contact with TierOne obviously, working on extensive integration plans, etc., and in very close contact with their loan officers and their credit people, etc., and have very significant visibility into their loan portfolio.

I would say, as we sit here today, that our view as to their loan portfolio has not changed, based on developments in the residential market.

So I would say there's no change there, Bob.

Sameer Gokhale, KBW.

Good morning, John and Tom.

I just had a question about -- you know, it seems like, this quarter, credit again was fine and yet the stock has sold off very significantly.

And then if it's not correct, then maybe the concern has to be on the funding side, and I think you gave some good commentary on your credit facilities.

But you know the question I had was, in this kind of environment when you talk about committed credit facility, does committed really mean the same thing in this environment?

I mean, how would you view a committed credit facility?

What do you think that means?

I mean, can you provide some color on that?

What kind of scenarios can those credit facilities being pulled?

I think that would be helpful just for [investors] to get some comfort on the funding side of the equation.

Sure, Sameer.

Just to provide a little historical context here, I did run a specialty finance business that was public in the late '90s, specifically in the fall of '98, called Healthcare Financial Partners.

Back then, that company had about ten peers and I think, after the fall of '98, eight of those ten peers went out of business.

The two that didn't go out of business was my company and another one, because we had committed credit facilities and everyone else financed on repo.

So we started this company with a very defined view as to how we would finance our business.

We said from the beginning that we would enter into what we called committed credit facilities that have terms that are not repo, that are not subject to mark-to-market margin calls.

Even at the end of their term, they are typically not due; they become liquidating pools -- because we are very focused on matching our liabilities with our assets.

If you finance longer-term assets like we have with short-term liabilities like repo, it seems like everything is going well when the markets are good but it can turn very quickly.

So we've been very, very focused on this point and we've constantly made reference to it.

Okay.

Yes, that commentary is really helpful.

Thank you.

Just I feel obligated to add just one more piece of detail there.

There's a trade-off you make when you do that, and the trade-off is leverage.

In the past, we've been questioned by shareholders as to why we don't drive more leverage in the business, even though the asset quality is certainly very high and the credit performance has been included, and if you look at the kind of assets we have when we put them on other institutions' balance sheets, they would want it (inaudible) leverage.

We've said very specifically that you can get high leverage with repo until you can't, right?

If you want committed credit facilities, you will compromise some measure of leverage to obtain committed credit facilities.

That's a decision we specifically made for environments like this.

I think the commentary that Tom made earlier and I just want to emphasize, when he explained that actually our ratio of senior debt capital or credit facilities, if you will, to junior capital is 2-to-1.

When you really unpack that can you realize that the assets are senior secured and they are effectively at 2-to-1 leverage in the core business, I don't think you can find a finance company that's actually running with lower true leverage.

You may see enterprises with 1-to-1 leverage, but their investments are inherently mezzanine or subordinate in nature.

You take senior assets and you effectively have 2-to-1 leverage on them, I think it makes the point that the Company's liquidity is solid and it's in part due to the point you raised, which is we have these committed facilities.

Okay, that's really very helpful commentary, John.

Maybe the follow-up I had was on your our RMBS portfolio.

I know you said those are very kind of super-prime and AAA-rated securities.

There was a small write-down this quarter in the portfolio, it looks like.

I know it's not part of your adjusted earnings, but I was just curious.

After the end of the quarter, what happened to the value of that portfolio in the month towards the end of July -- if there were additional write-downs?

Just some outlook for Q3 as to what you're seeing there, given to they are such high-quality securities.

Well, they are very high-quality securities, and the marks -- or as you know, we're also accounting for all of that on a trading basis, so we're marking the assets and the hedges to market.

What you see there on the income statement and also on the adjusted earnings reconciliation is what I would call the small noise that exists in the portfolio.

We have it very, very fully hedged.

There is a little bit of noise in there, sometimes positive, sometimes negative.

There was a lot of volatility, obviously, with interest rates in the second quarter, which accounts for the size of the number, but it's not anything that we are concerned about.

I think the performance of the portfolio since the end of the quarter has been just fine.

You know, we've been using BlackRock as our portfolio advisor, and it has been very, very effectively hedged throughout the six or so quarters we've had it.

