Form 10-Q

10-Q 1 d244773d10q.htm FORM 10-Q Form 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011

Commission File No. 1-31753

CapitalSource Inc.

(Exact name of registrant as specified in its charter)


Delaware		35-2206895
(State of Incorporation)		(I.R.S. Employer Identification No.)

5404 Wisconsin Avenue, 2nd Floor

Chevy Chase, MD 20815

(Address of Principal Executive Offices, Including Zip Code)

(301) 841-2700

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer þ	Accelerated filer ¨	Non-accelerated filer ¨	Smaller reporting company ¨
		(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ

As of October 27, 2011, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 274,756,774.

TABLE OF CONTENTS


		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2011 (unaudited) and December 31, 2010		3
	Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2011 and 2010		4
	Consolidated Statement of Shareholders’ Equity (unaudited) for the nine months ended September 30, 2011		5
	Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2011 and 2010		6
	Notes to the Unaudited Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		56
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		93
Item 4.	Controls and Procedures		93

PART II. OTHER INFORMATION
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		94
Item 5.	Other Information		94
Item 6.	Exhibits		94
Signatures			95
Index to Exhibits			96

CapitalSource Inc.

Consolidated Balance Sheets


	September 30, 2011			December 31, 2010
	(Unaudited)
	($ in thousands)
ASSETS
Cash and cash equivalents	$	496,844		$	820,450
Restricted cash (including $0.8 million and $46.5 million, respectively, of cash that can only be used to settle obligations of consolidated VIEs)		50,138			128,586
Investment securities:
Available-for-sale, at fair value		1,457,426			1,522,911
Held-to-maturity, at amortized cost		102,651			184,473

Total investment securities		1,560,077			1,707,384
Loans:
Loans held for sale		32,837			205,334
Loans held for investment		5,790,590			6,152,876
Less deferred loan fees and discounts		(68,421	)		(106,438	)
Less allowance for loan losses		(208,352	)		(329,122	)

Loans held for investment, net (including $614.3 million and $889.7 million, respectively, of loans that can only be used to settle obligations of consolidated VIEs)		5,513,817			5,717,316

Total loans		5,546,654			5,922,650
Interest receivable		39,266			57,393
Other investments		57,883			71,889
Goodwill		173,135			173,135
Other assets		435,425			563,920

Total assets	$	8,359,422		$	9,445,407


LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Deposits	$	4,885,831		$	4,621,273
Credit facilities		—			67,508
Term debt (including $345.9 million and $693.5 million, respectively, in obligations of consolidated VIEs for which there is no recourse to the general credit of CapitalSource Inc.)		347,744			979,254
Other borrowings		1,151,557			1,375,884
Other liabilities		268,105			347,546

Total liabilities		6,653,237			7,391,465
Shareholders’ equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)		—			—
Common stock ($0.01 par value, 1,200,000,000 shares authorized; 275,786,277 and 323,225,355 shares issued and outstanding, respectively)		2,758			3,232
Additional paid-in capital		3,612,593			3,911,341
Accumulated deficit		(1,940,991	)		(1,870,572	)
Accumulated other comprehensive income, net		31,825			9,941

Total shareholders’ equity		1,706,185			2,053,942

Total liabilities and shareholders’ equity	$	8,359,422		$	9,445,407

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Operations


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(Unaudited)
	($ in thousands, except per share data)
Net interest income:
Interest income:
Loans	$	107,161		$	138,220		$	344,308		$	443,267
Investment securities		13,635			14,608			44,675			44,818
Other		680			302			2,070			1,179

Total interest income		121,476			153,130			391,053			489,264
Interest expense:
Deposits		13,422			14,490			40,203			46,127
Borrowings		21,066			43,418			86,844			137,539

Total interest expense		34,488			57,908			127,047			183,666

Net interest income		86,988			95,222			264,006			305,598
Provision for loan losses		35,118			38,771			81,450			282,973

Net interest income after provision for loan losses		51,870			56,451			182,556			22,625
Operating expenses:
Compensation and benefits		31,047			28,565			90,524			92,171
Professional fees		5,824			8,792			23,926			27,659
Other administrative expenses		15,690			17,410			47,694			51,733

Total operating expenses		52,561			54,767			162,144			171,563
Other income (expense):
Gain on investments, net		19,141			29,943			51,381			46,279
Loss on derivatives		(2,113	)		(1,968	)		(4,262	)		(9,919	)
(Loss) gain on extinguishment of debt		(113,679	)		—			(113,679	)		1,096
Net expense of real estate owned and other foreclosed assets		(12,098	)		(7,372	)		(32,626	)		(91,039	)
Other income, net		17,448			20,147			34,946			37,252

Total other (expense) income		(91,301	)		40,750			(64,240	)		(16,331	)

Net (loss) income from continuing operations before income taxes		(91,992	)		42,434			(43,828	)		(165,269	)
Income tax (benefit) expense		(11,280	)		(35,668	)		17,131			(18,836	)

Net (loss) income from continuing operations		(80,712	)		78,102			(60,959	)		(146,433	)
Net income from discontinued operations, net of taxes		—			—			—			9,489
Net gain from sale of discontinued operations, net of taxes		—			—			—			21,696

Net (loss) income		(80,712	)		78,102			(60,959	)		(115,248	)
Net loss attributable to noncontrolling interests		—			(83	)		—			(83	)

Net (loss) income attributable to CapitalSource Inc.	$	(80,712	)	$	78,185		$	(60,959	)	$	(115,165	)

Basic (loss) income per share:
From continuing operations	$	(0.26	)	$	0.24		$	(0.19	)	$	(0.46	)
From discontinued operations	$	—		$	—		$	—		$	0.10
Attributable to CapitalSource Inc.	$	(0.26	)	$	0.24		$	(0.19	)	$	(0.36	)
Diluted (loss) income per share:
From continuing operations	$	(0.26	)	$	0.24		$	(0.19	)	$	(0.46	)
From discontinued operations	$	—		$	—		$	—		$	0.10
Attributable to CapitalSource Inc.	$	(0.26	)	$	0.24		$	(0.19	)	$	(0.36	)
Average shares outstanding:
Basic		306,535,063			321,070,479			315,719,413			320,723,068
Diluted		306,535,063			325,337,737			315,719,413			320,723,068
Dividends declared per share	$	0.01		$	0.01		$	0.03		$	0.03

See accompanying notes.

CapitalSource Inc.

Consolidated Statement of Shareholders’ Equity


	Common Stock			Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income, net		Total Shareholders’ Equity
	(Unaudited)
	($ in thousands)
Total shareholders’ equity as of December 31, 2010	$	3,232		$	3,911,341		$	(1,870,572	)	$	9,941	$	2,053,942
Net loss		—			—			(60,959	)		—		(60,959	)
Other comprehensive loss:
Unrealized gain, net of tax		—			—			—			21,884		21,884

Total comprehensive loss													(39,075	)
Dividends paid		—			70			(9,460	)		—		(9,390	)
Stock option expense		—			4,064			—			—		4,064
Exercise of options		4			1,458			—			—		1,462
Restricted stock activity		21			4,560			—			—		4,581
Repurchase of common stock		(499	)		(308,900	)		—			—		(309,399	)

Total shareholders’ equity as of September 30, 2011	$	2,758		$	3,612,593		$	(1,940,991	)	$	31,825	$	1,706,185

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Cash Flows


	Nine Months Ended September 30,
	2011			2010
	(Unaudited)
	($ in thousands)
Operating activities:
Net loss	$	(60,959	)	$	(115,248	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Stock option expense		4,064			3,504
Restricted stock expense		5,972			7,851
Loss (gain) on extinguishment of debt		113,679			(1,096	)
Amortization of deferred loan fees and discounts		(53,972	)		(55,295	)
Paid-in-kind interest on loans		27,925			2,092
Provision for loan losses		81,450			282,973
Provision for unfunded commitments		—			(442	)
Amortization of deferred financing fees and discounts		18,029			43,890
Depreciation and amortization		1,901			1,582
Provision for deferred income taxes		44,762			14,091
Non-cash gain on investments, net		(62,617	)		(7,045	)
Gain on assets acquired through business combination		—			(3,724	)
Gain on deconsolidation of 2006-A Trust		—			(16,723	)
Non-cash loss on foreclosed assets and other property and equipment disposals		26,448			57,194
Unrealized loss (gain) on derivatives and foreign currencies, net		5,950			(2,079	)
Accretion of discount on commercial real estate “A” participation interest		—			(9,523	)
Decrease in interest receivable		18,127			26,698
Decrease in loans held for sale, net		190,947			4,750
Decrease in other assets		63,482			18,522
Decrease in other liabilities		(96,492	)		(28,410	)

Cash provided by operating activities		328,696			223,562
Investing activities:
Decrease in restricted cash		78,448			60,688
Decrease in commercial real estate “A” participation interest, net		—			534,674
Assets acquired through business combination, net of cash acquired		—			(98,800	)
Cash received from 2006-A Trust delegation and sale transaction		—			7,000
Decrease in loans, net		125,335			1,210,818
Cash received for real estate		—			339,643
Reduction (acquisition) of marketable securities, available for sale, net		119,013			(561,613	)
Reduction of marketable securities, held to maturity, net		90,556			47,208
Reduction of other investments, net		42,699			26,310
Acquisition of property and equipment, net		(47,920	)		(3,089	)

Cash provided by investing activities		408,131			1,562,839
Financing activities:
Payment of deferred financing fees		—			(5,913	)
Deposits accepted, net of repayments		264,558			143,632
Repayments on credit facilities, net		(68,792	)		(453,906	)
Borrowings of term debt		—			14,784
Repayments and extinguishment of term debt		(724,080	)		(1,821,431	)
Repayments of other borrowings		(232,767	)		(198,175	)
Repurchase of common stock		(291,424	)		—
Proceeds from exercise of options		1,462			356
Payment of dividends		(9,390	)		(9,718	)

Cash used in financing activities		(1,060,433	)		(2,330,371	)

Decrease in cash and cash equivalents		(323,606	)		(543,970	)
Cash and cash equivalents as of beginning of period		820,450			1,177,020

Cash and cash equivalents as of end of period	$	496,844		$	633,050


Supplemental information:
Noncash transactions from investing and financing activities:
Third-party assumption of debt	$	—		$	203,679
Assets acquired through foreclosure		12,454			83,978

See accompanying notes.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank. We are a commercial lender that, primarily through our wholly owned subsidiary, CapitalSource Bank, provides financial products to small and middle market businesses nationwide and provides depository products and services in southern and central California.

For the three and nine months ended September 30, 2011 and the three months ended September 30, 2010, we operated as two reportable segments: 1) CapitalSource Bank and 2) Other Commercial Finance. For the six months ended June 30, 2010, we operated as three reportable segments: 1) CapitalSource Bank, 2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. Our Healthcare Net Lease segment comprised our direct real estate investment business activities, which we exited completely with the sale of all of the assets related to this segment during 2010, and consequently, we have presented the financial condition and results of operations within our Healthcare Net Lease segment as discontinued operations for all periods presented. We have reclassified all comparative period results to reflect our two current reportable segments. For additional information, see Note 19, Segment Data.

Note 2. Summary of Significant Accounting Policies

Interim Consolidated Financial Statements Basis of Presentation

Our interim consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments and eliminations, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The current period’s results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the Securities and Exchange Commission on February 28, 2011 (“Form 10-K”).

The accompanying financial statements reflect our consolidated accounts and those of other entities in which we have a controlling financial interest including our majority-owned subsidiaries and variable interest entities (“VIEs”) for which we determined that we are the primary beneficiary. All significant intercompany accounts and transactions have been eliminated.

Reclassifications

Certain amounts in prior period consolidated financial statements have been reclassified to conform to the current period presentation, including the reclassification of fee income to interest income or other income, net and the reclassification of letter of credit fee expense from interest expense to other income, net in our audited consolidated statements of operations. Accordingly, the reclassifications have been appropriately reflected throughout our consolidated financial statements.

Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements as of December 31, 2010, included in our Form 10-K.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

New Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (“FASB”) amended its guidance on fair value measurements and disclosure, which was intended to improve transparency in financial reporting by requiring enhanced disclosures related to fair value measurements. These new disclosures provided for disclosure of transfers between Level 1 and Level 2 of the fair value hierarchy, of fair value measurements for each class of assets and liabilities presented, of separate information for acquisitions, sales, issuances, and settlements in the rollforward of activity of Level 3 fair value measurements, and of valuation techniques used in recurring and nonrecurring fair value measurements for both Level 2 and Level 3 measurements. We adopted this guidance on January 1, 2010, except for the guidance related to acquisitions, sales, issuances, and settlements in the rollforward of activity of Level 3 fair value measurements, which is effective for annual reporting periods ending after December 15, 2010, and for interim periods within those annual reporting periods. We adopted the guidance related to the rollforward of activity of Level 3 fair value measurements on January 1, 2011, and it did not have a material impact on our consolidated financial statements.

In July 2010, the FASB amended its guidance on financing receivables to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment and class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. This guidance was implemented over three effective dates. Disclosure requirements related to the end of a period, other than those surrounding troubled debt restructurings (“TDRs”), were adopted on October 1, 2010 and included as part of our 2010 annual report on Form 10-K. Subsequently, disclosure requirements related to activity during a period, other than those surrounding TDRs, were adopted on January 1, 2011. Finally, disclosure requirements for TDRs were adopted on July 1, 2011. The adoption of this guidance only impacted our disclosures and did not impact our financial position or the results of our operations. For further information, see Note 5, Loans and Credit Quality.

In April 2011, the FASB amended its guidance on loans to clarify which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a financing receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring includes a concession that the lender would not have otherwise granted if those conditions did not exist; and (b) the debtor is experiencing financial difficulties. This guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. We adopted this guidance on July 1, 2011, and it did not have a material impact on our consolidated financial statements. For further information, see Note 5, Loans and Credit Quality.

In May 2011, the FASB amended its guidance on fair value measurements to achieve common disclosure requirements for GAAP and International Financial Accounting Standards (“IFRS”). The amendments clarify existing GAAP requirements for fair value measurements and eliminate wording differences between current GAAP and IFRS guidelines. This guidance is effective for interim and annual periods beginning after December 15, 2011. We plan to adopt this guidance as of January 1, 2012, and we anticipate that the adoption will not have a material impact on our consolidated financial statements.

In June 2011, the FASB amended its guidance on the presentation of comprehensive income. This guidance eliminates the option to report other comprehensive income and its components in the consolidated statement of shareholders’ equity. An entity may elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements. Each component of net income and of other comprehensive income needs to be displayed under either alternative. This guidance is effective for interim and annual periods beginning after December 15, 2011. We plan to adopt this guidance as of January 1, 2012, and we anticipate that the adoption will not have a material impact on our consolidated financial statements.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

In September 2011, the FASB amended its guidance on testing goodwill for impairment. The revised guidance provides entities with the option to perform a qualitative assessment before calculating the fair value of a reporting unit. If qualitative factors indicate that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, then the two-step method of testing goodwill for impairment would be required. Otherwise, no additional impairment testing would be necessary. The amendment is effective for annual and interim goodwill tests performed for fiscal years beginning after December 31, 2011. Early adoption is permitted. We anticipate that the adoption of this guidance will not have a material impact on our consolidated financial statements.

Note 3. Discontinued Operations

In 2010, we completed the sale of our long-term healthcare facilities, and as a result, we exited the skilled nursing home ownership business. Consequently, we have presented the results of operations for this business as discontinued operations for all periods presented. Additionally, the results of the discontinued operations include the activities of other healthcare facilities that have been sold since the inception of the business.

The condensed statements of operations for the three and nine months ended September 30, 2011 and 2010 for our discontinued operations were as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2011		2010		2011		2010
	($ in thousands)
Revenue:
Operating lease income	$	—	$	—	$	—	$	28,750
Expenses:
Interest		—		—		—		15,183
Depreciation		—		—		—		2,540
General and administrative		—		—		—		1,481
Other expense		—		—		—		57

Total expenses		—		—		—		19,261
Gain from sale of discontinued operations		—		—		—		21,696

Net income attributable to discontinued operations	$	—	$	—	$	—	$	31,185

Note 4. Cash and Cash Equivalents and Restricted Cash

As of September 30, 2011 and December 31, 2010, our cash and cash equivalents and restricted cash balances were as follows:


	September 30, 2011				December 31, 2010
	Unrestricted		Restricted(1)		Unrestricted		Restricted(1)
	($ in thousands)
Cash and cash equivalents and restricted cash:
Cash and due from banks	$	208,038	$	49,385	$	576,276	$	58,814
Interest-bearing deposits in other banks(2)		63,912		—		70,383		10,213
Other short-term investments(3)		224,894		753		173,791		59,559

Total cash and cash equivalents and restricted cash	$	496,844	$	50,138	$	820,450	$	128,586

(1)	Restricted cash includes principal and interest collections received from loans held in securitization trusts and cash that has been pledged as collateral supporting letters of credit.

(2)	Included in these balances for CapitalSource Bank were $58.0 million and $63.6 million in deposits at the Federal Reserve Bank (“FRB”) as of September 30, 2011 and December 31, 2010, respectively.

(3)

Cash is invested in short term investment grade commercial paper which is rated by at least two of the three major rating agencies (S&P, Moody’s or Fitch) and has a rating of A1 (S&P) P1 (Moody’s) or F1 (Fitch) and in a short-term money market fund which has a rating of AAAm (S&P) and Aaa (Moody’s).

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 5. Loans and Credit Quality

As of September 30, 2011 and December 31, 2010, our outstanding loan balance was $5.8 billion and $6.4 billion, respectively. Included in these amounts were loans held for sale and loans held for investment. As of September 30, 2011 and December 31, 2010, interest and fee receivables totaled $34.9 million and $52.7 million, respectively.

Loans Held for Sale

We determine when to sell a loan on a loan-by-loan basis and consider several factors, including the credit quality of the loan, any financing secured by the loan and any requirements related to the release of liens and use of sales proceeds, the potential sale price relative to our loan valuation, our liquidity needs, and the resources necessary to ensure an adequate recovery if we continued to hold the loan. When our analysis indicates that the proper strategy is to sell a loan, we initiate the sale process and designate the loan as held for sale.

During the three and nine months ended September 30, 2011, we transferred to held for sale, from held for investment, loans with a carrying value of $38.7 million and $204.4 million, respectively, which included $4.5 million and $170.2 million of impaired loans, respectively. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We incurred $1.4 million of losses due to valuation adjustments at the time of transfer during the nine months ended September 30, 2011. We did not incur any such losses during the three months ended September 30, 2011. We also reclassified $28.6 million of loans from held for sale to held for investment during the nine months ended September 30, 2011, based on our intent to retain these loans for investment. We did not make any such reclassifications during the three months ended September 30, 2011.

During the three and nine months ended September 30, 2010, we transferred to held for sale, from held for investment, loans with a carrying value of $40.1 million and $132.9 million, which included $37.2 million and $92.3 million of impaired loans, respectively. We incurred $1.2 million and $8.7 million, respectively, of losses due to valuation adjustments at the time of transfer for the three and nine months ended September 30, 2010. We also reclassified $49.5 million of loans from held for sale to held for investment during the three and nine months ended September 30, 2010, based upon our intent to retain these loans for investment.

During the three and nine months ended September 30, 2011, we recognized net pre-tax gains of $10.0 million and $14.4 million, respectively, related to sales of loans. During the three and nine months ended September 30, 2010, we recognized a net pre-tax gain of $2.8 million and a net pre-tax loss of $4.7 million, respectively, related to sales of loans.

As of September 30, 2011 and December 31, 2010, loans held for sale with an outstanding balance of $3.1 million and $14.7 million, respectively, were classified as non-accrual loans. We did not record any fair value write-downs on non-accrual loans held for sale during the three and nine months ended September 30, 2011. We recorded $5.6 million in fair value write-downs on non-accrual loans held for sale during the three and nine months ended September 30, 2010.

Loans Held for Investment

Loans held for investment are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts received or premiums paid on purchased loans. We maintain an allowance for loan and lease losses for loans held for investment, which is calculated based on management’s estimate of incurred loan losses inherent in our loan portfolio as of the balance sheet date. This methodology is used consistently to develop our allowance for loan losses for all loans in our loan portfolio, and, as such, we maintain a single portfolio segment. The loans in our portfolio are grouped into seven loan classes, based on the level that we use to assess and monitor the risk and performance of the portfolio, including the nature of the borrower, collateral and lending arrangement.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Non-performing loans are loans which are accounted for on a non-accrual basis, accruing loans which are contractually past due 90 days or more as to principal or interest payments and other loans which have been identified as TDRs as defined by GAAP.

As of September 30, 2011 and December 31, 2010, the carrying value of each class of loans held for investment, separated by performing and non-performing categories, was as follows:


	September 30, 2011						December 31, 2010
Class	Performing		Non-Performing		Total		Performing		Non-Performing		Total
	($ in thousands)
Asset-based	$	1,088,714	$	90,004	$	1,178,718	$	1,352,039	$	194,625	$	1,546,664
Cash flow		1,788,555		167,095		1,955,650		1,558,783		264,786		1,823,569
Healthcare asset-based		261,826		919		262,745		269,339		2,925		272,264
Healthcare real estate		546,117		27,005		573,122		841,774		28,866		870,640
Multi-family		780,777		2,753		783,530		328,300		11,010		339,310
Real estate		642,901		179,300		822,201		725,972		356,087		1,082,059
Small business		134,811		11,392		146,203		101,761		10,171		111,932

Total(1)	$	5,243,701	$	478,468	$	5,722,169	$	5,177,968	$	868,470	$	6,046,438

(1)	Excludes loans held for sale. Balances are net of deferred loan fees and discounts.

During the three and nine months ended September 30, 2011, we purchased loans held for investment with an unpaid principal balance of $87.3 million and $434.6 million, respectively.

As of September 30, 2011 and December 31, 2010, CapitalSource Bank pledged loans held for investment with an unpaid principal balance of $388.4 million and $166.1 million, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

Credit risk within our loan portfolio is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral.

We use a variety of tools to continuously monitor a client’s ability to perform under its obligations. Additionally, we syndicate loan exposure to other lenders, sell loans and use other risk mitigation techniques to manage the size and risk profile of our loan portfolio.

Credit risk management for the loan portfolio begins with an assessment of the credit risk profile of a client generally based on an analysis of the client’s payment performance, cash flow and financial position. As part of the overall credit risk assessment of a client, each credit exposure is assigned an internal risk rating that is subject to approval based on defined credit approval standards. While rating criteria vary by product, each loan rating focuses on the same two factors: financial performance and collateral. Subsequent to loan origination, risk ratings are monitored on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the client’s financial condition, cash flow or financial position. We use risk rating aggregations to measure and evaluate concentrations within the loan portfolio. In making decisions regarding credit, we consider risk rating, collateral and industry concentration limits.

We believe that the likelihood of not being paid according to the contractual terms of a loan is, in large part, dependent upon the assessed level of risk associated with the loan. The internal rating that is assigned to a loan provides a view as to the relative risk of each loan. We employ an internal risk rating scale to establish a view of the credit quality of each loan. This scale is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:

•

Pass — Loans with standard, acceptable levels of credit risk;

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

•

Special mention — Loans that have potential weaknesses that deserve close attention, and which, if left uncorrected, may result in a loss or deterioration of our credit position;

•

Substandard — Loans that are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected; and

•

Doubtful — Loans that have all the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses make collection or liquidation in full improbable based on currently existing facts, conditions, and values.

As of September 30, 2011 and December 31, 2010, the carrying value of each class of loans held for investment, by internal risk rating, was as follows:


	Internal Risk Rating
Class	Pass		Special Mention		Substandard		Doubtful		Total
	($ in thousands)

As of September 30, 2011:
Asset-based	$	887,776	$	134,024	$	103,789	$	53,129	$	1,178,718
Cash flow		1,509,696		44,798		370,017		31,139		1,955,650
Healthcare asset-based		200,452		47,371		14,922		—		262,745
Healthcare real estate		489,439		51,180		31,553		950		573,122
Multi-family		774,825		5,643		309		2,753		783,530
Real estate		450,944		36,581		296,222		38,454		822,201
Small business		129,900		4,812		2,156		9,335		146,203

Total(1)	$	4,443,032	$	324,409	$	818,968	$	135,760	$	5,722,169

As of December 31, 2010:
Asset-based	$	1,207,990	$	39,612	$	169,986	$	129,076	$	1,546,664
Cash flow		1,110,779		216,399		350,287		146,104		1,823,569
Healthcare asset-based		245,486		9,243		15,509		2,026		272,264
Healthcare real estate		773,955		37,730		47,090		11,865		870,640
Multi-family		330,017		—		8,919		374		339,310
Real estate		396,044		98,401		470,034		117,580		1,082,059
Small business		97,444		6,278		5,514		2,696		111,932

Total(1)	$	4,161,715	$	407,663	$	1,067,339	$	409,721	$	6,046,438

(1)	Excludes loans held for sale. Balances are net of deferred loan fees and discounts.

Non-Accrual and Past Due Loans

We will place a loan on non-accrual status if there is substantial doubt about the borrower’s ability to service its debt and other obligations or if the loan is 90 or more days past due and is not well-secured and in the process of collection. When a loan is placed on non-accrual status, accrued and unpaid interest is reversed and the recognition of interest and fee income on that loan will stop until factors no longer indicate collection is doubtful and the loan has been brought current. Payments received on non-accrual loans are generally first applied to principal. A loan may be returned to accrual status when its interest or principal is current, repayment of the remaining contractual principal and interest is expected or when the loan otherwise becomes well-secured and is in the process of collection. Cash payments received from the borrower and applied to the principal balance of the loan while the loan was on non-accrual status are not reversed if a loan is returned to accrual status.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2011 and December 31, 2010, the carrying value of non-accrual loans was as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Asset-based	$	52,144	$	142,847
Cash flow		85,214		183,606
Healthcare asset-based		708		2,925
Healthcare real estate		27,005		28,866
Multi-family		2,753		11,010
Real estate		136,536		265,615
Small business		6,643		4,980

Total(1)	$	311,003	$	639,849

(1)	Excludes loans held for sale and purchased credit impaired loans. Balances are net of deferred loan fees and discounts.

As of September 30, 2011 and December 31, 2010, the delinquency status of loans in our loan portfolio was as follows:


	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Greater than 90 Days Past Due and Accruing
	($ in thousands)
As of September 30, 2011:
Asset-based	$	7,238	$	8,053	$	15,291	$	1,157,228	$	1,172,519	$	1,213
Cash flow		—		13,812		13,812		1,941,838		1,955,650		—
Healthcare asset-based		—		—		—		262,746		262,746		—
Healthcare real estate		—		21,111		21,111		552,011		573,122		—
Multi-family		—		188		188		783,342		783,530		—
Real estate		7,834		79,353		87,187		733,951		821,138		—
Small business		588		5,282		5,870		135,584		141,454		—

Total(1)	$	15,660	$	127,799	$	143,459	$	5,566,700	$	5,710,159	$	1,213


As of December 31, 2010:
Asset-based	$	8,074	$	27,130	$	35,204	$	1,500,537	$	1,535,741	$	3,244
Cash flow		10,573		60,644		71,217		1,752,352		1,823,569		—
Healthcare asset-based		—		—		—		272,264		272,264		—
Healthcare real estate		—		25,887		25,887		840,527		866,414		—
Multi-family		2,324		9,293		11,617		327,692		339,309		—
Real estate		54		148,197		148,251		924,590		1,072,841		45,783
Small business		4,317		4,981		9,298		97,444		106,742		—

Total(1)	$	25,342	$	276,132	$	301,474	$	5,715,406	$	6,016,880	$	49,027

(1)	Excludes loans held for sale and purchased credit impaired loans. Balances are net of deferred loan fees and discounts.

Impaired Loans

We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the original loan agreement. In this regard, impaired loans include loans for which we expect to encounter a significant delay in the collection of and/or a shortfall in the amount of contractual payments due to us.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Assessing the likelihood that a loan will not be paid according to its contractual terms involves the consideration of all relevant facts and circumstances and requires a significant amount of judgment. For such purposes, factors that are considered include:

•

the current performance of the borrower;

•

the current economic environment and financial capacity of the borrower to preclude a default;

•

the willingness of the borrower to provide the support necessary to preclude a default (including the potential for successful resolution of a potential problem through modification of terms); and

•

the borrower’s equity position in, and the value of, the underlying collateral, if applicable, based on our best estimate of the fair value of the collateral.

In assessing the adequacy of available evidence, we consider whether the receipt of payments is dependent on the fiscal health of the borrower or the sale, refinancing or foreclosure of the loan.

We continue to recognize interest income on loans that have been identified as impaired but that have not been placed on non-accrual status.

