Form 10-Q

10-Q 1 d409140d10q.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, 2012

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.)

633 West 5^th Street, 33rd Floor

Los Angeles, CA 90071

(Address of Principal Executive Offices, Including Zip Code)

(213) 443-7700

(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 ¨

(Do not check if a smaller reporting company)

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 31, 2012, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 211,532,310.

TABLE OF CONTENTS


		Page

PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2012 (unaudited) and December 31, 2011		3
	Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2012 and 2011		4
	Consolidated Statements of Comprehensive Income (unaudited) for the three and nine months ended September 30, 2012 and 2011		5
	Consolidated Statement of Shareholders’ Equity (unaudited) for the nine months ended September 30, 2012		6
	Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2012 and 2011		7
	Notes to the Unaudited Consolidated Financial Statements		8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		45
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		80
Item 4.	Controls and Procedures		80

PART II. OTHER INFORMATION

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		81
Item 5.	Other Information		81
Item 6.	Exhibits		81
Signatures			82
Index to Exhibits			83


2

CapitalSource Inc.

Consolidated Balance Sheets


	September 30, 2012			December 31, 2011
	(Unaudited)
	($ in thousands, except share amounts)
ASSETS
Cash and cash equivalents	$	615,495		$	458,548
Restricted cash (including $1.9 million and $23.7 million, respectively, of cash that can only be used to settle obligations of consolidated VIEs)		71,412			65,484
Investment securities:
Available-for-sale, at fair value		1,094,070			1,188,002
Held-to-maturity, at amortized cost		108,066			111,706
Total investment securities		1,202,136			1,299,708
Loans held for sale		84,883			193,021
Loans held for investment, gross		5,948,119			5,758,990
Less deferred loan fees and discounts		(53,907	)		(68,843	)
Total Loans held for investment (including $394.5 million and $504.5 million, respectively, of loans that can only be used to settle obligations of consolidated VIEs)		5,894,212			5,690,147
Less allowance for loan and lease losses		(126,630	)		(153,631	)
Total loans held for investment, net		5,767,582			5,536,516
Interest receivable		31,894			38,796
Other investments		66,791			81,245
Goodwill		173,135			173,135
Deferred tax assets, net		370,577			45,445
Other assets		293,396			408,170
Total assets	$	8,677,301		$	8,300,068
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Deposits	$	5,535,482		$	5,124,995
Term debt (including $203.3 million and $309.4 million, respectively, in obligations of consolidated VIEs for which there is no recourse to the general credit of CapitalSource Inc.)		203,307			309,394
Other borrowings		1,009,880			1,015,099
Other liabilities		185,172			275,434
Total liabilities		6,933,841			6,724,922
Commitments and contingencies (Note 13)
Shareholders’ equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)		—			—
Common stock ($0.01 par value, 1,200,000,000 shares authorized; 215,238,561 and 256,112,205 shares issued/outstanding, respectively)		2,152			2,561
Additional paid-in capital		3,217,582			3,487,911
Accumulated deficit		(1,498,131	)		(1,934,732	)
Accumulated other comprehensive income, net		21,857			19,406
Total shareholders’ equity		1,743,460			1,575,146
Total liabilities and shareholders’ equity	$	8,677,301		$	8,300,068

See accompanying notes.


3

CapitalSource Inc.

Consolidated Statements of Operations


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(Unaudited)
	($ in thousands, except per share data)
Net interest income:
Interest income:
Loans	$	105,066		$	107,161		$	322,437		$	344,308
Investment securities		9,784			13,635			29,737			44,675
Other		384			680			1,119			2,070
Total interest income		115,234			121,476			353,293			391,053
Interest expense:
Deposits		12,738			13,422			38,669			40,203
Borrowings		6,775			21,066			21,866			86,844
Total interest expense		19,513			34,488			60,535			127,047
Net interest income		95,721			86,988			292,758			264,006
Provision for loan and lease losses		8,959			35,118			30,567			81,450
Net interest income after provision for loan and lease losses		86,762			51,870			262,191			182,556
Non-interest income, net:
Loan fees		4,174			3,421			11,899			11,435
Leased equipment income		3,299			901			9,815			974
Gain on sales of investments, net		1,856			19,141			929			51,381
Loss on derivatives, net		(978	)		(2,113	)		(649	)		(4,262	)
Other non-interest income, net		946			11,134			7,303			15,445
Total non-interest income		9,297			32,484			29,297			74,973
Non-interest expense:
Compensation and benefits		25,523			31,047			77,347			90,524
Professional fees		2,469			3,097			9,158			12,985
Occupancy expenses		3,422			3,690			13,402			11,663
FDIC fees and assessments		1,507			1,375			4,419			4,706
General depreciation and amortization		1,330			1,662			4,536			5,283
Other administrative expenses		7,660			8,022			30,902			28,780
Total operating expenses		41,911			48,893			139,764			153,941
Leased equipment depreciation		2,307			668			6,883			708
Expense of real estate owned and other foreclosed assets, net		2,308			12,835			6,579			34,124
Loss (gain) on extinguishment of debt		—			113,679			(8,059	)		113,679
Other non-interest expense, net		483			271			(908	)		(1,095	)
Total non-interest expense		47,009			176,346			144,259			301,357
Net income (loss) before income taxes		49,050			(91,992	)		147,229			(43,828	)
Income tax expense (benefit)		18,003			(11,280	)		(296,305	)		17,131
Net income (loss)	$	31,047		$	(80,712	)	$	443,534		$	(60,959	)
Basic income (loss) per share	$	0.14		$	(0.26	)	$	1.94		$	(0.19	)
Diluted income (loss) per share	$	0.14		$	(0.26	)	$	1.88		$	(0.19	)
Average shares outstanding:
Basic		219,664,637			306,535,063			229,091,849			315,719,413
Diluted		226,441,294			306,535,063			235,712,522			315,719,413
Dividends declared per share	$	0.01		$	0.01		$	0.03		$	0.03

See accompanying notes.


4

CapitalSource Inc.

Consolidated Statements of Comprehensive Income


	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012			2011
	(Unaudited)
	($ in thousands)
Net income (loss)	$	31,047	$	(80,712	)	$	443,534		$	(60,959	)
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on available-for-sale securities, net of tax		2,315		(4,078	)		2,802			21,219
Unrealized (loss) gain on foreign currency translation, net of tax		—		(10,795	)		(351	)		665
Other comprehensive income (loss)		2,315		(14,873	)		2,451			21,884
Comprehensive income (loss)	$	33,362	$	(95,585	)	$	445,985		$	(39,075	)

See accompanying notes.


5

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, 2011	$	2,561		$	3,487,911		$	(1,934,732	)	$	19,406	$	1,575,146
Net income		—			—			443,534			—		443,534
Other comprehensive income		—			—			—			2,451		2,451
Dividends paid		—			106			(6,933	)		—		(6,827	)
Stock option expense		—			1,229			—			—		1,229
Exercise of options		7			3,188			—			—		3,195
Restricted stock activity		(4	)		7,370			—			—		7,366
Repurchase of common stock		(412	)		(282,222	)		—			—		(282,634	)
Total shareholders’ equity as of September 30, 2012	$	2,152		$	3,217,582		$	(1,498,131	)	$	21,857	$	1,743,460

See accompanying notes.


6

CapitalSource Inc.

Consolidated Statements of Cash Flows


	Nine Months Ended September 30,
	2012			2011
	(Unaudited) ($ in thousands)
Operating activities:
Net income	$	443,534		$	(60,959	)
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option expense		1,229			4,064
Restricted stock expense		8,838			5,972
(Gain) loss on extinguishment of debt		(8,059	)		113,679
Amortization of deferred loan fees and discounts		(31,799	)		(53,972	)
Paid-in-kind interest on loans		6,370			27,925
Provision for loan losses		30,567			81,450
Amortization of deferred financing fees and discounts		1,252			18,029
Depreciation and amortization		14,032			1,901
(Benefit) provision for deferred income taxes		(326,823	)		44,762
Non-cash gain on investments, net		(2,133	)		(62,617	)
Non-cash loss on foreclosed assets and other property and equipment disposals		816			26,448
Unrealized (gain) loss on derivatives and foreign currencies, net		(950	)		5,950
Decrease in interest receivable		6,902			18,127
Decrease in loans held for sale, net		23,113			190,947
Decrease in other assets		120,194			63,482
Decrease in other liabilities		(102,153	)		(96,492	)
Cash provided by operating activities		184,930			328,696
Investing activities:
(Increase) decrease in restricted cash		(5,928	)		78,448
(Increase) decrease in loans, net		(160,541	)		125,335
Reduction of marketable securities, available for sale, net		75,594			119,013
Reduction of marketable securities, held to maturity, net		4,893			90,556
Reduction of other investments, net		13,920			42,699
Acquisition of property and equipment, net		(5,462	)		(47,920	)
Cash (used in) provided by investing activities		(77,524	)		408,131
Financing activities:
Deposits accepted, net of repayments		410,487			264,558
Repayments on credit facilities, net		—			(68,792	)
Repayments and extinguishment of term debt		(106,118	)		(724,080	)
Borrowings under (repayments of) other borrowings		20,931			(232,767	)
Repurchase of common stock		(272,127	)		(291,424	)
Proceeds from exercise of options		3,195			1,462
Payment of dividends		(6,827	)		(9,390	)
Cash provided by (used in) financing activites		49,541			(1,060,433	)
Increase (decrease) in cash and cash equivalents		156,947			(323,606	)
Cash and cash equivalents as of beginning of period		458,548			820,450
Cash and cash equivalents as of end of period	$	615,495		$	496,844
Supplemental information
Supplemental information:
Noncash transactions from investing and financing activities:	$	12,372		$	10,911

See accompanying notes.


7

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 consolidated subsidiaries. References to CapitalSource Bank include its consolidated subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its consolidated 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 to customers in southern and central California and, to a lesser extent, our borrowers.

For the three and nine months ended September 30, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our legacy loan portfolio and investment activities at the Parent Company. For additional information, see Note 16, 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 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, 2011, as filed with the Securities and Exchange Commission on February 28, 2012 (“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”) where 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 the presentation of our consolidated statements of operations to include the captions of non-interest income and non-interest expense as compared to operating expenses and other income (expense). 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 for the year ended December 31, 2011, included in our Form 10-K.

New Accounting Pronouncements

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 adopted this guidance on January 1, 2012, and it did 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 solely 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 adopted this guidance on January 1, 2012 and, although it impacted our financial statement presentation, it did not have a material impact on our consolidated results of operations, financial position or cash flows.


8

Note 3. Cash

and Cash Equivalents and Restricted Cash

As of September 30, 2012 and December 31, 2011, our cash and cash equivalents and restricted cash balances were as follows:


	September 30, 2012				December 31, 2011
	Unrestricted		Restricted⁽¹⁾		Unrestricted		Restricted⁽¹⁾
	($ in thousands)
Cash and cash equivalents and restricted cash:
Cash and due from banks	$	237,589	$	29,554	$	231,701	$	41,808
Interest-bearing deposits in other banks⁽²⁾		157,970		—		186,868		16
Other short-term investments⁽³⁾		219,936		41,858		39,979		23,660
Total cash and cash equivalents and restricted cash	$	615,495	$	71,412	$	458,548	$	65,484

⁽¹⁾	Restricted cash includes principal and interest collections received from loans held in securitization trusts, loan-related escrow and reserve accounts, and cash that has been pledged as collateral supporting letters of credit and derivative liabilities.

⁽²⁾	Included in these balances for CapitalSource Bank were $155.2 million and $179.1 million in deposits at the Federal Reserve Bank (“FRB”) as of September 30, 2012 and December 31, 2011, respectively.

⁽³⁾

Unrestricted 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 restricted cash is invested in a short-term money market fund which has ratings of AAAm (S&P) and Aaa (Moody’s), as well as 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).

Note 4. Loans

and Credit Quality

As of September 30, 2012 and December 31, 2011, our outstanding loan balance was $6.0 billion and $5.9 billion, respectively. These amounts include loans held for sale and loans held for investment. As of September 30, 2012 and December 31, 2011, interest and fee receivables on these loans totaled $28.7 million and $35.0 million, respectively.

Loans held for sale are recorded at the lower of cost or fair value, less costs to sell. 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, 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.

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 and lease losses inherent in our loan and lease portfolio as of the balance sheet date. This methodology is used consistently to develop our allowance for loan and lease losses for all loans and leases in our loan portfolio.

During the three and nine months ended September 30, 2012, we transferred loans with a carrying value of $112.1 million and $213.0 million, respectively, which included $23.7 million and $55.0 million of impaired loans, respectively, from held for investment to held for sale. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We incurred $0.4 million of losses due to lower of cost or fair value adjustments at the time of transfer during the three and nine months ended September 30, 2012, which is recorded within Other Non-Interest Income on the Consolidated Statement of Operations. We reclassified $5.0 million of loans from held for sale to held for investment during the nine months ended September 30, 2012, based on our intent to retain these loans for investment. We did not make any such reclassifications during the three months ended September 30, 2012.

During the three and nine months ended September 30, 2011, we transferred loans with a carrying value of $38.7 million and $204.4 million, respectively, from held for investment to held for sale 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 lower of cost or fair value adjustments at the time of transfer during the nine months ended September 30, 2011, which is recorded within Other Non-Interest Income on the Consolidated Statement of Operations. We did not incur any losses during the three months ended September 30, 2011. We 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.


9

During the three months ended September 30, 2012, we recognized net losses on the sale of loans of $0.9 million. During the nine months ended September 30, 2012, we recognized net gains on the sale of loans of $2.1 million. During the three and nine months ended September 30, 2011, we recognized net gains on the sale of loans of $10.0 million and $14.4 million, respectively.

As of December 31, 2011, loans held for sale with an outstanding balance of $2.9 million were classified as non-accrual loans. We did not have any loans held for sale that were on non-accrual status as of September 30, 2012. 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, 2012 and 2011.

During the nine months ended September 30, 2012, we purchased loans held for investment with an outstanding principal balance at the time of purchase of $78.3 million. We did not purchase any loans held for investment during the three months ended September 30, 2012.