Okay, that's great.

Thank you.

Carl Drake, SunTrust Robinson Humphrey.

First question, John, on your dividend comment about the impact in the second half from slower originations -- could you provide a little more color?

Is that related to payout ratio differences, or maybe provide a little color on your comments there?

Sure, Carl.

The comments I was making were really trying to explain the key variables in our financial model and how it relates to dividends.

Clearly, average assets is a key variable, as is the profitability of the portfolio.

In the first half of the year, the profitability of the portfolio was ahead of expectations.

We expect the same kind of profitabilities in the portfolio for the second half of the year, but we do expect the average assets in the portfolio to be slightly lower than we had modeled.

So the point I was making is that we're reaffirming dividend guidance but we're getting there in a slightly different way.

I mean, the business has performed better than we expected, which actually allows us to do the right thing now which is as I said, step back from the table a little bit (technical difficulty) we started to do in the second quarter because of our view as to what was starting to happen in the credit markets, and we thought there would be better opportunities.

If those better opportunities unfold in the fall, even if we step back in aggressively, we will probably end up with lower average assets.

So, because the business has been better than we expected, we can actually afford to step back from the table and deliver on our guidance, which I think is an important point.

So that's really what I was getting at.

I was trying to provide a little further commentary that we're getting to the dividend guidance in a slightly different way.

I don't actually think a bad way.

You know, it's better to have higher profitability and lower asset growth and save your dry powder and your liquidity to take advantage of what will be a better market.

As I said in my comments, I think this is going to be the finest lending environment we've seen in five years, and this company is ideally positioned to take advantage of it and, in my judgment, will become a more profitable enterprise.

I think we are fortunate and it's because of good planning by Tom and his team that we can take advantage of this market the way will be able to.

But my comments were more just around sustained dividend guidance but getting there in a slightly different manner.

Okay, that's helpful.

The follow-up on funding -- given the dislocation in the CLO market, if you could provide a little bit of a color on -- you said in the short-term you will see some rising cost of funds until you get deposit funding in there.

Maybe you could touch on spread widening in the CLO market and how that might impact you and also the ILC application and whether or not that's something that's still actively pursuing, and the timing on that as well.

Well, there clearly has been some spread widening in the CLO markets.

I mean, we've not come to market, so I guess we don't know the answer for us specifically.

But you know, there has been some widening.

I think we will see how that market develops.

I mean, we have -- had planned to do additional securitization, at least one additional securitization this year.

We will see how it goes.

But we do have, as we identified in the press release, significant liquidity remaining in our credit facility.

So we've got, I think, plenty of bandwidth here, or plenty of running room here to kind of wait and see how market conditions evolve.

While spreads are widening on the liability side -- and I think John pointed out that, in the short-term, that would tend to increase our cost of funds -- we also expect to see widening of spreads on the asset side and probably more widening on the asset side, which is what gives us the confidence that, long-term, this is going to be very favorable for CapitalSource.

Then obviously, with our ILC application and our merger agreement with TierOne, adding deposit-based funding will serve to lower our cost of funds as well as further broaden and diversify them.

Just to add one more little detail to that, when we announced the TierOne acquisition, we had a data point or a slide that we put up that I'm sure is on our Web site or we could dig up, that shows movements in BBB spreads, versus movements in deposit-based funding.

The observation we were making at the time is that BBB spreads are volatile.

They stay stable and then, every few years, they get out of whack, and the deposit-based funding is consistent across all market conditions.

We indicated that was one of the reasons we wanted deposit-based funding, in addition to providing additional source of liquidity.

With TierOne, we have deposit-based funding around the corner.

We also have a fully approved ILC application, which could provide us deposit-based funding.

So what's nice about the way this is playing out is that we think asset spreads are going to widening.

Most of our liabilities, the spreads are actually locked in; the only thing that's not locked in is things that are in our warehouse that are waiting to be securitized, as Tom said.

We are likely get an uptick in cost of funds in those securitizations from where we had been able to execute in the past.

That will cause cost of funds to rise.

But then when the deposit-based funding comes on board, it will actually lower cost of funds.

Meanwhile, the asset spreads will continue to widen, we think, for some period of time.