As of September 30, 2011 and December 31, 2010, information pertaining to our impaired loans was as follows:


	September 30, 2011							December 31, 2010
	Carrying Value(1)		Legal Principal Balance(2)		Related Allowance			Carrying Value(1)		Legal Principal Balance(2)		Related Allowance
	($ in thousands)
With no related allowance recorded:
Asset-based	$	56,471	$	70,631	$	—		$	96,514	$	180,659	$	—
Cash flow		94,168		137,861		—			128,658		205,454		—
Healthcare asset-based		3,213		14,135		—			463		825		—
Healthcare real estate		27,005		33,866		—			18,881		19,892		—
Multi-family		2,753		3,779		—			11,010		15,402		—
Real estate		123,578		197,844		—			323,292		407,423		—
Small business		10,318		15,511		—			9,861		17,708		—

Total		317,506		473,627		—			588,679		847,363		—
With allowance recorded:
Asset-based		33,533		43,931		(4,459	)		98,762		112,732		(21,684	)
Cash flow		82,181		107,720		(20,493	)		142,171		191,172		(33,069	)
Healthcare asset-based		—		—		—			2,462		11,614		(675	)
Healthcare real estate		—		—		—			9,984		11,278		(2,323	)
Real estate		20,260		45,665		(4,129	)		69,128		92,833		(21,076	)
Small business		1,072		1,135		(349	)		310		359		(141	)

Total		137,046		198,451		(29,430	)		322,817		419,988		(78,968	)

Total impaired loans	$	454,552	$	672,078	$	(29,430	)	$	911,496	$	1,267,351	$	(78,968	)

(1)	Carrying value of impaired loans before applying specific reserves. Excludes loans held for sale. Balances are net of deferred loan fees and discounts.

(2)	Represents the contractual amounts owed to us by borrowers.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Average balances and interest income recognized on impaired loans by loan class for the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2011				2010				2011				2010
	Average Balance		Interest Income Recognized(1)		Average Balance		Interest Income Recognized(1)		Average Balance		Interest Income Recognized(1)		Average Balance		Interest Income Recognized(1)
	($ in thousands)
No allowance recorded:
Asset-based	$	64,154	$	672	$	154,945	$	1,068	$	71,759	$	2,064	$	151,457	$	4,464
Cash flow		111,406		2,247		150,079		1,113		117,493		5,968		199,346		5,125
Healthcare asset-based		1,380		—		1,342		—		1,166		101		1,945		131
Healthcare real estate		27,194		—		19,642		11		22,550		165		20,415		11
Multi-family		2,510		—		5,275		—		7,012		—		2,275		—
Real estate		102,895		183		189,155		2,098		204,302		3,104		156,320		4,450
Small business		8,998		—		1,424		—		9,673		—		570		—

Total		318,537		3,102		521,862		4,290		433,955		11,402		532,328		14,181
With allowance recorded:
Asset-based		39,038		—		62,561		—		54,564		—		55,272		—
Cash flow		77,553		824		123,966		606		119,464		2,487		106,064		1,151
Healthcare asset-based		363		—		4,119		—		1,023		—		5,032		—
Healthcare real estate		—		—		7,681		—		6,507		—		8,952		180
Multi-family		154		—		2,424		—		538		—		13,624		—
Real estate		22,261		—		340,466		—		38,753		—		468,648		201
Small business		1,521		—		1,636		—		739		—		654		—

Total		140,890		824		542,853		606		221,588		2,487		658,246		1,532

Total impaired loans	$	459,427	$	3,926	$	1,064,715	$	4,896	$	655,543	$	13,889	$	1,190,574	$	15,713

(1)

We recognized $0.1 million of cash basis interest income on impaired loans during the nine months ended September 30, 2011, and $0.1 million and $0.4 million during the three and nine months ended September 30, 2010. We did not recognize any cash basis interest income on impaired loans during the three months ended September 30, 2011.

As of September 30, 2011 and December 31, 2010, the carrying value of impaired loans with no related allowance recorded was $317.5 million and $588.7 million, respectively. Of these amounts, $117.8 million and $222.4 million, respectively, related to loans that were charged off to their carrying values. These charge offs were primarily the result of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $199.7 million and $366.3 million related to loans that had no recorded charge offs or specific reserves as of September 30, 2011 and December 31, 2010, respectively, based on our estimate that we ultimately will collect all principal and interest amounts due.

If our non-accrual loans had performed in accordance with their original terms, interest income would have been increased by $21.3 million and $83.0 million for the three and nine months ended September 30, 2011, respectively, and $32.1 million and $111.5 million for the three and nine months ended September 30, 2010, respectively.

Allowance for Loan Losses

Our allowance for loan losses represents management’s estimate of incurred loan losses inherent in our loan and lease portfolio as of the balance sheet date. The estimation of the allowance for loan losses is based on a variety of factors, including past loan loss experience, the current credit profile and financial position of our borrowers, adverse situations that have occurred that may affect the borrowers’ ability to repay, the estimated

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

value of underlying collateral and general economic conditions. Provisions for loan losses are recognized when available information indicates that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated.

We perform quarterly and systematic detailed reviews of our loan portfolio to identify credit risks and to assess the overall collectability of the portfolio. The allowance on certain pools of loans with similar characteristics is estimated using reserve factors that are reflective of historical loss rates.

Our portfolio is reviewed regularly, and, on a periodic basis, individual loans are reviewed and assigned a risk rating. Loans subject to individual reviews are analyzed and segregated by risk according to our internal risk rating scale. These risk ratings, in conjunction with an analysis of historical loss experience, current economic conditions, industry performance trends, and any other pertinent information, including individual valuations on impaired loans, are factored in the estimation of the allowance for loan losses. The historical loss experience is updated quarterly to incorporate the most recent data reflective of the current economic environment.

If the recorded investment in an impaired loan exceeds the present value of payments expected to be received, the fair value of the collateral and/or the loan’s observable market price, a specific allowance is established as a component of the allowance for loan losses.

When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan losses. To the extent we later collect from the original borrower amounts previously charged off, we will recognize a recovery through the allowance for loan losses for the amount received.

We also consider whether losses may have been incurred in connection with unfunded commitments to lend. In making this assessment, we exclude from consideration those commitments for which funding is subject to our approval based on the adequacy of underlying collateral that is required to be presented by a borrower or other terms and conditions. Reserves for losses related to unfunded commitments are included within other liabilities on our consolidated balance sheets.

Activity in the allowance for loan losses related to our loans held for investment for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Balance as of beginning of period	$	199,138		$	578,633		$	329,122		$	586,696
Charge offs		(27,314	)		(59,861	)		(207,244	)		(296,663	)
Recoveries		1,478			275			17,454			578

Net charge offs		(25,836	)		(59,586	)		(189,790	)		(296,085	)
Charge offs upon transfer to held for sale		(68	)		(26,042	)		(12,430	)		(41,808	)
Deconsolidation of 2006-A Trust		—			(138,134	)		—			(138,134	)
Provision for loan losses		35,118			38,771			81,450			282,973

Balance as of end of period	$	208,352		$	393,642		$	208,352		$	393,642

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2011 and December 31, 2010, the balances of the allowance for loan losses and the carrying value of loans held for investment disaggregated by impairment methodology were as follows:


	September 30, 2011					December 31, 2010
	Loans		Allowance for Loan Losses			Loans		Allowance for Loan Losses
	($ in thousands)
Individually evaluated for impairment	$	449,745	$	(29,430	)	$	904,466	$	(78,019	)
Collectively evaluated for impairment		5,328,835		(178,922	)		5,217,393		(249,912	)
Acquired loans with deteriorated credit quality		12,010		—			31,017		(1,191	)

Total	$	5,790,590	$	(208,352	)	$	6,152,876	$	(329,122	)

Troubled Debt Restructurings

During the three and nine months ended September 30, 2011, loans with an aggregate carrying value, which includes principal, deferred fees and accrued interest, of $47.1 million and $270.6 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and nine months ended September 30, 2010, loans with an aggregate carrying value of $278.4 million and $840.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. Loans involved in TDRs are assessed as impaired, generally for a period of at least one year following the restructuring. A loan that has been involved in a TDR might no longer be assessed as impaired one year subsequent to the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. As of September 30, 2011, two loans with an aggregate carrying value of $35.6 million that had been previously restructured in a TDR were not classified as impaired as they performed in accordance with the restructured terms for twelve consecutive months. As of December 31, 2010, all of our loans restructured in TDRs were classified as impaired loans.

The aggregate carrying values of loans that had been restructured in TDRs as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Non-accrual	$	170,647	$	400,851
Accruing		155,120		154,262

Total	$	325,767	$	555,113

We recorded charge offs related to these restructured loans of $4.7 million and $30.8 million for the three months ended September 30, 2011 and 2010, respectively, and $139.1 million and $125.5 million for the nine months ended September 30, 2011 and 2010, respectively. The specific reserves related to these loans were $21.9 million and $35.5 million as of September 30, 2011 and December 31, 2010, respectively. We had unfunded commitments related to these restructured loans of $79.6 million and $118.8 million as of September 30, 2011 and December 31, 2010, respectively.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2011, the number and aggregate carrying values of loans involved in TDRs that occurred during the three and nine months ended September 30, 2011 were as follows:


	Three Months Ended September 30, 2011						Nine Months Ended September 30, 2011
	Number of Loans		Carrying Value Prior to TDR		Carrying Value Subsequent to TDR		Number of Loans		Carrying Value Prior to TDR		Carrying Value Subsequent to TDR
	($ in thousands)						($ in thousands)
Asset-based
Maturity extension		1	$	8,129	$	8,129		3	$	16,305	$	16,305
Payment deferral		—		—		—		1		676		676
Multiple concessions		—		—		—		2		30,029		30,029
Discounted payoffs		—		—		—		2		4,288		—
Foreclosures		1		7,330		—		1		7,330		—

		2		15,459		8,129		9		58,628		47,010
Cash flow
Maturity extension		—		—		—		1		35		35
Payment deferral		1		8,726		8,726		5		54,793		54,793
Multiple concessions		3		6,165		6,165		4		14,658		14,658
Discounted payoffs		4		15,285		—		4		15,285		—
Foreclosures		—		—		—		2		8,798		—

		8		30,176		14,891		16		93,569		69,486
Healthcare asset-based
Maturity extension		—		—		—		1		607		607

		—		—		—		1		607		607
Healthcare real estate
Maturity extension		—		—		—		1		2,978		2,978

		—		—		—		1		2,978		2,978
Multi-family
Interest rate and fee reduction		—		—		—		1		278		278
Multiple concessions		—		—		—		1		1,717		1,717

		—		—		—		2		1,995		1,995
Real estate
Maturity extension		—		—		—		2		6,239		6,239
Multiple concessions		—		—		—		1		76,613		76,613
Discounted payoffs		—		—		—		1		14,097		—
Foreclosures		—		—		—		3		8,298		—

		—		—		—		7		105,247		82,852
Small business
Foreclosures		1		1,197		—		3		1,903		—

		1		1,197		—		3		1,903		—

Total (1)		11	$	46,832	$	23,020		39	$	264,927	$	204,928

(1)	Excludes loans held for sale and purchased credit impaired loans.

The types of concessions that are assessed to determine if modifications to our loans should be classified as TDRs include, but are not limited to, maturity extensions, payment deferrals, interest rate and/or fee reductions, forgiveness of loan principal, interest, and/or fees, or multiple concessions comprised of a combination of some or all of these items. We also classify discounted loan payoffs and loan foreclosures as TDRs.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2011, the number and aggregate carrying values of loans that experienced defaults after the initial restructuring during the three and nine months ended September 30, 2011 were as follows:


	Three Months Ended September 30, 2011				Nine Months Ended September 30, 2011
	Number of Loans		Carrying Value		Number of Loans		Carrying Value
	($ in thousands)				($ in thousands)
Asset-based		—	$	—		2	$	31,326
Multi-family		—		—		1		188
Real estate		1		19,151		2		20,260

Total(1)(2)		1	$	19,151		5	$	51,774

(1)	Excludes loans held for sale and purchased credit impaired loans.

(2)	Includes only TDRs that have occurred within the previous 12 months and for which there was a payment default during the period. TDRs that occurred prior to January 1, 2011 were assessed under the superseded accounting standards.

Loans involved in TDRs are deemed to be impaired. Such impaired loans, including those that subsequently experienced defaults during the periods presented, are individually evaluated in accordance with our allowance for loan losses methodology under the same guidelines as non-TDR loans that are classified as impaired.

For a loan that accrues interest immediately after that loan is restructured in a TDR, we generally do not charge off a portion of the loan as part of the restructuring. If a portion of a loan has been charged off, we will not accrue interest on the remaining portion of the loan if the charged off portion is still contractually due from the borrower. However, if the charged off portion of the loan is legally forgiven through concessions to the borrower, then the restructured loan may be placed on accrual status if the remaining contractual amounts due on the loan are reasonably assured of collection. In addition, for certain TDRs, especially those involving a commercial real estate loan, we may split the loan into an A note and a B note, placing the performing A note on accrual status and charging off the B note. For an amortizing loan with monthly payments, the borrower is required to demonstrate sustained payment performance for a minimum of six months to return a non-accrual restructured loan to accrual status.

Our evaluation of whether collection of interest and principal is reasonably assured is based on the facts and circumstances of each individual borrower and our assessment of the borrower’s ability and intent to repay in accordance with the revised loan terms. We generally consider such factors as historical operating performance and payment history of the borrower, indications of support by sponsors and other interest holders, the terms of the modified loan, the value of any collateral securing the loan and projections of future performance of the borrower as part of this evaluation.

Foreclosed Assets

Real Estate Owned (“REO”)

When we foreclose on a real estate asset that collateralizes a loan, we record the asset at its estimated fair value less costs to sell at the time of foreclosure if the related REO is classified as held for sale. Upon foreclosure, we evaluate the asset’s fair value as compared to the loan’s carrying amount and record a charge off when the carrying amount of the loan exceeds fair value less costs to sell. For REO determined to be held for sale, subsequent valuation adjustments are recorded as a valuation allowance, which is recorded as a component of net expense of real estate owned and other foreclosed assets in our consolidated statements of operations. REO that does not meet the criteria of held for sale is classified as held for use and initially recorded at its fair value. Except for land, the real estate asset is subsequently depreciated over its estimated useful life. Fair value adjustments on REO held for use are recorded only if the carrying amount of an asset is not recoverable and exceeds its fair value.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2011 and December 31, 2010, we had $28.6 million and $92.3 million, respectively, of REO classified as held for sale, which was recorded in other assets in our consolidated balance sheets. Activity related to REO held for sale for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Balance as of beginning of period	$	47,012		$	138,950		$	92,265		$	101,401
Acquired in business combination		—			—			—			2,014
Transfers from loans held for investment and other assets		1,543			11,085			15,132			89,416
Fair value adjustments		(6,725	)		(2,670	)		(19,849	)		(29,904	)
Transfers from REO held for use		—			—			—			2,850
Real estate sold		(13,266	)		(67,849	)		(58,984	)		(86,261	)

Balance as of end of period	$	28,564		$	79,516		$	28,564		$	79,516

During the three and nine months ended September 30, 2011, we recognized losses of $3.0 million and $1.6 million, respectively, on the sales of REO held for sale as a component of net expense of real estate owned and other foreclosed assets in our consolidated statements of operations. During the three and nine months ended September 30, 2010, we recognized gains of $3.9 million and $2.5 million, respectively, on the sales of REO held for sale as a component of net expense of real estate owned and other foreclosed assets in our consolidated statements of operations.

As of September 30, 2011 and December 31, 2010, we had $1.4 million of REO classified as held for use, which was recorded in other assets in our consolidated balance sheets. We did not recognize any impairment losses on REO classified as held for use during the three and nine months ended September 30, 2011. During the three and nine months ended September 30, 2010, we recognized impairment losses of $2.7 million and $12.9 million, respectively, on REO held for use as a component of net expense of real estate owned and other foreclosed assets in our consolidated statements of operations.

Other Foreclosed Assets

When we foreclose on a borrower whose underlying collateral consists of loans, we record the acquired loans at the estimated fair value less costs to sell at the time of foreclosure. At the time of foreclosure, we record charge offs when the carrying amount of the original loan exceeds the estimated fair value of the acquired loans. We may also write down or record allowances on the acquired loans subsequent to foreclosure if such loans experience additional credit deterioration. As of September 30, 2011 and December 31, 2010, we had $17.7 million and $55.8 million, respectively, of loans acquired through foreclosure, net of allowances of $1.3 million and $3.2 million, respectively, which were recorded in other assets in our consolidated balance sheets. Provision for losses and gains and losses on sales on our other foreclosed assets, which were recorded as a component of net expense of real estate owned and other foreclosed assets in our consolidated statements of operations, for the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	($ in thousands)
Provision for losses on other foreclosed assets	$	2,475	$	1,250	$	9,880	$	40,119
Gains on sales of other foreclosed assets		—		—		1,647		—

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 6. Investments

Investment Securities, Available-for-Sale

As of September 30, 2011 and December 31, 2010, our investment securities, available-for-sale were as follows:


	September 30, 2011									December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	($ in thousands)
Agency callable notes	$	114,972	$	658	$	—		$	115,630	$	164,219	$	418	$	(1,749	)	$	162,888
Agency debt		44,776		493		—			45,269		102,263		1,167		—			103,430
Agency discount notes		—		—		—			—		164,917		57		—			164,974
Agency MBS		1,119,741		33,483		(215	)		1,153,009		860,441		15,035		(5,321	)		870,155
Asset-backed securities		16,734		904		—			17,638		—		—		—			—
Collateralized loan obligation		11,019		7,975		—			18,994		12,249		—		—			12,249
Corporate debt		5,745		26		(15	)		5,756		5,013		122		—			5,135
Equity security		202		170		—			372		202		61		—			263
Municipal bond		3,235		—		—			3,235		—		—		—			—
Non-agency MBS		78,187		930		(1,163	)		77,954		112,917		1,640		(873	)		113,684
U.S. Treasury and agency securities		19,109		460		—			19,569		90,587		24		(478	)		90,133

Total	$	1,413,720	$	45,099	$	(1,393	)	$	1,457,426	$	1,512,808	$	18,524	$	(8,421	)	$	1,522,911

Included in investment securities, available-for-sale, were callable notes issued by Fannie Mae, Freddie Mac, the Federal Home Loan Bank (“FHLB”) and Federal Farm Credit Bank (“Agency callable notes”), bonds issued by the FHLB (“Agency debt”), discount notes issued by Fannie Mae, Freddie Mac and the FHLB (“Agency discount notes”), commercial and residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (“Agency MBS”), asset-backed securities, investments in a collateralized loan obligation, corporate debt, an equity security, a municipal bond, commercial and residential mortgage-backed securities issued by non-government agencies (“Non-agency MBS”), and U.S. Treasury and agency securities.

The amortized cost and fair value of investment securities, available-for-sale that CapitalSource Bank pledged as collateral as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011				December 31, 2010
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	718,807	$	740,341	$	877,766	$	889,888
FRB		16,997		15,923		35,056		34,256
Non-government correspondent bank(1)		39,927		39,928		37,979		37,989
Government agency(2)		26,743		27,636		29,069		29,305

Total	$	802,474	$	823,828	$	979,870	$	991,438

(1)	Represents the amounts CapitalSource Bank pledged as collateral for letters of credit and foreign exchange contracts.

(2)	Represents the amounts CapitalSource Bank pledged as collateral to secure funds deposited by a local government agency.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Realized gains or losses resulting from the sale of investments are calculated using the specific identification method and are included in gain on investments, net, in our consolidated statements of operations. Proceeds and gross pre-tax gains from sales of investment securities, available-for-sale for the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	($ in thousands)
Proceeds from sales	$	67,532	$	39,991	$	137,738	$	79,491
Gross pre-tax gains from sales		1,623		4,285		16,130		5,901

During the three and nine months ended September 30, 2011, we recognized a $4.1 million net after-tax loss and a $21.2 million net after-tax gain, respectively, related to our investment securities, available-for-sale, as a component of accumulated other comprehensive income, net in our consolidated balance sheets.

During the nine months ended September 30, 2011, we recorded $1.5 million of other-than-temporary impairments (“OTTI”) on our investment securities, available-for-sale, included as a component of gain on investments, net, in our consolidated statements of operations, related to a decline in the fair value of one municipal bond. We recorded no OTTI during the three months ended September 30, 2011. We recorded $0.3 million of OTTI during the nine months ended September 30, 2010, as a component of gain on investments, net in our consolidated statements of operations, related to a decline in the fair value of our equity security. We recorded no OTTI during the three months ended September 30, 2010.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists of commercial mortgage-backed securities rated AAA held by CapitalSource Bank. The amortized costs and estimated fair values of the investment securities, held-to-maturity, that CapitalSource Bank pledged as collateral as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011				December 31, 2010
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	7,585	$	8,125	$	21,260	$	22,431
FRB		85,268		87,081		143,927		153,756

Total	$	92,853	$	95,206	$	165,187	$	176,187

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Unrealized Losses on Investment Securities

As of September 30, 2011 and December 31, 2010, the gross unrealized losses and fair values of investment securities that were in unrealized loss positions were as follows:


	Less Than 12 Months					12 Months or More					Total
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value
	($ in thousands)
As of September 30, 2011
Investment securities, available-for-sale:
Agency MBS	$	(215	)		22,864	$	—		$	—	$	(215	)	$	22,864
Corporate debt		(15	)		—		—			—		(15	)		—
Non-agency MBS		(119	)		16,007		(1,044	)		14,311		(1,163	)		30,318

Total investment securities, available-for-sale	$	(349	)	$	38,871	$	(1,044	)	$	14,311	$	(1,393	)	$	53,182

Total investment securities, held-to-maturity(1)	$	(2,674	)	$	64,462	$	—		$	—	$	(2,674	)	$	64,462
As of December 31, 2010
Investment securities, available-for-sale:
Agency callable notes	$	(1,749	)	$	92,471	$	—		$	—	$	(1,749	)	$	92,471
Agency MBS		(5,321	)		252,844		—			—		(5,321	)		252,844
Non-agency MBS		(835	)		20,905		(38	)		8,384		(873	)		29,289
U.S. Treasury and agency securities		(478	)		20,151		—			—		(478	)		20,151

Total investment securities, available-for-sale	$	(8,383	)	$	386,371	$	(38	)	$	8,384	$	(8,421	)	$	394,755

Total investment securities, held-to-maturity(1)	$	(97	)	$	13,524	$	—		$	—	$	(97	)	$	13,524

(1)	Consists of commercial mortgage-backed securities rated AAA held by CapitalSource Bank.

Securities in unrealized loss positions are analyzed individually as part of our ongoing assessment of OTTI, and we do not believe that any unrealized losses in our portfolio as of September 30, 2011 and December 31, 2010 represent OTTI. The losses are primarily related to one Agency MBS, two non-Agency MBS, and three commercial MBS. The unrealized losses are attributable to fluctuations in the market prices of the securities due to current market conditions and interest rate levels. Agency securities have the highest debt rating and are guaranteed by government-sponsored entities. The non-Agency MBS securities also have strong debt ratings and debt metrics. Each commercial MBS with unrealized losses as of September 30, 2011 was investment grade and had a credit support level that exceeds 20%, which, in accordance with CapitalSource Bank investment policy, is the minimum required for purchases of this type of security. As such, we expect to recover the entire amortized cost basis of the impaired securities. We have the ability and the intention to hold these securities until their fair values recover to cost or maturity.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Contractual Maturities

As of September 30, 2011, the contractual maturities of our available-for-sale and held-to-maturity investment securities were as follows:


	Investment Securities, Available-for-Sale				Investment Securities, Held-to-Maturity
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	($ in thousands)
Due in one year or less	$	25,015	$	25,111	$	—	$	—
Due after one year through five years		113,740		114,735		26,511		30,348
Due after five years through ten years(1)		93,131		96,180		—		—
Due after ten years(2)(3)		1,181,834		1,221,400		76,140		74,007

Total	$	1,413,720	$	1,457,426	$	102,651	$	104,355

(1)	Includes Agency and Non-agency MBS, with fair values of $29.1 million and $34.4 million, respectively, and weighted-average expected maturities of 2.52 years and 0.97 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2011.

(2)	Includes Agency and Non-agency MBS, including CMBS, with fair values of $1.1 billion and $117.5 million, respectively, and weighted-average expected maturities of 2.95 years and 2.63 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2011.

(3)	Includes securities with no stated maturity.

Other Investments

As of September 30, 2011 and December 31, 2010, our other investments were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Investments carried at cost	$	34,572	$	33,062
Investments carried at fair value		200		222
Investments accounted for under the equity method		23,111		38,605

Total	$	57,883	$	71,889

Proceeds and net pre-tax gains from the sales of other investments during the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	($ in thousands)
Proceeds from sales	$	9,803	$	16,938	$	29,823	$	42,409
Net pre-tax gains from sales		5,020		13,726		22,271		27,179

During the three and nine months ended September 30, 2011, we recorded OTTI of $0.3 million and $0.7 million, respectively, relating to our investments carried at cost. During the three and nine months ended September 30, 2010, we recorded OTTI of $0.5 million and $2.7 million, respectively, relating to our investments carried at cost.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 7. Guarantor Information

The following represents the supplemental consolidating condensed financial information as of September 30, 2011 and December 31, 2010 and for the three and nine months ended September 30, 2011 and 2010 of (i) CapitalSource Inc., which is the issuer of our 2014 Senior Secured Notes, as well as our Senior Debentures and Subordinated Debentures (together, the “Debentures”), (ii) CapitalSource Finance LLC (“CapitalSource Finance”), which is a guarantor of our 2014 Senior Secured Notes and the Debentures, and (iii) our subsidiaries that are not guarantors of the 2014 Senior Secured Notes or the Debentures. CapitalSource Finance, a wholly owned indirect subsidiary of CapitalSource Inc., has guaranteed our 2014 Senior Secured Notes and the Senior Debentures, fully and unconditionally, on a senior basis and has guaranteed the Subordinated Debentures, fully and unconditionally, on a senior subordinate basis. Separate consolidated financial statements of the guarantor are not presented, as we have determined that they would not be material to investors. During the three months ended September 30, 2011, our 3.5% and 4.0% Convertible Debentures were repurchased and retired.