As of September 30, 2012 and December 31, 2011, CapitalSource Bank pledged loans held for investment with an unpaid principal balance of $738.7 million and $459.5 million, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

As of September 30, 2012 and December 31, 2011, the outstanding unpaid principal balance of loans, by type of loan, was as follows:


	September 30, 2012				December 31, 2011
	($ in thousands except percentages)
Commercial	$	3,512,672	60	%	$	3,491,259	61	%
Real estate		2,334,664	39			2,133,210	38
Real estate — construction		46,876	1			65,678	1
Total⁽¹⁾	$	5,894,212	100	%	$	5,690,147	100	%

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

Non-performing loans include all loans on non-accrual status and accruing loans which are contractually past due 90 days or more as to principal or interest payments. Our remediation efforts on these loans are based upon the characteristics of each specific situation and 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 the loan, 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.

As of September 30, 2012 and December 31, 2011, the carrying value of loans by class, separated by performing and non-performing categories, was as follows:


	September 30, 2012						December 31, 2011
Class	Performing		Non-Performing		Total		Performing		Non-Performing		Total
	($ in thousands)
Asset-based	$	1,320,783	$	48,616	$	1,369,399	$	1,238,807	$	35,621	$	1,274,428
Cash flow		1,881,909		68,326		1,950,235		1,833,103		110,280		1,943,383
Healthcare asset-based		183,836		—		183,836		268,604		822		269,426
Healthcare real estate		514,112		17,001		531,113		561,882		23,600		585,482
Multifamily		864,693		2,014		866,707		852,766		1,703		854,469
Real estate		754,725		14,587		769,312		506,985		93,266		600,251
Small business		215,367		8,243		223,610		152,206		10,502		162,708
Total⁽¹⁾	$	5,735,425	$	158,787	$	5,894,212	$	5,414,353	$	275,794	$	5,690,147

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.


10

Credit Quality

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, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral. We continuously monitor a client’s ability to perform under its obligations. Additionally, we manage the size and risk profile of our loan portfolio by syndicating loan exposure to other lenders and selling loans.

Under our credit risk management process, each loan is assigned an internal risk rating that is based on defined credit review standards. While rating criteria vary by product, each loan rating focuses on: the client’s financial performance and financial standing, the client’s ability to repay the loan, and the adequacy of the collateral securing the loan. Subsequent to loan origination, risk ratings are monitored and reassessed 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 credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by client industries and real estate property types (where applicable).

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, and we believe that our internal risk rating process provides a view as to the relative risk of each loan. This risk rating 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;

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.


11

As of September 30, 2012 and December 31, 2011, the carrying value of each class of loans by internal risk rating, was as follows:


	Internal Risk Rating
Class	Pass		Special Mention		Substandard		Doubtful		Total
	($ in thousands)
As of September 30, 2012:
Asset-based	$	1,254,320	$	34,901	$	45,710	$	34,468	$	1,369,399
Cash flow		1,654,652		41,877		210,793		42,913		1,950,235
Healthcare asset-based		113,939		48,487		21,410		—		183,836
Healthcare real estate		450,558		47,515		33,040		—		531,113
Multifamily		843,556		20,547		2,604		—		866,707
Real estate		731,051		12,407		25,854		—		769,312
Small business		209,176		5,522		7,416		1,496		223,610
Total⁽¹⁾	$	5,257,252	$	211,256	$	346,827	$	78,877	$	5,894,212
As of December 31, 2011:
Asset-based	$	953,406	$	180,588	$	132,848	$	7,586	$	1,274,428
Cash flow		1,602,838		27,018		228,502		85,025		1,943,383
Healthcare asset-based		177,996		75,980		15,397		53		269,426
Healthcare real estate		489,099		72,783		23,600		—		585,482
Multifamily		849,251		3,516		1,702		—		854,469
Real estate		428,750		42,634		128,867		—		600,251
Small business		143,709		8,869		1,470		8,660		162,708
Total⁽¹⁾	$	4,645,049	$	411,388	$	532,386	$	101,324	$	5,690,147

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

Non-Accrual and Past Due Loans

We place a loan on non-accrual status when 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 is discontinued 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 client 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.

If our non-accrual loans had performed in accordance with their original terms, interest income on the outstanding legal balance of these loans would have been $21.2 million and $71.5 million higher for the three and nine months ended September 30, 2012, respectively, and $21.3 million and $83.0 million higher for the three and nine months ended September 30, 2011, respectively.

As of September 30, 2012 and December 31, 2011, the carrying value of non-accrual loans by class was as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Asset-based	$	48,616	$	35,621
Cash flow		68,326		110,280
Healthcare asset-based		—		822
Healthcare real estate		17,001		23,600
Multifamily		2,014		1,703
Real estate		14,587		87,663
Small business		8,243		10,502
Total⁽¹⁾	$	158,787	$	270,191

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.


12

As of September 30, 2012 and December 31, 2011, the delinquency status of loans by class 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, 2012:
Asset-based	$	29,785	$	438	$	30,223	$	1,339,176	$	1,369,399	$	—
Cash flow		312		5,217		5,529		1,944,706		1,950,235		—
Healthcare asset-based		—		—		—		183,836		183,836		—
Healthcare real estate		—		17,001		17,001		514,112		531,113		—
Multifamily		—		1,021		1,021		865,686		866,707		—
Real estate		—		14,351		14,351		754,961		769,312		—
Small business		214		5,123		5,337		218,273		223,610		—
Total⁽¹⁾	$	30,311	$	43,151	$	73,462	$	5,820,750	$	5,894,212	$	—
As of December 31, 2011:
Asset-based	$	2,611	$	11,063	$	13,674	$	1,260,754	$	1,274,428	$	—
Cash flow		218		9,701		9,919		1,933,464		1,943,383		—
Healthcare asset-based		—		—		—		269,426		269,426		—
Healthcare real estate		—		17,951		17,951		567,531		585,482		—
Multifamily		1,565		188		1,753		852,716		854,469		—
Real estate		5,762		44,049		49,811		550,440		600,251		5,603
Small business		2,213		9,182		11,395		151,313		162,708		—
Total⁽¹⁾	$	12,369	$	92,134	$	104,503	$	5,585,644	$	5,690,147	$	5,603

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

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.

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 client;

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

the willingness of the client 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 client’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 client 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.


13

As of September 30, 2012 and December 31, 2011, information pertaining to our impaired loans was as follows:


	September 30, 2012							December 31, 2011
	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	$	59,814	$	102,099	$	—		$	55,445	$	89,519	$	—
Cash flow		56,057		124,576		—			80,453		143,131		—
Healthcare asset-based		—		12,011		—			3,937		15,133		—
Healthcare real estate		17,001		21,183		—			23,600		28,961		—
Multifamily		2,014		2,134		—			1,703		2,988		—
Real estate		19,516		96,891		—			123,766		226,359		—
Small business		9,414		16,416		—			14,679		20,938		—
Total		163,816		375,310		—			303,583		527,029		—

With allowance recorded:
Asset-based		10,729		10,921		(4,017	)		7,472		9,847		(2,030	)
Cash flow		91,546		104,667		(15,796	)		105,740		117,766		(24,418	)
Total		102,275		115,588		(19,813	)		113,212		127,613		(26,448	)
Total impaired loans	$	266,091	$	490,898	$	(19,813	)	$	416,795	$	654,642	$	(26,448	)

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

⁽²⁾	Represents the contractual amounts owed to us by borrowers. The difference between the carrying value and the contractual amounts owed relates to the previous recognition of charge offs and are net of deferred loan fees and discounts.


14

Average balances and interest income recognized on impaired loans, by loan class, for the three and nine months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2012				2011				2012				2011
	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	$	85,203	$	1,028	$	64,154	$	672	$	70,495	$	2,549	$	71,759	$	2,064
Cash flow		72,361		834		111,406		2,247		71,747		2,871		117,493		5,968
Healthcare asset-based		—		78		1,380		—		1,342		233		1,166		101
Healthcare real estate		23,937		—		27,194		—		26,252		—		22,550		165
Multifamily		1,595		17		2,510		—		1,268		17		7,012		—
Real estate		31,037		478		102,895		183		66,391		3,461		204,302		3,104
Small business		10,129		—		8,998		—		12,883		—		9,673		—
Total		224,262		2,435		318,537		3,102		250,378		9,131		433,955		11,402

With allowance recorded:
Asset-based		7,932		—		39,038		—		8,440		74		54,564		—
Cash flow		86,207		1,030		77,553		824		100,313		2,422		119,464		2,487
Healthcare asset-based		—		—		363		—		—		—		1,023		—
Healthcare real estate		—		—		—		—		785		—		6,507		—
Multifamily		—		—		154		—		—		—		538		—
Real estate		—		—		22,261		—		—		—		38,753		—
Small business		—		—		1,521		—		—		—		739		—
Total		94,139		1,030		140,890		824		109,538		2,496		221,588		2,487
Total impaired loans	$	318,401	$	3,465	$	459,427	$	3,926	$	359,916	$	11,627	$	655,543	$	13,889

⁽¹⁾	We recognized $0.1 million of cash basis interest income on impaired loans during the nine months ended September 30, 2011. We did not recognize any cash basis interest income on impaired loans during the three and nine months ended September 30, 2012 or the three months ended September 30, 2011.

As of September 30, 2012 and December 31, 2011, the carrying value of impaired loans with no related allowance recorded was $163.8 million and $303.6 million, respectively. Of these amounts, $50.5 million and $136.3 million, respectively, related to loans that were charged off to their carrying values. These charge offs were primarily the result of impairment measurements of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $113.3 million and $167.3 million related to loans that had no recorded charge offs or specific reserves as of September 30, 2012 and December 31, 2011, respectively, based on our estimate that we ultimately will collect all principal and interest amounts due.

Allowance for Loan and Lease Losses

Our allowance for loan and lease losses represents management’s estimate of incurred loan and lease losses inherent in our loan and lease portfolio as of the balance sheet date. The estimation of the allowance for loan and lease losses is based on a variety of factors, including past loan and lease 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 value of underlying collateral and general economic conditions. Provisions for loan and lease 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 derived from historical loss rates.


15

Each loan is assigned an internal risk rating that is based on defined credit review standards. While rating criteria vary by product, each loan rating focuses on: the client’s financial performance and financial standing, the client’s ability to repay the loan, and the adequacy of the collateral securing the loan. Subsequent to loan origination, risk ratings are monitored and reassessed 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 credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by client industries and real estate property types (where applicable).

These risk ratings, analysis of historical loss experience (updated quarterly), current economic conditions, industry performance trends, and any other pertinent information, including individual valuations on impaired loans are all considered when estimating the allowance for loan and lease losses.

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 and lease losses.

When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan and lease 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 and lease 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.

Activity in the allowance for loan and lease losses related to our loans held for investment for the three and nine months ended September 30, 2012 and 2011 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Allowance for loan and lease losses at beginning of period	$	133,359		$	199,138		$	153,631		$	329,122
Charge offs		(23,090	)		(27,314	)		(69,032	)		(207,244	)
Recoveries		7,590			1,478			12,911			17,454
Net charge offs		(15,500	)		(25,836	)		(56,121	)		(189,790	)
Charge offs upon transfer to held for sale		(188	)		(68	)		(1,447	)		(12,430	)
Provision for loan and lease losses		8,959			35,118			30,567			81,450
Allowance for loan and lease losses at end of period		126,630			208,352			126,630			208,352
Allowance for credit losses on unfunded lending commitments at beginning of period⁽¹⁾		3,486			1,895			4,877			3,261
Provision (release) for unfunded lending commitments		483			270			(908	)		(1,096	)
Allowance for credit losses on unfunded lending commitments at end of period⁽¹⁾		3,969			2,165			3,969			2,165
Total allowance for loan, lease and unfunded lending commitments	$	130,599		$	210,517		$	130,599		$	210,517

⁽¹⁾	Represents additional credit loss reserves for unfunded lending commitments and letters of credit recorded in Other Liabilities on the Consolidated Balance Sheet.


16

As of September 30, 2012 and December 31, 2011, the balances of the allowance for loan and lease losses and the carrying value of loans held for investment disaggregated by impairment methodology were as follows:


	September 30, 2012					December 31, 2011
	Loans⁽¹⁾		Allowance for Loan and Lease Losses			Loans⁽¹⁾		Allowance for Loan and Lease Losses
	($ in thousands)
Individually evaluated for impairment	$	261,668	$	(19,813	)	$	409,902	$	(26,448	)
Collectively evaluated for impairment		5,628,122		(106,817	)		5,273,352		(127,183	)
Acquired loans with deteriorated credit quality		4,422		—			6,893		—
Total	$	5,894,212	$	(126,630	)	$	5,690,147	$	(153,631	)

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

Troubled Debt Restructurings

The types of concessions that are assessed to determine if modifications to our loans should be classified as troubled debt restructurings (“TDRs”) include, but are not limited to, interest rate and/or fee reductions, maturity extensions, payment deferrals, 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.

During the three and nine months ended September 30, 2012, the aggregate carrying value of loans involved in TDRs were $72.8 million and $164.5 million, respectively, as of their respective restructuring dates. During the three and nine months ended September 30, 2011, the aggregate carrying values of loans involved in a TDR were $47.1 million and $270.6 million, respectively, as of their respective restructuring dates. Aggregate carrying value includes principal, deferred fees and accrued interest. Loans involved in TDRs are classified as impaired upon closing on the TDR. Generally, a loan that has been involved in a TDR is no longer classified as impaired one year subsequent to the restructuring, assuming the loan performs under the restructured terms and the restructured terms are commensurate with current market terms. In most cases, the restructured terms of loans involved in TDRs are not commensurate with current market terms.

As loans involved in TDRs are deemed to be impaired, such impaired loans, including those that subsequently experienced defaults, are individually evaluated in accordance with our allowance for loan and lease losses methodology under the same guidelines as non-TDR loans that are classified as impaired. Our evaluation of whether collection of interest and principal is reasonably assured is based on the facts and circumstances of each individual client and our assessment of the client’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 client, indications of support by sponsors and other interest holders, the terms of the TDR, the value of any collateral securing the loan and projections of future performance of the client as part of this evaluation.

The accrual status for loans involved in a TDR is assessed as part of the evaluation mentioned above. 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 client. However, if the charged off portion of the loan is legally forgiven through concessions to the client, 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 loans involved in a TDR that have been classified as non-accrual, the borrower is required to demonstrate sustained payment performance for a minimum of six months to return to accrual status.