So I think we are actually set up really nicely, actually, as this thing plays out.

We just wanted to kind of unpack some of the variables for the market and explain how we think about these things.

Thank you.

Don Fandetti, Citigroup.

A quick question, John or Tom, around your convert deal -- you filed an 8-K talking about some restrictions from the Office of Thrift Supervision on one of your larger shareholders.

Have there been any additional developments in terms of working that out?

No, Don.

I think we did receive some comments about is that going to be a problem?

I think I can say very clearly that will not be a problem.

Fantastic.

So the issues with our shareholders as it relates to -- we have what we consider to be very good and very large insiders who sit on the Board.

The regulators require those insiders to kind of reaffirm that they don't "control" the Company, because if so, then they would want to regulate those people, and those people certainly don't want to be regulated.

So you have to execute certain agreements that limit your ability to "control" the Company.

These agreements are broadly called "passivity agreements".

We reference them in great detail, but without getting into too much detail, I can say that the execution of those agreements will not be an issue as it relates to obtaining our deposit growth.

Okay, great.

john, you've been obviously through some cycles here.

What sort of gives you the confidence that the CLO market will open up?

I know you guys usually are just issuing the senior securities.

Secondly, do you have any back-up facilities?

I know some of your peers have agreements with banks that will actually buy their CLO bonds.

We don't have any agreements with banks to buy our CLO bonds, in part because I think of the liquidity position of the Company and the excess liquidity we have doesn't require that for us.

Listen, the CLO market will reopen.

It's just a question of price and structure.

This market has to obtain some form of equilibrium because there is a significant supply and demand imbalance driven by a variety of things, obviously starting with residential.

Residential caused the extension of a lot of kind of asset managers who bought Junior bonds, and threw off the whole secured capital markets.

Until all of stuff gets through the markets, meaning big LBO loans that have to get sold and other stuff that's waiting to get -- that is in the queue, we're not going to see equilibrium in that market.

But I do expect there to be equilibrium in the market ultimately.

I do expect the capital markets to open up.

Even in the fall of '98, you could get deals done but they weren't at very attractive prices or structures.

This becomes very problematic if you're in a business that has low spreads, because when this happens, you suddenly have assets that can't produce a positive ROE.

Kind of overnight, your whole profitability model gets thrown.

When you have a business that inherently has wider spreads, which ours does, you have more flexibility in aggregating these times and continuing to deliver on your profitability.

Okay, thank you.

Tom, I don't know if you'd add anything to that.

Yes, the only thing I would add to that is that also, if one looks at our securitizations, I mean due to the very high quality of assets we have, you know, a very high percentage of the capital structure of those deals is AAA, so it's typically 70%, 75%, you know, so obviously much higher confidence levels around, even in today's market, executing or completing those portions of transactions.

At a 75% level there, that's equates to about a 3-to-1 leverage level, which would be accretive from this senior debt and subordinate capital ratio both John and I mentioned.

Yes, I guess what perplexes me a little bit on John's comments is that it seems like everybody is waiting; no one is really buying because they think spreads are going to widen because the banks are going to push all this stuff out and yet I'm just trying to figure out who is actually going to step in and buy (inaudible) let that clear-out process happen.

Well, listen, there's two types -- in the past few years, there's been two types of buyers.

There have been what I call cash buyers -- banks, pension funds, insurance companies -- and then synthetic buyers, which have been people who bought bonds and repackaged them and resecuritized them.

Recently, a lot of the market started to be dominated by the synthetic buyers, which really existed at the pleasure of other lenders in some ways.

Based on the disruption in the market, you've seen those synthetic buyers really not be in the market.

So you simply have a big supply-and-demand issue going on.

The cash buyers are still there.

There is a fair amount of liquidity globally.

I think people are asking themselves, maybe there wasn't as much liquidity as we all thought, but there is a fair amount of liquidity globally.

I think what has to happen is deals have to get done, even at the wide spreads and bad structures, and then people will say "Okay, there's the market." Then they can start tacking off that.

So, I think you'll see people stepping in, and people are stepping in; deals are getting done.

You know, it's all about getting market equilibrium.

I think that's a little bit feeling your way in the dark is what the market is doing now.