For additional information related to our 2014 Senior Secured Notes and Debentures, see Note 10, Borrowings.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Balance Sheet

September 30, 2011


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Assets
Cash and cash equivalents	$	9,667		$	246,530		$	237,702		$	2,945		$	—		$	496,844
Restricted cash		—			34,299			15,697			142			—			50,138
Investment securities:
Available-for-sale, at fair value		—			1,434,825			—			22,601			—			1,457,426
Held-to-maturity, at amortized cost		—			102,651			—			—			—			102,651

Total investment securities		—			1,537,476			—			22,601			—			1,560,077
Loans:
Loans held for sale		—			29,708			—			3,129			—			32,837
Loans held for investment		—			5,231,002			186,811			372,777			—			5,790,590
Less deferred loan fees and discounts		—			(56,568	)		(6,486	)		(8,754	)		3,387			(68,421	)
Less allowance for loan losses		—			(170,644	)		(10,067	)		(27,641	)		—			(208,352	)

Loans held for investment, net		—			5,003,790			170,258			336,382			3,387			5,513,817

Total loans		—			5,033,498			170,258			339,511			3,387			5,546,654
Interest receivable		—			26,826			21,293			(8,853	)		—			39,266
Investment in subsidiaries		1,860,843			3,763			1,506,481			1,461,297			(4,832,384	)		—
Intercompany receivable		1,912			—			47,447			112,594			(161,953	)		—
Other investments		—			35,318			13,847			8,718			—			57,883
Goodwill		—			173,135			—			—			—			173,135
Other assets		31,279			223,524			80,729			162,518			(62,625	)		435,425

Total assets	$	1,903,701		$	7,314,369		$	2,093,454		$	2,101,473		$	(5,053,575	)	$	8,359,422

Liabilities and shareholders’ equity
Liabilities:
Deposits	$	—		$	4,885,831		$	—		$	—		$	—		$	4,885,831
Term debt		1,836			345,908			—			—			—			347,744
Other borrowings		174,263			540,000			437,294			—			—			1,151,557
Other liabilities		21,081			97,160			88,812			126,197			(65,145	)		268,105
Intercompany payable		—			—			112,594			49,359			(161,953	)		—

Total liabilities		197,180			5,868,899			638,700			175,556			(227,098	)		6,653,237
Shareholders’ equity:
Common stock		2,758			921,000			—			—			(921,000	)		2,758
Additional paid-in capital		3,612,927			(93,555	)		427,881			1,938,887			(2,273,547	)		3,612,593
(Accumulated deficit) retained earnings		(1,940,989	)		596,277			1,000,927			(38,942	)		(1,558,264	)		(1,940,991	)
Accumulated other comprehensive income, net		31,825			21,748			25,946			25,972			(73,666	)		31,825

Total shareholders’ equity		1,706,521			1,445,470			1,454,754			1,925,917			(4,826,477	)		1,706,185

Total liabilities and shareholders’ equity	$	1,903,701		$	7,314,369		$	2,093,454		$	2,101,473		$	(5,053,575	)	$	8,359,422

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Balance Sheet

December 31, 2010


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Assets
Cash and cash equivalents	$	94,614		$	353,666		$	252,012		$	120,158		$	—		$	820,450
Restricted cash		—			39,335			85,142			4,109			—			128,586
Investment securities:
Available-for-sale, at fair value		—			1,510,384			—			12,527			—			1,522,911
Held-to-maturity, at amortized cost		—			184,473			—			—			—			184,473

Total investment securities		—			1,694,857			—			12,527			—			1,707,384
Commercial real estate "A" participation interest, net		—			—			—			—			—			—
Loans:
Loans held for sale		—			171,887			16,202			17,245			—			205,334
Loans held for investment		—			5,008,287			284,445			860,144			—			6,152,876
Less deferred loan fees and discounts		—			(79,877	)		(10,362	)		(18,429	)		2,230			(106,438	)
Less allowance for loan losses		—			(223,553	)		(29,626	)		(75,943	)		—			(329,122	)

Loans held for investment, net		—			4,704,857			244,457			765,772			2,230			5,717,316

Total loans		—			4,876,744			260,659			783,017			2,230			5,922,650
Interest receivable		—			25,780			18,174			13,439			—			57,393
Investment in subsidiaries		2,339,200			3,594			1,561,468			1,623,244			(5,527,506	)		—
Intercompany receivable		375,000			9			134,079			301,241			(810,329	)		—
Other investments		—			52,066			13,887			5,936			—			71,889
Goodwill		—			173,135			—			—			—			173,135
Other assets		89,198			249,119			156,557			234,034			(164,988	)		563,920

Total assets	$	2,898,012		$	7,468,305		$	2,481,978		$	3,097,705		$	(6,500,593	)	$	9,445,407

Liabilities and shareholders’ equity
Liabilities:
Deposits	$	—		$	4,621,273		$	—		$	—		$	—		$	4,621,273
Credit facilities		—			65,606			—			1,902			—			67,508
Term debt		285,731			693,523			—			—			—			979,254
Other borrowings		523,650			412,000			440,234			—			—			1,375,884
Other liabilities		34,658			170,408			121,227			208,816			(187,563	)		347,546
Intercompany payable		—			46,850			301,241			441,372			(789,463	)		—

Total liabilities		844,039			6,009,660			862,702			652,090			(977,026	)		7,391,465
Shareholders’ equity:
Common stock		3,232			921,000			—			—			(921,000	)		3,232
Additional paid-in capital		3,911,344			74,588			679,241			2,556,428			(3,310,260	)		3,911,341
(Accumulated deficit) retained earnings		(1,870,544	)		457,302			930,076			(114,898	)		(1,272,508	)		(1,870,572	)
Accumulated other comprehensive income, net		9,941			5,755			9,959			4,087			(19,801	)		9,941

Total CapitalSource Inc. shareholders’ equity		2,053,973			1,458,645			1,619,276			2,445,617			(5,523,569	)		2,053,942
Noncontrolling interests		—			—			—			(2	)		2			—

Total shareholders’ equity		2,053,973			1,458,645			1,619,276			2,445,615			(5,523,567	)		2,053,942

Total liabilities and shareholders’ equity	$	2,898,012		$	7,468,305		$	2,481,978		$	3,097,705		$	(6,500,593	)	$	9,445,407

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Operations

Three Months Ended September 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans	$	8,457		$	93,630		$	4,955		$	8,015		$	(7,896	)	$	107,161
Investment securities		—			12,515			—			1,120			—			13,635
Other		—			327			353			—			—			680

Total interest income		8,457			106,472			5,308			9,135			(7,896	)		121,476
Interest expense:
Deposits		—			13,422			—			—			—			13,422
Borrowings		14,409			3,346			3,740			8,116			(8,545	)		21,066

Total interest expense		14,409			16,768			3,740			8,116			(8,545	)		34,488

Net interest (loss) income		(5,952	)		89,704			1,568			1,019			649			86,988
Provision for loan losses		—			32,319			6,036			(3,237	)		—			35,118

Net interest (loss) income after provision for loan losses		(5,952	)		57,385			(4,468	)		4,256			649			51,870
Operating expenses:
Compensation and benefits		228			13,289			18,866			—			(1,336	)		31,047
Professional fees		610			1,062			3,478			674			—			5,824
Other administrative expenses		1,013			18,917			9,480			5,303			(19,023	)		15,690

Total operating expenses		1,851			33,268			31,824			5,977			(20,359	)		52,561
Other (expense) income:
Gain on investments, net		—			15,160			13			3,968			—			19,141
Gain (loss) on derivatives		—			1,007			5,983			(9,103	)		—			(2,113	)
Loss on debt extinguishment		(113,679	)		—			—			—			—			(113,679	)
Net expense of real estate owned and other foreclosed assets		—			(6,949	)		(161	)		(4,988	)		—			(12,098	)
Other (expense) income, net		(23	)		11,350			19,231			7,089			(20,199	)		17,448
Earnings (loss) in subsidiaries		16,747			(369	)		28,250			17,777			(62,405	)		—

Total other (expense) income		(96,955	)		20,199			53,316			14,743			(82,604	)		(91,301	)

Net (loss) income before income taxes		(104,758	)		44,316			17,024			13,022			(61,596	)		(91,992	)
Income tax (benefit) expense		(24,046	)		15,545			—			(2,779	)		—			(11,280	)

Net (loss) income	$	(80,712	)	$	28,771		$	17,024		$	15,801		$	(61,596	)	$	(80,712	)

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Operations

Three Months Ended September 30, 2010

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net investment income:
Interest income:
Loans	$	10,193		$	105,834		$	15,471		$	23,109		$	(16,387	)	$	138,220
Investment securities		—			14,429			30			149			—			14,608
Other		—			299			2			1			—			302

Total interest income		10,193			120,562			15,503			23,259			(16,387	)		153,130
Interest expense:
Deposits		—			14,490			—			—			—			14,490
Borrowings		24,126			7,344			7,676			17,649			(13,377	)		43,418

Total interest expense		24,126			21,834			7,676			17,649			(13,377	)		57,908

Net interest (loss) income		(13,933	)		98,728			7,827			5,610			(3,010	)		95,222
Provision for loan losses		—			25,362			(1,522	)		14,931			—			38,771

Net interest (loss) income after provision for loan losses		(13,933	)		73,366			9,349			(9,321	)		(3,010	)		56,451
Operating expenses:
Compensation and benefits		218			12,089			16,258			—			—			28,565
Professional fees		776			594			5,332			2,090			—			8,792
Other administrative expenses		1,155			18,010			10,991			9,145			(21,891	)		17,410

Total operating expenses		2,149			30,693			32,581			11,235			(21,891	)		54,767
Other income:
Gain (loss) on investments, net		—			8,925			(29	)		21,047			—			29,943
(Loss) gain on derivatives		—			(1,291	)		7,092			(7,769	)		—			(1,968	)
Net expense of real estate owned and other foreclosed assets		—			(2,486	)		(1,535	)		(3,351	)		—			(7,372	)
Other (expense) income, net		(578	)		3,688			10,300			28,363			(21,626	)		20,147
Earnings (loss) in subsidiaries		58,644			(220	)		50,724			40,575			(149,723	)		—

Total other income		58,066			8,616			66,552			78,865			(171,349	)		40,750

Net income from continuing operations before income taxes		41,984			51,289			43,320			58,309			(152,468	)		42,434
Income tax (benefit) expense		(36,201	)		(957	)		—			1,490			—			(35,668	)

Net income from continuing operations		78,185			52,246			43,320			56,819			(152,468	)		78,102
Net loss attributable to noncontrolling interests		—			—			—			(83	)		—			(83	)

Net income attributable to CapitalSource Inc.	$	78,185		$	52,246		$	43,320		$	56,902		$	(152,468	)	$	78,185

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Operations

Nine Months Ended September 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans	$	28,834		$	297,093		$	14,901		$	38,601		$	(35,121	)	$	344,308
Investment securities		—			38,837			7			5,831			—			44,675
Other		—			969			1,094			7			—			2,070

Total interest income		28,834			336,899			16,002			44,439			(35,121	)		391,053
Interest expense:
Deposits		—			40,203			—			—			—			40,203
Borrowings		62,685			14,110			12,688			31,906			(34,545	)		86,844

Total interest expense		62,685			54,313			12,688			31,906			(34,545	)		127,047

Net interest (loss) income		(33,851	)		282,586			3,314			12,533			(576	)		264,006
Provision for loan losses		—			37,862			42,981			607			—			81,450

Net interest (loss) income after provision for loan losses		(33,851	)		244,724			(39,667	)		11,926			(576	)		182,556
Operating expenses:
Compensation and benefits		1,130			38,433			53,715			—			(2,754	)		90,524
Professional fees		6,179			2,958			13,405			1,384			—			23,926
Other administrative expenses		3,186			61,704			29,987			14,953			(62,136	)		47,694

Total operating expenses		10,495			103,095			97,107			16,337			(64,890	)		162,144
Other (expense) income:
Gain on investments, net		—			35,222			43			16,116			—			51,381
(Loss) gain on derivatives		—			(128	)		10,420			(14,554	)		—			(4,262	)
Loss on debt extinguishment		(113,679	)		—			—			—			—			(113,679	)
Net expense of real estate owned and other foreclosed assets		—			(19,881	)		(397	)		(12,348	)		—			(32,626	)
Other (expense) income, net		(357	)		23,240			60,200			13,681			(61,818	)		34,946
Earnings (loss) in subsidiaries		76,695			(1,545	)		137,027			72,966			(285,143	)		—

Total other (expense) income		(37,341	)		36,908			207,293			75,861			(346,961	)		(64,240	)

Net (loss) income before income taxes		(81,687	)		178,537			70,519			71,450			(282,647	)		(43,828	)
Income tax (benefit) expense		(20,728	)		40,089			(10	)		(2,220	)		—			17,131

Net (loss) income	$	(60,959	)	$	138,448		$	70,529		$	73,670		$	(282,647	)	$	(60,959	)

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Operations

Nine Months Ended September 30, 2010

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net investment income:
Interest income:
Loans	$	30,234		$	317,645		$	40,213		$	100,543		$	(45,368	)	$	443,267
Investment securities		—			44,068			107			643			—			44,818
Other		—			1,169			5			5			—			1,179

Total interest income		30,234			362,882			40,325			101,191			(45,368	)		489,264
Interest expense:
Deposits		—			46,127			—			—			—			46,127
Borrowings		77,588			24,240			22,886			51,640			(38,815	)		137,539

Total interest expense		77,588			70,367			22,886			51,640			(38,815	)		183,666

Net interest (loss) income		(47,354	)		292,515			17,439			49,551			(6,553	)		305,598
Provision for loan losses		—			122,943			(24,769	)		184,799			—			282,973

Net interest (loss) income after provision for loan losses		(47,354	)		169,572			42,208			(135,248	)		(6,553	)		22,625
Operating expenses:
Compensation and benefits		1,078			37,931			53,162			—			—			92,171
Professional fees		1,937			1,839			19,240			4,643			—			27,659
Other administrative expenses		3,522			49,075			35,874			21,342			(58,080	)		51,733

Total operating expenses		6,537			88,845			108,276			25,985			(58,080	)		171,563
Other (expense) income:
Gain on investments, net		—			22,871			118			23,290			—			46,279
(Loss) gain on derivatives		—			(1,996	)		23,229			(31,152	)		—			(9,919	)
Gain on debt extinguishment		1,096			—			—			—			—			1,096
Net expense of real estate owned and other foreclosed assets		—			(11,670	)		(2,537	)		(76,832	)		—			(91,039	)
Other (expense) income, net		(2,173	)		34,831			38,401			23,961			(57,768	)		37,252
(Loss) earnings in subsidiaries		(97,174	)		(3,839	)		102,996			89,898			(91,881	)		—

Total other (expense) income		(98,251	)		40,197			162,207			29,165			(149,649	)		(16,331	)

Net (loss) income from continuing operations before income taxes		(152,142	)		120,924			96,139			(132,068	)		(98,122	)		(165,269	)
Income tax (benefit) expense		(36,977	)		(834	)		—			18,975			—			(18,836	)

Net (loss) income from continuing operations		(115,165	)		121,758			96,139			(151,043	)		(98,122	)		(146,433	)
Net income from discontinued operations, net of taxes		—			—			—			9,489			—			9,489
Net gain from sale of discontinued operations, net of taxes		—			—			—			21,696			—			21,696

Net (loss) income		(115,165	)		121,758			96,139			(119,858	)		(98,122	)		(115,248	)
Net loss attributable to noncontrolling interests		—			—			—			(83	)		—			(83	)

Net (loss) income attributable to CapitalSource Inc.	$	(115,165	)	$	121,758		$	96,139		$	(119,775	)	$	(98,122	)	$	(115,165	)

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Cash Flows

Nine Months Ended September 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Operating activities:
Net (loss) income	$	(60,959	)	$	138,448		$	70,529		$	73,670		$	(282,647	)	$	(60,959	)
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:
Stock option expense		—			1,344			2,720			—			—			4,064
Restricted stock expense		—			2,512			3,460			—			—			5,972
Loss on debt extinguishment		113,679			—			—			—			—			113,679
Amortization of deferred loan fees and discounts		—			(39,748	)		(5,902	)		(8,322	)		—			(53,972	)
Paid-in-kind interest on loans		—			29,706			(674	)		(1,107	)		—			27,925
Provision for loan losses		—			37,862			42,981			607			—			81,450
Amortization of deferred financing fees and discounts		16,720			2,196			269			(1,156	)		—			18,029
Depreciation and amortization		—			(172	)		2,073			—			—			1,901
Provision for deferred income taxes		12,433			4,861			—			27,468			—			44,762
Non-cash gain on investments, net		—			(43,484	)		(346	)		(18,787	)		—			(62,617	)
Non-cash loss (gain) on foreclosed assets and other property and equipment disposals		—			16,982			(241	)		9,707			—			26,448
Unrealized (gain) loss on derivatives and foreign currencies, net		—			(365	)		(22,759	)		29,074			—			5,950
(Increase) decrease in interest receivable		—			(1,046	)		(3,119	)		22,292			—			18,127
Decrease in loans held for sale, net		—			169,022			10,993			10,932			—			190,947
Decrease in intercompany note receivable		373,088			9			86,632			188,647			(648,376	)		—
Decrease in other assets		16,026			47,682			95,955			6,182			(102,363	)		63,482
Decrease in other liabilities		(32,964	)		(72,992	)		(31,510	)		(81,444	)		122,418			(96,492	)
Net transfers with subsidiaries		134,201			205,411			(186,597	)		(437,630	)		284,615			—

Cash provided by (used in) operating activities, net of impact of acquisitions		572,224			498,228			64,464			(179,867	)		(626,353	)		328,696
Investing activities:
Decrease in restricted cash		—			5,036			69,445			3,967			—			78,448
(Increase) decrease in loans, net		—			(340,996	)		44,057			423,431			(1,157	)		125,335
Reduction of marketable securities, available for sale, net		—			100,013			—			19,000			—			119,013
Reduction of marketable securities, held to maturity, net		—			90,556			—			—			—			90,556
Reduction of other investments, net		—			32,141			387			10,171			—			42,699
Acquisition of property and equipment, net		—			(46,852	)		(1,068	)		—			—			(47,920	)

Cash (used in) provided by investing activities		—			(160,102	)		112,821			456,569			(1,157	)		408,131
Financing activities:
Deposits accepted, net of repayments		—			264,558			—			—			—			264,558
Decrease in intercompany note payable		—			(46,850	)		(188,647	)		(392,013	)		627,510			—
Repayments on credit facilities, net		—			(66,890	)		—			(1,902	)		—			(68,792	)
Repayments and extinguishment of term debt		—			(724,080	)		—			—			—			(724,080	)
(Repayments of) borrowings under other borrowings		(357,819	)		128,000			(2,948	)		—			—			(232,767	)
Repurchase of common stock		(291,424	)		—			—			—			—			(291,424	)
Proceeds from exercise of options		1,462			—			—			—			—			1,462
Payment of dividends		(9,390	)		—			—			—			—			(9,390	)

Cash used in financing activities		(657,171	)		(445,262	)		(191,595	)		(393,915	)		627,510			(1,060,433	)

Decrease in cash and cash equivalents		(84,947	)		(107,136	)		(14,310	)		(117,213	)		—			(323,606	)
Cash and cash equivalents as of beginning of period		94,614			353,666			252,012			120,158			—			820,450

Cash and cash equivalents as of end of period	$	9,667		$	246,530		$	237,702		$	2,945		$	—		$	496,844

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Consolidating Statement of Cash Flows

Nine Months Ended September 30, 2010

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non-Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non-Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Operating activities:
Net (loss) income	$	(115,165	)	$	121,758		$	96,139		$	(119,858	)	$	(98,122	)	$	(115,248	)
Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:
Stock option expense		—			1,205			2,299			—			—			3,504
Restricted stock expense		—			1,585			6,266			—			—			7,851
Gain on extinguishment of debt		(1,096	)		—			—			—			—			(1,096	)
Amortization of deferred loan fees and discounts		—			(26,995	)		(19,384	)		(8,916	)		—			(55,295	)
Paid-in-kind interest on loans		—			(2,595	)		2,932			1,755			—			2,092
Provision for loan losses		—			122,943			(24,769	)		184,799			—			282,973
Provision for unfunded commitments		—			(442	)		—			—			—			(442	)
Amortization of deferred financing fees and discounts		21,490			13,599			314			8,487			—			43,890
Depreciation and amortization		—			(2,676	)		2,818			1,440			—			1,582
(Benefit) provision for deferred income taxes		—			(8,169	)		(209	)		22,469			—			14,091
Non-cash loss (gain) on investments, net		—			902			(173	)		(7,774	)		—			(7,045	)
Non-cash loss on foreclosed assets and other property and equipment disposals		—			8,827			4,294			44,073			—			57,194
Gain on assets acquired through business combination		—			(3,724	)		—			—			—			(3,724	)
Gain on deconsolidation of 2006-A Trust		—			—			—			(16,723	)		—			(16,723	)
Unrealized (gain) loss on derivatives and foreign currencies, net		—			(2,206	)		(30,453	)		30,580			—			(2,079	)
Accretion of discount on commercial real estate “A” participation interest		—			(9,523	)		—			—			—			(9,523	)
(Increase) decrease in interest receivable		—			(15,056	)		65,235			(23,481	)		—			26,698
Decrease (increase) in loans held for sale, net		—			335			(3,053	)		7,468			—			4,750
(Increase) decrease in intercompany receivable		—			—			(11,967	)		14,240			(2,273	)		—
(Increase) decrease in other assets		(37,925	)		(2,091	)		(19,909	)		69,456			8,991			18,522
(Decrease) increase in other liabilities		(17,160	)		(8,662	)		(23,600	)		35,917			(14,905	)		(28,410	)
Net transfers with subsidiaries		350,745			(83,974	)		26,946			(385,772	)		92,055			—

Cash provided by (used in) operating activities, net of impact of acquisitions		200,889			105,041			73,726			(141,840	)		(14,254	)		223,562
Investing activities:
Decrease (increase) in restricted cash		—			50,616			(39,345	)		49,417			—			60,688
Decrease in commercial real estate “A” participation interest		—			534,674			—			—			—			534,674
Assets acquired through business combination, net of cash acquired		—			(98,800	)		—			—			—			(98,800	)
Cash received from 2006-A Trust delegation and sale transaction		—			—			—			7,000			—			7,000
Decrease (increase) in loans, net		—			65,289			(95,146	)		1,233,476			7,199			1,210,818
Cash received for real estate		—			—			—			339,643			—			339,643
Acquisition of marketable securities, available for sale, net		—			(561,613	)		—			—			—			(561,613	)
Reduction of marketable securities, held to maturity, net		—			47,208			—			—			—			47,208
(Acquisition) reduction of other investments, net		—			(27,229	)		126			53,413			—			26,310
(Acquisition) disposal of property and equipment, net		—			(980	)		(2,978	)		869			—			(3,089	)

Cash provided by (used in) investing activities		—			9,165			(137,343	)		1,683,818			7,199			1,562,839
Financing activities:
Payment of deferred financing fees		(2,082	)		(7,963	)		—			4,132			—			(5,913	)
Deposits accepted, net of repayments		—			143,632			—			—			—			143,632
(Decrease) increase in intercompany payable		—			—			(14,240	)		7,185			7,055			—
Repayments on credit facilities, net		(193,637	)		(81,643	)		(54,199	)		(124,427	)		—			(453,906	)
Borrowings of term debt		—			—			—			14,784			—			14,784
Repayments and extinguishment of term debt		—			(679,394	)		—			(1,142,037	)		—			(1,821,431	)
(Repayments of) borrowings under other borrowings		(34,144	)		100,000			(59	)		(263,972	)		—			(198,175	)
Proceeds from exercise of options		356			—			—			—			—			356
Payment of dividends		(9,718	)		—			—			—			—			(9,718	)

Cash used in financing activities		(239,225	)		(525,368	)		(68,498	)		(1,504,335	)		7,055			(2,330,371	)

(Decrease) increase in cash and cash equivalents		(38,336	)		(411,162	)		(132,115	)		37,643			—			(543,970	)
Cash and cash equivalents as of beginning of period		99,103			760,343			265,977			51,597			—			1,177,020

Cash and cash equivalents as of end of period	$	60,767		$	349,181		$	133,862		$	89,240		$	—		$	633,050

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 8. Deposits

As of September 30, 2011 and December 31, 2010, CapitalSource Bank had $4.9 billion and $4.6 billion, respectively, in deposits insured up to the maximum limit by the Federal Deposit Insurance Corporation (“FDIC”). As of September 30, 2011 and December 31, 2010, CapitalSource Bank had $305.0 million and $266.7 million, respectively, of certificates of deposit in the amount of $250,000 or more and $1.9 billion and $1.7 billion, respectively, of certificates of deposit in the amount of $100,000 or more.

As of September 30, 2011 and December 31, 2010, the weighted-average interest rates for savings and money market deposit accounts were 0.75% and 0.83%, respectively, and for certificates of deposit were 1.18% and 1.27%, respectively. The weighted-average interest rates for all deposits as of September 30, 2011 and December 31, 2010 were 1.08% and 1.18%, respectively.

As of September 30, 2011 and December 31, 2010, interest-bearing deposits at CapitalSource Bank were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Interest-bearing deposits:
Money market	$	244,636	$	236,811
Savings		842,162		694,157
Certificates of deposit		3,799,033		3,690,305

Total interest-bearing deposits	$	4,885,831	$	4,621,273

As of September 30, 2011, certificates of deposit at CapitalSource Bank detailed by maturity were as follows ($ in thousands):


Maturing by:
September 30, 2012	$	3,249,051
September 30, 2013		436,499
September 30, 2014		27,360
September 30, 2015		43,698
September 30, 2016		42,425

Total	$	3,799,033

For the three and nine months ended September 30, 2011 and 2010, interest expense on deposits was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Savings and money market	$	2,176		$	1,937		$	6,215		$	6,381
Certificates of deposit		11,310			12,613			34,169			39,923
Fees for early withdrawal		(64	)		(60	)		(181	)		(177	)

Total interest expense on deposits	$	13,422		$	14,490		$	40,203		$	46,127

Note 9. Variable Interest Entities

Troubled Debt Restructurings

Certain of our loan modifications qualify as events that require reconsideration of our borrowers as variable interest entities. Through reconsideration, we determined that certain of our borrowers involved in TDRs did not hold sufficient equity at risk to finance their activities without subordinated financial support. As a result, we concluded that these borrowers were VIEs.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

We also determined that we should not consolidate these borrowers because we do not have a controlling financial interest. The equity investors of these borrowers have the power to direct the activities that will have the most significant impact on the economics of these borrowers. These equity investors’ interests also provide them with rights to receive benefits in the borrowers that could potentially be significant. As a result, we have determined that the equity investors continue to have a controlling financial interest in the borrowers subsequent to the restructuring.

Our interests in borrowers qualifying as variable interest entities were $229.5 million and $493.7 million as of September 30, 2011 and December 31, 2010, respectively, and are included in loans held for investment in our consolidated balance sheets. For certain of these borrowers, we may have obligations to fund additional amounts through either unfunded commitments or letters of credit issued to or on behalf of these borrowers. Consequently, our maximum exposure to loss as a result of our involvement with these entities was $314.5 million and $610.6 million as of September 30, 2011 and December 31, 2010, respectively.

Term Debt Securitizations

In conjunction with our commercial term debt securitizations, we established and contributed loans to separate single purpose entities (collectively, referred to as the “Issuers”). The Issuers are structured to be legally isolated, bankruptcy remote entities. The Issuers issued notes and certificates that are collateralized by their underlying assets, which primarily comprise loans contributed to the securitizations. We service the underlying loans contributed to the Issuers and earn periodic servicing fees paid from the cash flows of the underlying loans. The Issuers have all of the legal obligations to repay the outstanding notes and certificates and we have no legal obligation to contribute additional assets to the Issuers. As of September 30, 2011 and December 31, 2010, the total outstanding balances of these commercial term debt securitizations were $572.7 million and $1.0 billion, respectively. These amounts include $226.8 million and $328.2 million of notes and certificates that we held as of September 30, 2011 and December 31, 2010, respectively.

We have determined that the Issuers are variable interest entities, subject to applicable consolidation guidance and have concluded that the entities were designed to pass along risks related to the credit performance of the underlying loan portfolio. Except as set forth below, as a result of our power to direct the activities that most significantly impact the credit performance of the underlying loan portfolio and our economic interests in the Issuers, we have concluded that we are the primary beneficiary of each of the Issuers. Consequently, except as set forth below, we report the assets and liabilities of the Issuers in our consolidated financial statements, including the underlying loans and the issued notes and certificates held by third parties. As of September 30, 2011 and December 31, 2010, the carrying amounts of the consolidated liabilities related to the Issuers were $346.3 million and $697.5 million, respectively. These amounts include term debt recorded in our consolidated balance sheets and represent obligations for which there is only legal recourse to the Issuers. As of September 30, 2011 and December 31, 2010, the carrying amounts of the consolidated assets related to the Issuers were $623.6 million and $901.9 million, respectively. These amounts include loans held for investment, net recorded in our consolidated balance sheets and relate to assets that can only be used to settle obligations of the Issuers.

During the third quarter of 2010, we delegated certain of our collateral management and special servicing rights in the 2006-A term debt securitization trust (the “2006-A” Trust) and sold our equity interest and certain notes issued by the 2006-A trust for $7.0 million. As a result of the transaction, we determined that we no longer had the power to direct the activities that most significantly impact the economic performance of the 2006-A Trust. In making this determination, we assessed the character and significance of the servicing and collateral management fees paid to the delegate and concluded that such fees represented an implicit variable interest in the 2006-A Trust. This assessment involved significant judgment surrounding the credit performance and timing of cash flows of the underlying assets of the 2006-A Trust, including the performance of additional assets to be purchased by the 2006-A Trust, pursuant to the terms of the indenture. In October 2010, we assigned our special servicing rights so that we are no longer the named special servicer of the 2006-A Trust.

As a result of the determination above, we concluded that we were no longer the primary beneficiary and deconsolidated the 2006-A Trust. We also concluded that the deconsolidation of the 2006-A Trust qualified as a financial asset transfer and that the transaction resulted in our surrendering control over the financial assets held by the 2006-A Trust. This resulted in the removal of carrying amounts of $801.9 million of loans, $55.7 million

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

of restricted cash and $891.3 million of term debt from our consolidated balance sheet and the recognition of a gain of $16.7 million, recorded in other income, net in our consolidated statement of income for the three months ended September 30, 2010. As of September 30, 2011, the fair value of interests in the 2006-A Trust that we had repurchased in the market subsequent to the initial securitization and held as of September 30, 2011 was $19.0 million and was classified as investment securities, available-for-sale in our consolidated balance sheets. We have no additional funding commitments or other obligations related to these interests. Except for a guarantee provided to a swap counterparty of the 2006-A Trust, we have not provided any additional financial support to the 2006-A Trust during the nine months ended September 30, 2011. This swap exposure had a fair value to the counterparty of $16.0 million as of September 30, 2011. The interests in the Trust and the swap guarantee comprise our maximum exposure to loss related to the 2006-A Trust. During the nine months ended September 30, 2011, we recognized a gain of $13.3 million, included in gain on investments, net in our consolidated statements of income, on the sale of certain of our interests in the 2006-A Trust. In addition, during the three and nine months ended September 30, 2011, we recorded gross unrealized losses of $2.2 million and gross unrealized gains of $8.0 million, respectively, included as a component of other comprehensive income, on the securities that we still hold in the 2006-A Trust as of September 30, 2011.

Note 10. Borrowings

For additional information on our borrowings, see Note 11, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2010, included in our Form 10-K.

As of September 30, 2011 and December 31, 2010, the composition of our outstanding borrowings was as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Credit facilities	$	—	$	67,508
Term debt (1)		347,744		979,254
Other borrowings:
Convertible debt, net (2)		174,263		523,650
Subordinated debt		437,294		437,286
FHLB SF borrowings		540,000		412,000
Notes payable		—		2,948

Total other borrowings		1,151,557		1,375,884

Total borrowings	$	1,499,301	$	2,422,646

(1)	Amounts presented are net of discounts of $0.1 million and $14.4 million as of September 30, 2011 and December 31, 2010, respectively.

(2)	Amounts presented are net of discounts of $0.7 million and $6.9 million as of September 30, 2011 and December 31, 2010, respectively.

Credit Facilities

As of December 31, 2010, we had access to one secured credit facility with committed capacity of $167.5 million to finance our commercial loans and for general corporate purposes. Undrawn capacity on the secured credit facility was limited by issued and outstanding letters of credit totaling $21.0 million as of December 31, 2010. We terminated this credit facility on April 12, 2011.

Term Debt

As of September 30, 2011 and December 31, 2010, the carrying amounts of our term debt related to securitizations were $345.9 million and $693.5 million, respectively. In June 2011, all outstanding term debt of the 2007-2 securitization held by third parties was repaid in full.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

During the three months ended September 30, 2011, we repurchased $298.1 million of our outstanding 12.75% 2014 Senior Secured Notes and paid a redemption price of $376.4 million. We recorded a pre-tax loss of $111.1 million on the extinguishment of debt in our consolidated statements of operations. As of September 30, 2011 and December 31, 2010, the 12.75% 2014 Senior Secured Notes had balances of $1.8 million and $285.7 million, respectively, net of discounts of $0.1 million and $14.3 million, respectively.