17

The aggregate carrying values of loans that had been restructured in TDRs as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual	$	89,149	$	130,389
Accruing		129,077		178,614
Total	$	218,226	$	309,003

The specific reserves related to these loans were $8.1 million and $7.3 million as of September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012 and December 31, 2011, we had unfunded commitments related to these restructured loans of $46.8 million and $103.1 million, respectively.

The following table rolls forward the balance of loans modified in TDRs for the three and nine months ended September 30, 2012 and 2011:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Beginning balance of TDRs	$	246,209		$	454,351		$	309,003		$	555,113
New TDRs		39,102			22,516			61,363			117,796
Draws and pay downs on existing TDRs, net		(36,606	)		(22,782	)		(74,378	)		(102,032	)
Loan sales and payoffs		(24,317	)		(123,738	)		(50,448	)		(205,987	)
Charge offs post modification		(6,162	)		(4,580	)		(27,314	)		(39,122	)
Ending balance of TDRs	$	218,226		$	325,767		$	218,226		$	325,768


18

The number and aggregate carrying values of loans involved in TDRs that occurred during the three and nine months ended September 30, 2012 were as follows:


	Three Months Ended September 30, 2012						Nine Months Ended September 30, 2012
	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)
Asset-based:
Maturity extension		—	$	—	$	—		1	$	350	$	350
Discounted payoffs		2		1,630		—		3		1,818		—
Foreclosures		—		—		—		1		2,000		—
Multiple concessions		32		31,540		22,638		34		34,913		25,339
		34		33,170		22,638		39		39,081		25,689

Cash flow:
Maturity extension		—		—		—		2		3,886		3,886
Payment deferral		1		736		736		1		736		736
Multiple concessions		1		30,148		18,293		9		57,247		45,392
		2		30,884		19,029		12		61,869		50,014

Healthcare real estate:
Discounted payoffs		2		6,963		—		2		6,963		—
		2		6,963		—		2		6,963		—

Multifamily:
Foreclosures		—		—		—		2		1,040		—
		—		—		—		2		1,040		—

Real estate:
Maturity extension		—		—		—		2		48,709		48,709
Discounted payoffs		—		—		—		1		4,246		—
		—		—		—		3		52,955		48,709

Small business:
Payment deferral		1		558		558		1		558		558
Discounted payoffs		1		252		—		2		849		—
Foreclosures		3		969		—		4		1,208		—
		5		1,779		558		7		2,615		558
Total⁽¹⁾		43	$	72,796	$	42,225		65	$	164,523	$	124,970

⁽¹⁾	Includes deferred loan fees and discounts.


19

A summary of concessions granted by loan type, including the accrual status of the loans as of September 30, 2012 and December 31, 2011 was as follows:


	September 30, 2012						December 31, 2011
	Non-accrual		Accrual		Total		Non-accrual		Accrual		Total
	($ in thousands)
Commercial
Maturity extension	$	20,768	$	58,505	$	79,273	$	24,208	$	72,174	$	96,382
Payment deferral		248		—		248		252		8,335		8,587
Multiple concessions		55,916		65,502		121,418		37,766		26,718		64,484
		76,932		124,007		200,939		62,226		107,227		169,453
Real estate
Interest rate and fee reduction		—		—		—		188		—		188
Maturity extension		62		—		62		1,023		41,213		42,236
Payment deferral		639		—		639		47,849		—		47,849
Multiple concessions		—		5,070		5,070		861		146		1,007
		701		5,070		5,771		49,921		41,359		91,280
Real estate — construction
Maturity extension		11,279		—		11,279		18,242		—		18,242
Multiple concessions		237		—		237		—		30,028		30,028
		11,516		—		11,516		18,242		30,028		48,270
Total	$	89,149	$	129,077	$	218,226	$	130,389	$	178,614	$	309,003

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.


20

Losses incurred on TDRs since their initial restructuring by concession and loan type for the three and nine months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	($ in thousands)
Commercial
Interest rate and fee reduction	$	—	$	—	$	—	$	18,728
Maturity extension		325		733		4,174		9,444
Payment deferral		—		2,230		4		9,606
Multiple concessions		7,911		214		14,633		33,051
		8,236		3,177		18,811		70,829
Real estate
Interest rate and fee reduction		—		—		—		9
Maturity extension		—		29		950		428
Payment deferral		—		—		—		11,162
Multiple concessions		—		—		23		—
		—		29		973		11,599
Real estate — construction
Maturity extension		—		4,541		4,709		19,159
Multiple concessions		613		—		958		—
		613		4,541		5,667		19,159
Total	$	8,849	$	7,747	$	25,451	$	101,587

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and nine months ended September 30, 2012, 97.7% and 84.3%, 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, 2012. We did not recognize any interest income for the three months ended September 30, 2012, on commercial loans that experienced losses during this period. We recognized approximately $74 thousand of interest income for the nine months ended September 30, 2012 on the commercial loans that experienced losses during these periods.

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 did not recognize any interest income for the three months ended September 30, 2011, on commercial loans that experienced losses during these periods. We recognized approximately $0.2 million of interest income for the nine months ended September 30, 2011 on the commercial loans that experienced losses during this period.

Foreclosed Assets

Real Estate Owned (“REO”)

When we foreclose on a real estate asset that collateralizes a loan or other assets, we record the acquired assets 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 asset’s carrying amount and record a charge off when the carrying amount of the asset 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. 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 acquired, 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 estimated fair value less cost to sell.


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As of September 30, 2012 and December 31, 2011, we had $16.3 million and $23.6 million, respectively, of REO classified as held for sale, which was recorded as a component of other assets. Activity related to REO held for sale for the three and nine months ended September 30, 2012 and 2011 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	17,528		$	47,012		$	23,649		$	92,265
Transfers from loans held for investment and other assets		3,215			1,543			14,832			15,132
Fair value adjustments		(1,135	)		(6,725	)		(3,564	)		(19,849	)
Real estate sold		(3,294	)		(13,266	)		(18,603	)		(58,984	)
Balance as of end of period	$	16,314		$	28,564		$	16,314		$	28,564

During the three and nine months ended September 30, 2012, we recognized gains of $28 thousand and losses of $0.3 million, respectively, on the sales of REO held for sale as a component of expense of real estate owned and other foreclosed assets, net. 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.

As of December 31, 2011, we had $1.4 million of REO classified as held for use, which was recorded in other assets. As of September 30, 2012, we had no REOs classified as held for use. During the three and nine months ended September 30, 2012, we recorded an impairment charge of $1.4 million relating to REO held for use as a component of expense of real estate owned and other foreclosed assets, net. During the three and nine months ended September 30, 2011, we did not recognize any impairment losses on REO held for use.

Other Foreclosed Assets

When we foreclose on a borrower whose underlying collateral consists of loans or other assets, we record the acquired assets 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 assets. We may also write down or record allowances on the acquired loans or assets subsequent to foreclosure if such loans or assets experience additional deterioration. As of September 30, 2012 and December 31, 2011, we had $9.0 million and $14.7 million, respectively, of loans acquired through foreclosure, net of valuation allowances of $0.1 million and $0.9 million, respectively, which were recorded in other assets. The reserve release and provision for losses and gains on sales of other foreclosed assets, which were recorded as a component of expense of real estate owned and other foreclosed assets, net for the three and nine months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012			2011
	($ in thousands)
Provision (reserve release) for losses on other foreclosed assets	$	77	$	2,475	$	(948	)	$	9,880
Gains on sales of other foreclosed assets		—		—		—			1,647


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Note 5. Investments

Investment Securities, Available-for-Sale

As of September 30, 2012 and December 31, 2011, our investment securities, available-for-sale were as follows:


	September 30, 2012									December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	($ in thousands)
Agency securities	$	971,379	$	24,283	$	(416	)	$	995,246	$	1,031,275	$	25,656	$	(103	)	$	1,056,828
Asset-backed securities		10,557		428		—			10,985		15,023		604		(20	)		15,607
Collateralized loan obligation		13,141		11,078		(72	)		24,147		11,915		5,848		—			17,763
Corporate debt		—		—		—			—		742		—		(42	)		700
Equity security		—		—		—			—		202		191		—			393
Municipal bond		—		—		—			—		3,235		—		—			3,235
Non-agency MBS		44,619		813		(36	)		45,396		67,662		831		(1,563	)		66,930
U.S. Treasury and agency securities		17,632		664		—			18,296		25,902		644		—			26,546
Total	$	1,057,328	$	37,266	$	(524	)	$	1,094,070	$	1,155,956	$	33,774	$	(1,728	)	$	1,188,002

Included in investment securities, available-for-sale, were agency securities which included Federal Home Loan Bank (“FHLB”) issued callable and non-callable notes and commercial and residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae; asset-backed securities; investments in a collateralized loan obligation; commercial and residential mortgage-backed securities issued by non-government agencies (“Non-agency MBS”) and U.S. Treasury and agency asset-backed securities issued by the Small Business Administration (“SBA ABS”).

The amortized cost and fair value of investment securities, available-for-sale pledged as collateral as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012				December 31, 2011
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	209,790	$	218,115	$	475,694	$	490,437
Government Agency⁽¹⁾		11,197		11,319		44,462		45,816
	$	220,987	$	229,434	$	520,156	$	536,253

⁽¹⁾	Represents the amounts pledged as collateral to secure funds deposited by a local or state government agency.

Realized gains or losses resulting from the sale of investments are calculated using the specific identification method and are included in gain on sales of investments, net. We had proceeds from sales of $1.3 million on available-for-sale investment securities and recognized $0.4 million of related net pre-tax gains during the nine months ended September 30, 2012. We did not sell any available-for-sale investment securities during the three months ended September 30, 2012. We had proceeds from sales of $67.5 million and $137.7 million on available-for-sale securities and recognized $1.6 million and $16.1 million of related pre-tax gains during the three and nine months ended September 30, 2011, respectively.

During the three and nine months ended September 30, 2012, we recorded $140 thousand and $1.2 million, respectively, of other-than-temporary impairments (“OTTI”) in our available-for-sale portfolio relating to a decline in the fair value of our municipal bond which was recorded as a component of gain on sales of investments, net. We recorded no OTTI during the three months ended September 30, 2011. We recorded $1.5 million of OTTI during the nine months ended September 30, 2011, relating to a decline in the fair value of our municipal bond, which was recorded as a component of gain on sales of investments, net.


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Investment Securities, Held-to-Maturity

As of September 30, 2012 and December 31, 2011, the balances of our investment securities, held-to-maturity were $108.1 million and $111.7 million, respectively, and consisted of commercial mortgage-backed securities rated BBB or higher. The amortized costs and estimated fair values of the investment securities, held-to-maturity pledged as collateral as of September 30, 2012 and December 31, 2011

were as follows:


	September 30, 2012				December 31, 2011
Source:	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	4,057	$	4,550	$	7,177	$	7,681
FRB		86,673		88,690		93,899		94,305
	$	90,730	$	93,240	$	101,076	$	101,986

Unrealized Losses on Investment Securities

As of September 30, 2012 and December 31, 2011, 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, 2012
Investment securities, available-for-sale:
Agency securities	$	(345	)	$	65,688	$	(71	)	$	9,309	$	(416	)	$	74,997
Collateralized loan obligation		(72	)		4,772		—			—		(72	)		4,772
Non-agency MBS		(0	)		274		(36	)		2,869		(36	)		3,143
Total investment securities, available-for-sale	$	(417	)	$	70,734	$	(107	)	$	12,178	$	(524	)	$	82,912
Total investment securities, held-to-maturity	$	—		$	—	$	(641	)	$	58,836	$	(641	)	$	58,836
As of December 31, 2011
Investment securities, available-for-sale:
Agency securities	$	(103	)	$	35,704	$	—		$	—	$	(103	)	$	35,704
Asset-backed securities		(20	)		4,826		—			—		(20	)		4,826
Corporate debt		(42	)		700		—			—		(42	)		700
Non-agency MBS		(169	)		14,921		(1,394	)		13,406		(1,563	)		28,327
Total investment securities, available-for-sale	$	(334	)	$	56,151	$	(1,394	)	$	13,406	$	(1,728	)	$	69,557
Total investment securities, held-to-maturity	$	(3,018	)	$	64,012	$	—		$	—	$	(3,018	)	$	64,012

Investment securities in unrealized loss positions are analyzed individually as part of our ongoing assessment of OTTI. As of September 30, 2012 and December 31, 2011, we do not believe that any unrealized losses in our investment securities portfolio represent an OTTI. The


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unrealized losses are primarily related to one Agency MBS and one commercial MBS. The losses are attributable to fluctuations in the market prices of the securities due to market conditions and interest rate levels. Agency securities have the highest debt rating and are backed by government-sponsored entities. As of September 30, 2012, each of the non-agency MBS with unrealized losses was investment grade and well supported. As of September 30, 2012, one held-to-maturity security, a commercial MBS, was in an unrealized loss position. The commercial MBS is rated AAA, has credit support over 50% and has minimal delinquencies. Based on our analysis of each security in an unrealized loss position, we expect to recover the entire amortized cost basis of the impaired securities.

Contractual Maturities

As of September 30, 2012, 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	$	23,315	$	23,359	$	—	$	—
Due after one year through five years		5,000		5,031		27,195		29,853
Due after five years through ten years⁽¹⁾		44,946		47,201		59,477		58,837
Due after ten years⁽²⁾⁽³⁾		984,067		1,018,479		21,394		23,133
Total	$	1,057,328	$	1,094,070	$	108,066	$	111,823

⁽¹⁾

Includes Agency, Non-agency MBS and CMBS, with fair values of $20.6 million, $15.6 million and $58.8 million, respectively, and weighted-average expected maturities of 2.21 years, 1.41 years and 1.71 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2012.

⁽²⁾

Includes Agency, Non-agency MBS, CMBS and SBA ABS, with fair values of $946.2 million, $29.8 million, $23.1 million and $18.3 million, respectively, and weighted-average expected maturities of 2.78 years, 2.58 years, 4.74 years and 7.31 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2012.

⁽³⁾	Includes securities with no stated maturity.