A couple of deals are getting done, some aren't, but people are starting to get the sense as to where the market is, I think.

Then they will start getting done, because there are people out to invest, and there is product.

Right now, we have a situation where the amount of product is greater than the number of people who are going to invest.

So it's going to take a little bit of time for that product to run down until you get the equilibrium.

That will be the new market.

But I'm certain that new market will have wider spreads and more conservative structures, which I'm both very happy about because I think it's the right thing and secondly, I think it creates a great opportunity for CapitalSource.

David Hochstim, Bear Stearns.

I'm wondering.

Could you just say how much new business you need to write in the couple of quarters to hold the portfolio steady?

Balances didn't grow or decline?

Then the follow-up would be -- I'm sorry if I missed it, but did you say what you think is happening with your ILC fully completed application?

I think, your two questions, I didn't hear them that well.

The first was how much business do we need to write to keep the portfolio where it is?

Yes.

That's really -- obviously the key variable there is runoff.

Runoff can be lumpy.

But I don't think I can answer that question specifically, in part because I don't know.

Tom, do you have a better sense as to -- I don't have our historical runoff numbers.

No, I think we've generally thought about the business as sort of a 10%-ish runoff business (multiple speakers)

Yes, net 20% runoff, 10% organic growth kind of thing.

Yes.

Annually?

Yes.

Okay.

Our ILC application has been approved.

You know, we hadn't accepted it in part because we had the TierOne acquisition pending and we wanted to sequence things right and handle the integration of TierOne.

But the ILC application is available for us, or an ILC is available for us to take as soon as we decide to do that.

Okay, so you're not going to do it until after TierOne, or is there a reason you will?

I didn't say that.

I think, as I said, we announced the TierOne acquisition and that was our number one priority.

We are excited about that.

We've been working hard at integration.

We didn't want to -- you know, from just a bandwidth perspective, we wanted to focus on the OTS, handle the application, handle the integration of TierOne and then lift up and make a sequencing decision about that.

Okay, thanks.

Henry Coffey, Ferris Baker Watts.

Everyone, excellent quarter by the way.

Can you give me some -- really just two unrelated questions.

Can you give me some inside into the sort of size and nature of your syndicated loan and CDO/CLO pipeline?

I mean, I know you've been sort aggregating assets for both purposes.

You know, what are the sizes?

What do the spreads look like in that sort of small piece of the business?

Oh, you are talking about our CLO Asset Management business, Henry?

Right.

Well, we have -- we had filled up -- just for the other callers so they know what we're talking about here -- we have part of our business that is embedded in our corporate finance business that we originate broadly syndicated loans, and we don't put them on our balance sheet but we put them into these off-balance-sheet vehicles.

The reason we did that is, in order to help our ability to sell loans, we wanted to have a pool of capital to buy loans and we didn't want to put them on our balance sheet.

So, we started this CLO Asset Management business, which as we've said, is a fairly small part of the business.

The main reason we did it is not for the asset management fee income -- which we are getting in that business, by the way -- but more just to enhance our syndication capability.

We've done one CLO, which has already been completed, which is -- I'm not sure what the -- it moves around a little bit; it has a revolving feature to it.

But it's mid 3s, I think (multiple speakers).

Yes, it's about 370 million.

Yes, that's CLO 1, which is all done.

Then CLO 2 has been ramped up, which is of similar size.

That transaction is in warehouse and needs to be securitized.

Is CLO number to, is that something you have risk on or is that being held by somebody else?

We have a very small, low, low, low single-digit risk to it.

In terms of your committed funding then?

Yes, that's right.

It's all balance sheet and the amount of capital we have would best be described as definitely below 5%.

Then a second completely unrelated question -- with the pending acquisition of The Thrift, what plans have you made to, A, sort of insure us against any earnings losses tied to the real estate business in Florida.

Sort of B, how are you going to put these deposits to work?

We have not really had any detail on that yet.

There are obviously some restrictions in terms of what you can do and can't do.

Well, I think, in terms of insuring that the going-forward capital so our shareholders don't have loss, that involves accurately and appropriately reserving for the balance sheet.

Right?

Right.