Convertible Debt

During the three months ended September 30, 2011, we tendered, repurchased and retired our outstanding 3.5% and 4.0% Convertible Debentures at par for an aggregate of $280.5 million. In addition, we repurchased $75.1 million of the outstanding principal of our 7.25% Convertible Debentures for $77.3 million and recorded a related pre-tax loss of $2.6 million on the extinguishment of debt in our consolidated statements of operations. As of September 30, 2011 and December 31, 2010, the carrying amounts of the liability and equity components of our convertible debt were as follows:


	September 30, 2011			December 31, 2010
	($ in thousands)
Convertible debt principal	$	174,914		$	530,523
Less: debt discount		(651	)		(6,873	)

Net carrying value	$	174,263		$	523,650

Equity components recorded in additional paid-in capital	$	—		$	101,220

As of September 30, 2011, the conversion prices and the number of shares used to determine the aggregate consideration that would have been delivered upon conversion of our convertible debentures were as follows:


	Conversion Price		Number of Shares
7.25% Senior Subordinated Convertible Debentures due 2037	$	27.09		6,455,708

For the three and nine months ended September 30, 2011 and 2010, the interest expense recognized on our Convertible Debentures and the effective interest rates on the liability components were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Interest expense recognized on:
Contractual interest coupon	$	4,223		$	7,491		$	18,926		$	22,745
Amortization of deferred financing fees		72			299			677			1,029
Amortization of debt discount		636			2,595			5,896			7,870

Total interest expense recognized	$	4,931		$	10,385		$	25,499		$	31,644

Effective interest rate on the liability component:
3.5% Senior Convertible Debentures due 2034		7.16	%		7.25	%		7.16	%		7.25	%
4.0% Senior Subordinated Convertible Debentures due 2034		7.85	%		7.68	%		7.85	%		7.68	%
7.25% Senior Subordinated Convertible Debentures due 2037		7.79	%		7.79	%		7.79	%		7.79	%

The unamortized discounts on our 7.25% Convertible Debentures will be amortized through the first put date of July 15, 2012.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FHLB SF Borrowings and FRB Credit Program

CapitalSource Bank is a member of the FHLB SF. As of September 30, 2011 and December 31, 2010, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:


	September 30, 2011			December 31, 2010
	($ in thousands)
Borrowing capacity	$	926,753		$	885,842
Less: outstanding principal		(540,000	)		(412,000	)
Less: outstanding letters of credit		(600	)		(600	)

Unused borrowing capacity	$	386,153		$	473,242

CapitalSource Bank is an approved depository institution under the primary credit program of the FRB of San Francisco’s discount window eligible to borrow from the FRB for short periods, generally overnight. As of September 30, 2011 and December 31, 2010, collateral with amortized costs of $102.3 million and $179.0 million, respectively, and fair values of $103.0 million and $188.0 million, respectively, had been pledged under this program. As of September 30, 2011 and December 31, 2010, there were no borrowings outstanding.

Note 11. Shareholders’ Equity

Common Stock Shares Outstanding

Common stock share activity for the nine months ended September 30, 2011 was as follows:


Outstanding as of December 31, 2010	323,225,355
Exercise of options	422,375
Restricted stock and other stock activities	2,027,247
Repurchase of common stock	(49,888,700	)

Outstanding as of September 30, 2011	275,786,277

As of September 30, 2011, our Board of Directors had authorized the repurchase of $385.0 million of our common stock over a period of up to two years commencing in December 2010 the (“Stock Repurchase Program”). During the nine months ended September 30, 2011, we repurchased 49.9 million shares of our common stock at an aggregate price of $308.6 million pursuant to the Stock Repurchase Program. All shares were retired upon repurchase.

Note 12. Income Taxes

We provide for income taxes as a “C” corporation on income earned from operations. For the tax year ended December 31, 2010, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We intend to reconsolidate our subsidiaries in 2011 for federal tax purposes. We are subject to federal, foreign, state and local taxation in various jurisdictions.

In 2009, we established a valuation allowance against a substantial portion of our net deferred tax assets for subsidiaries where we determined that there was significant negative evidence with respect to our ability to realize such assets. Negative evidence we considered in making this determination included the incurrence of operating losses at several of our subsidiaries, and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of September 30, 2011 and December 31, 2010, the total valuation allowance was $474.4 million and $413.8 million, respectively. Although realization is not assured, we believe it is more likely than not that the net deferred tax assets of $40.4 million as of September 30, 2011 will be realized. We intend to maintain a valuation allowance with respect to our deferred tax assets until sufficient positive evidence exists to support its reduction or reversal.

During the three and nine months ended September 30, 2011, we recorded income tax benefit of $11.3 million and income tax expense of $17.1 million, respectively. The benefit for the three months ended September 30, 2011 was primarily the result of the change in valuation allowance related to the deferred tax assets of

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

CapitalSource Bank. The expense for the nine months ended September 30, 2011 was primarily related to the re-establishment of a valuation allowance at the consolidated group level with respect to CapitalSource Bank’s net deferred tax assets, and state income tax expenses incurred by CapitalSource Bank. The valuation allowance was recorded in connection with our plan to reconsolidate our corporate entities for federal tax purposes in 2011. For the three and nine months ended September 30, 2010, we recorded income tax benefit of $35.7 million and $18.8 million, respectively. The effective income tax rate on our consolidated net (loss) income from continuing operations was 12.3% and (39.1)% for the three and nine months ended September 30, 2011, respectively, and (84.1)% and 11.4% for the three and nine months ended September 30, 2010, respectively.

We file income tax returns with the United States and various state, local and foreign jurisdictions and generally remain subject to examinations by these tax jurisdictions for tax years 2006 through 2010. We are currently under examination by the Internal Revenue Service for the tax years 2006 to 2008 and by certain states for the tax years 2006 to 2009.

Note 13. Comprehensive (Loss) Income

Comprehensive (loss) income for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Net (loss) income from continuing operations	$	(80,712	)	$	78,102		$	(60,959	)	$	(146,433	)
Net income from discontinued operations, net of tax		—			—			—			9,489
Gain from sale of discontinued operations, net of tax		—			—			—			21,696

Net (loss) income		(80,712	)		78,102			(60,959	)		(115,248	)
Unrealized (loss) gain on available-for-sale securities, net of tax (1)		(4,078	)		1,016			21,219			7,491
Unrealized (loss) gain on foreign currency translation, net of tax		(10,795	)		23,749			665			(6,224	)
Unrealized loss on cash flow hedges, net of tax		—			(22	)		—			(66	)

Comprehensive (loss) income		(95,585	)		102,845			(39,075	)		(114,047	)
Comprehensive loss attributable to noncontrolling interests		—			(83	)		—			(83	)

Comprehensive (loss) income attributable to CapitalSource Inc.	$	(95,585	)	$	102,928		$	(39,075	)	$	(113,964	)

(1)	Includes a tax benefit of $10.0 million related to fair value adjustments on available-for-sale securities for the nine months ended September 30, 2011. There was no such tax benefit during the three months ended September 30, 2011.

Accumulated other comprehensive income, net, as of September 30, 2011 and December 31, 2010 was as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Unrealized gain on available-for-sale securities, net of tax (1)	$	26,982	$	5,763
Unrealized gain on foreign currency translation, net of tax		4,843		4,178

Accumulated other comprehensive income, net	$	31,825	$	9,941

(1)	Includes a tax benefit of $10.0 million related to fair value adjustments on available-for-sale securities as of September 30, 2011.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

During the three months ended September 30, 2011, we determined that the sales and paydowns of a liquidating portfolio of loans within a foreign subsidiary constituted a substantially complete liquidation of a foreign entity in accordance with GAAP. As a result, we reclassified the foreign currency translation adjustment related to our investment in this subsidiary from accumulated other comprehensive income and recorded a gain on sale of investments of $9.2 million for the three months ended September 30, 2011.

Note 14. Net (Loss) Income Per Share

The computations of basic and diluted net (loss) income per share for the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,					Nine Months Ended September 30,
	2011			2010		2011			2010
	($ in thousands, except per share data)
Net (loss) income:
From continuing operations	$	(80,712	)	$	78,102	$	(60,959	)	$	(146,433	)
From discontinued operations, net of taxes		—			—		—			9,489
From sale of discontinued operations, net of taxes		—			—		—			21,696

Total from discontinued operations		—			—		—			31,185
Attributable to CapitalSource Inc.	$	(80,712	)	$	78,185	$	(60,959	)	$	(115,165	)
Average shares — basic		306,535,063			321,070,479		315,719,413			320,723,068
Effect of dilutive securities:
Option shares		—			884,277		—			—
Restricted shares		—			158,011		—			—
Stock units		—			3,224,970		—			—

Average shares — diluted		306,535,063			325,337,737		315,719,413			320,723,068

Basic net (loss) income per share
From continuing operations	$	(0.26	)	$	0.24	$	(0.19	)	$	(0.46	)
From discontinued operations, net of taxes		—			—		—			0.10
Attributable to CapitalSource Inc.		(0.26	)		0.24		(0.19	)		(0.36	)
Diluted net (loss) income per share
From continuing operations	$	(0.26	)	$	0.24	$	(0.19	)	$	(0.46	)
From discontinued operations, net of taxes		—			—		—			0.10
Attributable to CapitalSource Inc.		(0.26	)		0.24		(0.19	)		(0.36	)

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The shares that have an antidilutive effect in the calculation of diluted net (loss) income per share attributable to CapitalSource Inc. and have been excluded from the computations above were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
Stock units		3,427,158		3,653,579		3,427,158		3,653,579
Stock options		7,437,391		8,596,113		7,437,391		8,596,113
Shares issuable upon conversion of convertible debt		—		14,097,586		—		14,097,586
Unvested restricted stock		4,633,282		2,201,088		4,633,282		2,201,088

Note 15. Bank Regulatory Capital

CapitalSource Bank is subject to various regulatory capital requirements established by federal and state regulatory agencies. Failure to meet minimum capital requirements can result in regulatory agencies initiating certain mandatory and possibly additional discretionary actions that, if undertaken, could have a direct material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, CapitalSource Bank must meet specific capital guidelines that involve quantitative measures of its assets and liabilities as calculated under regulatory accounting practices. CapitalSource Bank’s capital amounts and other requirements are also subject to qualitative judgments by its regulators about risk weightings and other factors. See Item 1, Business — Supervision and Regulation, in our Form 10-K and Supervision and Regulation within Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q for a further description of CapitalSource Bank’s regulatory requirements.

Under prompt corrective action regulations, a “well-capitalized” bank must have a total risk-based capital ratio of 10%, a Tier 1 risk-based capital ratio of 6%, and a Tier 1 leverage ratio of 5%. Under its approval order from the FDIC, CapitalSource Bank must be “well-capitalized” and at all times have a minimum total risk-based capital ratio of 15%, a minimum Tier-1 risk-based capital ratio of 6% and a minimum Tier 1 leverage ratio of 5%. CapitalSource Bank’s ratios and the minimum requirements as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011										December 31, 2010
	Actual					Minimum Required					Actual					Minimum Required
	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
	($ in thousands)
Tier-1 Leverage	$	848,198		13.50	%	$	314,093		5.00	%	$	756,821		13.15	%	$	287,830		5.00	%
Tier-1 Risk-Based Capital		848,198		16.87			301,714		6.00			756,821		16.86			269,335		6.00
Total Risk-Based Capital		911,771		18.13			754,285		15.00			813,822		18.13			673,336		15.00

Note 16. Commitments and Contingencies

We provide standby letters of credit in conjunction with several of our lending arrangements and property lease obligations. As of September 30, 2011 and December 31, 2010, we had issued $82.7 million and $143.4 million, respectively, in stand-by letters of credit which expire at various dates over the next nine years. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be required to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. These arrangements had carrying amounts totaling $2.4 million and $3.8 million and were included in other liabilities in our consolidated balance sheets as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011 and December 31, 2010, we had unfunded commitments to extend credit to our clients of $1.4 billion and $1.9 billion, respectively, including unfunded commitments to extend credit by CapitalSource Bank of $874.4 million and $958.7 million, respectively, and by the Parent Company of $489.9

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

million and $977.7 million, respectively. Additional information on these contingencies is included in Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2010, included in our Form 10-K.

During the years ended December 31, 2010 and 2009, we sold all of our direct real estate investment properties. We are responsible for indemnifying the current owners for any remediation, including costs of removal and disposal of asbestos that existed prior to the sales, through the third anniversary date of the sale. We will recognize any remediation costs if notified by the current owners of their intention to exercise their indemnification rights; however, no such notification has been received to date. As of September 30, 2011, sufficient information was not available to estimate our potential liability for conditional asset retirement obligations as the obligations to remove the asbestos from these properties continue to have indeterminable settlement dates.

From time to time we are party to legal proceedings. We do not believe that any currently pending or threatened proceeding, if determined adversely to us, would have a material adverse effect on our business, financial condition or results of operations, including our cash flows.

Note 17. Derivative Instruments

We are exposed to certain risks related to our ongoing business operations. The primary risks managed through the use of derivative instruments are interest rate risk and foreign exchange risk. We do not enter into derivative instruments for speculative purposes. As of September 30, 2011, none of our derivatives were designated as hedging instruments pursuant to GAAP.

We enter into various derivative instruments to manage our exposure to interest rate risk. The objective is to manage interest rate sensitivity by modifying the characteristics of certain assets and liabilities to reduce the adverse effect of changes in interest rates. We primarily use interest rate swaps and basis swaps to manage our interest rate risks.

Interest rate swaps are contracts in which a series of interest rate cash flows, based on a specific notional amount as well as fixed and variable interest rates, are exchanged over a prescribed period. To minimize the economic effect of interest rate fluctuations specific to our fixed rate debt and certain fixed rate loans, we enter into interest rate swap agreements whereby either we pay a fixed interest rate and receive a variable interest rate or we pay a variable interest rate and receive a fixed interest rate over a prescribed period.

We also enter into basis swaps to eliminate risk between our LIBOR-based term debt securitizations and the prime-based loans pledged as collateral for that debt. These basis swaps modify our exposure to interest rate risk typically by converting our prime rate loans to a one-month LIBOR rate. The objective of this swap activity is to protect us from risk that interest collected under the prime rate loans will not be sufficient to service the interest due under the one-month LIBOR-based term debt.

We enter into forward exchange contracts to hedge foreign currency denominated loans we originate against foreign currency fluctuations. The objective is to manage the uncertainty of future foreign exchange rate fluctuations. These forward exchange contracts provide for a fixed exchange rate which has the effect of reducing or eliminating changes to anticipated cash flows to be received from foreign currency-denominated loan transactions as the result of changes to exchange rates.

Derivative instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk exposure consists primarily of the termination value of agreements where we are in a favorable position. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from certain counterparties and monitor all exposure and collateral requirements daily. We continually monitor the fair value of collateral received from counterparties and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. We also posted collateral of $10.0 million related to counterparty requirements

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

for foreign exchange contracts at CapitalSource Bank as of September 30, 2011. Our agreements generally include master netting agreements whereby we are entitled to settle our individual derivative positions with the same counterparty on a net basis upon the occurrence of certain events. As of September 30, 2011, our derivative counterparty exposure was as follows ($ in thousands):


Gross derivative counterparty exposure	$	60,770
Master netting agreements		(40,148	)

Net derivative counterparty exposure	$	20,622

We report our derivatives in our consolidated balance sheets at fair value on a gross basis irrespective of our master netting arrangements. We held $19.8 million of collateral against our derivative instruments that were in an asset position as of September 30, 2011. For derivatives that were in a liability position, we had posted collateral of $56.4 million as of September 30, 2011.

As of September 30, 2011, the notional amounts and fair values of our various derivative instruments as well as their locations in our consolidated balance sheets were as follows:


	September 30, 2011						December 31, 2010
			Fair Value						Fair Value
	Notional Amount		Other Assets		Other Liabilities		Notional Amount		Other Assets		Other Liabilities
	($ in thousands)
Interest rate contracts	$	1,169,408	$	58,759	$	94,872	$	1,287,399	$	41,309	$	77,410
Foreign exchange contracts		37,279		2,011		—		35,557		—		877

Total	$	1,206,687	$	60,770	$	94,872	$	1,322,956	$	41,309	$	78,287

The gains and losses on our derivative instruments recognized during the three and nine months ended September 30, 2011 and 2010 as well as the locations of such gains and losses in our consolidated statements of operations were as follows:


		Gain (Loss) Recognized in Income

		Three Months Ended September 30,						Nine Months Ended September 30,
	Location	2011			2010			2011			2010
		($ in thousands)
Interest rate contracts	Loss on derivatives	$	(4,176	)	$	(1,101	)	$	(4,792	)	$	(8,424	)
Foreign exchange contracts	Loss on derivatives		2,063			(867	)		530			(1,495	)

Total		$	(2,113	)	$	(1,968	)	$	(4,262	)	$	(9,919	)

Note 18. Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain of our assets and liabilities and to determine fair value disclosures. Investment securities, available-for-sale, warrants and derivatives are recorded at fair value on a recurring basis. In addition, we may be required, in specific circumstances, to measure certain of our assets at fair value on a nonrecurring basis, including investment securities, held-to-maturity, loans held for sale, loans held for investment, REO and certain other investments.

Fair Value Determination

Fair value is based on quoted market prices or by using market based inputs where available. Given the nature of some of our assets and liabilities, clearly determinable market based valuation inputs are often not available; therefore, these assets and liabilities are valued using internal estimates. As subjectivity exists with respect to many of our valuation estimates used, the fair values we have disclosed may not equal prices that we may ultimately realize if the assets are sold or the liabilities settled with third parties.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Below is a description of the valuation methods for our assets and liabilities recorded at fair value on either a recurring or nonrecurring basis. While we believe the valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain assets and liabilities could result in a different estimate of fair value at the measurement date.

Assets and Liabilities

Cash

Cash and cash equivalents and restricted cash are recorded at historical cost. The carrying amount is a reasonable estimate of fair value as these instruments have short-term maturities and interest rates that approximate market.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consist of U.S. Treasury bills, Agency discount notes, Agency callable notes, Agency debt, Agency MBS, Non-agency MBS, and corporate debt securities that are carried at fair value on a recurring basis and classified as available-for-sale securities. Fair value adjustments on these investments are generally recorded through other comprehensive income. However, if impairment on an investment, available-for-sale is deemed to be other-than-temporary, all or a portion of the fair value adjustment may be reported in earnings. The securities are valued using quoted prices from external market participants, including pricing services. If quoted prices are not available, the fair value is determined using quoted prices of securities with similar characteristics or independent pricing models, which utilize observable market data such as benchmark yields, reported trades and issuer spreads. These securities are primarily classified within Level 2 of the fair value hierarchy.

Investment securities, available-for-sale, also consist of a collateralized loan obligation, which include the interests we hold in the deconsolidated 2006-A Trust, and a municipal bond, whose values are determined using internally developed valuation models. These models may utilize discounted cash flow techniques for which key inputs include the timing and amount of future cash flows and market yields. Market yields are based on comparisons to other instruments for which market data is available. These models may also utilize industry valuation benchmarks, such as multiples of EBITDA, to determine a value for the underlying enterprise. Given the lack of active and observable trading in the market, our collateralized loan obligation and municipal bond are classified in Level 3.

Investment securities, available-for-sale, also consist of equity securities which are valued using the stock price of the underlying company in which we hold our investment. Our equity securities are classified in Level 1 or 2 depending on the level of activity within the market.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consist of commercial mortgage-backed-securities. These securities are generally recorded at amortized cost, but are recorded at fair value on a non-recurring basis to the extent we record an OTTI on the securities. Fair value measurements are determined using quoted prices from external market participants, including pricing services. If quoted prices are not available, the fair value is determined using quoted prices of securities with similar characteristics or independent pricing models, which utilize observable market data such as benchmark yields, reported trades and issuer spreads.

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value, with fair value adjustments recorded on a nonrecurring basis. The fair value is determined using actual market transactions when available. In situations when market transactions are not available, we use the income approach through internally developed valuation models to estimate the fair value. This requires the use of significant judgment surrounding discount rates and the

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

timing and amounts of future cash flows. Key inputs to these valuations also include costs of completion and unit settlement prices for the underlying collateral of the loans. Fair values determined through actual market transactions are classified within Level 2 of the fair value hierarchy, while fair values determined through internally developed valuation models are classified within Level 3 of the fair value hierarchy.

Loans Held for Investment

Loans held for investment are recorded at outstanding principal, net of any deferred fees and unamortized purchase discounts or premiums and net of an allowance for loan losses. We may record fair value adjustments on a nonrecurring basis when we have determined that it is necessary to record a specific reserve against a loan and we measure such specific reserve using the fair value of the loan’s collateral. To determine the fair value of the collateral, we may employ different approaches depending on the type of collateral.

In cases where our collateral is a fixed or other tangible asset, including commercial real estate, our determination of the appropriate method to use to measure fair value depends on several factors including the type of collateral that we are evaluating, the age of the most recent appraisal performed on the collateral, and the time required to obtain an updated appraisal. Typically, we obtain an updated third-party appraisal to estimate fair value using external valuation specialists.

For impaired collateral dependent commercial real estate loans, we typically obtain an updated appraisal as of the date the loan is deemed impaired to measure the amount of impairment. In situations where we are unable to obtain a timely updated appraisal, we perform internal valuations which utilize assumptions and calculations similar to those customarily utilized by third party appraisers and consider relevant property specific facts and circumstances. In certain instances, our internal assessment of value may be based on adjustments to outdated appraisals by analyzing the changes in local market conditions and asset performance since the appraisals were performed. The outdated appraisal values may be discounted by percentages that are determined by analyzing changes in local market conditions since the dates of the appraisals as well as by consulting databases, comparable market sale prices, brokers’ opinions of value and other relevant data. We do not make adjustments that increase the values indicated by outdated appraisals by using higher recent sale comparisons.

Impaired collateral dependent commercial real estate loans for which ultimate collection depends solely on the sale of the collateral are charged off to the estimated fair value of the collateral less estimated costs to sell. For certain of these loans, we charged off to an amount different than the value indicated by the most recent appraisal. This was primarily the result of both factors causing the appraisal to be outdated as outlined above and other factors surrounding the loans not considered by appraisals, such as pending loan sales and other transaction specific factors. As of September 30, 2011 and December 31, 2010, we charged off an additional $65.2 million, net, and $58.2 million, net, respectively, in loan balances compared with amounts that would have been charged off based on the appraised values of the collateral. In addition, we have impaired collateral dependent commercial real estate loans with a carrying amount as of September 30, 2011 of $4.5 million for which we do not have appraisals. Valuations for the real estate collateral securing these loans are based on observable transactions and industry metrics.

Our policy on updating appraisals related to these originated impaired collateral dependent commercial real estate loans generally is to obtain current appraisals subsequent to the impairment date if there are significant changes to the underlying assumptions from the most recent appraisal. Some factors that could cause significant changes include the passage of more than twelve months since the time of the last appraisal; the volatility of the local market; the availability of financing; the inventory of competing properties; new improvements to, or lack of maintenance of, the subject property or competing surrounding properties; a change in zoning; environmental contamination; or failure of the project to meet material assumptions of the original appraisal. This policy for updating appraisals does not vary by commercial real estate loan type.

We continue to monitor collateral values on partially charged-off impaired collateral dependent commercial real estate loans and may record additional charge offs upon receiving updated appraisals. We do not return such partially charged-off loans to performing status, except in limited circumstances when such loans have been

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

formally restructured and have met key performance criteria including compliance with restructured payment terms. We do not return such partially charged-off loans to performing status based solely on the results of appraisals.

In cases where our collateral is not a fixed or tangible asset, we typically use industry valuation benchmarks to determine the value of the asset or the underlying enterprise.

When fair value adjustments are recorded on loans held for investment, we typically classify them in Level 3 of the fair value hierarchy.

We determine the fair value estimates of loans held for investment for fair value disclosures primarily using external valuation specialists. These valuation specialists group loans based on credit rating and collateral type, and the fair value is estimated utilizing discounted cash flow techniques. The valuations take into account current market rates of return, contractual interest rates, maturities and assumptions regarding expected future cash flows. Within each respective loan grouping, current market rates of return are determined based on quoted prices for similar instruments that are actively traded, adjusted as necessary to reflect the illiquidity of the instrument. This approach requires the use of significant judgment surrounding current market rates of return, liquidity adjustments and the timing and amounts of future cash flows.

Other Investments

Other investments accounted for under the cost or equity methods of accounting are carried at fair value on a nonrecurring basis to the extent that they are determined to be other-than-temporarily impaired during the period. As there is rarely an observable price or market for such investments, we determine fair value using internally developed models. Our models utilize industry valuation benchmarks, such as multiples of EBITDA, to determine a value for the underlying enterprise. We reduce this value by the value of debt outstanding to arrive at an estimated equity value of the enterprise. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the pricing indicated by the external event will be used to corroborate our private equity valuation. Fair value measurements related to these investments are typically classified within Level 3 of the fair value hierarchy.

Warrants

Warrants are carried at fair value on a recurring basis and generally relate to privately held companies. Warrants for privately held companies are valued based on the estimated value of the underlying enterprise. This fair value is derived principally using a multiple determined either from comparable public company data or from the transaction where we acquired the warrant and a financial performance indicator based on EBITDA or another revenue measure. Given the nature of the inputs used to value privately held company warrants, they are classified in Level 3 of the fair value hierarchy.

FHLB SF Stock

Our investment in FHLB stock is recorded at historical cost. FHLB stock does not have a readily determinable fair value, but may be sold back to the FHLB at its par value with stated notice. The investment in FHLB SF stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB and its overall financial condition. No impairment losses on our investment in FHLB stock have been recorded through September 30, 2011.

Derivative Assets and Liabilities

Derivatives are carried at fair value on a recurring basis and primarily relate to interest rate swaps, caps, floors, basis swaps and forward exchange contracts which we enter into to manage interest rate risk and foreign exchange risk. Our derivatives are principally traded in over-the-counter markets where quoted market prices are

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

not readily available. Instead, derivatives are measured using market observable inputs such as interest rate yield curves, volatilities and basis spreads. We also consider counterparty credit risk in valuing our derivatives. We typically classify our derivatives in Level 2 of the fair value hierarchy.

Real Estate Owned

REO is initially recorded at its estimated fair value less costs to sell at the time of foreclosure if the related REO is classified as held for sale. REO held for sale is carried at the lower of its carrying amount or fair value subsequent to the date of foreclosure, with fair value adjustments recorded on a nonrecurring basis. REO held for use is recorded at its carrying amount, net of accumulated depreciation, with fair value adjustments recorded on a nonrecurring basis if the carrying amount of the real estate is not recoverable and exceeds its fair value. When available, the fair value of REO is determined using actual market transactions. When market transactions are not available, the fair value of REO is typically determined based upon recent appraisals by third parties. We may or may not adjust these third party appraisal values based on our own internally developed judgments and estimates. To the extent that market transactions or third party appraisals are not available, we use the income approach through internally developed valuation models to estimate the fair value. This requires the use of significant judgment surrounding discount rates and the timing and amounts of future cash flows. Fair values determined through actual market transactions are classified within Level 2 of the fair value hierarchy while fair values determined through third party appraisals and through internally developed valuation models are classified within Level 3 of the fair value hierarchy.

Other Foreclosed Assets

When we foreclose on a borrower whose underlying collateral consists of loans, we record the acquired loans at the estimated fair value at the time of foreclosure. Valuation of that collateral, which often is a pool of many small balance loans, is typically performed utilizing internally-developed estimates. These estimates rely upon default and recovery rates, market discount rates and the underlying value of collateral supporting the loans. Underlying collateral values may be supported by appraisals or broker price opinions. When fair value adjustments are recorded on these loans, we typically classify them in Level 3 of the fair value hierarchy.

Deposits

Deposits are carried at historical cost. The carrying amounts of deposits for savings and money market accounts and brokered certificates of deposit are deemed to approximate fair value as they either have no stated maturities or short-term maturities. Certificates of deposit are grouped by maturity date, and the fair value is estimated utilizing discounted cash flow techniques. The interest rates applied are rates currently being offered for similar certificates of deposit within the respective maturity groupings.

Credit Facilities

The fair value of credit facilities is estimated based on current market interest rates for similar debt instruments adjusted for the remaining time to maturity.

Term Debt

Term debt comprises term debt securitizations and our 2014 Senior Secured Notes. For disclosure purposes, the fair values of our term debt securitizations and 2014 Senior Secured Notes are determined based on actual prices from recent third party purchases of our debt when available and based on indicative price quotes received from various market participants when recent transactions have not occurred.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Other Borrowings

Our other borrowings comprise convertible debt and subordinated debt. For disclosure purposes, the fair value of our convertible debt is determined from quoted market prices in active markets or, when the market is not active, from quoted market prices for debt with similar maturities. The fair value of our subordinated debt is determined based on recent third party purchases of our debt when available and based on indicative price quotes received from market participants when recent transactions have not occurred.

Off-Balance Sheet Financial Instruments

Loan Commitments and Letters of Credit

Loan commitments and letters of credit generate ongoing fees at our current pricing levels, which are recognized over the term of the commitment period. For disclosure purposes, the fair value is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current creditworthiness of the counterparties and current market conditions. In addition, for loan commitments, the market rates of return utilized in the valuation of the loans held for investment as described above are applied to this analysis to reflect current market conditions.