Other Investments

As of September 30, 2012 and December 31, 2011, our other investments were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Investments carried at cost	$	30,241	$	36,252
Investments carried at fair value		—		192
Investments accounted for under the equity method		36,550		44,801
Total	$	66,791	$	81,245

Proceeds and net pre-tax gains from sales of other investments for the three and nine months ended September 30, 2012 were as follows:


	Three months ended September 30,				Nine months ended September 30,
	2012		2011		2012		2011
	($ in thousands)
Proceeds from sales	$	1,860	$	9,803	$	6,200	$	29,823
Net pre-tax gain from sales		924		5,020		3,943		22,271

During the three and nine months ended September 30, 2012, we recorded $0.5 million and $5.2 million, respectively, of OTTI in our other investments portfolio relating to a decline in the fair value of investments carried at cost which was recorded as a component of gain on sale of investments, net. During the three and nine months ended September 30, 2011, we recorded $0.3 million and $0.7 million, respectively, of OTTI relating to a decline in the fair value of other investments carried at cost.


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Note 6. Deposits

As of September 30, 2012 and December 31, 2011, CapitalSource Bank had $5.5 billion and $5.1 billion, respectively, in deposits insured up to the maximum limit by the Federal Deposit Insurance Corporation (“FDIC”). As of September 30, 2012 and December 31, 2011, CapitalSource Bank had $534.9 million and $383.9 million, respectively, of certificates of deposit in the amount of $250,000 or more and $2.4 billion and $2.0 billion, respectively, of certificates of deposit in the amount of $100,000 or more.

As of September 30, 2012 and December 31, 2011, the weighted-average interest rates were 0.51% and 0.75% for savings and money market deposit accounts, respectively, and 1.00% and 1.14% for certificates of deposit, respectively. The weighted-average interest rates for all deposits as of September 30, 2012 and December 31, 2011 were 0.91% and 1.06%, respectively.

As of September 30, 2012 and December 31, 2011, interest-bearing deposits at CapitalSource Bank were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Interest-bearing deposits:
Money market	$	270,929	$	260,032
Savings		761,416		836,521
Certificates of deposit		4,503,137		4,028,442
Total interest-bearing deposits	$	5,535,482	$	5,124,995

As of September 30, 2012, certificates of deposit detailed by maturity were as follows ($ in thousands):


Maturing by:
September 30, 2013	$	3,634,768
September 30, 2014		752,560
September 30, 2015		54,767
September 30, 2016		44,528
September 30, 2017		16,514
Total	$	4,503,137

For the three and nine months ended September 30, 2012 and 2011, interest expense on deposits was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Savings and money market	$	1,374		$	2,176		$	4,801		$	6,215
Certificates of deposit		11,409			11,310			34,020			34,169
Fees for early withdrawal		(45	)		(64	)		(152	)		(181	)
Total interest expense on deposits	$	12,738		$	13,422		$	38,669		$	40,203

Note 7. 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.

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.


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Our interests in borrowers qualifying as VIEs were $123.4 million and $207.3 million as of September 30, 2012 and December 31, 2011, respectively, and are included in loans held for investment. 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 $166.7 million and $288.9 million as of September 30, 2012 and December 31, 2011, 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, 2012 and December 31, 2011, the total outstanding balances of these commercial term debt securitizations were $425.9 million and $534.9 million, respectively. These amounts include $222.6 million and $225.5 million of notes and certificates that we held as of September 30, 2012 and December 31, 2011, 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, 2012 and December 31, 2011, the carrying amounts of the consolidated liabilities related to the Issuers were $203.5 million and $309.7 million, respectively. These amounts include term debt and represent obligations for which there is only legal recourse to the Issuers. As of September 30, 2012 and December 31, 2011, the carrying amounts of the consolidated assets related to the Issuers were $401.3 million and $511.4 million, respectively. These amounts include loans held for investment, net and relate to assets that can only be used to settle obligations of the Issuers.

During 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. 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. Therefore, we concluded that we were no longer the primary beneficiary and deconsolidated the 2006-A Trust.

As of September 30, 2012 and December 31, 2011, the fair value of our remaining interests in the 2006-A Trust that we had repurchased in the market subsequent to the initial securitization and held as of September 30, 2012 and December 31, 2011 was $24.1 million and $17.8 million, respectively, and was classified as investment securities, available-for-sale. 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 since the deconsolidation. This swap exposure had a fair value to the counterparty of $14.4 million and $15.1 million as of September 30, 2012 and December 31, 2011, respectively. The interests in the Trust and the swap guarantee comprise our maximum exposure to loss related to the 2006-A Trust. During the three and nine months ended September 30, 2012, we recorded gross unrealized gains of $4.2 million and $5.2 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, 2012.


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Note 8. Borrowings

As of September 30, 2012 and December 31, 2011, the composition of our outstanding borrowings was as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Term debt, net⁽¹⁾	$	203,307	$	309,394
Other borrowings:
Convertible debt, net⁽²⁾		—		28,903
Subordinated debt		409,880		436,196
FHLB SF borrowings		600,000		550,000
Total other borrowings		1,009,880		1,015,099
Total borrowings	$	1,213,187	$	1,324,493

⁽¹⁾	Amounts presented are net of debt discounts of $31 thousand and $0.1 million as of September 30, 2012 and December 31, 2011, respectively.

⁽²⁾	Amounts presented are net of debt discounts of $0.1 million as of December 31, 2011.

Convertible Debt

We have issued convertible debentures as part of our financing activities. Our 3.5% Senior Convertible Debentures due 2034 (originally issued in July 2004) and our 4.0% Senior Subordinated Convertible Debentures due 2034 (originally issued in April 2007) were repurchased in full during 2011 and extinguished.

During the three and nine months ended September 30, 2012, we repurchased $23.2 million and $29.0 million, respectively, of the outstanding principal of the 7.25% Convertible Debentures for $23.2 million and $29.1 million, respectively, and recorded related pre-tax losses of $0.1 million for the nine months ended September 30, 2012, on the extinguishment of debt. We did not incur any related pre-tax gain or loss for the three months ended September 30, 2012. The repurchase of $23.2 million in July 2012 amounted to the remaining outstanding balance of the 7.25% Convertible Debentures and therefore resulted in an extinguishment of debt.

For the three and nine months ended September 30, 2012 and 2011, 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,
	2012		2011			2012		2011
	($ in thousands)
Interest expense recognized on:
Contractual interest coupon	$	72	$	4,223		$	1,006	$	18,926
Amortization of deferred financing fees		1		72			7		677
Amortization of debt discount		5		636			66		5,896
Total interest expense recognized	$	78	$	4,931		$	1,079	$	25,499
Effective interest rate on the liability component:
3.5% Senior Convertible Debentures due 2034		—		7.16	%		—		7.16	%
4.0% Senior Subordinated Convertible Debentures due 2034		—		7.85	%		—		7.85	%
7.25% Senior Subordinated Convertible Debentures due 2037		—		7.79	%		—		7.79	%


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Subordinated Debt

We have issued subordinated debt to statutory trusts (“TP Trusts”) that are formed for the purpose of issuing preferred securities to outside investors, which we refer to as Trust Preferred Securities (“TPS”). We generally retained 100% of the common securities issued by the TP Trusts, representing 3% of their total capitalization. The terms of the subordinated debt issued to the TP Trusts and the TPS issued by the TP Trusts are substantially identical.

The TP Trusts are wholly owned indirect subsidiaries of CapitalSource. However, we have not consolidated the TP Trusts for financial statement purposes. We account for our investments in the TP Trusts under the equity method of accounting pursuant to relevant GAAP requirements.

In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and cancelled in June 2012, and we recognized a related pre-tax gain of $8.2 million on the extinguishment of debt.

The carrying value of our subordinated debt was $409.9 million and $436.2 million as of September 30, 2012 and December 31, 2011, respectively.

FHLB SF Borrowings and FRB Credit Program

CapitalSource Bank is a member of the FHLB SF. As of September 30, 2012 and December 31, 2011, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:


	September 30, 2012			December 31, 2011
	($ in thousands)
Borrowing capacity	$	808,163		$	838,531
Less: outstanding principal		(600,000	)		(550,000	)
Less: outstanding letters of credit		(300	)		(600	)
Unused borrowing capacity	$	207,863		$	287,931

CapitalSource Bank is an approved depository institution under the primary credit program of the FRB SF’s discount window and is eligible to borrow from the FRB for short periods, generally overnight. As of September 30, 2012 and December 31, 2011, collateral with amortized costs of $86.7 million and $93.9 million, respectively, and fair values of $88.7 million and $94.3 million, respectively, had been pledged under this program. As of September 30, 2012 and December 31, 2011, there were no borrowings outstanding.

Note 9. Shareholders’

Equity

Common Stock Shares Outstanding

Common stock share activity for the nine months ended September 30, 2012 was as follows:


Outstanding as of December 31, 2011	256,112,205
Repurchase of common stock	(41,213,800	)
Exercise of options	767,429
Restricted stock and other stock activities	(427,273	)
Outstanding as of September 30, 2012	215,238,561


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Accumulated other comprehensive income, net

Accumulated other comprehensive income, net, as of September 30, 2012 and December 31, 2011 was as follows:


	September 30, 2012
	Unrealized Gain on Investment Securities, Available-for-Sale, net of tax		Unrealized Gain on Foreign Currency Translation, net of tax			Accumulated Other Comprehensive Income, Net
	($ in thousands)
Beginning balance	$	19,055	$	351		$	19,406
Other comprehensive income (loss)		2,802		(351	)		2,451
Ending balance	$	21,857	$	—		$	21,857


	December 31, 2011
	Unrealized Gain on Investment Securities, Available-for-Sale, net of tax		Unrealized Gain on Foreign Currency Translation, net of tax			Accumulated Other Comprehensive Income, Net
	($ in thousands)
Beginning balance	$	5,763	$	4,178		$	9,941
Other comprehensive income (loss)		13,292		(3,827	)		9,465
Ending balance	$	19,055	$	351		$	19,406

Note 10. Income

Taxes

We provide for income taxes as a “C” corporation on income earned from operations. For the tax years ended 2010 and 2009, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We have reconsolidated 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 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 history of operating losses and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of September 30, 2012 and December 31, 2011, the valuation allowance was $159.4 million and $515.2 million, respectively.

In June 2012, we reversed $347.4 million of the valuation allowance. Each of the deferred tax assets was evaluated based on our evaluation of the available positive and negative evidence with respect to our ability to realize the deferred tax asset, including considering their associated character and jurisdiction. The decision to reverse a large portion of the valuation allowance was based on our evaluation of all positive and negative evidence which did not include any significant tax planning strategies. A cumulative loss position, such as we had for the previous three-year period ended December 31, 2011, is generally considered significant negative evidence in assessing the realizability of a deferred tax asset. However, subsequent to the establishment of the valuation allowance in 2009, significant positive evidence had developed which overcame this negative evidence such that, during the nine months ended September 30, 2012, management determined that it is more likely than not that the deferred tax asset will be realized. This determination was made not based upon a single event or occurrence, but based upon the accumulation of all positive and negative evidence including recent trends in our earnings and taxable income. Other positive evidence included the projection of future taxable income based on strong CapitalSource Bank earnings, improving asset performance trends, substantial decline in the Parent Company’s operations and assets, and one-time losses included in the three-year cumulative pre-tax loss (i.e., debt extinguishment loss). Additionally, we believe we will be in a cumulative pre-tax income position by the end of 2012, for the three-year period then ended.


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A valuation allowance of $159.4 million remains in effect as of September 30, 2012 with respect to deferred tax assets where we believe sufficient evidence does not exist at this time to support a reduction in the allowance. It is more likely than not that the remaining deferred tax assets subject to a valuation allowance will not be realized.

Consolidated income tax expense (benefit) for the three months ended September 30, 2012 and 2011 was $18.0 million and $(11.3) million, respectively. The expense for the three months ended September 30, 2012 was primarily the result of tax expense on pre-tax income from CapitalSource Bank. The tax 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 CapitalSource Bank. Consolidated income tax (benefit) expense for the nine months ended September 30, 2012 and 2011 was $(296.3) million and $17.1 million, respectively. The tax benefit for the nine months ended September 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets. The tax expense recorded for the nine months ended September 30, 2011 was primarily related to the reestablishment 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 effective income tax rate on our consolidated net income (loss) was 36.7% and (201.3)% for the three and nine months ended September 30, 2012, respectively, and 12.3% and (39.1)% for the three and nine months ended September 30, 2011, 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 through 2008, and by certain state jurisdictions for the tax years 2006 through 2010.

Note 11. Net

Income Per Share

The computations of basic and diluted net income per share for the three and nine months ended September 30, 2012 and 2011, respectively, were as follows:


	Three Months Ended September 30,					Nine Months Ended September 30,
	2012		2011			2012		2011
	($ in thousands, except per share data)
Net income (loss)	$	31,047	$	(80,712	)	$	443,534	$	(60,959	)
Average shares — basic		219,664,637		306,535,063			229,091,849		315,719,413
Effect of dilutive securities:
Option shares		2,383,884		—			2,333,940		—
Stock units and unvested restricted stock		4,392,773		—			4,286,733		—
Average shares — diluted		226,441,294		306,535,063			235,712,522		315,719,413
Basic net income (loss) per share	$	0.14	$	(0.26	)	$	1.94	$	(0.19	)
Diluted net income (loss) per share	$	0.14	$	(0.26	)	$	1.88	$	(0.19	)

The weighted average shares that have an anti-dilutive effect in the calculation of diluted net 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,
	2012		2011		2012		2011
Stock units		5,881		3,427,158		7,433		3,427,158
Stock options		793,571		7,437,391		1,099,851		7,437,391
Unvested restricted stock		2,645		4,633,282		197,131		4,633,282

Note 12. 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


31

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, 2012 and December 31, 2011 were as follows:


	September 30, 2012										December 31, 2011
	Actual					Minimum Required					Actual					Minimum Required
	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
	($ in thousands)
Tier-1 Leverage	$	896,768		12.82	%	$	349,736		5.00	%	$	877,746		13.61	%	$	322,559		5.00	%
Tier-1 Risk-Based Capital		896,768		15.43			348,630		6.00			877,746		16.17			325,714		6.00
Total Risk-Based Capital		969,762		16.69			871,574		15.00			945,978		17.43			814,284		15.00

Note 13. 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, 2012 and December 31, 2011, we had issued $58.0 million and $79.4 million, respectively, in stand-by letters of credit which expire at various dates over the next 5 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.