So that, when we own the Bank, we will believe strongly that the reserves against its book of business are appropriate so that the combined companies will have adequate reserves against whatever credit losses (inaudible), all of which was factored into our underwriting, all of which was factored into our modeling, and all of which was factored into our guidance around the institution.

As I said to Bob earlier, that hasn't changed.

I think, as it relates to putting the deposits to use, we would like to do it as much as possible but again, to repeat what I said on the call and a comment that I've -- received a lot of comments about -- our orientation towards the regulator is respectable and differential, and we've got a business plan pending.

It's inappropriate to comment on how much we can use the institution until we get through that process.

John Hecht, JMP Securities.

Good morning, guys.

John, I guess I would ask if you could give a little bit more commentary on your pipeline, particularly in relation to your commentary that you're going to be a little bit more selective on assets in the second half of the year and your discussion that average asset balances might slow in terms of their growth.

What products are you focusing on now and where are you seeing the best opportunity?

You know, John, we've always been disciplined on the credit, and we saw the opportunity, I think, starting a few months ago, that we thought pricing, we might -- based on what's happening in the capital markets, it would translate into some disruption which could lead to wider spreads.

So we started pushing through wider spreads which, until our markets were completely in sync with what was going on in the world, translated into low originations, if you know what I mean.

Put another way, CapitalSource I think raised prices before anyone else.

Until the market catches up, people think -- why would they go with us because why are we raising spreads?

That translates into low origination.

I would say the market right now is rapidly raising pricing, so I think it's kind of coming our way.

But we were there early, so what does that translate into?

Us not doing as much business.

So you know, the pipeline is good.

I think our specialty businesses, in particular our healthcare business -- I made an observation on the call that I think I will reference, which is that if you look at our healthcare real estate, healthcare AR or rediscount businesses, which are (technical difficulty) specialty businesses, for example, we have $4.4 billion of loans and less than $1 million of non-accruals in that whole book, for that's a 1 million or less of non-accruals against $4.4 billion of loans.

That shows you how those specialty group businesses are performing, so obviously in an environment like this, you want to really focus on your specialty businesses if you are getting better risk-adjusted returns.

So the only comment I would make is I think, to the extent we're going to focus anywhere, it would probably be more on our specialty businesses right now.

Okay.

Then, in terms of maybe a little bit more commentary on near-term margin outlook, it looks like margins were a teeny bit down during the quarter when you exclude prepayments, and that looked like it was related to mix shift.

You're talking about the benefits of widening spreads coming through the balance sheet, and the benefits of the deposits, you know, should you attain those, to be also helpful in terms of observing widening margins.

But the intermediate term, how should we think about the way margins [go up] before those benefits really come to fruition?

Well, a couple of things -- as I already identified in the remarks, I mean, I think our yield was very strong this quarter and above our expectations.

It was lower than the first quarter but I think almost all of that can be explained by the decrease in prepayment fees, which were just really exceptionally strong in the first quarter.

But that is a number that just kind of moves around a little bit.

You know, the portfolios continue to -- I don't want to say surprise but impress us on the upside in terms of higher-than-expected yields.

We had been forecasting the yields to come down in the business and margins to compress for two reasons, right?

Number one, you know, we had been trying to move the leverage in the commercial business up into that four to five times range.

We've kind of gotten it there now.

But as you add leverage, you're adding interest expense, so that just mathematically reduces the margin.

I don't think there's any issues there.

But then secondly, and this is sort of a subtle point, again going back to the REIT election, the whole point about this was to make the estate-related businesses more competitive.

Due to the tax efficiencies and the REIT structure, we can actually charge less on a pre-tax basis and make the same or better after-tax returns.

So the incremental real estate businesses that we've been going after using this tax efficiency of the REIT is lower pre-tax spread, which kind of shows up in yield and in margin.

So you know, I would say that our expectations for margin are to decrease, which has been our expectation all along, but we've been favorably surprised really all year long due to the favorable performance out of the -- on the yield side.

Okay, I appreciate that.

Thank you very much.

Scott Valentin, FBR Capital Markets.

Thanks for taking my question.

Two questions -- one, on the comp and benefit line, it was down a little bit from the first quarter to second quarter.

I was curious if there's anything in there and maybe what we should think as a run-rate for compensation and benefits.