Assets and Liabilities Carried at Fair Value on a Recurring Basis

Assets and liabilities have been grouped in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of September 30, 2011 were as follows:


	Fair Value Measurement as of September 30, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)
Assets
Investment securities, available-for-sale:
Agency callable notes	$	115,630	$	—	$	115,630	$	—
Agency debt		45,269		—		45,269		—
Agency MBS		1,153,009		—		1,153,009		—
Assets-backed securities		17,638		—		17,638		—
Collateralized loan obligation		18,994		—		—		18,994
Corporate debt		5,756		—		5,025		731
Equity security		372		372		—		—
Municipal bond		3,235		—		—		3,235
Non-agency MBS		77,954		—		77,954		—
U.S. Treasury and agency securities		19,569		—		19,569		—

Total investment securities, available-for-sale		1,457,426		372		1,434,094		22,960
Investments carried at fair value:
Warrants		200		—		—		200
Other assets held at fair value:
Derivative assets		60,770		—		60,770		—

Total assets	$	1,518,396	$	372	$	1,494,864	$	23,160

Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	94,872	$	—	$	94,872	$	—

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of December 31, 2010 were as follows:


	Fair Value Measurement as of December 31, 2010		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)
Assets
Investment securities, available-for-sale:
Agency callable notes	$	162,888	$	—	$	162,888	$	—
Agency debt		103,430		—		103,430		—
Agency discount notes		164,974		—		164,974		—
Agency MBS		870,155		—		870,155		—
Collateralized loan obligation		12,249		—		—		12,249
Corporate debt		5,135		—		5,120		15
Equity security		263		263		—		—
Non-agency MBS		113,684		—		113,684		—
U.S. Treasury and agency securities		90,133		—		90,133		—

Total investment securities, available-for-sale		1,522,911		263		1,510,384		12,264
Investments carried at fair value:
Warrants		222		—		—		222
Other assets held at fair value:
Derivative assets		41,309		—		41,309		—

Total assets	$	1,564,442	$	263	$	1,551,693	$	12,486

Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	78,287	$	—	$	78,287	$	—

A summary of the changes in the fair values of assets carried at fair value for the three months ended September 30, 2011 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Corporate Debt		Collateralized Loan Obligation			Municipal Bonds		Total			Warrants			Total Assets
	($ in thousands)
Balance as of July 1, 2011	$	717	$	20,446		$	3,235	$	24,398		$	210		$	24,608
Realized and unrealized gains (losses):									—
Included in income		14		734			—		748			(5	)		743
Included in other comprehensive loss, net		—		(2,186	)		—		(2,186	)		—			(2,186	)

Total realized and unrealized gains (losses)		14		(1,452	)		—		(1,438	)		(5	)		(1,443	)

Sales:
Sales		—		—			—		—			(5	)		(5	)

Balance as of September 30, 2011	$	731	$	18,994		$	3,235	$	22,960		$	200		$	23,160

Unrealized gains (losses) as of September 30, 2011	$	14	$	734		$	—	$	748		$	(10	)	$	738

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the changes in the fair values of assets carried at fair value for the three months ended September 30, 2010 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale

	Corporate Debt			Collateralized Loan Obligation		Total			Warrants			Total Assets
	($ in thousands)
Balance as of July 1, 2010	$	4,772		$	—	$	4,772		$	684		$	5,456
Realized and unrealized gains (losses):													—
Included in income		1,101			—		1,101			(36	)		1,065
Included in other comprehensive income, net		(903	)		—		(903	)		—			(903	)

Total realized and unrealized gains (losses)		198			—		198			(36	)		162

Acquisitions and sales:
Acquisitions		—			13,848		13,848			—			13,848
Sales		(4,970	)		—		(4,970	)		—			(4,970	)

Total acquisitions and sales		(4,970	)		13,848		8,878			—			8,878

Balance as of September 30, 2010	$	—		$	13,848	$	13,848		$	648		$	14,496

Unrealized losses as of September 30, 2010	$	—		$	—	$	—		$	(36	)	$	(36	)

Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the three months ended September 30, 2011 and 2010, reported in interest income and gain on investments, net were as follows:


	Interest Income				Gain on Investments, Net
	Three Months Ended September 30,
	2011		2010		2011			2010
	($ in thousands)
Total gains (losses) included in earnings for the period	$	748	$	—	$	(5	)	$	1,065
Unrealized gains (losses) relating to assets still held at reporting date		748		—		(10	)		(36	)

A summary of the changes in the fair values of assets carried at fair value for the nine months ended September 30, 2011 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Corporate Debt			Collateralized Loan Obligation			Municipal Bonds			Total			Warrants			Total Assets
	($ in thousands)
Balance as of January 1, 2011	$	15		$	12,249		$	—		$	12,264		$	222		$	12,486
Realized and unrealized gains (losses):
Included in income		14			17,770			(1,496	)		16,288			(4	)		16,284
Included in other comprehensive loss, net		(15	)		7,975			—			7,960			—			7,960

Total realized and unrealized (losses) gains		(1	)		25,745			(1,496	)		24,248			(4	)		24,244

Acquisitions and sales:
Acquisitions		717			—			4,731			5,448			—			5,448
Sales		—			(19,000	)		—			(19,000	)		(18	)		(19,018	)

Total acquisitions and sales		717			(19,000	)		4,731			(13,552	)		(18	)		(13,570	)

Balance as of September 30, 2011	$	731		$	18,994		$	3,235		$	22,960		$	200		$	23,160

Unrealized gains (losses) as of September 30, 2011	$	14		$	3,086		$	(1,496	)	$	1,604		$	(23	)	$	1,581

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the changes in the fair values of assets and liabilities carried at fair value for the nine months ended September 30, 2010 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Non-agency MBS			Corporate Debt			Collateralized Loan Obligation			Total			Warrants			Total Assets
	($ in thousands)
Balance as of January 1, 2010	$	61		$	4,457		$	1,326		$	5,844		$	1,392		$	7,236
Realized and unrealized gains (losses):
Included in income		—			1,226			636			1,862			(744	)		1,118
Included in other comprehensive income, net		—			(713	)		(308	)		(1,021	)		—			(1,021	)

Total realized and unrealized gains (losses)		—			513			328			841			(744	)		97

Acquisitions and sales:
Acquisitions		—			—			12,194			12,194			—			12,194
Sales		(61	)		(4,970	)		—			(5,031	)		—			(5,031	)

Total acquisitions and sales		(61	)		(4,970	)		12,194			7,163			—			7,163

Balance as of September 30, 2010	$	—		$	—		$	13,848		$	13,848		$	648		$	14,496

Unrealized losses as of September 30, 2010	$	—		$	—		$	—		$	—		$	(744	)	$	(744	)

Realized and unrealized gains and losses on assets classified in Level 3 of the fair value hierarchy included in income for the nine months ended September 30, 2011 and 2010, reported in interest income and gain on investments, net were as follows:


	Interest Income				Gain on Investments, Net
	Nine Months Ended September 30,
	2011		2010		2011			2010
	($ in thousands)
Total gains included in earnings for the period	$	4,494	$	159	$	11,790		$	959
Unrealized gains (losses) relating to assets still held at reporting date		3,095		—		(1,514	)		(744	)

Assets Carried at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis. As described above, these adjustments to fair value usually result from the application of lower of cost or fair value accounting or write downs of individual assets. The table below provides the fair values of those assets for which nonrecurring fair value adjustments were recorded during the three and nine months ended September 30, 2011, classified by their position in the fair value hierarchy. The table also provides the gains (losses) related to those assets recorded during the three and nine months ended September 30, 2011.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS


									Total Losses
	Fair Value Measurement		Quoted Prices in Active Markets for Identical		Significant Other Observable		Significant Unobservable		Three Months Ended			Nine Months Ended
	as of September 30, 2011		Assets (Level 1)		Inputs (Level 2)		Inputs (Level 3)		September 30, 2011			September 30, 2011
	($ in thousands)
Assets
Loans held for investment (1)	$	132,357	$	—	$	—	$	132,357	$	(27,711	)	$	(103,180	)
Investments carried at cost		1,880		—		—		1,880		(363	)		(717	)
Investments accounted for under the equity method		694		—		—		694		(56	)		(56	)
REO (2)		22,556		—		—		22,556		(6,725	)		(15,413	)
Loans acquired through foreclosure, net		16,855		—		—		16,855		(2,475	)		(9,880	)

Total assets	$	174,342	$	—	$	—	$	174,342	$	(37,330	)	$	(129,246	)

(1)	Represents impaired loans held for investment measured at fair value of the collateral less transaction costs of $9.7 million.

(2)	Represents REO measured at fair value of the collateral less transaction costs of $1.4 million.

The table below provides the fair values of those assets for which nonrecurring fair value adjustments were recorded during the three and nine months ended September 30, 2010, classified by their position in the fair value hierarchy. The table also provides the gains (losses) related to those assets recorded during the three and nine months ended September 30, 2010.


									Total Losses
	Fair Value Measurement		Quoted Prices in Active Markets for Identical		Significant Other Observable		Significant Unobservable		Three Months Ended			Nine Months Ended
	as of September 30, 2010		Assets (Level 1)		Inputs (Level 2)		Inputs (Level 3)		September 30, 2010			September 30, 2010
	($ in thousands)
Assets
Loans held for sale	$	36,979	$	—	$	36,979	$	—	$	(988	)	$	(41,060	)
Loans held for investment (1)		315,358		—		—		315,358		(26,641	)		(70,131	)
Investments carried at cost		1,090		—		—		1,090		(486	)		(2,732	)
REO (2)		52,393		—		—		52,393		(6,090	)		(37,800	)
Loans acquired through foreclosure, net		61,560		—		—		61,560		(1,250	)		(40,119	)

Total assets	$	467,380	$	—	$	36,979	$	430,401	$	(35,455	)	$	(191,842	)

(1)	Represents impaired loans held for investment measured at fair value of the loan’s collateral less transaction costs of $10.4 million.

(2)	Represents REO measured at fair value of the collateral less transaction costs of $1.9 million.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Fair Value of Financial Instruments

A financial instrument is defined as cash, evidence of an ownership interest in an entity, or a contract that creates a contractual obligation or right to deliver or receive cash or another financial instrument from a second entity on potentially favorable terms. The methods and assumptions used in estimating the fair values of our financial instruments are described above.

The table below provides fair value estimates for our financial instruments as of September 30, 2011 and December 31, 2010, excluding financial assets and liabilities for which carrying value is a reasonable estimate of fair value and those which are recorded at fair value on a recurring basis.


	September 30, 2011				December 31, 2010
	Carrying Value		Fair Value		Carrying Value		Fair Value
	($ in thousands)
Assets:
Loans held for investment, net	$	5,513,817	$	5,418,061	$	5,717,316	$	5,767,160
Investments carried at cost		34,572		63,126		33,062		64,735
Investment securities, held-to-maturity		102,651		104,355		184,473		195,438
Liabilities:
Deposits		4,885,831		4,895,519		4,621,273		4,628,903
Credit facilities		—		—		67,508		66,464
Term debt		347,744		275,160		979,254		921,169
Convertible debt, net		174,263		178,194		523,650		539,297
Subordinated debt		437,294		253,631		437,286		253,626
Loan commitments and letters of credit		—		22,542		—		32,972

Note 19. Segment Data

For the three and nine months ended September 30, 2011, and the three months ended September 30, 2010, we operated as two reportable segments: 1) CapitalSource Bank and 2) Other Commercial Finance. For the six months ended June 30, 2010, we operated as three reportable segments: 1) CapitalSource Bank, 2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. Our Healthcare Net Lease segment comprised our direct real estate investment business activities, which we exited completely with the sale of all of the assets related to this segment during 2010. We have reclassified all comparative period results to reflect our two current reportable segments. In addition, for comparative purposes, overhead and other intercompany allocations have been reclassified from the Healthcare Net Lease segment into the Other Commercial Finance segment for the three and nine months ended September 30, 2010.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The financial results of our operating segments as of and for the three months ended September 30, 2011 were as follows:


	Three Months Ended September 30, 2011
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	92,173	$	28,653		$	650		$	121,476
Interest expense		15,982		18,506			—			34,488
Provision for loan losses		13,725		21,393			—			35,118
Operating expenses		33,664		36,201			(17,304	)		52,561
Total other income (expense), net		12,933		(87,089	)		(17,145	)		(91,301	)

Net income (loss) before income taxes		41,735		(134,536	)		809			(91,992	)
Income tax expense (benefit)		16,513		(27,793	)		—			(11,280	)

Net income (loss)	$	25,222	$	(106,743	)	$	809		$	(80,712	)

Total assets as of September 30, 2011	$	6,547,719	$	1,870,608		$	(58,905	)	$	8,359,422
Total assets as of December 31, 2010		6,117,368		3,418,897			(90,858	)		9,445,407

The financial results of our operating segments for the three months ended September 30, 2010 were as follows:


	Three Months Ended September 30, 2010
	CapitalSource Bank			Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	86,212		$	69,745		$	(2,827	)	$	153,130
Interest expense		16,024			41,884			—			57,908
Provision for loan losses		14,552			24,219			—			38,771
Operating expenses		28,597			40,795			(14,625	)		54,767
Other income, net		7,148			47,962			(14,360	)		40,750

Net income from continuing operations before income taxes		34,187			10,809			(2,562	)		42,434
Income tax benefit		(2,707	)		(32,961	)		—			(35,668	)

Net income from continuing operations	$	36,894		$	43,770		$	(2,562	)	$	78,102

The financial results of our operating segments for the nine months ended September 30, 2011 were as follows:


	Nine Months Ended September 30, 2011
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	274,467	$	116,968		$	(382	)	$	391,053
Interest expense		46,804		80,243			—			127,047
Provision for loan losses		23,636		57,814			—			81,450
Operating expenses		99,199		119,203			(56,258	)		162,144
Total other income (expense), net		18,898		(29,984	)		(53,154	)		(64,240	)

Net income (loss) before income taxes		123,726		(170,276	)		2,722			(43,828	)
Income tax expense (benefit)		38,448		(21,317	)		—			17,131

Net income (loss)	$	85,278	$	(148,959	)	$	2,722		$	(60,959	)

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The financial results of our operating segments for the nine months ended September 30, 2010 were as follows:


	Nine Months Ended September 30, 2010
	CapitalSource Bank			Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	246,592		$	249,411		$	(6,739	)	$	489,264
Interest expense		49,756			133,910			—			183,666
Provision for loan losses		107,350			175,623			—			282,973
Operating expenses		82,180			131,694			(42,311	)		171,563
Other income, net		22,374			3,294			(41,999	)		(16,331	)

Net income (loss) from continuing operations before income taxes		29,680			(188,522	)		(6,427	)		(165,269	)
Income tax benefit		(5,226	)		(13,610	)		—			(18,836	)

Net income (loss) from continuing operations	$	34,906		$	(174,912	)	$	(6,427	)	$	(146,433	)

The accounting policies of each of the individual operating segments are the same as those described in Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2010, included in our Form 10-K.

Intercompany Eliminations

The intercompany eliminations consist of eliminations for intercompany activity among the segments. Such activities primarily include services provided by the Parent Company to CapitalSource Bank and by CapitalSource Bank to the Parent Company, and daily loan collections received at CapitalSource Bank for Parent Company loans and daily loan disbursements paid at the Parent Company for CapitalSource Bank loans.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q, including the footnotes to our unaudited consolidated financial statements included herein, contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which are subject to numerous assumptions, risks, and uncertainties, including certain plans, expectations, goals and projections and statements about our deposit base and loan growth at CapitalSource Bank, our intention to originate loans at CapitalSource Bank, our Parent Company portfolio runoff, streamlining operations of the Parent Company and CapitalSource Bank, adequacy of reserves, our liquidity and capital position, our plans regarding our 7.25% Convertible Debentures, CapitalSource Bank’s ability to maintain sufficient liquidity and ratios under various projected scenarios, the timing and form of deployment of excess capital at the Parent Company, expectations regarding our application to become a bank holding company and converting CapitalSource Bank’s charter to a commercial charter, the performance of our loans, including troubled debt restructurings (“TDRs”), loan yields, the impact of accounting pronouncements, taxes and tax audits and examinations, our unfunded commitments and deposit demands, our delinquent, non-accrual and impaired loans, our SPEs, our intent to file a consolidated income tax return in 2011, and our valuation allowance with respect to, and our realization and utilization of, net deferred tax assets. All statements contained in this Form 10-Q that are not clearly historical in nature are forward-looking, and the words “anticipate,” “assume,” “intend,” “believe,” “forecast,” “expect,” “estimate,” “plan,” “continue,” “will,” “should,” “look forward” and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: changes in economic or market conditions or investment or lending opportunities may result in increased credit losses and delinquencies in our portfolio and impair our ability to consummate transactions on favorable terms; disruptions in economic and credit markets could prevent us from optimizing the amount of leverage we employ and could adversely affect our liquidity position, movements in interest rates and lending spreads may adversely affect our borrowing strategy; we may not be successful in maintaining or growing deposits or deploying capital in favorable lending transactions or originating or acquiring assets in accordance with our strategic plan; competitive and other market pressures could adversely affect loan pricing; reduced demand for our services; declines in asset values; expenses being higher than the income generated by the portfolio; additional capital needed by CapitalSource Bank to meet regulatory requirements; drawdown of unfunded commitments substantially in excess of historical drawings; substantial run off of CapitalSource Bank portfolio; compression of spreads; higher than anticipated increase in operating expenses; the nature, extent, and timing of any governmental actions and reforms; the success and timing of our business strategies; restrictions imposed on us by our regulators or indebtedness, assumptions we made in connection with the various projected scenarios for CapitalSource Bank liquidity could be erroneous, continued or worsening charge offs, reserves and delinquencies may adversely affect our earnings and financial results; changes in tax laws or regulations could adversely affect our business; and other risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2010 as filed with the SEC on February 28, 2011 (“Form 10 -K”), and other documents filed by us with the SEC. All forward-looking statements included in this Form 10-Q are based on information available at the time the statement is made.

We are under no obligation to (and expressly disclaim any such obligation to) update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

The information contained in this section should be read in conjunction with our consolidated financial statements and related notes and the information contained elsewhere in this Form 10-Q and in our Form 10-K.

Overview

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank. We are a commercial lender which, primarily through our wholly owned subsidiary, CapitalSource Bank, provides financial products to small and middle market businesses nationwide and provides depository products and services in southern and central California. As of September 30, 2011, we had an outstanding loan principal balance of $5.8 billion.

Through our CapitalSource Bank segment activities, we provide financial products primarily to small and middle market businesses throughout the United States and also offer depository products and services in southern and central California, which are insured by the Federal Deposit Insurance Corporation (“FDIC”) to the maximum amounts permitted by law. As of September 30, 2011, CapitalSource Bank had an outstanding loan principal balance of $4.5 billion and deposits of $4.9 billion.

Through our Other Commercial Finance segment activities, the Parent Company provides financial products primarily to small and middle market businesses. Our activities in the Parent Company consist primarily of satisfying existing loan commitments made prior to CapitalSource Bank’s formation and receiving payments on our existing loan portfolio. As of September 30, 2011, the Parent Company had an outstanding loan principal balance of $1.3 billion.

Current Developments

During 2011, we have continued to simplify and strengthen our business by growing CapitalSource Bank and reducing the relative size of our Parent Company within our overall enterprise. During the three months ended September 30, 2011, we increased the profitability of CapitalSource Bank, continued to originate new loans in CapitalSource Bank through our broad lending platform, maintained generally stable credit performance, and redeemed significant amounts of Parent Company indebtedness. During the three months ended September 30, 2011, we reduced the Parent Company’s outstanding recourse indebtedness by $643.0 million, resulting in Parent Company outstanding recourse indebtedness of $613.4 million as of September 30, 2011, representing decreases of $643.0 million and $633.3 million from June 30, 2011 and December 31, 2010, respectively.

In addition to growing assets and increasing profitability at CapitalSource Bank, our current strategy is to have our remaining Parent Company assets run off over time, streamline operations of CapitalSource Bank and the Parent Company to the extent permitted by applicable regulation, reduce expenses, and return excess Parent Company capital to our shareholders through a combination of stock repurchases and/or increased or special dividends or distributions. We intend to regularly assess alternatives for implementing our strategy and may consider accelerated dispositions of Parent Company assets and prepayments of debt and alternative uses of Parent Company capital, including contributions to CapitalSource Bank, if attractive opportunities become available. Subject to economic and market conditions, among other factors, we could pursue any of these alternatives either separately or in combination with one another, or we may not pursue any of them. There is no assurance as to the approach we will employ to achieve these objectives or whether we will be successful.

In December 2010, our Board of Directors authorized the repurchase of $150.0 million of our common stock over a period of up to two years. In July 2011 and September 2011, our Board of Directors authorized the repurchase of an additional $35.0 million and $200.0 million, respectively, of our common stock pursuant to the Stock Repurchase Program. We repurchased 49.9 million shares of our common stock at an aggregate price of $308.6 million during the nine months ended September 30, 2011. The total repurchase capacity available under the Stock Repurchase Program as of September 30, 2011 was approximately $66.5 million. In October 2011, our Board of Directors authorized the repurchase of an additional $200.0 million of our common stock pursuant to the Stock Repurchase Program. All shares repurchased under this plan were retired upon settlement. Any share repurchases made under the Stock Repurchase Program will be made through open market purchases or privately negotiated transactions. The form, amount and timing of any repurchases or other return of Parent Company capital will depend on market conditions and other factors and will be subject to applicable legal, contractual and regulatory constraints, and may be suspended or discontinued at any time.

Consistent with our efforts to streamline the organization and recognizing that the majority of our assets are in CapitalSource Bank, we recently announced changes to the executive structure of the consolidated organization. Steven A. Museles, currently Co-Chief Executive Officer of the Parent Company, and Donald F. Cole, currently Chief Financial Officer of the Parent Company, each will resign from his position at December 31, 2011. Mr. Museles will provide consulting services to the Company, and he will continue as a member of our Board of Directors until our next annual meeting of shareholders. John A. Bogler, currently Chief Financial Officer of CapitalSource Bank, will remain in that role and will succeed Mr. Cole as Chief Financial Officer of the Parent Company effective January 1, 2012. The Company also appointed Laird M. Boulden to serve as the Parent Company’s President effective as of October 26, 2011, and as the Chief Lending Officer of CapitalSource Bank effective as of January 1, 2012. As of January 1, 2012, the Company’s headquarters will be located in Los Angeles, California.

Our longer term strategy remains to convert CapitalSource Bank’s charter from an industrial bank charter to a commercial bank charter, likely by having the Parent Company apply to become a bank holding company under the Bank Holding Company Act of 1956.

Explanation of Reporting Metrics

Interest Income. Interest income represents interest earned on loans, investment securities, other investments, cash and cash equivalents, and collateral management fees as well as amortization of loan origination fees, net of the direct costs of origination and the amortization of purchase discounts and premiums, which are amortized into income using the interest method. Although the majority of our loans charge interest at variable rates that adjust periodically, we also have loans charging interest at fixed rates.

Interest Expense. Interest expense is the amount paid on deposits and borrowings, including the amortization of deferred financing fees and debt discounts. Interest expense includes borrowing costs associated with credit facilities, term debt, convertible debt, subordinated debt, Federal Home Loan Bank of San Francisco (“FHLB SF”) borrowings and interest paid to depositors. Our 2014 Senior Secured Notes, convertible debt and certain series of our subordinated debt bear a fixed rate of interest. Deferred financing fees, debt discounts and the costs of issuing debt, such as commitment fees and legal fees, are amortized over the estimated life of the borrowing. Loan prepayments that trigger mandatory or optional debt repayments and repurchases may materially affect interest expense on our term debt since in the period of prepayment the amortization of deferred financing fees and debt acquisition costs is accelerated.

Provision for Loan Losses. The provision for loan losses is the periodic cost of maintaining an appropriate allowance for loan and lease losses inherent in our portfolio. As the size and mix of loans within these portfolios change, or if the credit quality of the portfolios change, we record a provision to appropriately adjust the allowance for loan losses.

Operating Expenses. Operating expenses include compensation and benefits, professional fees, travel, rent, insurance, depreciation and amortization, marketing and other general and administrative expenses, including deposit insurance premiums.

Other Income/Expense. Other income (expense) consists of gains (losses) on the sale of loans, gains (losses) on the sale of debt and equity investments, dividends, unrealized appreciation (depreciation) on certain investments, other-than-temporary impairment on investment securities, available for sale, gains (losses) on derivatives, due diligence deposits forfeited, unrealized appreciation (depreciation) of our equity interests in certain non-consolidated entities, servicing income, income from our management of various loans held by third parties, gains (losses) on debt extinguishment at the Parent Company, net expense of real estate owned and other foreclosed assets, and other miscellaneous fees and expenses.

Income Taxes. We provide for income taxes as a “C” corporation on income earned from operations. For the tax year ended December 31, 2010, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We intend to reconsolidate our subsidiaries beginning in 2011 for federal tax purposes. We are subject to federal, foreign, state and local taxation in various jurisdictions.

We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates for the periods in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the change.

Periodic reviews of the carrying amount of deferred tax assets are made to determine if the establishment of a valuation allowance is necessary. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. All evidence, both positive and negative, is evaluated when making this determination. Items considered in this analysis include the ability to carry back losses to recoup taxes previously paid, the reversal of temporary differences, tax planning strategies, historical financial performance, expectations of future earnings and the length of statutory carryforward periods. Significant judgment is required in assessing future earning trends and the timing of reversals of temporary differences.

We have a valuation allowance related to a substantial portion of our net deferred tax assets based on our determination that there was significant negative evidence with respect to our ability to realize such assets. Negative evidence we considered in making this determination included the incurrence of operating losses at several of our subsidiaries, and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of September 30, 2011 and December 31, 2010, the total valuation allowance was $474.4 million and $413.8 million, respectively. Although realization is not assured, we believe it is more likely than not that the net deferred tax assets of $40.4 million as of September 30, 2011 will be realized. We intend to maintain a valuation allowance with respect to our deferred tax assets until sufficient positive evidence exists to support its reduction or reversal.

Operating Results for the Three and Nine Months Ended September 30, 2011

As further described below, the most significant factors influencing our consolidated results of operations for the three and nine months ended September 30, 2011, compared to the three and nine months ended September 30, 2010 were:

•

Losses on extinguishment of debt;

•

Decreased provision for loan losses;

•

Decreased balance of our loan portfolio;

•

Deconsolidation of the 2006-A term debt securitization (the “2006-A Trust”);

•

Decreased balance of Parent Company indebtedness;

•

Changes in lending and borrowing spreads; and

•

Gains on our investments.

Our consolidated operating results for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010, were as follows:


	Three Months Ended September 30,						%			Nine Months Ended September 30,						%
	2011			2010			Change			2011			2010			Change
	($ in thousands)
Interest income	$	121,476		$	153,130			(21	)	$	391,053		$	489,264			(20	)
Interest expense		34,488			57,908			40			127,047			183,666			31
Provision for loan losses		35,118			38,771			9			81,450			282,973			71
Operating expenses		52,561			54,767			4			162,144			171,563			5
Other (expense) income		(91,301	)		40,750			(324	)		(64,240	)		(16,331	)		(293	)
Net (loss) income from continuing operations before income taxes		(91,992	)		42,434			(317	)		(43,828	)		(165,269	)		73
Income tax (benefit) expense		(11,280	)		(35,668	)		(68	)		17,131			(18,836	)		(191	)
Net (loss) income from continuing operations		(80,712	)		78,102			(203	)		(60,959	)		(146,433	)		58
Net income from discontinued operations, net of taxes		—			—			N/A			—			9,489			(100	)
Gain from sale of discontinued operations, net of taxes		—			—			N/A			—			21,696			(100	)
Net (loss) income		(80,712	)		78,102			(203	)		(60,959	)		(115,248	)		47
Net loss attributable to noncontrolling interests		—			(83	)		(100	)		—			(83	)		(100	)
Net (loss) income attributable to CapitalSource Inc.		(80,712	)		78,185			(203	)		(60,959	)		(115,165	)		47

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the nine months ended September 30, 2011 and 2010 were as follows:


	Nine Months Ended September 30,
	2011							2010
	Weighted Average Balance		Net Interest Income		Average Yield/ Cost			Weighted Average Balance		Net Interest Income		Average Yield/ Cost
	($ in thousands)
Total interest-earning assets(1)	$	8,314,338	$	391,053		6.29	%	$	10,071,659	$	489,264		6.49	%
Total interest-bearing liabilities(2)		6,832,710		127,047		2.49			8,339,492		183,666		2.94

Net interest spread			$	264,006		3.80	%			$	305,598		3.55	%

Net interest margin						4.25	%						4.06	%

(1)	Interest-earning assets include cash and cash equivalents, restricted cash, marketable securities, loans, the “A” Participation Interest and investments in debt securities.

(2)	Interest-bearing liabilities include deposits, credit facilities, term debt, convertible debt, subordinated debt and other borrowings.

Operating Expenses

Consolidated operating expenses decreased to $52.6 million for the three months ended September 30, 2011 from $54.8 million for the three months ended September 30, 2010. The decrease was primarily due to a $3.0

million decrease in professional fees and a $1.7 million decrease in other administrative expenses, partially offset by a $2.5 million increase in compensation and benefits.

Consolidated operating expenses decreased to $162.1 million for the nine months ended September 30, 2011 from $171.6 million for the nine months ended September 30, 2010. The decrease was primarily due to a $4.0 million decrease in other administrative expenses, a $3.7 million decrease in professional fees and a $1.6 million decrease in compensation and benefits.

Income Taxes

Consolidated income tax benefit decreased to $11.3 million for the three months ended September 30, 2011 from $35.7 million for the three months ended September 30, 2010. The benefit for the three months ended September 30, 2011 was primarily the result of a decrease in the valuation allowance related to the deferred tax assets of CapitalSource Bank.