As of September 30, 2012 and December 31, 2011, we had unfunded commitments to extend credit to our clients of $1.2 billion and $1.4 billion, respectively, including unfunded commitments to extend credit by CapitalSource Bank of $1.0 billion and $944.7 million, respectively, and by the Parent Company of $186.2 million and $408.0 million, respectively.

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 14. 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, 2012, none of our derivatives were designated as hedging instruments pursuant to GAAP.

We may enter into various derivative instruments to manage our exposure to interest rate risk. The objective would be to reduce the volatility of our earnings that may otherwise result due to changes in interest rates.

We have entered 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 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 have entered 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


32

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. As of September 30, 2012, we also posted collateral of $10.0 million related to counterparty requirements for foreign exchange contracts at CapitalSource Bank. 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, 2012, we were in a liability position for the derivative instruments, therefore, we did not utilize the master netting agreement as of September 30, 2012.

We report our derivatives in our consolidated balance sheets at fair value on a gross basis irrespective of our master netting arrangements. We held no derivative instruments that were in an asset position as of September 30, 2012. For derivatives that were in a liability position, we had posted collateral of $1.5 million as of September 30, 2012.

There were no interest rate swaps terminated during the three months ended September 30, 2012. During the nine months ended September 30, 2012, we terminated interest rate swaps of $53.2 million which were in an asset position and $87.1 million which were in a liability position as of the respective termination dates. As a result of these terminations, we received $8.3 million, net of collateral held and posted.

As of September 30, 2012 and December 31, 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, 2012						December 31, 2011
			Fair Value						Fair Value
	Notional Amount		Other Assets		Other Liabilities		Notional Amount		Other Assets		Other Liabilities
	($ in thousands)
Interest rate contracts	$	9,437	$	—	$	17	$	1,128,647	$	58,935	$	93,110
Foreign exchange contracts		30,611		—		946		25,946		167		183
Total	$	40,048	$	—	$	963	$	1,154,593	$	59,102	$	93,293

The gains and losses on our derivative instruments recognized during the three and nine months ended September 30, 2012 and 2011 as well as the locations of such gains and losses in our consolidated statements of operations were as follows:


		Three Months Ended September 30,						Nine Months Ended September 30,
	Location	2012			2011			2012			2011
		($ in thousands)
Interest rate contracts	(Loss) gain on derivatives, net	$	(2	)	$	(4,176	)	$	339		$	(4,792	)
Foreign exchange contracts	(Loss) gain on derivatives, net		(976	)		2,063			(988	)		530
Total		$	(978	)	$	(2,113	)	$	(649	)	$	(4,262	)

Note 15. 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.


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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.

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 callable notes, Agency debt, Agency MBS, Non-agency MBS, asset-backed securities, and a collateralized loan obligation 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, consisted of a corporate debt security as of June 30, 2012, which was subsequently settled as of September 30, 2012. At December 31, 2011, we valued our corporate debt security using unobservable inputs that were significant to the fair value measurement. As a result, we classified the fair value measurement within level 3 of the fair value

hierarchy. In March 2012, we received market information surrounding the fair value of the security. As a result, we transferred the asset from Level 3 to Level 2 of the fair value hierarchy. Our policy is to record such transfers as of the last day of the reporting period. No other available-for-sale securities were transferred from or into Level 3 as of September 30, 2012.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists 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 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 and lease 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, 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


34

performed on the collateral, and the time required to obtain an updated appraisal. Typically, we obtain an updated third-party appraisal from an external valuation specialist or use prior or pending transactions to estimate fair value. We may or may not adjust these amounts based on our own internally developed judgments and estimates. These adjustments typically include discounts for lack of marketability and foreign property discounts. We may also utilize industry valuation benchmarks such as revenue multiples for operating commercial properties. Significant decreases to any of these inputs would result in decreases in the fair value measurements. For certain loans collateralized by residential real estate, we utilize discounted cash flow techniques to determine the fair value of the underlying collateral. Significant unobservable inputs used in these fair value measurements include recovery rates and marketability discounts. Significant decreases in recovery rates or significant increases in marketability discounts would result in significant decreases in the fair value measurements.

An impaired loan is considered collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.

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, 2012 and December 31, 2011, we charged off an

additional $48.3 million, net, and $88.0 million, net, respectively, in loan balances compared with amounts that would have been charged off based on the appraised values of the collateral.

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 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, 2012, $61.0 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.

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 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 such as EBITDA multiples to determine the value of the asset or the underlying enterprise. Decreases in these benchmarks would result in significant decreases in the fair value measurements.

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 risk rating and collateral type, and the fair value is estimated utilizing discounted cash flow techniques. The valuations take into account


35

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 net revenue or EBITDA, to determine a value for the underlying enterprise. Significant decreases to these valuation benchmarks would result in significant decreases in the fair value measurements. 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. The fair value is derived through an option pricing model which utilizes the expected term and volatility of the underlying shares to determine the fair value of the warrant. Decreases in these inputs would result in significant decreases in the fair value measurements. Given the lack of trading activity surrounding the underlying shares, we classify the fair value warrant in Level 3 of the fair value hierarchy.

FHLB SF Stock

Our investment in FHLB SF stock is recorded at historical cost. FHLB SF stock does not have a readily determinable fair value, but may be sold back to the FHLB SF 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 SF and its overall financial condition. No impairment losses on our investment in FHLB SF stock have been recorded through September 30, 2012.

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 not readily available. Instead, the fair value of derivatives is 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. These adjustments typically include discounts for lack of marketability and foreign property discounts. Significant increases to these inputs would result in significant decreases in the fair value measurements. 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 recovery rates, prepayment rates and market discount rates. Significant decreases in recovery rates or prepayment rates and significant increases in market discount


36

rates in isolation would result in significant decreases in the fair value measurements. Generally, a change in the assumption used for the recovery rate is accompanied by a similar change in the prepayment rate assumption. Fair value measurements for these loans are classified 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 our term debt securitizations. For disclosure purposes, the fair values of our term debt securitizations 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.

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.


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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, 2012 were as follows:


	Fair Value Measurement as of September 30, 2012		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 securities	$	995,246	$	—	$	995,246	$	—
Assets-backed securities		10,985		—		10,985		—
Collateralized loan obligation		24,147		—		—		24,147
Non-agency MBS		45,396		—		45,396		—
U.S. Treasury and agency securities		18,296		—		18,296		—
Total assets	$	1,094,070	$	—	$	1,069,923	$	24,147
Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	963	$	—	$	963	$	—

Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of December 31, 2011 were as follows:


	Fair Value Measurement as of December 31, 2011		Level 1		Level 2		Level 3
	($ in thousands)
Assets
Investment securities, available-for-sale:
Agency securities	$	1,056,828	$	—	$	1,056,828	$	—
Asset-backed securities		15,607		—		15,607		—
Collateralized loan obligation		17,763		—		—		17,763
Corporate debt		700		—		—		700
Equity security		393		393		—		—
Municipal bond		3,235		—		—		3,235
Non-agency MBS		66,930		—		66,930		—
U.S. Treasury and agency securities		26,546		—		26,546		—
Total investment securities, available-for-sale		1,188,002		393		1,165,911		21,698
Investments carried at fair value:
Warrants		193		—		—		193
Other assets held at fair value:
Derivative assets		59,102		—		59,102		—
Total assets	$	1,247,297	$	393	$	1,225,013	$	21,891
Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	93,293	$	—	$	93,293	$	—


38

A summary of the changes in the fair values of assets and liabilities carried at fair value for the three months ended September 30, 2012 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Collateralized Loan Obligation			Municipal Bond⁽¹⁾			Non-agency MBS			Total
Balance as of July 1, 2012	$	19,864		$	2,129		$	—		$	21,993
Realized and unrealized gains (losses):
Included in income		695			(140	)		695			1,250
Included in other comprehensive income, net		4,142			—			—			4,142
Total realized and unrealized gains (losses)		4,837			(140	)		695			5,392
Total settlements:
Settlements		(554	)		(1,989	)		(695	)		(3,238	)
Balance as of September 30, 2012	$	24,147		$	—			—		$	24,147

⁽¹⁾	In September 2012, the municipal bond was settled as the Company secured the collateral; the collateral was transferred to other assets at its fair value less cost of sales of $2.0 million.

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, 2012 and 2011, reported in interest income and gain on investments, net were as follows:


	Interest Income				(Loss) Gain on Investments, Net
	Three Months Ended September 30,
	2012		2011		2012			2011
	($ in thousands)
Total gains (losses) included in earnings for the period	$	1,390	$	748	$	(140	)	$	(5	)
Unrealized gains (losses) relating to assets still held at reporting date		695		748		—			(10	)

A summary of the changes in the fair values of assets and liabilities carried at fair value for the nine months ended September 30, 2012 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 Bond⁽¹⁾			Non-agency MBS			Total			Warrants			Total Assets
	($ in thousands)
Balance as of January 1, 2012	$	700		$	17,763		$	3,235		$	—		$	21,698		$	193		$	21,891
Realized and unrealized gains (losses):
Included in income		11			2,312			(1,246	)		695			1,772			5			1,777
Included in other comprehensive income, net		(45	)		5,159			—			—			5,114			—			5,114
Total realized and unrealized gains (losses)		(34	)		7,471			(1,246	)		695			6,886			5			6,891
Transfers out of Level 3		(666	)		—			—			—			(666	)		—			(666	)
Sales and settlements
Sales		—			—			—			—			—			(198	)		(198	)
Settlements⁽¹⁾		—			(1,087	)		(1,989	)		(695	)		(3,771	)		—			(3,771	)
Total settlements and sales		—			(1,087	)		(1,989	)		(695	)		(3,771	)		(198	)		(3,969	)
Balance as of September 30, 2012	$	—		$	24,147		$	—		$	—		$	24,147		$	—		$	24,147

⁽¹⁾	In September 2012, the municipal bond was settled as the Company secured the collateral; the collateral was transferred to other assets at its fair value less cost of sales of $2.0 million.


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Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the nine months ended September 30, 2012 and 2011, reported in interest income and gain on investments, net were as follows:


	Interest Income				(Loss) Gain on Investments, Net
	Nine Months Ended September 30,
	2012		2011		2012			2011
	($ in thousands)
Total gains (losses) included in earnings for the period	$	3,018	$	4,494	$	(1,241	)	$	11,790
Unrealized gains (losses) relating to assets still held at reporting date		2,312		3,095		—			(1,514	)

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, excluding related transaction costs, for which nonrecurring fair value adjustments were recorded as of September 30, 2012 and December 31, 2011, classified by their position in the fair value hierarchy.


	September 30, 2012								December 31, 2011
	Fair Value Measurement		Level 1		Level 2		Level 3		Fair Value Measurement		Level 1		Level 2		Level 3
	($ in thousands)
Assets
Loans held for sale	$	18,371	$	—	$	18,371	$	—	$	161,293	$	—	$	161,293	$	—
Loans held for investment		34,256		—		—		34,256		92,909		—		—		92,909
Investments carried at cost		820		—		—		820		4,863		—		—		4,863
Investments accounted for under the equity method		—		—		—		—		694		—		—		694
Real estate owned		15,960		—		6,461		9,499		17,398		—		—		17,398
Loans acquired through foreclosure, net		—		—		—		—		11,667		—		—		11,667
Total assets	$	69,407	$	—	$	24,832	$	44,575	$	288,824	$	—	$	161,293	$	127,531

The following table presents the net losses of the above assets resulting from nonrecurring fair value adjustments for the three and nine months ended September 30, 2012 and 2011:


	Three months ended September 30,				Nine months ended September 30,
	2012		2011		2012		2011
Loans held for investments	$	2,343	$	27,711	$	23,317	$	103,180
Loans held for sale		397				397
Investments carried at cost		492		363		5,192		717
Investments accounted for under the equity method		1		56		1		56
REO		1,433		6,725		3,419		15,413
Loans acquired through foreclosure, net		—		2,475		—		9,880
Total net loss (gain) from nonrecurring measurements	$	4,666	$	37,330	$	32,326	$	129,246


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Significant Unobservable Inputs and Valuation Techniques of Level 3 Fair Value Measurements

For our fair value measurements classified in Level 3 of the fair value hierarchy as of September 30, 2012, a summary of the significant unobservable inputs and valuation techniques is as follows:


	Fair Value Measurement as of September 30, 2012		Valuation Techniques	Unobservable Input	Range (Weighted Average)
	($ in thousands)
Assets
Loans held for investment
Services	$	11,885	Market Comparables	EBITDA Multiple Marketablility Discount Price Per Square Foot Illiquidity Discount	3.0x - 6.0x (5.0x) 20.0% - 57.0% (48.6%) $109.48 35.0%

Commercial Real Estate		18,801	Market Comparables	Recovery Rate Marketablility Discount Price Per Acre Foreign Discount	52.0% 8.0% - 42.0% (37.4%) $1,022.50 40.0%

Residential Real Estate		3,570	Market Comparables	Recovery Rate Capitalization Rate	19.7% - 34.3% (20.1%) 8.7%
Total loans held for investment		34,256

Investments carried at cost		820	Market Comparables	Net Revenue Multiple EBITDA Multiple Illiquidity Discount	9.3x 6.8x - 12.9x (9.5x) 25.0%

REO		9,499	Third Party Appraisals	Marketability Discount Foreign Discount Price Per Square Foot	30.0% - 54.6% (53.2%) 40.0% $40.00
Total assets	$	44,575

The table above excludes the collateralized loan obligation categorized within Level 3 of the fair value hierarchy because the fair value of this asset is measured using third-party pricing information without adjustments.