Then, two, you mentioned Other Income, the gain on equity investments.

I was just curious as to how any impact that wider spreads will have on the ability to realize gains off the investment portfolio.

Right.

Well, with respect to comp and benefits, I think one thing if you look at it -- our headcount has been pretty stable.

That's obviously the biggest driver of compensation expense.

That's just due to being very focused on the management and the operational side of the business and being prudent with respect to staffing and expenses there.

So, I think we are in a good place with respect to headcount growth, which will be the driver of compensation expense.

With respect to gains on the equity portfolio, I mean, we have about $190 million of investments in the balance sheet.

You can see about $140 million of that is this equity portfolio that I've talked about.

This is really the fourth quarter in a row where we've seen strong performance there.

You know, usually it has been a $5 million to $8-ish million number per quarter, this quarter exceptionally strong due to a couple of very nice gains there and also this one effectively recovery from a prior workout, which we're very pleased about.

Moshe Orenbuch, Credit Suisse.

This is actually Doug Harter for Moshe.

I just wanted to know.

John, you just said that you see spreads starting to increase.

I wanted to know your thoughts on how far along in that process we are, and sort of when you expect them to get to sort of the right risk-adjusted returns for you, and how, on the outside, can we sort of monitor were those spreads are?

It's a good question, and it's a question that I can't answer with absolute clarity because I think the market is feeling its way through.

But I would expect, on new lending opportunities that we see, that, on a blended basis, the bandwidth of wider spreads would probably be 50 to 125.

I know that's a wide bandwidth.

It varies a little bit by the business, but I think, depending upon the business and how effective it's been, it would be more on the low-end -- 50.

But for some of the businesses that are perhaps a little more affected by that kind of whipsaw of capital, it could be up to 125, even 150, which is quite a bit.

Right.

So you are seeing the wider spreads on your specialty businesses as well even though --?

Yes, yes.

Again, I think we are early.

If this was a ball game, we're in the second or third inning here.

So I mean, we started, I think pretty early, in pushing back on spreads based on -- I mean, when you start seeing things widening in the capital markets, you know it will translate into the whole market, but there's a tail.

So I think, the first sign that we saw spreads widening in the capital markets, we started trying to push out some.

I mean, it was our judgment that we would be early.

We tried to push spreads through that would translate into lower originations.

But it was also our judgment that we didn't have a choice, because we knew our borrowing costs were going to go up; we had to immediately start translating that to the asset side.

If that resulted in lower originations for a time, that's just what you have to do.

All right, thanks.

Operator, we have time for one more question please.

[Darren Pillar], Lehman Brothers.

And thanks.

Can you guys please just comment on how you are seeing credit equality in general in commercial so far this quarter, since the end of last quarter?

Also, just really quickly comment on cash flow.

Cash flow loan growth, I guess given this environment, there's been some discussion that backlog on some private equity deals will be under a little more question, and if you are seeing any sign of that.

Yes, I mean, I said earlier, Darren, that the credit pipeline remains stable, so there's probably nothing more I can say about that that (technical difficulty).

Then as it relates to --.

Hello?

Ma'am?

Sorry.

The second part of your question, Darren, was about cash flow loans, I believe.

Yes.

Yes.

Clearly, there's an enormous amount of bridge loans that are yet to be syndicated.

I don't think people even have completely accurate estimates as it relates to that number.

But it's significant, $100 billion perhaps.

Until those things clear out, there will not be equilibrium in the leverage lending market because, if you can buy -- if someone can buy a piece of a loan of a good, large, global credit at $0.93 on the dollar, and that equates to a [5.50] over spread, you're certainly not going to make loans in the new origination market at 450 over, or at least they shouldn't.

So you know, I think you have that kind of lack of equilibrium that's going on.

So, we are certainly pushing through high spreads in our leverage lending or our corporate finance business because of the reality of what's going on in the market.

But that's one of the markets where there is -- because of the overhang of these large LBO loans, there's a real lack of equilibrium in that market.

All right, that includes our call.

A reminder that a transcript of the call will be posted on the CapitalSource Web site later today.

Thanks again for joining us.

Thank you.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Have a wonderful day.