Consolidated income tax expense for the nine months ended September 30, 2011 was $17.1 million, compared to an income tax benefit of $18.8 million for the nine months ended September 30, 2010. The income tax expense was primarily the result of the re-establishment of a valuation allowance related to CapitalSource Bank pursuant to our plan to reconsolidate in 2011 and state income taxes incurred by CapitalSource Bank during the nine months ended September 30, 2011.

Comparison of the Three and Nine Months Ended September 30, 2011 and 2010

CapitalSource Bank Segment

Operating results for CapitalSource Bank segment for the three and nine months ended September 30, 2011, compared to the three and nine months ended September 30, 2010, were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2011		2010			% Change			2011		2010			% Change
	($ in thousands)
Interest income	$	92,173	$	86,212			7		$	274,467	$	246,592			11
Interest expense		15,982		16,024			—			46,804		49,756			6
Provision for loan losses		13,725		14,552			6			23,636		107,350			78
Operating expenses		33,664		28,597			(18	)		99,199		82,180			(21	)
Other income		12,933		7,148			81			18,898		22,374			(16	)
Income tax expense (benefit)		16,513		(2,707	)		(710	)		38,448		(5,226	)		(836	)
Net income		25,222		36,894			(32	)		85,278		34,906			144

Interest Income

Three months ended September 30, 2011 and 2010

Total interest income increased to $92.2 million for the three months ended September 30, 2011 from $86.2 million for the three months ended September 30, 2010, with an average yield on interest-earning assets of 5.97% for the three months ended September 30, 2011 compared to 6.10% for the three months ended September 30, 2010. During the three months ended September 30, 2011 and 2010, interest income on loans was $79.3 million and $69.8 million, respectively, yielding 7.51% and 7.80% on average loan balances of $4.2 billion and $3.6 billion, respectively. During the three months ended September 30, 2011 and 2010, $2.9 million and $7.9 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the yield on loans by 0.27% and 0.88%, respectively.

During the three months ended September 30, 2011 and 2010, interest income from our investments, including available-for-sale and held-to-maturity securities, was $12.5 million and $14.4 million, respectively, yielding 3.14% and 3.41% on average balances of $1.6 billion and $1.7 billion, respectively. During the three months ended September 30, 2011, we purchased $143.8 million of investment securities, available-for-sale, while $100.4 million and $35.9 million of principal repayments were received from our investment securities,

available-for-sale and held-to-maturity, respectively. For the three months ended September 30, 2010, we purchased $327.9 million and $9.7 million of investment securities, available-for-sale and held-to-maturity, respectively, while $282.7 million and $10.6 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During each of the three months ended September 30, 2011 and 2010, interest income on cash and cash equivalents was $0.3 million, yielding 0.38% and 0.40% on average balances of $325.1 million and $273.2 million, respectively.

The “A” Participation Interest, representing our share of a pool of commercial real estate loans and related assets, was paid off during the fourth quarter of 2010. Interest income on the “A” Participation Interest was $1.7 million during the three months ended September 30, 2010, yielding 8.07% on an average balance of $83.2 million. The “A” Participation Interest was purchased at a discount which was accreted into income using the interest method. During the three months ended September 30, 2010, we accreted $1.3 million of discount into interest income on loans in our consolidated statements of operations.

Nine months ended September 30, 2011 and 2010

Total interest income increased to $274.5 million for the nine months ended September 30, 2011 from $246.6 million for the nine months ended September 30, 2010, with an average yield on interest-earning assets of 6.19% for the nine months ended September 30, 2011, compared to 5.91% for the nine months ended September 30, 2010. During the nine months ended September 30, 2011 and 2010, interest income on loans was $234.7 million and $188.4 million, respectively, yielding 7.89% and 7.66% on average loan balances of $4.0 billion and $3.3 billion, respectively. During the nine months ended September 30, 2011 and 2010, $12.4 million and $23.2 million, respectively, of interest income was not recognized for loans on non-accrual, which negatively impacted the yield on loans by 0.42% and 0.94%, respectively.

During the nine months ended September 30, 2011 and 2010, interest income from our investments, including available-for-sale and held-to-maturity securities, was $38.8 million and $44.1 million, respectively, yielding 3.29% and 3.72% on an average balance of $1.6 billion in each period. During the nine months ended September 30, 2011, we purchased $591.9 million of investment securities, available-for-sale while $573.1 million and $90.6 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively. For the nine months ended September 30, 2010, we purchased $1.3 billion and $9.7 million of investment securities, available-for-sale and held-to-maturity, respectively, while $673.2 million and $56.8 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the nine months ended September 30, 2011 and 2010, interest income on cash and cash equivalents was $0.9 million and $1.1 million, respectively, yielding 0.35% and 0.34% on average balances of $348.9 million and $429.2 million, respectively.

Interest income on the “A” Participation Interest was $12.9 million during the nine months ended September 30, 2010, yielding 6.86% on an average balance of $252.2 million. During the nine months ended September 30, 2010, we accreted $9.5 million of discount into interest income on loans in our consolidated statements of operations.

Interest Expense

Three months ended September 30, 2011 and 2010

Total interest expense remained flat at $16.0 million for the three months ended September 30, 2011 and 2010. Our average balances of interest-bearing liabilities, which consist of deposits and FHLB SF borrowings, increased to $5.3 billion for the three months ended September 30, 2011 from $4.9 billion for the three months ended September 30, 2010. As a result, our average cost of interest-bearing liabilities decreased to 1.19% for the three months ended September 30, 2011 from 1.30% for the three months ended September 30, 2010.

Our interest expense on deposits for the three months ended September 30, 2011 and 2010 was $13.4 million and $14.5 million, respectively, with an average cost of deposits of 1.10% and 1.26%, respectively, on average balances of $4.8 billion and $4.6 billion, respectively. During the three months ended September 30, 2011, $766.2 million of our time deposits with a weighted average interest rate of 1.01% matured, and $900.3 million of new and renewed time deposits were issued at a weighted average interest rate of 0.89%. During the three months ended September 30, 2010, $780.2 million of our time deposits matured with a weighted average interest rate of 1.08%, and $872.5 million of new and renewed time deposits were issued at a weighted average interest rate of 0.99%. Additionally, during the three months ended September 30, 2011, the weighted average interest rate of our liquid account deposits, which consist of savings and money market accounts, declined from 0.84% as of June 30, 2011 to 0.75% as of September 30, 2011.

During the three months ended September 30, 2011, our interest expense on FHLB SF borrowings was $2.6 million with an average cost of 2.01% on an average balance of $506.4 million. During the three months ended September 30, 2011, there were $1.4 billion in advances taken and $1.4 billion of maturities, including short-term advances and maturities of $1.3 billion. The short-term advances were used primarily for funding of loans. During the three months ended September 30, 2010, our interest expense on borrowings was $1.5 million with an average cost of 1.93% on an average balance of $315.2 million. During the three months ended September 30, 2010, there were $175.0 million in advances taken and $140.0 million of maturities, and there were no short-term advances and maturities.

Nine months ended September 30, 2011 and 2010

Total interest expense decreased to $46.8 million for the nine months ended September 30, 2011 from $49.8 million for the nine months ended September 30, 2010. The decrease was primarily due to a decrease in the average cost of interest-bearing liabilities, which was 1.21% and 1.38%, during the nine months ended September 30, 2011 and 2010, respectively. Our average balances of interest-bearing liabilities were $5.2 billion and $4.8 billion during the nine months ended September 30, 2011 and 2010, respectively.

Our interest expense on deposits for the nine months ended September 30, 2011 and 2010 was $40.2 million and $46.1 million, respectively, with an average cost of deposits of 1.13% and 1.35%, respectively, on average balances of $4.7 billion and $4.6 billion, respectively. During the nine months ended September 30, 2011, $2.8 billion of our time deposits matured with a weighted average interest rate of 1.06%, and $3.1 billion of new time deposits were issued at a weighted average interest rate of 0.94%. During the nine months ended September 30, 2010, $3.5 billion of our time deposits matured with a weighted average interest rate of 1.50%, and $3.5 billion of new time deposits were issued at a weighted average interest rate of 1.16%. Additionally, during the nine months ended September 30, 2011, the weighted average interest rate of our liquid account deposits, which consist of savings and money market accounts, decreased from 0.83% at the beginning of the year to 0.75% at the end of the quarter.

During the nine months ended September 30, 2011, our interest expense on FHLB SF borrowings was $6.6 million with an average cost of 2.02% on an average balance of $435.9 million. During the nine months ended September 30, 2011, there were $1.7 billion in advances taken and $1.6 billion of maturities, including short-term advances and maturities of $1.5 billion. During the nine months ended September 30, 2010, our interest expense on borrowings was $3.6 million with an average cost of 1.89% on an average balance of $256.3 million. During the nine months ended September 30, 2010, there were $315.0 million of advances taken and $215.0 million of maturities, including $60.0 million of short-term advances and maturities.

Net Interest Margin

Three months ended September 30, 2011 and 2010

The yields of interest earning assets and the costs of interest-bearing liabilities in this segment for the three months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,
	2011							2010
	Weighted Average Balance		Net Interest Income		Average Yield/ Cost			Weighted Average Balance		Net Interest Income		Average Yield/ Cost
	($ in thousands)
Total interest-earning assets(1)	$	6,123,923	$	92,173		5.97	%	$	5,603,442	$	86,212		6.10	%
Total interest-bearing liabilities(2)		5,340,354		15,982		1.19			4,894,955		16,024		1.30

Net interest spread			$	76,191		4.78	%			$	70,188		4.80	%

Net interest margin						4.94	%						4.97	%

(1)	Interest-earning assets include cash and cash equivalents, investments, the commercial real estate “A” Participation Interest and loans.

(2)	Interest-bearing liabilities include deposits and borrowings.

The yields of interest earning assets and the costs of interest-bearing liabilities in this segment for the nine months ended September 30, 2011 and 2010 were as follows:


	Nine Months Ended September 30,
	2011							2010
	Weighted Average Balance		Net Interest Income		Average Yield/ Cost			Weighted Average Balance		Net Interest Income		Average Yield/ Cost
	($ in thousands)
Total interest-earning assets(1)	$	5,925,633		274,467		6.19	%	$	5,574,073	$	246,592		5.91	%
Total interest-bearing liabilities(2)		5,185,108		46,804		1.21			4,835,988		49,756		1.38

Net interest spread			$	227,663		4.98	%			$	196,836		4.53	%

Net interest margin						5.14	%						4.72	%

(1)	Interest-earning assets include cash and cash equivalents, investments, the commercial real estate “A” Participation Interest and loans.

(2)	Interest-bearing liabilities include deposits and borrowings.

Provision for Loan Losses

Our provision for loan losses is based on our evaluation of the adequacy of the existing allowance for loan losses in relation to total loan portfolio and our periodic assessment of the inherent risks relating to the loan portfolio resulting from our review of selected individual loans. For details of activity in our provision for loan losses, see the Credit Quality and Allowance for Loan Losses section.

Operating Expenses

Three months ended September 30, 2011 and 2010

Operating expenses increased to $33.7 million for the three months ended September 30, 2011 from $28.6 million for the three months ended September 30, 2010. The increase was primarily due to a $2.5 million increase in compensation and benefits, a $1.5 million increase in loan referral and other fees due to an increase in new loans funded by CapitalSource Bank and a $1.3 million increase in professional fees.

CapitalSource Bank relies on the Parent Company to refer loans and to provide loan origination due diligence services. For these services CapitalSource Bank pays the Parent Company fees based upon the commitment amount of each new loan funded by CapitalSource Bank during the period. CapitalSource Bank also pays the Parent Company to perform certain underwriting and other services. These fees are eliminated in consolidation. The fees are included in other operating expenses and were $11.2 million and $9.7 million for the three months ended September 30, 2011 and 2010, respectively.

Nine months ended September 30, 2011 and 2010

Operating expenses increased to $99.2 million for the nine months ended September 30, 2011 from $82.2 million for the nine months ended September 30, 2010. The increase was primarily due to a $13.3 million increase in loan referral and other fees due to an increase in new loans funded by CapitalSource Bank, and a $4.0 million increase in compensation and benefits. Fees paid by CapitalSource Bank to the Parent Company for loan referrals, loan due diligence services and certain underwriting services were $38.0 million and $24.8 million for the nine months ended September 30, 2011 and 2010, respectively.

Other Income

CapitalSource Bank services loans and other assets, which are owned by the Parent Company and third parties, for which it receives fees based on the number of loans or other assets serviced. Loans being serviced by CapitalSource Bank for the benefit of others were $2.8 billion and $4.7 billion as of September 30, 2011 and December 31, 2010, respectively, of which $1.3 billion and $2.5 billion were owned by the Parent Company.

Three months ended September 30, 2011 and 2010

Other income increased to $12.9 million for the three months ended September 30, 2011 from $7.1 million for the three months ended September 30, 2010 primarily due to $4.2 million in gains on sales of loans and $1.6 million in sales of investments compared to no such gains during the three months ended September 30, 2010, and a $1.3 million increase in gains on derivatives. These factors were partially offset by a $1.4 million increase in net expense of real estate owned and other foreclosed assets.

Nine months ended September 30, 2011 and 2010

Other income decreased to $18.9 million for the nine months ended September 30, 2011 from $22.4 million for the nine months ended September 30, 2010 primarily due to a $10.2 million increase in net expense of real estate owned and other foreclosed assets and a $4.5 million loss on the sale of unfunded commitments during the nine months ended September 30, 2011. In addition, loan servicing fees paid by the Parent Company to CapitalSource Bank decreased by $2.1 million as a result of the sale of our direct real estate investments during 2010 and a decrease in the Parent Company’s loan portfolio. These factors were partially offset by $4.1 million increase in gains on sales of loans, realized gains of $2.8 million on sales of investments during the nine months ended September 30, 2011, as compared to no such gains during the nine months ended September 30, 2010, an increase in borrower loan and servicing fees of $2.8 million, a $1.4 million increase in foreign currency exchange losses and a $1.1 million provision reversal of our allowance for unfunded commitments.

Other Commercial Finance Segment

Our Other Commercial Finance segment operating results for the three and nine months ended September 30, 2011, compared to the three and nine months ended September 30, 2010, were as follows:


	Three Months Ended September 30,									Nine Months Ended September 30,
	2011			2010			% Change			2011			2010			% Change
	($ in thousands)
Interest income	$	28,653		$	69,745			(59	)	$	116,968		$	249,411			(53	)
Interest expense		18,506			41,884			56			80,243			133,910			40
Provision for loan losses		21,393			24,219			12			57,814			175,623			67
Operating expenses		36,201			40,795			11			119,203			131,694			9
Other (expense) income		(87,089	)		47,962			(282	)		(29,984	)		3,294			(1,010	)
Income tax benefit		(27,793	)		(32,961	)		(16	)		(21,317	)		(13,610	)		57
Net (loss) income		(106,743	)		43,770			(344	)		(148,959	)		(174,912	)		15

Interest Income

Three months ended September 30, 2011 and 2010

Interest income decreased to $28.7 million for the three months ended September 30, 2011 from $69.7 million for the three months ended September 30, 2010, primarily due to a decrease in average total interest-earning assets. During the three months ended September 30, 2011, our average balance of interest-earning assets decreased by $1.4 billion, or 41.7%, compared to the three months ended September 30, 2010, due to the runoff of Parent Company loans. During the three months ended September 30, 2011, yield on average interest-earning assets decreased to 5.67% from 8.05% for the three months ended September 30, 2010.

Nine months ended September 30, 2011 and 2010

Interest income decreased to $117.0 million for the nine months ended September 30, 2011 from $249.4 million for the nine months ended September 30, 2010, primarily due to a decrease in average total interest-earning assets. During the nine months ended September 30, 2011, our average balance of interest-earning assets decreased by $2.1 billion, or 47.2%, compared to the nine months ended September 30, 2010, due to the deconsolidation of the 2006-A Trust during 2010 and the runoff of Parent Company loans. During the nine months ended September 30, 2011, yield on average interest-earning assets decreased to 6.56% from 7.38% for the nine months ended September 30, 2010.

Interest Expense

Three months ended September 30, 2011 and 2010

Interest expense decreased to $18.5 million for the three months ended September 30, 2011 from $41.9 million for the three months ended September 30, 2010 primarily due to a decrease in average interest-bearing liabilities of $1.2 billion, or 49.2%, primarily due to the reduction of the outstanding balances on our credit facilities and other term debt. Our cost of borrowings decreased to 5.70% for the three months ended September 30, 2011 from 6.55% for the three months ended September 30, 2010, as a result of lower expenses following the termination of our credit facilities and certain convertible debt.

Nine months ended September 30, 2011 and 2010

The decrease in interest expense to $80.2 million for the nine months ended September 30, 2011 from $133.9 million for the nine months ended September 30, 2010 was primarily due to a decrease in average interest-bearing liabilities of $1.9 billion, or 53.0%, primarily due to the impact of the deconsolidation of the 2006-A Trust in July 2010 and the reduction of the outstanding balances on our credit facilities and other term

debt. Our cost of borrowings increased to 6.51% for the three months ended September 30, 2011 from 5.11% for the three months ended September 30, 2010, as a result of the termination of certain of our credit facilities, the deconsolidation of the 2006-A Trust and decreases in our remaining securitization balances, which generally had lower borrowing costs than the remaining outstanding borrowings.

Net Interest Margin

Three months ended September 30, 2011 and 2010

Net interest margin was 2.01% for the three months ended September 30, 2011, a decrease of 1.20% from 3.21% for the three months ended September 30, 2010. Net interest spread was (0.03%) for the three months ended September 30, 2011, a decrease of 1.53% from 1.50% for the three months ended September 30, 2010. The decreases in net interest margin and net interest spread were primarily due to the decrease in our average yield on interest-earning assets, partially offset by a decrease in our cost of borrowings.

The yields of interest earning assets and the costs of interest-bearing liabilities in this segment for the three months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,
	2011							2010
	Weighted Average Balance		Net Interest Income		Average Yield/ Cost			Weighted Average Balance		Net Interest Income		Average Yield/ Cost
	($ in thousands)
Total interest-earning assets(1)	$	2,003,654	$	28,653		5.67	%	$	3,438,987	$	69,745		8.05	%
Total interest-bearing liabilities(2)		1,288,807		18,506		5.70			2,535,383		41,884		6.55

Net interest spread			$	10,147		(0.03	)%			$	27,861		1.50	%

Net interest margin						2.01	%						3.21	%

(1)	Interest-earning assets include cash and cash equivalents, restricted cash, loans and investments.

(2)	Interest-bearing liabilities include secured and unsecured credit facilities, term debt, convertible debt and subordinated debt.

Nine months ended September 30, 2011 and 2010

Net interest margin was 2.06% for the nine months ended September 30, 2011, a decrease of 1.36% from 3.42% for the nine months ended September 30, 2010. Net interest spread was 0.05% for the nine months ended September 30, 2011, a decrease of 2.22% from 2.27% for the nine months ended September 30, 2010. The decreases in net interest margin and net interest spread were primarily due to the decrease in our yield on average interest-earning assets and the increase in our cost of borrowings.

The yields of interest-earning assets and the costs of interest-bearing liabilities in this segment for the nine months ended September 30, 2011 and 2010 were as follows:


	Nine Months Ended September 30,
	2011							2010
	Weighted Average Balance		Net Interest Income		Average Yield/ Cost			Weighted Average Balance		Net Interest Income		Average Yield/ Cost
	($ in thousands)
Total interest-earning assets(1)	$	2,385,213	$	116,968		6.56	%	$	4,520,528	$	249,411		7.38	%
Total interest-bearing liabilities(2)		1,647,602		80,243		6.51			3,503,504		133,910		5.11

Net interest spread			$	36,725		0.05	%			$	115,501		2.27	%

Net interest margin						2.06	%						3.42	%

(1)	Interest-earning assets include cash and cash equivalents, restricted cash, loans and investments in debt securities.

(2)	Interest-bearing liabilities include secured and unsecured credit facilities, term debt, convertible debt and subordinated debt.

Provision for Loan Losses

Our provision for loan losses is based on our evaluation of the adequacy of the existing allowance for loan losses in relation to total loan portfolio and our periodic assessment of the inherent risks relating to the loan portfolio resulting from our review of selected individual loans. For details of activity in our provision for loan losses, see Credit Quality and Allowance for Loan Losses section.

Operating Expenses

Three months ended September 30, 2011 and 2010

Operating expenses decreased to $36.2 million for the three months ended September 30, 2011 from $40.8 million for the three months ended September 30, 2010, primarily due to a $4.3 million decrease in professional fees. Operating expenses as a percentage of average total assets increased to 5.69% for the three months ended September 30, 2011 from 4.06% for the three months ended September 30, 2010 due to the decrease in total assets as a result of the runoff of Parent Company loans.

Nine months ended September 30, 2011 and 2010

Operating expenses decreased to $119.2 million for the nine months ended September 30, 2011 from $131.7 million for the nine months ended September 30, 2010, primarily due to a $4.9 million decrease in professional fees, a $4.7 million decrease in administrative expenses and a $3.0 million decrease in compensation and benefits. Operating expenses as a percentage of average total assets increased to 5.36% for the nine months ended September 30, 2011 from 3.57% for the nine months ended September 30, 2010 due to the decrease in total assets as a result of the deconsolidation of the 2006-A Trust and the runoff of Parent Company loans.

Other Income (Expense)

Three months ended September 30, 2011 and 2010

Other expense was $87.1 million for the three months ended September 30, 2011 compared to other income of $48.0 million for the three months ended September 30, 2010. This change was primarily due to $113.7 million in losses on extinguishment of debt, including a $111.1 million loss related to the repurchase of $298.1 million of our $12.75% Senior Secured Notes and a $2.6 million loss related to the repurchase of $75.1 million of our 7.5% Convertible Debentures during the three months ended September 30, 2011, and a $16.7 million gain on the deconsolidation of the 2006-A Trust during the three months ended September 30, 2010.

Nine months ended September 30, 2011 and 2010

Other expense was $30.0 million for the nine months ended September 30, 2011 compared to other income of $3.3 million for the nine months ended September 30, 2010. This change was primarily due to losses on extinguishment of debt, a non-recurring gain on deconsolidation of the 2006-A Trust during 2010 and a decrease in gains on investments, partially offset by a decrease in net expense of real estate owned and other foreclosed assets, as described below.

During the nine months ended September 30, 2011, we incurred $113.7 million in losses on extinguishment of debt, including a $111.1 million loss related to the repurchase of $298.1 million of our $12.75% Senior Secured Notes and a $2.6 million loss related to the repurchase of our 7.5% Convertible Debentures during the nine months ended September 30, 2011, compared to $1.1 million in gains on extinguishment of debt during the nine months ended September 30, 2010.

Net expense of real estate owned and other foreclosed assets decreased to $22.4 million for the nine months ended September 30, 2011 from $91.0 million for the nine months ended September 30, 2010, primarily due to a $30.2 million decrease in the provision for loans acquired through foreclosure, a $15.5 million decrease in unrealized losses on real estate owned, and a $12.9 million decrease in impairment losses on real estate owned.

Gains on investments, net increased to $48.5 million for the nine months ended September 30, 2011 from $46.3 million for the nine months ended September 30, 2010, primarily due to an $11.8 million increase in realized gains on sales of investments, which was partially offset by an $11.1 million decrease in dividend income, and a $2.7 million decrease in unrealized losses on investments.

Other expense for the nine months ended September 30, 2010 was positively impacted by a $16.7 million increase in gains on loans held for sale and a $16.0 million increase in intercompany servicing fees, which are included in other income, net, and a $4.8 million decrease in loss on derivatives, partially offset by $16.7 million non-recurring gain on the deconsolidation of the 2006-A Trust during the nine months ended September 30, 2010.

Financial Condition

CapitalSource Bank Segment

As of September 30, 2011 and December 31, 2010, the CapitalSource Bank segment included:


	September 30, 2011		December 31, 2010
	($ in thousands)
Assets:
Cash and cash equivalents (1)	$	247,114	$	377,054
Investment securities, available-for-sale		1,434,094		1,510,384
Investment securities, held-to-maturity		102,651		184,473
Loans (2)		4,536,197		3,848,511
FHLB SF stock		19,140		19,370

Total	$	6,339,196	$	5,939,792

Liabilities:
Deposits	$	4,885,831	$	4,621,273
FHLB SF borrowings		540,000		412,000

Total	$	5,425,831	$	5,033,273

(1)	As of September 30, 2011 and December 31, 2010, the amounts include restricted cash of $2.2 million and $23.5 million, respectively.

(2)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

Cash and Cash Equivalents

Cash and cash equivalents consist of amounts due from banks, U.S. Treasury securities, short-term investments and commercial paper with an initial maturity of three months or less. For additional information, see Note 4, Cash and Cash Equivalents and Restricted Cash, in our consolidated financial statements for the three and nine months ended September 30, 2011.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consists of discount notes issued by Fannie Mae, Freddie Mac and the FHLB (“Agency discount notes”), callable notes issued by Fannie Mae, Freddie Mac, the Federal Home Loan Bank (“FHLB”) and Federal Farm Credit Bank (“Agency callable notes”), bonds issued by the FHLB (“Agency debt”), residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (“Agency MBS”), asset-backed securities, residential mortgage-backed securities rated AAA issued by non-government-agencies (“Non-agency MBS”), corporate debt securities and U.S. Treasury and agency securities. As of September 30, 2011, CapitalSource Bank had pledged a significant portion of its investment

securities, available-for-sale, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) and the Federal Reserve Bank (“FRB”) as a source of borrowing capacity. For additional information, see Note 6, Investments, in our consolidated financial statements for the three and nine months ended September 30, 2011.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity, consists of AAA-rated commercial mortgage-backed securities. For additional information on our investment securities, held-to-maturity, see Note 6, Investments, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2011.

Loan Portfolio Composition

The CapitalSource Bank loan balances reflected in the portfolio statistics below include loans held for sale of $29.7 million and $14.2 million as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011 and December 31, 2010, the composition of the CapitalSource Bank loan portfolio by loan type was as follows:


	September 30, 2011				December 31, 2010
	($ in thousands)
Commercial	$	2,361,610	52	%	$	2,029,407	53	%
Real estate		2,166,055	47			1,634,062	42
Real estate — construction		8,532	1			185,042	5

Total (1)	$	4,536,197	100	%	$	3,848,511	100	%

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of September 30, 2011, the scheduled maturities of the CapitalSource Bank loan portfolio by loan type were as follows:


	Due in One Year or Less		Due in One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	306,607	$	1,552,730	$	502,273	$	2,361,610
Real estate		114,026		988,983		1,063,046		2,166,055
Real estate — construction		—		—		8,532		8,532

Total loans (1)	$	420,633	$	2,541,713	$	1,573,851	$	4,536,197

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of September 30, 2011, approximately 78% of the CapitalSource Bank accruing adjustable rate portfolio comprised loans that were subject to an interest rate floor and were accruing interest. Due to low market interest rates as of September 30, 2011, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 0.94% as of September 30, 2011. To the extent the underlying indices subsequently increase, CapitalSource Bank’s interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.

As of September 30, 2011, the composition of CapitalSource Bank loan balances by adjustable rate index and by loan type was as follows:


	Loan Type
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	803,518	$	895,540	$	—	$	1,699,058		37	%
2-Month LIBOR		10,177		—		—		10,177		1
3-Month LIBOR		560,226		9,067		—		569,293		12
6-Month LIBOR		42,550		86,033		—		128,583		3
Prime		479,814		110,400		8,532		598,746		13
Other		71,674		48,526		—		120,200		3

Total adjustable rate loans		1,967,959		1,149,566		8,532		3,126,057		69
Fixed rate loans		365,770		936,798		—		1,302,568		29
Loans on non-accrual status		27,881		79,691		—		107,572		2

Total loans (1)	$	2,361,610	$	2,166,055	$	8,532	$	4,536,197		100	%

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

FHLB SF Stock

Investments in FHLB SF stock are recorded at historical cost. FHLB SF stock does not have a readily determinable fair value, but can generally be sold back to the FHLB SF at par value upon stated notice. The investment in FHLB SF stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB and its overall financial condition. No impairment losses have been recorded through September 30, 2011.

Deposits

As of September 30, 2011 and December 31, 2010, a summary of CapitalSource Bank’s deposits by product type and the maturities of the certificates of deposit were as follows:


	September 30, 2011					December 31, 2010
	Balance		Weighted Average Rate			Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	244,636		0.72	%	$	236,811		0.78	%
Savings		842,162		0.76			694,157		0.84
Certificates of deposit		3,799,033		1.18			3,690,305		1.27

Total interest-bearing deposits	$	4,885,831		1.08		$	4,621,273		1.18


	September 30, 2011
	Balance		Weighted Average Rate
	($ in thousands)
Remaining maturity of certificates of deposit:
0 to 3 months	$	993,646		1.01	%
4 to 6 months		1,178,923		1.12
7 to 9 months		517,912		1.17
10 to 12 months		558,570		1.22
Greater than 12 months		549,982		1.58

Total certificates of deposit	$	3,799,033		1.18

FHLB SF Borrowings

FHLB SF borrowings increased to $540.0 million as of September 30, 2011 from $412.0 million as of December 31, 2010. These borrowings were used primarily for interest rate risk management and short-term funding purposes. The weighted-average remaining maturities of the borrowings were approximately 3.2 years and 2.3 years as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011, the remaining maturity and the weighted average interest rate of FHLB SF borrowings were as follows:


	September 30, 2011
	Balance		Weighted Average Rate
	($ in thousands)
Less than 1 year	$	108,000		1.26	%
After 1 year through 2 years		33,000		1.60
After 2 years through 3 years		80,000		1.54
After 3 years through 4 years		75,000		2.19
After 4 years through 5 years		199,000		2.07
After 5 years		45,000		2.68

Total	$	540,000		1.87	%

Other Commercial Finance Segment

As of September 30, 2011 and December 31, 2010, the Other Commercial Finance segment included:


	September 30, 2011		December 31, 2010
	($ in thousands)
Assets:
Investment securities, available-for-sale	$	23,332	$	12,527
Loans (1)		1,287,230		2,509,699
Other investments(2)		57,880		71,877

Total	$	1,368,442	$	2,594,103

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

(2)	Includes investments carried at cost, investments carried at fair value and investments accounted for under the equity method.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale consist of corporate debt, equity securities, a municipal bond and our interests in the 2006-A Trust.