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Fair Value of Financial Instruments

GAAP requires the disclosure of the estimated fair value of financial instruments which are not recorded at fair value. The table below provides fair value estimates for our financial instruments as of September 30, 2012 and December 31, 2011, 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, 2012										December 31, 2011
	Carrying Value		Fair Value								Carrying Value		Fair Value
	Carrying Value		Level 1		Level 2		Level 3		Total		Carrying Value		Level 1		Level 2		Level 3		Total
	($ in thousands)
Assets:
Loans held for sale	$	84,883	$	—	$	86,385	$	—	$	86,385	$	193,021	$	—	$	197,103	$	—	$	197,103
Loans held for investment, net		5,948,119		—		—		5,675,453		5,675,453		5,536,516		—		—		5,410,511		5,410,511
Investments carried at cost		30,241		—		—		66,321		66,321		36,252		—		—		64,076		64,076
Investment securities, held-to-maturity		108,066		—		111,823		—		111,823		111,706		—		112,972		—		112,972
Liabilities:
Deposits		5,535,482		—		5,544,749		—		5,544,749		5,124,995		—		5,135,843		—		5,135,843
Term debt		203,307		—		—		165,017		165,017		309,394		—		—		252,739		252,739
Convertible debt, net		—		—		—		—		—		28,903		—		29,739		—		29,739
Subordinated debt		409,880		—		272,570		—		272,570		436,196		—		252,994		—		252,994
Loan commitments and letters of credit		—		—		—		21,676		21,676		—		—		—		20,636		20,636

Note 16. Segment

Data

The financial results of our operating segments as of and for the three months ended September 30, 2012 were as follows:


	Three Months Ended September 30, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	99,807	$	16,899		$	(1,472	)	$	115,234
Interest expense		15,521		3,992			—			19,513
Provision for loan and lease losses		273		8,686			—			8,959
Non-interest income		13,585		1,439			(5,727	)		9,297
Non-interest expense		39,964		13,037			(5,992	)		47,009
Net income (loss) before income taxes		57,634		(7,377	)		(1,207	)		49,050
Income tax expense (benefit)		23,782		(5,779	)		—			18,003
Net income (loss)	$	33,852	$	(1,598	)	$	(1,207	)	$	31,047
Total assets as of September 30, 2012	$	7,285,953	$	1,412,243		$	(20,895	)	$	8,677,301
Total assets as of December 31, 2011		6,793,496		1,534,698			(28,126	)		8,300,068


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The financial results of our operating segments 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 and lease losses		13,725		21,393			—			35,118
Non-interest income		14,614		35,015			(17,145	)		32,484
Non-interest expense		35,345		158,305			(17,304	)		176,346
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	)

The financial results of our operating segments for the nine months ended September 30, 2012 were as follows:


	Nine Months Ended September 30, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	294,539	$	62,579		$	(3,825	)	$	353,293
Interest expense		46,974		13,561			—			60,535
Provision for loan and lease losses		14,745		15,822			—			30,567
Non-interest income		42,252		6,524			(19,479	)		29,297
Non-interest expense		124,307		40,226			(20,274	)		144,259
Net income (loss) before income taxes		150,765		(506	)		(3,030	)		147,229
Income tax expense (benefit)		62,047		(358,352	)		—			(296,305	)
Net income	$	88,718	$	357,846		$	(3,030	)	$	443,534

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 and lease losses		23,636		57,814			—			81,450
Non-interest income		27,954		100,173			(53,154	)		74,973
Non-interest expense		108,255		249,360			(56,258	)		301,357
Net income (loss) before income taxes		123,726		(170,276	)		2,722			(43,828	)
Income tax expense		38,448		(21,317	)		—			17,131
Net income (loss)	$	85,278	$	(148,959	)	$	2,722		$	(60,959	)


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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, 2011, 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, loan sales between the Parent Company and CapitalSource Bank, 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.


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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, including certain plans, expectations, strategies, goals, and projections and including statements about our expectations regarding Parent Company liquidity, CapitalSource Bank liquidity, Parent Company asset run off, return of capital to shareholders, including the timing, form and magnitude of any return of capital, prepayment of trust preferred securities, intentions to expand the CapitalSource Bank’s lending business, expectation about additional deferred tax asset valuation allowance reversal, accelerated disposition of Parent Company assets, calling of Parent Company securitized debt, Parent Company capital contributions to CapitalSource Bank, and realizing the allowed portion of the deferred tax asset, all which are subject to numerous assumptions, risks, and uncertainties. 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,’ ‘expect,’ ‘estimate,’ ‘forecast,’ ‘plan,’ ‘position,’ ‘project,’ ‘will,’ ‘should,’ ‘would,’ ‘seek,’ ‘continue,’ ‘outlook,’ ‘look forward,’ and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding preliminary and 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: continued or worsening disruptions in credit and other markets; borrowers’ lack of financial strength to repay loans; the Parent Company’s decision to make new loans or extend existing loans; the success and timing of other business strategies and asset sales; declines in asset values; lower than expected Parent Company’s recurring tax basis income; lower than expected taxable income at CapitalSource Bank for which CapitalSource Bank has to reimburse the Parent Company for income tax expenses in accordance with the tax sharing agreement; the need to retain capital for strategic or regulatory reasons including the implementation of Basel III standards; lower than anticipated liquidity; inability to attract qualified professionals; drawdown of Parent Company unfunded commitments substantially in excess of historical drawings; changes in economic or market conditions or investment or lending opportunities; continued or worsening credit losses, charge-offs, reserves and

delinquencies; competitive and other market pressures on product pricing and services; reduced demand for our services; our inability to grow deposits and access wholesale funding sources; regulatory safety and soundness considerations; changes in tax laws or regulations affecting our business; changes in tax characteristics of income generated; loan repayments higher than expected; excess Parent Company liquidity; our inability to generate sufficient earnings; tax planning or disallowance of tax benefits by tax authorities; and other factors described in CapitalSource’s 2011 Annual Report on Form 10-K and documents subsequently filed by CapitalSource with the Securities and Exchange Commission. All forward-looking statements included in this Form 10-Q are based on information available at the time of the release.

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 or the Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank.

For the three and nine months ended September 30, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our legacy loan portfolio and investment activities in the Parent Company. For additional information, see Note 16, Segment Data.

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 regulation. As of September 30, 2012, CapitalSource Bank had an outstanding loan principal balance of $5.3 billion and deposits of $5.5 billion.

Through our Other Commercial Finance segment activities, the Parent Company satisfies existing loan commitments made prior to CapitalSource Bank’s formation and receives payments on its existing loan portfolio. As of September 30, 2012, the Parent Company had an outstanding loan principal balance of $727.5 million.


45

Current Developments

As part of the transformation to a more traditional bank structure, we have been liquidating Parent Company assets, reducing Parent Company debt, using excess capital to repurchase stock, simplifying our consolidated operations and focusing our strategic growth initiatives entirely on CapitalSource Bank.

In addition to growing assets and increasing profitability at CapitalSource Bank, our current strategy is to run off our remaining Parent Company assets over time. We intend to regularly assess alternatives for implementing our strategy and may consider accelerated disposition of Parent Company assets, prepayments of Trust Preferred Securities, calling the securitized debt and alternative uses of Parent Company capital, including contributions to CapitalSource Bank, if attractive opportunities become available.

In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and cancelled during the second quarter. We recorded a related pre-tax gain of $8.2 million on the extinguishment of debt. As of September 30, 2012, the aggregate outstanding balance of the subordinated debt was $409.9 million.

As the Parent Company assets are repaid, the Company intends to return a substantial portion of our excess capital to shareholders through a combination of share repurchases and dividends. Since the Company began repurchasing shares in December 2010 through September 2012, we have repurchased approximately 112.8 million shares, or 34.9% of the shares outstanding since December 2010. Consistent with the objective of prudently returning excess capital to shareholders, on October 26, 2012, the Company’s Board of Directors approved a new share repurchase program with authority to purchase up to $250.0 million of outstanding shares through the end of 2013.

While share buybacks have been the primary means of returning excess capital to shareholders to date, we are also considering

additional mechanisms to return excess capital in the near term. In this regard, our Board has been actively considering (i) modifying our dividend policy to pay a regular quarterly dividend more commensurate with our banking industry peers and (ii) possibly paying one or more special dividends, if appropriate in light of buyback and regular dividend levels. Our Board intends to further consider these alternatives in the near term, and it is possible that the board could determine to take further action in 2012. However, our Board has not yet made a decision on these specific actions, and we cannot assure you that any such action(s) will be taken. Any such determinations will be subject to market conditions and other developments, the level of available cash, and other factors.

Our broader business strategy focuses on developing and growing our banking operations. As of September 30, 2012, CapitalSource Bank had $7.3 billion of assets. We offer a broad range of specialized senior secured, commercial loan products to small and middle-market businesses, and we offer our loan products on a nationwide basis, despite the regional nature of our deposit base. With a low cost deposit gathering platform based in southern and central California, we believe our business model is well positioned to deliver a broad range of customized financial solutions to borrowers.

Since September 30, 2011, CapitalSource Bank’s loan balance has grown by 17% and the Parent Company’s loan balance has decreased by 43%. Since the formation of the Bank, we have launched or acquired five lending platforms — equipment finance, small business, professional practice, multifamily lending and premium finance lending. It is our intent to continue to seek lending platforms and experienced individuals who will further augment our specialized businesses.

Operating Results for the Three and Nine Months Ended September 30, 2012

As further described below, the most significant factors influencing our consolidated results of operations for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 were:

Decreased deferred tax asset valuation allowance;

Increased net interest margin;

Decreased interest-earning assets;

Decreased provision for loan and lease losses;

Decreased losses on our investments;

Decreased expense of real estate owned and other foreclosed assets, net;

Significant loss on extinguishment of debt in 2011; and

Decreased operating expenses.


46

Our consolidated operating results for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2012		2011			% Change			2012			2011			% Change
	($ in thousands)
Interest income	$	115,234	$	121,476			-5.1	%	$	353,293		$	391,053			-9.7	%
Interest expense		19,513		34,488			-43.4			60,535			127,047			-52.4
Provision for loan and lease losses		8,959		35,118			-74.5			30,567			81,450			-62.5
Non-interest income		9,297		32,484			-71.4			29,297			74,973			-60.9
Non-interest expense		47,009		176,346			-73.3			144,259			301,357			-52.1
Income tax expense (benefit)		18,003		(11,280	)		259.6			(296,305	)		17,131			-1,829.6
Net income (loss)		31,047		(80,712	)		138.5			443,534			(60,959	)		827.6

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the nine months ended September 30, 2012 and 2011 were as follows:


	Nine Months Ended September 30,
	2012							2011
	Weighted Average Balance		Net Interest Income/Expense		Average Yield/Cost			Weighted Average Balance		Net Interest Income/Expense		Average Yield/Cost
	($ in thousands)
Loans⁽¹⁾	$	5,929,715	$	322,437		7.26	%	$	5,698,156	$	344,308		8.08	%
Investment securities		1,257,571		29,737		3.16			1,597,382		44,675		3.74
Cash and other interest-earning assets		397,327		1,119		0.38			1,018,800		2,070		0.27
Total asset-related balances		7,584,613		353,293		6.22			8,314,338		391,053		6.29
Deposits		5,347,534		38,669		0.97			4,749,229		40,203		1.13
Borrowings⁽²⁾		1,272,592		21,866		2.30			2,083,481		86,844		5.57
Total liabilities-related balances		6,620,126		60,535		1.22			6,832,710		127,047		2.49
Net interest income/spread			$	292,758		5.00	%			$	264,006		3.80	%
Net interest margin						5.16	%						4.25	%

⁽¹⁾	Loans balances are net of deferred loan fees and discounts.

⁽²⁾	Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.

Income Taxes

We provide for income taxes as a “C” corporation on income earned from operations. For the tax years ended 2010 and 2009, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We have consolidated our subsidiaries 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


47

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.

Consolidated income tax expense/(benefit) for the three months ended September 30, 2012 and 2011 was $18.0 million and $(11.3) million, respectively. The expense for the three months ended September 30, 2012 was primarily the result of the tax expense on the pre-tax book income from CapitalSource Bank. The tax 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 CapitalSource Bank. Consolidated income tax (benefit) expense for the nine months ended September 30, 2012 and 2011 was $(296.3) million and $17.1 million, respectively. The tax benefit for the nine months ended September 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets. The tax expense recorded for the nine months ended September 30, 2011 was primarily related to the reestablishment 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.

Comparison of the Three and Nine Months Ended September 30, 2012 and 2011

CapitalSource Bank Segment

Our CapitalSource Bank segment operating results for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011, were as follows:


	Three Months Ended September 30,							Nine Months Ended September 30,
	2012		2011		% Change			2012		2011		% Change
	($ in thousands)
Interest income	$	99,807	$	92,173		8.3	%	$	294,539	$	274,467		7.3	%
Interest expense		15,521		15,982		-2.9			46,974		46,804		0.4
Provision (benefit) for loan and lease losses		273		13,725		-98.0			14,745		23,636		-37.6
Non-interest income		13,585		14,614		-7.0			42,252		27,954		51.1
Non-interest expense		39,964		35,345		13.1			124,307		108,255		14.8
Income tax expense		23,782		16,513		44.0			62,047		38,448		61.4
Net income		33,852		25,222		34.2			88,718		85,278		4.0


48

Interest Income

Three months ended September 30, 2012 and 2011

Total interest income increased to $99.8 million for the three months ended September 30, 2012 from $92.2 million for the three months ended September 30, 2011, with an average yield on interest-earning assets of 5.88% for the three months ended September 30, 2012 compared to 5.97% for the three months ended September 30, 2011. Total interest income increased due to a $12.0 million increase in total loan interest income, offset by a $4.4 million decrease in total investment interest income. During the three months ended September 30, 2012 and 2011, total interest income on loans was $91.3 million and $79.3 million, respectively, yielding 6.95 % and 7.51% on average loan balances of $5.2 billion and $4.2 billion, respectively. Total loan interest income increased due to $12.3 million and $0.9 million increases on interest generated from loans held for investment and from direct financing lease interest and fees, respectively. Increases were offset by a $1.1 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on loans held for investment. During the three months ended September 30, 2012 and 2011, $2.2 million and $2.9 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the loan yields by 0.16% and 0.27%, respectively. During the three months ended September 30, 2012 and 2011, $77 thousand and $20 thousand, respectively, of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the three months ended September 30, 2012 and 2011, total interest income from our investments, including available-for-sale and held-to-maturity securities, was $8.1 million and $12.5 million, respectively, yielding 2.68% and 3.14% on an average balance of $1.2 billion and $1.6 billion, respectively. Total interest income on investments decreased $4.4 million primarily due to $2.5 million and $1.9 million decreases in interest income from the available-for-sale and held-to-maturity securities, respectively. The available-for-sale portfolio is mostly comprised of agency mortgage-backed securities, which have been experiencing an acceleration of premium amortizations due to updated prepayment assumptions. During the three months ended September 30, 2012, we purchased $26.0 million of investment securities, available-for-sale, while $80.5 million and $0.9 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, 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.

During the three months ended September 30, 2012 and 2011, interest income on cash and cash equivalents was $0.4 million, yielding 0.39% and 0.38% on average balances of $286.3 million and $325.1 million, respectively.

Nine months ended September 30, 2012 and 2011

Total interest income increased to $294.5 million for the nine months ended September 30, 2012 from $274.5 million for the nine months ended September 30, 2011, with an average yield on interest-earning assets of 5.96% for the nine months ended September 30, 2012 compared to 6.19% for the nine months ended September 30, 2011. Total interest income increased due to a $33.2 million increase in total loan interest income, offset by a $13.2 million decrease in total investment interest income. During the nine months ended September 30, 2012 and 2011, total interest income on loans was $267.9 million and $234.7 million, respectively, yielding 7.09% and 7.87% on average loan balances of $5.0 billion and $4.0 billion, respectively. Total loan interest income increased $33.2 million due to a $45.6 million increase in interest generated on loans held for investment and a $4.1 million increase in direct financing lease interest and fees. Increases were offset by a $16.5 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on loans held for investment. During the nine months ended September 30, 2012 and 2011, $7.3 million and $12.4 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the loan yields by 0.19% and 0.42%, respectively. During the nine months ended September 30, 2012 and 2011, $0.9 million and $55 thousand, respectively, of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the nine months ended September 30, 2012 and 2011, total interest income from our investments, including available-for-sale and held-to-maturity securities, was $25.6 million and $38.8 million, respectively, yielding 2.78% and 3.28% on an average balance of $1.2 billion and $1.6 billion, respectively. Total interest income on investments decreased $13.2 million due to a $5.4 million decrease in income from the available-for-sale portfolio and a $7.8 million decrease in held-to-maturity securities. The agency mortgage-backed securities within the available-for-sale portfolio experienced decelerated premium amortizations in the first quarter offset by accelerated amortization arising from updated prepayment assumptions. The held-to-maturity portfolio primarily includes commercial mortgage-backed securities which experienced a decrease due to fluctuations in interest rates and prepayment assumptions. During the nine months ended September 30, 2012, we purchased $175.4 million of investment securities, available-for-sale, while $260.3 million and $4.9 million of principal repayments were received


49

from our investment securities, available-for-sale and held-to-maturity, respectively. For 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.

During the nine months ended September 30, 2012 and 2011, interest income on cash and cash equivalents was $1.0 million and $0.9 million, respectively, yielding 0.41% and 0.35% on average balances of $293.5 million and $348.9 million, respectively.

Interest Expense

Three months ended September 30, 2012 and 2011

Total interest expense decreased to $15.5 million for the three months ended September 30, 2012 from $16.0 million for the three months ended September 30, 2011. The decrease was due to a decline in the average cost of interest-bearing liabilities which was 1.02% and 1.19% during the three months ended September 30, 2012 and 2011, respectively, offset by an increase in the average balance of interest-bearing liabilities which was $6.1 billion and $5.3 billion during the three months ended September 30, 2012 and 2011, respectively. Our interest expense on deposits for the three months ended September 30, 2012 and 2011 was $12.7 million and $13.4 million, respectively, with an average cost of deposits of 0.93% and 1.10%, respectively, on average balances of $5.5 billion and $4.8 billion, respectively. During the three months ended September 30, 2012, $1.1 billion of our time deposits matured with a weighted average interest rate of 0.96% and $1.3 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.86%. During the three months ended September 30, 2011, $766.2 million of our time deposits matured with a weighted average interest rate of 1.01% and $900.3 million of new and renewed time deposits were issued at a weighted average interest rate of 0.89%. Additionally, during the three months ended September 30, 2012, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, decreased from 0.56% at the beginning of the quarter to 0.51% at the end of the quarter.

During the three months ended September 30, 2012, our interest expense on borrowings, consisting of FHLB SF borrowings, was $2.8 million with an average cost of 1.85% on an average balance of $597.7 million. There were $13.0 million in new advances with a weighted-average-rate of 0.89% and $10.0 million in maturities with a weighted-average-rate of 2.26%. Weighted-average-rates for FHLB SF borrowings maturing within one year, one to five years, and greater than five years were 1.61%, 1.76%, and 2.21%,

respectively. In addition, the overall FHLB SF borrowings balance had a weighted-average-life of 1.70 years as compared to 4.90 years for new advances during the quarter. 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 of advances taken and $1.4 billion of maturities.

Nine months ended September 30, 2012 and 2011

Total interest expense increased to $47.0 million for the nine months ended September 30, 2012 from $46.8 million for the nine months ended September 30, 2011. The increase was due to an increase in the average balance of interest-bearing liabilities which was $5.9 billion and $5.2 billion during the nine months ended September 30, 2012 and 2011, respectively, offset by a decline in the average cost of interest-bearing liabilities which was 2.87% and 1.21% during the nine months ended September 30, 2012 and 2011, respectively. Our interest expense on deposits for the nine months ended September 30, 2012 and 2011 was $38.7 million and $40.2 million, respectively, with an average cost of deposits of 0.97 % and 1.13%, respectively, on average balances of $5.3 billion and $4.7 billion, respectively. During the nine months ended September 30, 2012, $4.2 billion of our time deposits matured with a weighted average interest rate of 1.01% and $3.8 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.87%. 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 and renewed time deposits were issued at a weighted average interest rate of 0.94%. Additionally, during the nine months ended September 30, 2012, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, decreased from 0.75% at the beginning of the year to 0.51% at the end of the period.

During the nine months ended September 30, 2012, our interest expense on borrowings, consisting of FHLB SF borrowings, was $8.3 million with an average cost of 1.90% on an average balance of $583.8 million. There were $98.0 million in advances with a weighted-average-rate of 1.02% and $48.0 million of maturities with a weighted-average-rate of 2.00%. The overall FHLB borrowings balance has a weighted-average-life of 1.70 years as compared to 5.46 years for new advances made during the year to date. 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 of advances taken and $1.6 billion of maturities.


50

Net Interest Margin

Three months ended September 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities for the three months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Loans⁽¹⁾	$	5,231,242	$	91,367		6.95	%	$	4,192,610	$	79,346		7.51	%
Investment securities		1,206,868		8,123		2.68			1,581,170		12,499		3.14
Cash and other interest-earning assets		314,439		317		0.40			350,143		327		0.37
Total interest-earning assets		6,752,549	$	99,807		5.88			6,123,923		92,173		5.97
Deposits		5,469,501		12,738		0.93			4,833,941		13,422		1.10
Borrowings⁽²⁾		597,674		2,783		1.85			506,413		2,560		2.01
Total interest-bearing liabilities		6,067,175		15,521		1.02			5,340,354		15,982		1.19
Net interest spread			$	84,286		4.86	%			$	76,191		4.78	%
Net interest margin						4.97	%						4.94	%

⁽¹⁾	Loans balances are net of deferred loan fees and discounts.

⁽²⁾	Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.

Nine months ended September 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the nine months ended September 30, 2012 and 2011 were as follows:


	Nine Months Ended September 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Loans⁽¹⁾	$	5,046,915	$	267,905		7.09	%	$	3,977,518	$	234,679		7.87	%
Investment securities		1,229,735		25,625		2.78			1,577,016		38,821		3.28
Cash and other interest-earning assets		321,395		1,008		0.42			371,099		967		0.35
Total interest-earning assets		6,598,045	$	294,538		5.96			5,925,633		274,467		6.19
Deposits		5,347,534		38,669		0.97			4,749,229		40,203		1.13
Borrowings⁽²⁾		583,785		8,305		1.90			435,879		6,601		2.02
Total interest-bearing liabilities		5,931,319		46,974		2.87			5,185,108		46,804		1.21
Net interest spread			$	247,564		3.10	%			$	227,663		4.98	%
Net interest margin						5.01	%						5.14	%

⁽¹⁾	Loans balances are net of deferred loan fees and discounts.

⁽²⁾	Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.


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Provision for Loan and Lease Losses

Our provision for loan and lease losses is based on our evaluation of the adequacy of the existing allowance for loan and lease 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 and lease losses, see the Credit Quality and Allowance for Loan and Lease Losses section.

Non-Interest Income

Comparison of three and nine months ended September 30, 2012 vs. 2011

CapitalSource Bank acts as servicer and agent for loans and other assets, which are owned by the Parent Company and partially owned by third parties, for which it receives fees based on the level of servicing effort for the loans and other assets. Such fee income is included as part of non-interest income. Loans serviced by CapitalSource Bank for the benefit of others were $6.6 billion and $2.5 billion as of September 30, 2012 and December 31, 2011, respectively, of which $5.7 billion and $1.0 billion, respectively, were owned by the Parent Company. CapitalSource Bank also provides tax, credit, treasury and other similar services to the Parent Company for which it receives fees.

In addition, we summarize the other various components of non-interest income for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 as follows:


	Three Months Ended											Nine Months Ended
	9/30/2012			9/30/2011		$ Change			% Change			9/30/2012			9/30/2011		$ Change			% Change
	($ in thousands)											($ in thousands)
Loan fees	$	3,469		$	1,804	$	1,665			92.3	%	$	9,566		$	5,373	$	4,193			78.0	%
Leased equipment income		3,299			901		2,398			266.1			9,814			974		8,840			907.6
(Loss) gain on investments, net		(1	)		1,624		(1,625	)		-100.1			(1	)		2,845		(2,846	)		-100.0
(Loss) gain on derivatives		(976	)		1,017		(1,993	)		-196.0			(989	)		346		(1,335	)		-385.8
Bank fees		150			156		(6	)		-3.8			180			192		(12	)		-6.3
(Loss) gain on sale of assets		(554	)		4,962		(5,516	)		-111.2			(520	)		5,701		(6,221	)		-109.1
Intercompany loan servicing revenue		2,305			2,866		(561	)		-19.6			8,273			9,977		(1,704	)		-17.1
Other		5,893			1,284		4,609			359.0			15,929			2,546		13,383			525.6
Total	$	13,585		$	14,614	$	(1,029	)		-7.0	%	$	42,252		$	27,954	$	14,298			51.1	%

Loan fees increased $1.7 million, or 92.3%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due an increase in average loan balances of $1.0 billion, or 24.8%, increasing related loan termination fees due to greater late fees, penalties, and recurring fees. Loans fees increased $4.2 million, or 78.0%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to loan termination fees, penalties and recurring fees.

Leased equipment income increased $2.4 million, or 266.1%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to $74.7 million, or 644.2%, increase in average equipment on operating leases from $11.5 million as of September 30, 2011 to $85.9 million as of September 30, 2012. Leased equipment income increased $8.8 million, or 907.6% from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to $80.7 million, or 1,771.0%, increase in average equipment on operating leases from $4.6 million as of September 30, 2011 to $85.2 million as of September 30, 2012.

Gain on investments, net, decreased $1.6 million, or 100.1%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to realized losses on the sale of equity securities and relatively decreased equity investments as of September 30, 2012. Gain on investments decreased $2.8 million, or 100.0%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 due to the reasons mentioned above.

Gain on derivatives decreased $2.0 million to a loss position, or 196.0%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 due to market adjustment of forward exchange contracts with the Canadian dollar. Gain on derivatives decreased $1.3 million, or 385.8%, from the nine months ended period September 30, 2011 to September 30, 2012 due to the reason mentioned above.


52

Gain on sale of assets decreased $5.5 million, or 111.2%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to $4.8 million decreased gain on sales of commercial loans to third parties and $765 thousand decrease in intercompany loan sales. Sale activities on loans have decreased since prior year, as the Bank continues to improve the asset quality of the loan portfolio. Gain on sale of assets decreased $6.2 million, or 109.1%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to $4.8 million decreased gain on sale of commercial loans, $818 thousand decrease in loans held for sale adjustments for lower of market or cost, and $765 thousand decrease in intercompany loan sales.

Other income increased $4.6 million, or 359.0%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due a $2.7 million increase in gains on foreign currency translations arising from loans denominated in foreign currencies. In addition, shared service revenue increased by $1.8 million as administrative and service functions have been transferred to the Bank. Other income increased $13.4 million, or 525.7%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due a $2.1 million increase in gains on foreign currency translations arising from loans denominated in foreign currencies. In addition, shared service revenue increased by $7.3 million as administrative and service functions have been transferred to the Bank, and SBA loan fees contributed to a $1.7 million increase.

Non-Interest Expense

Comparison of three and nine months ended September 30, 2012 vs. 2011

Prior to 2012, CapitalSource Bank relied on the Parent Company to refer loans and to provide loan origination due diligence services. For these services CapitalSource Bank paid the Parent Company fees based upon the commitment amount of each new loan funded by CapitalSource Bank during the period. CapitalSource Bank also paid the Parent Company to perform certain underwriting and other services. These fees were eliminated in consolidation. Effective January 1, 2012, the Parent Company no longer performed these services and CapitalSource Bank directly assumed the expenses for these services. The expenses are included in other non-interest expense and were $2.3 million and $11.2 million for the three months ended September 30, 2012 and 2011, respectively.

CapitalSource Bank subleases from the Parent Company office space in several locations and also leases space to the Parent Company in other facilities in which CapitalSource Bank is the primary lessee. In addition, we summarize the other various components of non-interest expense for three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 as follows:


	Three Months Ended										Nine Months Ended
	9/30/2012		9/30/2011		$ Change			% Change			9/30/2012		9/30/2011			$ Change			% Change
	($ in thousands)										($ in thousands)
Compensation and benefits	$	25,254	$	13,185	$	12,069			91.5	%	$	74,818	$	36,819		$	37,999			103.2	%
Professional fees		1,404		500		904			180.8			4,615		1,107			3,508			316.9
Occupancy expenses		2,520		1,798		722			40.2			7,660		5,249			2,411			45.9
FDIC fees and assessments		1,507		1,375		132			9.6			4,419		4,706			(287	)		-6.1
General depreciation and amortization		953		1,021		(68	)		-6.7			2,920		3,239			(319	)		-9.8
Other administrative expenses		5,464		15,118		(9,654	)		-63.9			21,629		47,319			(25,690	)		-54.3
Total operating expenses		37,102		32,997		4,105			12.4			116,061		98,439			17,622			17.9
						—
Leased equipment depreciation		2,307		668		1,639			245.4			6,883		708			6,175			872.2
Expense of real estate owned and other foreclosed assets, net		16		1,410		(1,394	)		-98.9			1,334		10,225			(8,891	)		-87.0
Total non-interest expense		539		270		269			99.6			29		(1,117	)		1,146			-102.6
Total	$	39,964	$	35,345	$	4,619			13.1	%	$	124,307	$	108,255		$	16,052			14.8	%


53

Compensation and benefits increased $12.1 million, or 91.5%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due the transfer of Parent Company employees to the Bank during the current year. Compensation and benefits increased $38.0 million, or 103.2%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 due to the reason mentioned above.