Other Investments

The Parent Company has made investments in some of our borrowers in connection with the loans provided to them. These investments usually include equity interests such as common stock, preferred stock, limited liability company interests, limited partnership interests and warrants.

Loan Portfolio Composition

The Other Commercial Finance loan balances reflected in the portfolio statistics below include loans held for sale of $3.1 million and $191.1 million as of September 30, 2011 and December 31, 2010, respectively.

As of September 30, 2011 and December 31, 2010, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:


	September 30, 2011				December 31, 2010
	($ in thousands)
Commercial	$	1,084,637	84	%	$	2,209,064	88	%
Real estate		136,571	11			192,096	8
Real estate — construction		66,022	5			108,539	4

Total (1)	$	1,287,230	100	%	$	2,509,699	100	%

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of September 30, 2011, the scheduled maturities of the Other Commercial Finance loan portfolio by loan type were as follows:


	Due in One Year or Less		Due in One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	250,457	$	823,431	$	10,749	$	1,084,637
Real estate		42,423		86,778		7,370		136,571
Real estate — construction		66,022		—		—		66,022

Total (1)	$	358,902	$	910,209	$	18,119	$	1,287,230

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of September 30, 2011, approximately 76% of the accruing adjustable rate loan portfolio comprised loans that were subject to an interest rate floor and were accruing interest. Due to low market interest rates as of September 30, 2011, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 1.4% as of September 30, 2011. To the extent the underlying indices subsequently increase, the interest yield on these adjustable rate loans will not rise as quickly due to the effect of the interest rate floors.

As of September 30, 2011, the composition of Other Commercial Finance loan balances by adjustable rate index and by loan type was as follows:


	Loan Type
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	357,381	$	72,125	$	—	$	429,506		33	%
2-Month LIBOR		33,683		—		—		33,683		3
3-Month LIBOR		167,311		10,179		—		177,490		13
6-Month LIBOR		600		—		—		600		1
1-Month EURIBOR		31,978		—		—		31,978		2
Prime		343,337		6,238		—		349,575		27
Other		1,599		—		—		1,599		1

Total adjustable rate loans		935,889		88,542		—		1,024,431		80
Fixed rate loans		27,607		9,949		—		37,556		3
Loans on non-accrual status		121,141		38,080		66,022		225,243		17

Total loans (1)	$	1,084,637	$	136,571	$	66,022	$	1,287,230		100	%

(1)	Excludes the impact of deferred loan fees and discounts and the allowance for loan losses. Includes lower of cost or fair value adjustments on loans held for sale.

Credit Quality and Allowance for Loan Losses

Consolidated

The outstanding unpaid principal balances of non-performing loans in our consolidated loan portfolio as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Non-accrual loans
Commercial	$	149,022	$	366,417
Real estate		117,771		131,758
Real estate – construction		66,022		200,611

Total loans on non-accrual	$	332,815	$	698,786

Accruing loans contractually past-due 90 days or more
Commercial	$	1,213	$	3,244
Real estate		—		6,238
Real estate – construction		—		39,806

Total accruing loans contractually past-due 90 days or more	$	1,213	$	49,288

Troubled debt restructurings(1)
Commercial	$	112,990	$	118,988
Real estate		41,837		35,689

Total troubled debt restructurings	$	154,827	$	154,677

Total non-performing loans
Commercial	$	263,225	$	488,649
Real estate		159,608		173,685
Real estate – construction		66,022		240,417

Total non-performing loans	$	488,855	$	902,751

(1)	Excludes non-accrual loans and accruing loans contractually past-due 90 days or more.

Potential problem loans are loans that are not considered non-performing loans, as disclosed above, but loans where management is aware of information regarding potential credit problems of a borrower that leads to serious doubts as to the ability of such borrowers to comply with the loan repayment terms. Such defaults could eventually result in the loans being reclassified as non-performing loans. As of December 31, 2010, we had $83.0 million in potential problem loans, primarily related to an impaired loan that was restructured during the first quarter of 2011. As of September 30, 2011, we had $11.6 million in potential problem loans, primarily related to five loans for which we have determined that it is probable that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement, but we have concluded that repayment in full of the loans is fully supported by existing collateral or an enterprise valuation of the borrower in accordance with our most recent valuation analysis.

Of our non-accrual loans, $6.8 million were 30-89 days delinquent and $144.7 million were over 90 days delinquent as of September 30, 2011, and $22.4 million were 30-89 days delinquent and $270.5 million were over 90 days delinquent as of December 31, 2010. Accruing loans 30-89 days delinquent were $8.9 million and $5.4 million as of September 30, 2011 and December 31, 2010, respectively.

Many of our real estate construction loans include an interest reserve that is established upon origination of the loan. We recognize interest income from the reserve during the construction period as long as the interest is deemed collectible. As part of our ongoing credit review process, we monitor the construction of the underlying

real estate to determine whether the project is progressing as originally planned. If we determine that adverse changes have occurred such that full payment of principal and interest is no longer expected, we will place the loan on non-accrual status and establish a specific reserve or charge off a portion of the principal balance, as appropriate.

We maintain a comprehensive credit policy manual that is supplemented by specific loan product underwriting guidelines. Among other things, the credit policy manual sets forth requirements that meet the regulations enforced by both the FDIC and the California Department of Financial Institutions (“DFI”). Several examples of such requirements are the loan-to-value limitations for real estate secured loans, various real estate appraisal and other third-party reports standards, and collateral insurance requirements.

Our underwriting guidelines outline specific underwriting standards and minimum specific risk acceptance criteria for each lending product offered, including the use of interest reserves. For additional information, see Credit Risk Management section included in our Form 10-K for the year ended December 31, 2010.

We maintain servicing procedures for real estate construction loans, and the objective of the procedures is to maintain the proper relationship between the loan amount funded and the value of the collateral securing the loan. The principal servicing tasks include, but are not limited to:

•

Monitoring construction of the project to evaluate the work in place, quality of construction (compliance with plans and specifications) and adequacy of the budget to complete the project. We generally use a third party consultant for this evaluation, but also maintain frequent contact with the borrower to obtain updates on the project.

•

Monitoring compliance with the terms and conditions of the loan agreement, which contains important construction and leasing provisions.

•

Reviewing and approving advance requests per the loan agreement which establishes the frequency, conditions and process for making advances. Typically, each loan advance is conditioned upon funding only for work in place, certification by the construction consultant, and sufficient funds remaining in the loan budget to complete the project.

Additionally, our risk rating policies require that the assignment of a risk rating should consider whether the capitalization of interest may be masking other performance related issues. The adequacy of the interest reserve generally is evaluated each time a risk rating conclusion is required or rendered with particular attention paid to the underlying value of the collateral and its ongoing support of the transaction. Obtaining updated third-party valuations is considered when significant negative variances to expected performance exist. Generally, our policy on updating appraisals is to obtain current appraisals subsequent to the impairment date if there are significant changes to the underlying assumptions from the most recent appraisal. Some factors that could cause significant changes include the passage of more than twelve months since the time of the last appraisal; the volatility of the local market; the availability of financing; the number of competing properties; new improvements to, or lack of maintenance of, the subject property or competing surrounding properties; a change in zoning; environmental contamination; or failure of the project to meet material assumptions of the original appraisal. We generally consider appraisals to be current if they are dated within the past twelve months. However, we may obtain an updated appraisal on a more frequent basis if in our determination there are significant changes to the underlying assumptions from the most recent appraisal. As of September 30, 2011, $69.1 million of our collateral dependent loans had an appraisal older than twelve months. The fair value of the collateral for these loans was determined through inputs outside of appraisals, including actual and comparable sales transactions, broker price opinions and other relevant data.

Five of the 15 loans that comprise our real estate construction portfolio as of September 30, 2011 have been extended, renewed or restructured since origination. These modifications have occurred for various reasons including, but not limited to, changes in business plans, work-out efforts that were best achieved via a restructuring or discounted payoff.

In considering the performing status of a real estate construction loan, the current payment of interest, whether in cash or through an interest reserve, is only one of the factors used in our analysis. Our impairment analysis generally considers the loan’s maturity, the likelihood of a restructuring of the loan and if that

restructuring constitutes a troubled debt restructuring, whether the borrower is current on interest and principal payments, the condition of underlying assets and the ability of the borrower to refinance the loan at market terms. Although an interest reserve may mitigate a delinquency that could cause impairment, other issues with the loan or borrower may lead to an impairment determination. Impairment is then measured based on a fair market or discounted cash flow value to assess the current value of the loan relative to the principal balance. If the valuation analysis indicates that repayment in full is doubtful, the loan will be placed on non-accrual status and designated as non-performing.

Interest income recognized on the real estate construction loan portfolio was $0.7 million and $3.4 million for the three and nine months ended September 30, 2011, respectively, and $2.8 million and $17.7 million for the three and nine months ended September 30, 2010, respectively. Cumulative capitalized interest on real estate construction loans in our portfolio as of September 30, 2011 and December 31, 2010 was $10.1 million and $86.4 million, respectively. As of September 30, 2011 and December 31, 2010, $66.0 million, or 88.6%, and $240.4 million, or 81.9%, respectively, of the total real estate construction loan portfolio was non-performing.

The decrease in the non-performing loan balance from December 31, 2010 to September 30, 2011 is primarily due to payoffs, charge offs, sales, and foreclosures on those loans, and a decrease in the number of loans that became non-performing during 2011.

The activity in the allowance for loan losses for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Balance as of beginning of period	$	199,138		$	578,633		$	329,122		$	586,696
Charge offs:
Commercial		(15,715	)		(24,770	)		(132,612	)		(82,525	)
Real estate		(8,485	)		(17,809	)		(46,245	)		(95,985	)
Real estate – construction		(3,114	)		(17,282	)		(28,387	)		(118,153	)

Total charge offs		(27,314	)		(59,861	)		(207,244	)		(296,663	)
Recoveries:
Commercial		1,198			253			4,656			497
Real estate		280			22			11,693			75
Real estate – construction		—			—			1,105			6

Total recoveries		1,478			275			17,454			578

Net charge offs		(25,836	)		(59,586	)		(189,790	)		(296,085	)
Charge offs upon transfer to held for sale		(68	)		(26,042	)		(12,430	)		(41,808	)
Deconsolidation of 2006-A Trust					(138,134	)					(138,134	)
Provision for loan losses:
General		(2,356	)		(20,172	)		(71,231	)		(63,816	)
Specific		37,474			58,943			152,681			346,789

Total provision for loan losses		35,118			38,771			81,450			282,973

Balance as of end of period	$	208,352		$	393,642		$	208,352		$	393,642

Allowance for loan losses ratio		3.58	%		5.94	%		3.58	%		5.94	%

Provision for loan losses as a percentage of total loans outstanding (annualized)		2.39	%		2.32	%		1.87	%		5.71	%

Net charge offs as a percentage of average loans outstanding (annualized)		1.86	%		4.95	%		4.67	%		5.91	%

Our allowance for loan losses decreased by $120.7 million to $208.4 million as of September 30, 2011 from $329.1 million as of December 31, 2010. This decrease consisted of a $71.2 million decrease in general reserves and a $49.5 million decrease in specific reserves on impaired loans as further described below. Our provision for loan losses decreased by $3.7 million and $201.5 million for the three and nine months ended September 30, 2011, respectively, as compared to the corresponding periods in 2010. Given the nature of the factors driving the change in provision for loan losses during the three and nine months ended September 30, 2011, provision levels recognized during the three and nine months ended September 30, 2011 should not be considered indicative of provision levels in the future.

The decrease in the general reserves was primarily due to a shift in the loan mix reflecting a decrease in non-impaired loans in categories with the greatest historical loss experience, lowered estimated losses to reflect that an increased percentage of our non-impaired loan portfolio has been originated in recent years where the credit outcome is expected to be more favorable, and a reduction in the amount of unpaid principal balance of non-impaired loans due to loan payoffs, principal payments and loan sales. As of September 30, 2011, the unpaid principal balance of non-impaired loans had decreased to $5.3 billion and the general reserves allocated to that portfolio had decreased to $178.9 million, representing an effective reserve percentage of 3.4%. As of December 31, 2010, the unpaid principal balance of non-impaired loans was $5.4 billion and the general reserves allocated to that portfolio were $250.2 million, representing an effective reserve percentage of 4.6%. The lower effective reserve percentage reflects the lower historical losses generally experienced by the non-impaired loans remaining in our portfolio as of September 30, 2011.

The decrease in specific reserves for the nine months ended September 30, 2011 was related to new specific reserves of $152.7 million, which were offset by recoveries of $17.5 million and net charge offs of $202.2 million taken during the period. The carrying values of our impaired loans reflect incurred losses that are inherent in our loan portfolio.

We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the original loan agreement. In this regard, impaired loans include those loans where we expect to encounter a significant delay in the collection of, and/or shortfall in the amount of contractual payments due to us as well as loans that we have assessed as impaired, but for which we ultimately expect to collect all payments.

We employ a formal quarterly process to both identify impaired loans and record appropriate specific reserves based on available collateral and other borrower-specific information. As of September 30, 2011, the unpaid principal balance of impaired loans was $461.8 million with a specific allowance attributable to that portfolio of $29.4 million. Additionally, as of September 30, 2011, $167.6 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of September 30, 2011 of $197.0 million represented an expected total loss of 29.6% of the legal balance of $664.6 million (the September 30, 2011 balance plus amounts previously charged off). As of December 31, 2010, the unpaid principal balance of impaired loans was $931.2 million with a specific allowance attributable to that portfolio of $79.0 million. Additionally, as of December 31, 2010, $463.1 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total prior charge offs and specific reserves as of December 31, 2010 of $505.3 million represented an expected total loss of 37.2% of the legal balance of $1.4 billion (the December 31, 2010 balance plus amounts previously charged off). The lower effective total loss percentage was due to impaired loans that had high cumulative charge offs and specific reserves that were resolved during the period.

CapitalSource Bank Segment

The outstanding unpaid principal balances of non-performing loans in the CapitalSource Bank loan portfolio as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Non-accrual loans
Commercial	$	27,881	$	45,919
Real estate		79,691		70,438
Real estate — construction		—		131,940

Total loans on non-accrual	$	107,572	$	248,297

Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	272

Total accruing loans contractually past-due 90 days or more	$	—	$	272

Troubled debt restructurings (1)
Real estate	$	35,599	$	35,689

Total troubled debt restructurings	$	35,599	$	35,689

Total non-performing loans
Commercial	$	27,881	$	46,191
Real estate		115,290		106,127
Real estate — construction		—		131,940

Total non-performing loans	$	143,171	$	284,258

(1)	Excludes non-accrual loans and accruing loans contractually past-due 90 days or more.

We had one potential problem loan with an unpaid principal balance of $3.8 million as of September 30, 2011, and one potential problem loan with an unpaid principal balance of $76.2 million as of December 31, 2010.

Of our non-accrual loans, $0.4 million and $3.9 million were 30-89 days delinquent, and $21.9 million and $69.8 million were over 90 days delinquent as of September 30, 2011 and December 31, 2010, respectively. Accruing loans 30-89 days delinquent were $0.2 million and $5.3 million as of September 30, 2011 and December 31, 2010, respectively.

The activity in the allowance for loan losses for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Balance as of beginning of period	$	108,592		$	164,561		$	124,878		$	152,508
Charge offs:
Commercial		—			(364	)		(1,177	)		(4,049	)
Real estate		(3,965	)		(15,910	)		(29,885	)		(57,387	)
Real estate — construction		—			(8,912	)		(11,530	)		(44,076	)

Total charge offs		(3,965	)		(25,186	)		(42,592	)		(105,512	)
Recoveries:
Commercial		75			—			160			—
Real estate		257			—			11,626			—
Real estate — construction		—			—			1,019			—

Total recoveries		332			—			12,805			—

Net charge offs		(3,633	)		(25,186	)		(29,787	)		(105,512	)
Charge offs upon transfer to held for sale		—			(22,922	)		(43	)		(23,341	)
Provision for loan losses:
General		1,605			(6,556	)		(14,081	)		(19,060	)
Specific		12,120			21,108			37,717			126,410

Total provision for loan losses		13,725			14,552			23,636			107,350

Balance as of end of period	$	118,684		$	131,005		$	118,684		$	131,005

Allowance for loan losses ratio		2.62	%		3.53	%		2.62	%		3.53	%

Provision for loan losses as a percentage of total loans outstanding (annualized)		1.20	%		1.56	%		0.70	%		3.87	%

Net charge offs as a percentage of average loans outstanding (annualized)		0.34	%		5.26	%		0.99	%		5.12	%

Our allowance for loan losses decreased by $6.2 million to $118.7 million as of September 30, 2011 from $124.9 million as of December 31, 2010. This decrease was comprised of a $14.1 million decrease in general reserves and a $7.9 million increase in specific reserves on impaired loans.

The decrease in general reserves was primarily due to a shift in the loan mix reflecting a decrease in non-impaired loans in categories with the greatest historical loss experience, lowered estimated losses to reflect that an increased percentage of our non-impaired loan portfolio has been originated in recent years where the credit outcome is expected to be more favorable, and a reduction in the amount of unpaid principal balance of non-impaired loans due to loan payoffs, principal payments and loan sales. As of September 30, 2011, the unpaid principal balance of non-impaired loans had increased to $4.4 billion and the general reserves allocated to that portfolio were $108.9 million, representing an effective reserve percentage of 2.5%. As of December 31, 2010, the unpaid principal balance of non-impaired loans was $3.5 billion and the general reserves allocated to that portfolio were $123.0 million, representing an effective reserve percentage of 3.5%. The lower effective reserve percentage reflects the lower historical losses generally experienced by the non-impaired loans remaining in our portfolio as of September 30, 2011.

The increase in specific reserves for the nine months ended September 30, 2011 was related to new specific reserves of $37.7 million, which were partially offset by recoveries of $12.8 million and net charge offs of $29.8 million taken during the period. The carrying values of our impaired loans reflect incurred losses that are inherent in our loan portfolio.

Given our loss experience, we consider our higher-risk loans to be commercial real estate loans originated in 2008 and prior. As of September 30, 2011 and December 31, 2010, commercial real estate loans originated in 2008 and prior had an outstanding principal balance of $395.2 million and $802.5 million, respectively. This amount was net of cumulative charge offs taken on these loans of $42.5 million and $31.2 million, respectively, representing net charge-off ratios of 10.8% and 3.9%, respectively.

During the three and nine months ended September 30, 2011, loans with an aggregate carrying value of $17.7 million and $125.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and nine months ended September 30, 2010, loans with an aggregate carrying value of $145.9 million and $343.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. Loans involved in these TDRs are assessed as impaired, generally for a period of at least one year following the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. The specific reserves allocated to loans that were involved in TDRs were $8.6 million as of September 30, 2011. There were no specific reserves allocated to loans that were involved in TDRs as of December 31, 2010.

During 2010, CapitalSource Bank restructured three commercial real estate loans into new loans using an “A note / B note” structure in which the B note component has been fully charged off. The contractual principal balances of these three loans prior to the restructurings totaled $91.6 million. In connection with the restructurings, $8.8 million of debt was forgiven and charged off, and $4.9 million was collected as principal payments, leaving $59.9 million of A notes and $18.2 million of B notes. In March 2011, one of these A / B note arrangements with an aggregate carrying value of $21.1 million as of December 31, 2010 was repaid in full, including the previously charged off B note. As of September 30, 2011, the aggregate carrying value of the remaining two A notes was $35.7 million, and as of December 31, 2010, the aggregate carrying value of the three A notes was $56.5 million. The B notes had no aggregate carrying value as of September 30, 2011 and December 31, 2010. During the three and nine months ended September 30, 2011, the remaining two A notes that were TDRs with an aggregate carrying value of $35.7 million were no longer classified as impaired as they performed in accordance with market-based restructured terms for twelve consecutive months.

The workout strategy discussed above results in the A note equaling a balance the borrower can service and is underwritten to a loan to value ratio based on the current collateral valuation. The A note may be assigned an internal risk rating of pass based on the revised terms and management’s assessment of the borrower’s ability and intent to repay. The A note is structured at a market interest rate, and the A note debt service is typically covered by the in-place property operations allowing it to be placed on accrual status. The reduced loan amount induces the borrower to continue to support the loan and maintain the collateral despite the observed reduction in the collateral value. The B note usually bears no interest or an interest rate significantly below the market rate. The A note contains amortization provisions, and the B note requires amortization only after the full repayment of the A note.

Accrual status for each loan, including restructured A notes, is considered on a loan by loan basis. The newly established principal balance of the A note is set at a level where the borrower is expected to keep the loan current and where the underlying collateral value adequately supports the loan. The revised structure is intended to allow the A loan to be placed on accrual status.

All loans that have undergone this A note / B note restructuring are considered TDRs. The A notes are deemed impaired and remain so classified for at least one year from the date of the restructuring. After one year, the A notes are evaluated quarterly to determine if the loan performance has complied with the terms of the TDR such that the impairment classification may be removed.

Other Commercial Finance Segment

The outstanding unpaid principal balances of non-performing loans in Other Commercial Finance loan portfolio as of September 30, 2011 and December 31, 2010 were as follows:


	September 30, 2011		December 31, 2010
	($ in thousands)
Non-accrual loans
Commercial	$	121,141	$	320,498
Real estate		38,080		61,320
Real estate — construction		66,022		68,671

Total loans on non-accrual	$	225,243	$	450,489

Accruing loans contractually past-due 90 days or more
Commercial	$	1,213	$	2,972
Real estate		—		6,238
Real estate — construction		—		39,806

Total accruing loans contractually past-due 90 days or more	$	1,213	$	49,016

Troubled debt restructurings (1)
Commercial	$	112,990	$	118,988
Real estate		6,238		—

Total troubled debt restructurings	$	119,228	$	118,988

Total non-performing loans
Commercial	$	235,344	$	442,458
Real estate		44,318		67,558
Real estate — construction		66,022		108,477

Total non-performing loans	$	345,684	$	618,493

(1)	Excludes non-accrual loans and accruing loans contractually past-due 90 days or more.

We had $7.8 million potential problem loans as of September 30, 2011. We had $6.8 million such potential problem loans as of December 31, 2010.

Of our non-accrual loans, $6.4 million and $18.5 million were 30-89 days delinquent, and $122.8 million and $200.7 million were over 90 days delinquent as of September 30, 2011 and December 31, 2010, respectively. Accruing loans 30-89 days delinquent were $8.7 million and $0.1 million as of September 30, 2011 and December 31, 2010, respectively.

The activity in the allowance for loan losses for the three and nine months ended September 30, 2011 and 2010 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	($ in thousands)
Balance as of beginning of period	$	90,546		$	414,072		$	204,244		$	434,188
Charge offs:
Commercial		(15,715	)		(24,406	)		(131,435	)		(78,476	)
Real estate		(4,520	)		(1,899	)		(16,360	)		(38,598	)
Real estate — construction		(3,114	)		(8,370	)		(16,857	)		(74,077	)

Total charge offs		(23,349	)		(34,675	)		(164,652	)		(191,151	)
Recoveries:
Commercial		1,123			253			4,496			497
Real estate		23			22			67			75
Real estate — construction		—			—			86			6

Total recoveries		1,146			275			4,649			578

Net charge offs		(22,203	)		(34,400	)		(160,003	)		(190,573	)
Charge offs upon transfer to held for sale		(68	)		(3,120	)		(12,387	)		(18,467	)
Deconsolidation of 2006-A term debt securitization					(138,134	)					(138,134	)
Provision for loan losses:
General		(3,961	)		(13,616	)		(57,150	)		(44,756	)
Specific		25,354			37,835			114,964			220,379

Total provision for loan losses		21,393			24,219			57,814			175,623

Balance as of end of period	$	89,668		$	262,637		$	89,668		$	262,637

Allowance for loan losses ratio		6.97	%		8.99	%		6.97	%		8.99	%

Provision for loan losses as a percentage of total loans outstanding (annualized)		6.59	%		3.29	%		6.00	%		8.04	%

Net charge offs as a percentage of average loans outstanding (annualized)		6.90	%		4.61	%		13.18	%		6.53	%

Our allowance for loan losses decreased by $114.5 million to $89.7 million as of September 30, 2011 from $204.2 million as of December 31, 2010. This decrease comprised a $57.1 million decrease in general reserves and a $57.4 million decrease in specific reserves on impaired loans as further described below.

The decrease in general reserves was a result of loan payoffs, sales and foreclosures. Our loans in categories with the greatest historical loss experience continue to pay off or be otherwise resolved. As of September 30, 2011, the unpaid principal balance of non-impaired loans had decreased to $933.7 million and the general reserves allocated to that portfolio were $70.0 million, representing an effective reserve percentage of 7.5%. As of December 31, 2010, the unpaid principal balance of non-impaired loans was $1.9 billion and the general reserves allocated to that portfolio were $127.2 million, representing an effective reserve percentage of 6.7%.

The decrease in specific reserves for the nine months ended September 30, 2011 was related to new specific reserves of $115.0 million, which were offset by recoveries of $4.6 million and net charge offs of $172.4 million taken during the period. The carrying values of our impaired loans reflect incurred losses that are inherent in our loan portfolio.

As of September 30, 2011, the majority of our loan portfolio comprised commercial loans. Given our loss experience, we consider our higher-risk loans within our commercial portfolio to be cash flow-based loans

related to the media, communications, retail, apparel, restaurant, and other industries. As of September 30, 2011, these higher-risk loans had an aggregate outstanding principal balance of $443.9 million, net of cumulative charge offs taken on these loans of $265.2 million.

During the three and nine months ended September 30, 2011, loans with an aggregate carrying value of $29.4 million and $145.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and nine months ended September 30, 2010, loans with an aggregate carrying value of $132.5 million and $497.0 million, respectively, as of their respective restructuring dates, were involved in TDRs. Additionally, loans involved in these TDRs are assessed as impaired, generally for a period of at least one year following the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. The specific reserves allocated to loans that were involved in TDRs were $13.3 million and $35.5 million as of September 30, 2011 and December 31, 2010, respectively.

Liquidity and Capital Resources

Liquidity is a measure of our sources of funds available to meet our obligations as they arise. We require cash to fund new and existing loan commitments, repay and service indebtedness, make new investments, fund net deposit outflows and pay expenses related to general business operations. Our primary sources of liquidity are cash and cash equivalents, new borrowings and deposits, proceeds from asset sales, principal and interest collections, and additional equity and debt financings.

We separately manage the liquidity of CapitalSource Bank and the Parent Company as required by regulation. Our liquidity management is based on our business plans for the Parent Company and CapitalSource Bank and assumptions related to expected cash inflows and outflows that we believe are reasonable. These business plans include the assumption that substantially all newly originated loans will be funded by CapitalSource Bank.

As of September 30, 2011, we had $1.4 billion of unfunded commitments to extend credit, of which $874.4 million were commitments of CapitalSource Bank and $489.9 million were commitments of the Parent Company. Due to their nature, we cannot know with certainty the aggregate amounts we will be required to fund under these unfunded commitments. In many cases, our obligation to fund unfunded commitments is subject to our clients’ ability to provide collateral to secure the requested additional fundings, the collateral’s satisfaction of eligibility requirements, our clients’ ability to meet specified preconditions to borrowing, including compliance with the loan agreements, and/or our discretion pursuant to the terms of the loan agreements. In other cases, however, there are no such prerequisites or discretion to future fundings by us, and our clients may draw on these unfunded commitments at any time. We forecast adequate liquidity to fund the expected borrower draws under these commitments. To the extent there are unfunded commitments with respect to a loan that is owned partially by CapitalSource Bank and the Parent Company, unless our client is in default, CapitalSource Bank is obligated in some cases, pursuant to intercompany agreements, to fund its portion of the unfunded commitment before the Parent Company is required to fund its portion. Our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract and lender liability for us and irreparably damage our reputation in the marketplace.

Unless otherwise specified, the figures presented in the following paragraphs are based on current forecasts and take into account activity since September 30, 2011. The information contained in this section should be read in conjunction with, and is subject to and qualified by the information set forth in our Risk Factors and the Cautionary Note Regarding Forward Looking Statements in our Form 10-K.

CapitalSource Bank Liquidity

The most significant variable in CapitalSource Bank’s liquidity management is our expectation regarding the net loan and deposit growth. CapitalSource Bank’s primary sources of liquidity include: deposits, payments of principal and interest on loans and securities, cash equivalents, and borrowings from the FHLB SF. Secondary sources of liquidity may also include: capital contributions and borrowings from the Parent Company, bank

borrowings, and the issuance of debt securities. We intend to maintain sufficient liquidity at CapitalSource Bank to meet depositor demands and fund loan commitments and operations as well as to maintain liquidity ratios required by our regulators.

CapitalSource Bank’s primary uses of liquidity include: funding new and existing loans, purchasing investment securities, funding net deposit outflows, paying operating expenses, payment of income taxes pursuant to our intercompany tax sharing arrangement and potentially the payment of dividends. CapitalSource Bank operates in accordance with the conditions imposed and contractual agreements entered in connection with regulatory approvals obtained upon its formation, including requirements that CapitalSource Bank maintain a total risk-based capital ratio of not less than 15%, capital levels required for a bank to be considered “well- capitalized” under relevant banking regulations. In addition, we have a policy to maintain 7.5% of CapitalSource Bank’s assets in unencumbered cash, cash equivalents and investments. In accordance with regulatory guidance, we have identified, modeled and planned for the financial, capital and liquidity impact of various events and scenarios that would cause a large outflow of deposits, a reduction in borrowing capacity, a material increase in loan funding obligations, a material increase in credit costs or any combination of these events. We anticipate that CapitalSource Bank would be able to maintain sufficient liquidity and ratios in excess of its required minimum ratios in these events and scenarios.

For information on CapitalSource Bank’s primary sources of liquidity, see Note 8, Deposits and Note 10, Borrowings, in our consolidated financial statements for the three months ended September 30, 2011 and in our audited consolidated financial statements in our Form 10-K for the year ended December 31, 2010.

Parent Company Liquidity

The Parent Company’s need for liquidity is based on our intention to run off over time the balance of our existing loan portfolio and other assets held in the Parent Company. The Parent Company’s primary sources of liquidity include cash and cash equivalents, income tax payments from CapitalSource Bank pursuant to our intercompany tax sharing arrangement, principal and interest payments, asset sales, loan sourcing fees from CapitalSource Bank for loan originations, and potentially dividends from CapitalSource Bank. The Parent Company also has access to secondary sources of liquidity including bank borrowings and the issuance of debt securities and the issuance of additional shares of equity.

The Parent Company’s primary uses of liquidity include interest and principal payments on our existing debt, operating expenses, share repurchases pursuant to our Stock Repurchase Program, any dividends that we may pay, and the funding of unfunded commitments. The Parent Company is required to repurchase its 7.25% Convertible Debentures in cash at the option of the noteholders on July 15, 2012. As of September 30, 2011, the outstanding principal balance on the 7.25% Convertible Debentures was $174.9 million.

During the three months ended September 30, 2011, we repurchased the outstanding 3.5% and 4.0% Convertible Debentures for an aggregate repurchase price of $280.5 million; $75.1 million of the outstanding principal balance of the 7.25% Convertible Debentures for $77.3 million; and $298.1 million of our 12.75% Senior Secured Notes for $376.4 million. As a result of these activities, liquidity was significantly lower at September 30, 2011 than June 30, 2011. The current level of liquidity is adequate to meet our expected needs for the next 12 months.

Pursuant to agreements with our regulators, to the extent CapitalSource Bank independently is unable to do so, the Parent Company must maintain CapitalSource Bank’s total risk-based capital ratio at not less than 15% and must maintain the capital levels of CapitalSource Bank at all times to meet the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. Additionally, pursuant to requirements of our regulators, the Parent Company has provided a $150.0 million unsecured revolving credit facility to CapitalSource Bank that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. As of September 30, 2011, there were no amounts outstanding under this facility.

The Parent Company is subject to financial and non-financial covenants under our indebtedness. If we were to default under our indebtedness by violating these covenants or otherwise, our investors’ remedies would include the ability to, among other things, transfer servicing to another servicer, foreclose on collateral, and/or accelerate payment of all amounts payable under such indebtedness.

Any share repurchases made under the stock repurchase plan will be made through open market purchases or privately negotiated transactions. The amount and timing of any repurchases will depend on market conditions and other factors and repurchases may be suspended or discontinued at any time. For additional information, see Note 12, Shareholders’ Equity, in our audited consolidated financial statements in our Form 10-K for the year ended December 31, 2010.

Commitments, Guarantees & Contingencies

As of September 30, 2011 and December 31, 2010, we had unfunded commitments to extend credit to our clients of $1.4 billion and $1.9 billion, respectively. Additional information on these contingencies is included in Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2010, included in our Form 10-K, and Liquidity and Capital Resources — Parent Company Liquidity herein.

We have non-cancelable operating leases for office space and office equipment, which expire over the next 14 years and contain provisions for certain annual rental escalations. For additional information, see Note 19, Commitments and Contingencies, in our audited consolidated financial statements in our Form 10-K for the year ended December 31, 2010.

We provide standby letters of credit in conjunction with several of our lending arrangements and under certain of our property leases. For additional information, see Note 16, Commitments and Contingencies, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2011.

In connection with certain securitization transactions, we have made customary representations and warranties regarding the characteristics of the underlying transferred assets and collateral. Prior to any securitization transaction, we generally performed due diligence with respect to the assets to be included in the securitization transaction and the collateral to ensure that they satisfy the representations and warranties. In our capacity as originator and servicer in certain securitization transactions, we may be required to repurchase or substitute loans which breach a representation and warranty as of their date of transfer to the securitization or financing vehicle.

Credit Risk Management

Credit risk is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. Credit risk exists primarily in our loan and derivative portfolios

and the portion of our investment portfolio comprised of non-agency MBS, non-agency ABS and CMBS. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral. We manage credit risk of our derivatives and credit-related arrangements by limiting the total amount of arrangements outstanding with an individual counterparty, by obtaining collateral based on the nature of the lending arrangement and management’s assessment of the client, and by applying uniform credit standards maintained for all activities with credit risk.

As appropriate, the Parent Company and CapitalSource Bank credit committees evaluate and approve credit standards and oversee the credit risk management function related to our loans and other investments. Their primary responsibilities include ensuring the adequacy of our credit risk management infrastructure, overseeing credit risk management strategies and methodologies, monitoring economic and market conditions having an impact on our credit-related activities, and evaluating and monitoring overall credit risk and monitoring our client’s financial condition and performance.

Substantially all new loans have been originated at CapitalSource Bank, and we maintain a comprehensive credit policy manual for those loans that is supplemented by specific loan product underwriting guidelines. Among other things, the credit policy manual sets forth requirements that meet the regulations enforced by both the FDIC and the DFI. Examples of such requirements include the loan to value limitations for real estate secured loans, standards for real estate appraisals and other third-party reports, and collateral insurance requirements.

Our underwriting guidelines outline specific underwriting standards and minimum specific risk acceptance criteria for each lending product offered. Loan types defined within these guidelines have three broad categories, within our commercial, real estate, and real estate construction loan portfolios. These categories include asset-based loans, cash flow loans, and real estate loans, and each of these broad categories has specific subsections that define in detail the following:

•

Loan structures, which includes the lien positions, amortization provisions and loan tenors;

•

Collateral descriptions and appropriate valuation methods;

•

Underwriting considerations which include minimum diligence and verification requirements; and

•

Specific risk acceptance criteria which enumerate for each loan type the minimum acceptable credit performance standards. Examples of these criteria include maximum loan-to-value amounts for real estate loans, maximum advance rate amounts for asset-based loans and minimum historical and projected debt service coverage amounts for all loans.

We measure and document each loan’s compliance with our specific risk acceptance criteria at underwriting. If at underwriting, there is an exception to these criteria, an explanation of the factors that mitigate this additional risk is considered before an approval is granted.

Credit risk management for the loan portfolio begins with an assessment of the credit risk profile of a client based on an analysis of the client’s payment performance, cash flow and financial position. As part of the overall credit risk assessment of a client, each credit exposure is assigned an internal risk rating that is subject to approval based on defined credit approval standards. While rating criteria vary by product, each loan rating focuses on the same two factors: financial performance and collateral. Subsequent to loan origination, risk ratings are monitored on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the client’s financial condition, cash flow or financial position. We use risk rating aggregations to measure and evaluate concentrations within the loan portfolio. In making decisions regarding credit, we consider risk rating, collateral and industry concentration limits.

Concentrations of Credit Risk

In our normal course of business, we engage in lending activities with clients primarily throughout the United States. As of September 30, 2011, the single largest industry concentration was real estate—rental and leasing, which made up approximately 19% of our loan portfolio. As of September 30, 2011, taken in the aggregate, non-healthcare real estate loans, which was our largest loan concentration, made up approximately 30% of our loan portfolio. As of September 30, 2011, the largest geographical concentration was California, which made up approximately 16% of our loan portfolio.

Selected information pertaining to our largest credit relationships as of September 30, 2011 was as follows:


Loan Balance	% of Total Portfolio			Loan Type	Industry	Amount of Loan(s) at Origination		Loan Commitment		Performing	Allowance for Loan Losses		Underlying Collateral (1)	Date of Last Collateral Appraisal	Amount of Last Appraisal
($ in thousands)
$209,540		3.6	%	Commercial and Real Estate - Construction	Accommodation and Food Services and Finance and Insurance		$173,663		$244,829	Partial (2)		$—	Timeshare receivables	n/a	n/a(2)
190,412		3.3		Real Estate	Accommodation and Food Services		5,006		194,314	Yes		—	Portfolio of vacation properties	Various ranging from December 2006 to May 2011	$534,270(3)
92,344		1.6		Real Estate	Health Care and Social Assistance		400,000		92,344	Yes		—	Nursing Care Facilities	May 2010	$458,500(4)

$492,296		8.5	%				$578,669		$531,487

(1)	Represents the primary collateral supporting the loan. In certain cases, there may be additional types of collateral.

(2)

The collateral that secures our loan balance of $209.5 million as of September 30, 2011 primarily consists of timeshare receivables and timeshare real estate that had a total value of $708.7 million as of September 30, 2011. Total senior debt, including our loan balance, secured by the collateral was $295.8 million as of September 30, 2011. This credit relationship includes multiple loans, one of which, with a balance of $37.3 million, is non-performing.

(3)	Total senior debt, including our loan balance, was $262.7 million as of September 30, 2011.

(4)	Total senior debt, including our loan balance, was $365.2 million as of September 30, 2011.

Non-performing loans in our portfolio of loans held for investment may include non-accrual loans, accruing loans contractually past due, or TDRs. Our remediation efforts on these loans are based upon the characteristics of each specific situation. The various remediation efforts that we may undertake include, among other things, one of or a combination of the following:

•

request that the equity owners of the borrower inject additional capital;

•

require the borrower to provide us with additional collateral;

•

request additional guaranties or letters of credit;

•

request the borrower to improve cash flow by taking actions such as selling non-strategic assets or reducing operating expenses;

•

modify the terms of our debt, including the deferral of principal or interest payments, where we will appropriately classify the modification as a TDR;

•

initiate foreclosure proceedings on the collateral, or

•

sell the loan in certain cases where there is an interested third-party buyer.

There were 129 credit relationships in the non-performing portfolio as of September 30, 2011, and our largest non-performing credit relationship totaled $53.6 million and comprised 11.0% of our total non-performing loans.

TDRs are loans that have been restructured as a result of deterioration in the borrower’s financial position and for which we have granted a concession to the borrower that we would not have otherwise granted if those conditions did not exist. Our concession strategies in TDRs are intended to minimize our economic losses as borrowers experience financial difficulty and provide an alternative to foreclosure. The success of these strategies is highly dependent on our borrowers’ ability and willingness to repay under the restructured terms of their loans. Continued adverse changes in the economic environment or in borrower performance could negatively impact the outcome of these strategies.

A summary of concessions granted by loan type, including the accrual status of the loans as of September 30, 2011 and December 31, 2010 was as follows:


	September 30, 2011						December 31, 2010
	Non-accrual		Accrual		Total		Non-accrual		Accrual		Total
	($ in thousands)
Commercial
Interest rate and fee reduction	$	—	$	—	$	—	$	24,185	$	—	$	24,185
Maturity extension		37,798		74,176		111,974		104,872		79,481		184,353
Payment deferral		12,544		8,965		21,509		18,235		4,189		22,424
Multiple concessions		40,244		30,083		70,327		57,912		35,121		93,033

		90,586		113,224		203,810		205,204		118,791		323,995
Real estate
Interest rate and fee reduction		2,068		—		2,068		1,880		—		1,880
Maturity extension		1,024		41,896		42,920		25,910		35,471		61,381
Payment deferral		53,427		—		53,427		—		—		—
Multiple concessions		1,232		—		1,232		—		—		—

		57,751		41,896		99,647		27,790		35,471		63,261
Real estate - construction
Maturity extension		22,310		—		22,310		153,982		—		153,982
Multiple concessions		—		—		—		13,875		—		13,875

		22,310		—		22,310		167,857		—		167,857

Total	$	170,647	$	155,120	$	325,767	$	400,851	$	154,262	$	555,113

We have experienced losses incurred on some TDRs subsequent to their initial restructuring. These losses include both additional specific reserves and charge offs on the restructured loans. The majority of such losses has been incurred on our commercial loans and is primarily due to the borrowers’ failure to consistently meet their financial forecasts that formed the bases for our restructured loans. Examples of circumstances that resulted in the borrowers not being able to meet their forecasts included acquisitions of other businesses that did not have the expected positive impact on financial results, significant delays in launching products and services, and continued deterioration in the pricing estimates of businesses and product lines that the borrower expected to sell to generate proceeds to repay the loan. In certain of these cases, the TDRs occurred prior to 2008, and the borrowers performed under the terms of the restructured loans for a period of time before their operations were negatively impacted by recent market conditions.

Losses incurred on TDRs since their initial restructuring by concession and loan type for the three and nine months ended September 30, 2011 and 2010 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	($ in thousands)
Commercial
Interest rate and fee reduction	$	—	$	2,506	$	18,728	$	7,326
Maturity extension		733		3,496		9,444		18,543
Payment deferral		2,230		10		9,606		478
Multiple concessions		214		11,073		33,051		15,759

		3,177		17,085		70,829		42,106
Real estate
Interest rate and fee reduction		—		—		9		—
Maturity extension		29		4,478		428		8,729
Payment Deferral		—		—		11,162		—
Multiple concessions		—		—		—		8,743

		29		4,478		11,599		17,472
Real estate — construction
Maturity extension		4,541		1,163		19,159		6,252
Multiple concessions		—		4,562		—		4,562

		4,541		5,725		19,159		10,814

Total	$	7,747	$	27,288	$	101,587	$	70,392

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and nine months ended September 30, 2011, 0.1% and 36.2%, respectively, related to loans for which the initial TDR on the borrower occurred prior to 2008, 7.1% and 77.0%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status as of September 30, 2011. We recognized $0.2 million interest income for the nine months ended September 30, 2011 on the commercial loans that experienced losses during this period. We did not recognize any such interest income for the three months ended September 30, 2011.

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and nine months ended September 30, 2010, 48.6% and 58.5%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and 99.3% of the additional losses recognized for the nine months ended September 30, 2010 are related to loans that were on non-accrual status as of September 30, 2010. We recognized approximately $0.1 million and $0.7 million of interest income for the three and nine months ended September 30, 2010 on the commercial loans that experienced losses during this period.

Market Risk Management

Market risk is the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions such as interest rate fluctuations. This risk is inherent in the financial instruments associated with our operations and/or activities, which result in the recognition of assets and liabilities in our consolidated financial statements, including loans, securities, short-term borrowings, long-term debt, trading account assets and liabilities and derivatives.

The primary market risk to which we are exposed is interest rate risk, which is inherent in the financial instruments associated with our operations, primarily including our loans and borrowings. Our traditional loan products are non-trading positions and are reported at amortized cost. Additionally, debt obligations that we incur to fund our business operations are recorded at historical cost. While U.S. generally accepted accounting principles (“GAAP”) requires a historical cost view of such assets and liabilities, these positions are still subject to changes in economic value based on varying market conditions.

Interest Rate Risk Management

Interest rate risk in our normal course of business refers to the change in earnings that may result from changes in interest rates, primarily various short-term interest rates, including LIBOR-based rates and the prime rate. The majority of our loan portfolio bears interest at a spread to the LIBOR rate or a prime-based rate with most of the remainder bearing interest at a fixed rate. The majority of our deposits are fixed rate, but with short term maturities. We also have fixed rate debt including convertible debt, senior secured notes, and FHLB borrowings. We attempt to mitigate our exposure to the earnings impact of the interest rate changes by engaging in hedging activities as discussed below. For additional information, see Note 17, Derivative Instruments, in our consolidated financial statements for the three and nine months ended September 30, 2011.

The estimated changes in net interest income for a 12-month period based on changes in the interest rates applied to the combined portfolios of our segments as of September 30, 2011, were as follows ($ in thousands):


Rate Change
(Basis Points)
+ 200	$	38,389
+ 100		13,606
– 100		(9,079	)
– 200		(9,820	)

For the purpose of the above analysis, we included loans, investment securities, borrowings, deposits and derivatives. In addition, we assumed that loans, investment securities and deposits are replaced as they run off. The new loans, investment securities and deposits are assumed to have interest rates that reflect our forecast of prevailing market terms. We also assumed that LIBOR and prime rates do not fall below 0% for loans and borrowings.

As of September 30, 2011, approximately 55% of the aggregate outstanding principal amount of our loans had interest rate floors and were accruing interest. Of the loans with interest rate floors and accruing interest, approximately 95% had contractual rates below the interest rate floor and the floor was providing a benefit to us. The loans with contractual interest rate floors as of September 30, 2011 were as follows:


	Amount Outstanding		Percentage of Total Portfolio
	($ in thousands)
Loans with contractual interest rates:
Below the interest rate floor	$	3,034,761		52	%
Exceeding the interest rate floor		82,393		1
At the interest rate floor		92,304		2
Loans with interest rate floors on non-accrual		202,618		4
Loans with no interest rate floor		2,411,351		41

Total	$	5,823,427		100	%

We enter into interest rate swap agreements to minimize the economic effect of interest rate fluctuations specific to our fixed rate debt and certain fixed rate loans. We also enter into additional basis swap agreements to hedge basis risk between our LIBOR-based term debt and the prime-based loans pledged as collateral for that debt. These basis swaps modify our exposure to interest rate risk by synthetically converting fixed rate and prime rate loans to one-month LIBOR. Our interest rate hedging activities partially protect us from the risk that interest collected under fixed-rate and prime rate loans will not be sufficient to service the interest due under the one-month LIBOR-based term debt.

We also use interest rate swaps to hedge the interest rate risk of certain fixed rate debt. These interest rate swaps modify our exposure to interest rate risk by synthetically converting fixed rate debt to one-month LIBOR.

We have also entered into relatively short-dated forward exchange agreements to minimize exposure to foreign currency risk arising from foreign currency denominated loans.

Critical Accounting Estimates

Accounting policies are integral to understanding our Management’s Discussion and Analysis of Financial Condition and Results of Operations. The preparation of the consolidated financial statements in conformity with

GAAP requires management to make certain judgments and assumptions based on information that is available at the time of the financial statements in determining accounting estimates used in the preparation of such statements. Our significant accounting policies are described in Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2010, included in our Form 10-K. Accounting estimates are considered critical if the estimate requires management to make assumptions and judgments about matters that were highly uncertain at the time the accounting estimate was made and if different estimates reasonably could have been used in the reporting period, or if changes in the accounting estimate are reasonably likely to occur from period to period that would have a material impact on our financial condition, results of operations or cash flows. We have established detailed policies and procedures to ensure that the assumptions and judgments surrounding these areas are adequately controlled, independently reviewed and consistently applied from period to period. Management has discussed the development, selection and disclosure of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed our disclosure related to these estimates. Our critical accounting estimates are described in Critical Accounting Estimates within Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Form 10-K for the year ended December 31, 2010.

Supervision and Regulation

This is an update to certain sections from our discussion of Supervision and Regulation in our Form 10-K. For further information and discussion of supervision and regulation matters, see Item I. Business — Supervision and Regulation, in our Form 10-K for the year ended December 31, 2010. Together with the discussion of supervision and regulation matters in our Form 10-K for the year ended December 31, 2010, the following describes some of the more significant laws, regulations, and policies that affect our operations, but is not intended to be a complete listing of all laws that apply to us. From time to time, federal, state and foreign legislation is enacted and regulations are adopted which may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. We cannot predict whether or when potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.

Our bank operations are subject to regulation by federal and state regulatory agencies. This regulation is intended primarily for the protection of depositors and the deposit insurance fund, and secondarily for the stability of the U.S. banking system. It is not intended for the benefit of stockholders of financial institutions. CapitalSource Bank is a California industrial bank and is subject to supervision and regular examination by the FDIC and the DFI. CapitalSource Bank’s deposits are insured by the FDIC up to the maximum amounts permitted by law.

Although the Parent Company is not directly regulated or supervised by the DFI, the FDIC, the Federal Reserve Board or any other federal or state bank regulatory authority either as a bank holding company or otherwise, the FDIC has authority pursuant to a contractual supervisory agreement with the Parent Company (the “Parent Company Agreement”) to examine the Parent Company, the relationship and transactions between it and CapitalSource Bank and the effect of such relationships and transactions on CapitalSource Bank. The Parent Company also is subject to regulation by other applicable federal and state agencies, such as the Securities and Exchange Commission. We are required to file periodic reports with these regulators and provide any additional information that they may require.

General

Like other banks, CapitalSource Bank must file reports in the ordinary course with applicable regulators concerning its activities and financial condition in addition to obtaining regulatory approvals prior to changing its approved business plan or entering into certain transactions such as mergers with, or acquisitions of, other financial institutions.

CapitalSource Bank completed its initial three-year de novo period in July 2011. The conditions contained in the FDIC Order granting deposit insurance that prohibit the payment of dividends by CapitalSource Bank, require certain reporting by the Parent Company (some of which are required under other laws and regulations) and impose limitations on organizational changes and intercompany contractual arrangements ceased to apply

after July 2011. The rest of the conditions contained in the Order effectively remain in place pursuant to the continued existence of the contractual agreements between the Parent Company, CapitalSource Bank and the FDIC until such time as we apply for and are granted relief by the FDIC from the requirements of these agreements. Among these remaining conditions is the requirement that CapitalSource Bank maintain a total risk-based capital ratio of not less than 15% to be supported by the Parent Company. Notwithstanding the termination of any of the conditions, CapitalSource Bank remains subject to bank safety and soundness requirements as well as to various regulatory capital requirements established by federal and state regulatory agencies, including any new conditions that our regulators may determine.

CapitalSource Bank also is required to file, and has filed, a revised business plan for years four to seven of an expanded de novo period, with the plan covering the time period from July 1, 2011 through June 30, 2015. During this time period, CapitalSource Bank may be subject to increased supervision than would otherwise not be applicable to a bank that has been in existence longer than three years, including enhanced FDIC supervision for compliance examinations and Community Reinvestment Act evaluations.

There are periodic examinations by the DFI and the FDIC to evaluate CapitalSource Bank’s safety and soundness and compliance with various regulatory requirements. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the regulators or Congress, could have a material adverse impact on our operations.

Pursuant to the Parent Company Agreement, the Parent Company has consented to examination by the FDIC for purposes of monitoring compliance with the laws and regulations applicable to CapitalSource Bank and its affiliates. The Parent Company and CapitalSource Bank also are parties to a Capital Maintenance and Liquidity Agreement (the “CMLA”) with the FDIC providing that, to the extent CapitalSource Bank independently is unable to do so, the Parent Company must maintain CapitalSource Bank’s total risk-based capital ratio at not less than 15% and must maintain CapitalSource Bank’s total risk-based capital ratio at all times to meet or exceed the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. Additionally, pursuant to requirements of the CMLA, the Parent Company has provided, and is required to continue to provide, a $150.0 million unsecured revolving credit facility that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. The Parent Company Agreement also requires the Parent Company to maintain the capital levels of CapitalSource Bank at the levels required in the CMLA.

Limitations on Dividends and Other Distributions

The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. The Federal Deposit Insurance Corporation Improvement Act prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.

In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank or the bank’s net income for its last three fiscal years (less any distributions to shareholders during this period). In the event a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with appropriate regulatory approval in an amount not exceeding the greatest of the bank’s retained earnings, the bank’s net income for its last fiscal year or the bank’s net income for its current fiscal year.

The federal banking agencies also have the authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain financial market risks, which are discussed in detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Market Risk Management section of this Form 10-Q and our Form 10-K. In addition, for additional information on our derivatives, see Note 17, Derivative Instruments, in our consolidated financial statements for the three and nine months ended September 30, 2011, and Note 22, Credit Risk, in our audited consolidated financial statements for the year ended December 31, 2010 included in our Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our management, including our Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2011. There have been no changes in our internal control over financial reporting during the three months ended September 30, 2011, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

A summary of our repurchases of shares of our common stock for the three months ended September 30, 2011 was as follows:


	Total Number of Shares Purchased (1)		Average Price Paid		Total Number of Shares Purchased as Part of Publicly Announced Plan or Programs		Maximum Number of Shares (or Approximate Dollar Value) that May Yet be Purchased Under the Plans (2)
July 1 — July 31, 2011		57,708	$	6.40		—		—
August 1 — August 31, 2011		21,750,800		5.90		21,750,800		—
September 1 — September 30, 2011		25,284,801		6.43		25,281,100		—

Total		47,093,309		6.18		47,031,900	$	84,402,960

(1)	Includes the number of shares acquired as payment by employees of applicable statutory minimum withholding taxes owed upon vesting of restricted stock granted under our Third Amended and Restated Equity Incentive Plan.

(2)

In December 2010, our Board of Directors authorized the repurchase of up to $150.0 million of our common stock over a period of up to two years, and during the three months ended September 30, 2011, our Board of Directors authorized the repurchase of an additional $235.0 million (for an aggregate of $385.0 million) of our common stock during such period (in the aggregate, the “Stock Repurchase Program”). In September 2011, we repurchased 28,137,900 shares of our common stock under the Stock Repurchase Program at an average price of $6.41 per share for a total purchase price of $180.4 million. Of these purchases, purchases of 2,856,800 shares at an average price of $6.27 per share were settled in October 2011, which, for accounting purposes, were recorded in September 2011. Any share repurchases made under the Stock Repurchase Program will be made through open market purchases or privately negotiated transactions. The amount and timing of any repurchases will depend on market conditions and other factors and repurchases may be suspended or discontinued at any time. All shares repurchased under the Stock Repurchase Program were retired upon settlement.

ITEM 5. OTHER INFORMATION

On October 28, 2011, CapitalSource Bank filed its Consolidated Reports of Condition and Income for A Bank With Domestic Offices Only — FFIEC 041, for the quarter ended September 30, 2011 (the “Call Report”) with the Federal Deposit Insurance Corporation (“FDIC”).

ITEM 6. EXHIBITS

(a) Exhibits

The Index to Exhibits attached hereto is incorporated herein by reference.

Signatures

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		CAPITALSOURCE INC.

Date: November 1, 2011		/s/ STEVEN A. MUSELES
		Steven A. Museles Director and Co-Chief Executive Officer (Principal Executive Officer)

Date: November 1, 2011		/s/ JAMES J. PIECZYNSKI
		James J. Pieczynski Director and Co-Chief Executive Officer (Principal Executive Officer)

Date: November 1, 2011		/s/ DONALD F. COLE
		Donald F. Cole Chief Financial Officer (Principal Financial Officer)

Date: November 1, 2011		/s/ BRYAN D. SMITH
		Bryan D. Smith Chief Accounting Officer (Principal Accounting Officer)

INDEX TO EXHIBITS


Exhibit No		Description
3.1		Second Amended and Restated Certificate of Incorporation (composite version; reflects all amendments through May 1, 2008) (incorporated by reference to exhibit 3.1 to the Form 10-Q filed by CapitalSource on May 12, 2008).
3.2		Amended and Restated Bylaws (composite version; reflects all amendments through February 16, 2011)(incorporated by reference to exhibit 3.1 to the Form 8-K filed by CapitalSource on February 18, 2011).
10.1		Employment Agreement dated October 26, 2011 between CapitalSource Inc., CapitalSource Bank and John A. Bogler.†*
10.2		Employment Agreement dated October 26, 2011 between CapitalSource Inc., CapitalSource Bank and Laird M. Boulden.†*
10.3		Amended and Restated Employment Agreement dated October 26, 2011 between CapitalSource Bank and Bryan M. Corsini †*
10.4		Separation Agreement dated October 26, 2011 between CapitalSource Inc. and Donald F. Cole.†*
10.5		Separation Agreement dated October 26, 2011 between CapitalSource Inc. and Steven A. Museles. †*
10.6		Consulting Agreement dated October 26, 2011 between CapitalSource Inc. and Steven A. Museles. †*
12.1		Ratio of Earnings to Fixed Charges.†
31.1.1		Rule 13a — 14(a) Certification of Chairman of the Board and Co-Chief Executive Officer.†
31.1.2		Rule 13a — 14(a) Certification of Chairman of the Board and Co-Chief Executive Officer.†
31.2		Rule 13a — 14(a) Certification of Chief Financial Officer.†
32		Section 1350 certifications.†
99.1		CapitalSource Bank’s Consolidated Reports of Condition and Income For A Bank with Domestic Office only-FFIEC 041, for the quarter ended September 30, 2011.†
101.INS		XBRL Instance Document†
101.SCH		XBRL Taxonomy Extension Schema Document†
101.CAL		XBRL Taxonomy Calculation Linkbase Document†
101.LAB		XBRL Taxonomy Label Linkbase Document†
101.PRE		XBRL Taxonomy Presentation Linkbase Document†
101.DEF		XBRL Taxonomy Definition Document†

†	Filed herewith.

*	Management contract or compensatory plan or arrangement.