Other administrative expenses decreased $9.7 million, or 63.9%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to a $10.1 million decrease in intercompany loan sourcing fees, which is an expense paid to the Parent for loan referrals. The overall increase is offset by slight increases various other administrative expenses, such as FDIC premiums, Bank IT expenses, and marketing. Other administrative expenses decreased $25.7 million, or 54.3 %, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to a $36.4 million decrease in intercompany loan sourcing fees, offset by slight increases various other administrative expenses.

Leased equipment depreciation increased $1.6 million, or 245.4%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due an increased asset base during 2012, which is managed by the equipment leasing unit of the Bank. Equipment increased from $45.1 million as of September 30, 2011 to $102.1 million as of September 30, 2012, representing a 126.6% increase which in line with the 245.4% increases in depreciation expense. Leased equipment depreciation increased $6.2 million, or 872.2%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 due to the reason mentioned above.

Other Commercial Finance Segment

Our Other Commercial Finance segment operating results for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011, were as follows:


	Three Months Ended September 30,									Nine Months Ended September 30,
	2012			2011			% Change			2012			2011			% Change
	($ in thousands)
Interest income	$	16,899		$	28,653			-41.0	%	$	62,579		$	116,968			-46.5	%
Interest expense		3,992			18,506			-78.4			13,561			80,243			-83.1
Provision for loan and lease losses		8,686			21,393			-59.4			15,822			57,814			-72.6
Non-interest income		1,439			35,015			-95.9			6,524			100,173			-93.5
Non-interest expense		13,037			158,305			-91.8			40,226			249,360			-83.9
Income tax (benefit) expense		(5,779	)		(27,793	)		79.2			(358,352	)		(21,317	)		-1,581.1
Net (loss) income		(1,598	)		(106,743	)		98.5			357,846			(148,959	)		340.2

Interest Income

Three months ended September 30, 2012 and 2011

Interest income decreased to $16.9 million for the three months ended September 30, 2012 from $28.7 million for the three months ended September 30, 2011, primarily due to a decrease in average total interest-earning assets. During the three months ended September 30, 2012, our average balance of interest-earning assets decreased by $1.1 billion, or 56.2%, compared to the three months ended September 30, 2011, due to the runoff of Parent Company loans. During the three months ended September 30, 2012, yield on average interest-earning assets increased to 7.66% from 5.67% for the three months ended September 30, 2011. During the three months ended September 30, 2012, our lending spread to average one-month LIBOR was 8.37% compared to 8.58% for the three months ended September 30, 2011. Fluctuations in loan yields are driven by various factors, such as prime rates or one-month LIBOR which impact lending rates, the coupon on loans that pay down or pay off, non-accrual loans, and modifications of interest rates on existing loans.

Nine months ended September 30, 2012 and 2011

Interest income decreased to $62.6 million for the nine months ended September 30, 2012 from $117.0 million for the nine months ended September 30, 2011, primarily due to a decrease in average total interest-earning assets. During the nine months ended September 30, 2012, our average balance of interest-earning assets decreased by $1.4 billion, or 58.7%, compared to the nine months ended September 30, 2011, due to the runoff of Parent Company loans. During the nine months ended September 30, 2012, yield on


54

average interest-earning assets increased to 8.49% from 6.56% for the nine months ended September 30, 2011. During the nine months ended September 30, 2012, our lending spread to average one-month LIBOR was 8.35% compared to 8.57% for the nine months ended September 30, 2011. Fluctuations in loan yields are driven by various factors, such as prime rates or one-month LIBOR which impact lending rates, the coupon on loans that pay down or pay off, non-accrual loans, and modifications of interest rates on existing loans.

Interest Expense

Three months ended September 30, 2012 and 2011

Interest expense decreased to $4.0 million for the three months ended September 30, 2012 from $18.5 million for the three months ended September 30, 2011, primarily due to a decrease in average interest-bearing liabilities from $1.3 billion as of September 30, 2011 to $0.6 billion as of September 30, 2012. The decrease in interest-bearing liabilities was primarily attributed to a 51.8% decrease from the reduction of the outstanding balances on our credit facilities and other term debt. Our cost of borrowings decreased to 2.56% for the three months ended September 30, 2012 from 5.70% for the three months ended September 30, 2011, as a result of the reduction and termination of certain of our credit facilities and decreases in our remaining securitization balances, all of which generally had higher borrowing costs than the remainder of our borrowings.

Nine months ended September 30, 2012 and 2011

Interest expense decreased to $13.6 million for the nine months ended September 30, 2012 from $80.2 million for the nine months ended September 30, 2011, primarily due to a decrease in average interest-bearing liabilities of $1.6 billion as of September 30, 2011 to $0.7 billion as of September 30, 2012. The decrease in interest-bearing liabilities was primarily attributed to a 58.2% decrease from the reduction of the outstanding balances on our credit facilities and other term debt. Our cost of borrowings decreased to 2.63% for the nine months ended September 30, 2012 from 6.51% for the nine months ended September 30, 2011, as a result of the reduction and termination of certain of our credit facilities and decreases in our remaining securitization balances, all of which generally had higher borrowing costs than the remainder of our borrowings.

Net Interest Margin

Three months ended September 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the three months ended September 30, 2012 and 2011 were as follows:


	Three Months Ended September 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Loans⁽¹⁾	$	763,361	$	15,171		7.91	%	$	1,256,049	$	27,165		5.60	%
Investment securities		21,140		1,661		31.26			25,142		1,136		17.98
Cash and other interest-earning assets		93,222		67		0.29			722,463		352		0.19
Total interest-earning assets		877,723	$	16,899		7.66			2,003,654		28,653		5.67
Borrowings⁽²⁾		621,371		3,992		2.56			1,288,808		18,506		5.70
Total interest-bearing liabilities		621,371		3,992		2.56			1,288,808		18,506		5.70
Net interest spread			$	12,907		5.11	%			$	10,147		-0.03	%
Net interest margin						5.85	%						2.01	%

⁽¹⁾	Loans balances are net of deferred loan fees and discounts.

⁽²⁾	Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.


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Nine months ended September 30, 2012 and 2011

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


	Nine Months Ended September 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Loans⁽¹⁾	$	881,071	$	58,357		8.85	%	$	1,717,146	$	110,011		8.56	%
Investment securities		27,836		4,112		19.73			20,366		5,854		38.40
Cash and other interest-earning assets		75,931		110		0.19			647,702		1,103		0.23
Total interest-earning assets		984,838		62,579		8.49			2,385,213		116,968		6.56
Borrowings⁽²⁾		688,807		13,560		2.63			1,647,602		80,243		6.51
Total interest-bearing liabilities		688,807		13,560		2.63			1,647,602		80,243		6.51
Net interest spread			$	49,019		5.86	%			$	36,725		0.05	%
Net interest margin						6.65	%						2.06	%

⁽¹⁾	Loans balances are net of deferred loan fees and discounts.

⁽²⁾	Borrowings include term debt and other borrowings, such as subordinated debt, convertible debt and FHLB borrowings.

Provision for Loan and Lease Losses

Our provision for loan and lease losses is based on our evaluation of the adequacy of the existing allowance for loan and lease 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 and Lease Losses section.

Non-Interest Income

Comparison of three and nine months ended September 30, 2012 vs. 2011

We summarize the various components of non-interest income for the segment three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 as follows:


	Three Months Ended												Nine Months Ended
	9/30/2012			9/30/2011			$ Change			% Change			9/30/2012		9/30/2011			$ Change			% Change
	($ in thousands)												($ in thousands)
Loan fees	$	705		$	1,617		$	(912	)		-56.4	%	$	2,334	$	6,062		$	(3,728	)		-61.5	%
Leased equipment income		—			—			—			—			—		—			—			—
Gain on investments, net		1,856			17,517			(15,661	)		-89.4			930		48,536			(47,606	)		-98.1
(Loss) gain on derivatives		(2	)		(3,130	)		3,128			-99.9			339		(4,608	)		4,947			-107.4
Bank fees		—			—			—			—			—		—			—			—
(Loss) gain on sale of assets		(386	)		5,138			(5,524	)		-107.5			1,676		8,760			(7,084	)		-80.9
Intercompany loan servicing revenue		6			—			6			—			92		—			92			—
Other		(740	)		13,873			(14,613	)		-105.3			1,153		41,423			(40,270	)		-97.2
Total	$	1,439		$	35,015		$	(33,576	)		-95.9	%	$	6,524	$	100,173		$	(93,649	)		-93.5	%

Gains on investments, net decreased $15.7 million, or 89.4%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to a $10.8 million decrease in realized gain on investment securities accounted for under the


56

equity method, a $2.7 million decrease in realized gain on investments carried at cost, and a $2.5 million decrease in dividend income. Gains on investments, net decreased $47.6 million, or 98.1%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to a $10.2 million decrease in realized gain on investment securities accounted for under the equity method, a $21.4 million decrease in realized gain on investments carried at cost, a $12.3 million decrease in realized gain on available-for-sale securities, and a $3.7 million decrease in dividend income.

Loss on derivatives decreased $3.1 million, 99.9%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to a $1.5 million decrease in unrealized loss on derivatives and a $1.9 million decrease in interest expense. Loss on derivatives decreased $4.9 million, or 107.4%, from a loss of $4.6 million for the nine months ended September 30, 2011 to a gain of $0.3 million for the nine months ended September 30, 2012. This decrease is primarily due to a $2.5 million realized gain on derivatives for the nine months ended September 30, 2012 compared to a $0.9 million gain for the nine months ended September 30, 2011, and a $3.3 million decrease in interest expense.

Gain on sale of assets decreased $5.5 million, or 107.5%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to a $5.6 million decrease of gain on loan sales and related lower of cost or market adjustments. Gain on sale of assets decreased $7.1 million, or 80.9%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to a $6.2 million decrease of gain on loan sales and related lower of cost or market adjustments, and a $0.9 million increase in losses from other company asset sale.

All other non-interest income decreased $14.6 million, or 105.3%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to a decrease of $12.2 million in intercompany revenue from CapitalSource Bank, and a $1.5 million decrease of equity in earnings from subsidiaries. All other non-interest income decreased $40.3 million, or 97.2%, from the nine months ended September 30, 2011 to the nine months ended September 30, 2012 primarily due to a decrease of $35.9 million in intercompany revenue from CapitalSource Bank, and a $3.6 million decrease of equity in earnings from subsidiaries.

Non-Interest expense

Comparison of three and nine months ended September 30, 2012 vs. 2011

We summarize the various components of non-interest expense for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011 as follows:


	Three Months Ended											Nine Months Ended
	9/30/2012			9/30/2011		$ Change			% Change			9/30/2012			9/30/2011		$ Change			% Change
	($ in thousands)											($ in thousands)
Compensation and benefits		269		$	19,197	$	(18,928	)		-98.6	%	$	2,529			56,458	$	(53,929	)		-95.5	%
Professional fees		1,065			2,597		(1,532	)		-59.0			4,543			11,879		(7,336	)		-61.8
Occupancy expenses		1,046			2,035		(989	)		-48.6			6,172			6,844		(672	)		-9.8
General depreciation and amortization		500			764		(264	)		-34.6			1,984			2,411		(427	)		-17.7
Other administrative expenses		7,922			8,608		(686	)		-8.0			28,749			34,168		(5,419	)		-15.9
Total operating expenses		10,802			33,201		(22,399	)		-67.5			43,977			111,760		(67,783	)		-60.7
Expense of real estate owned and other foreclosed assets, net		2,292			11,425		(9,133	)		-79.9			5,245			23,899		(18,654	)		-78.1
(Gain) loss on extinguishment of debt		—			113,679		(113,679	)		-100.0			(8,059	)		113,679		(121,738	)		-107.1
Other non-interest expense, net		(57	)		—		(57	)		-100.0			(937	)		22		(959	)		-4,359.1
Total	$	13,037		$	158,305	$	(145,268	)		-91.8	%	$	40,226		$	249,360	$	(209,134	)		-83.9	%

Compensation and benefits decreased $18.9 million, or 98.6%, from the three months ended September 30, 2011 to the three months ended September 30, 2012 primarily due to the transfer of Parent Company employees to CapitalSource Bank on January 1, 2012. Compensation and benefits also decreased $53.9 million, or 95.5%, from nine months ended September 30, 2011 to the nine months ended September 30, 2012 due to the reason mentioned above.


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Loss on extinguishment of debt of $113.7 million for the nine months ended September 30, 2011 changed to a gain of $8.1 million for the nine months ended September 30, 2012, primarily due to the repurchase of 12.75% 2014 Senior Secured Notes during the three months ended September 30, 2011 that resulted in a $111.1 pre-tax loss, and the repurchase of TP Trusts Subordinated Debt in March 2012 which resulted in a $8.2 million gain and $0.1 million loss on convertible debt.

Financial Condition

CapitalSource Bank Segment

As of September 30, 2012 and December 31, 2011, the CapitalSource Bank segment included:


	September 30, 2012			December 31, 2011
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	508,862		$	317,455
Investment securities, available-for-sale		1,069,923			1,159,119
Investment securities, held-to-maturity		108,066			111,706
Loans held for sale		44,952			129,946
Loans held for investment, net⁽²⁾		5,214,572			4,734,470
Allowance for loan and lease losses		(98,435	)		(94,650	)
Interest receivable		23,968			28,960
Other investments⁽³⁾		23,018			23,774
Goodwill		173,135			173,135
Deferred tax assets, net⁽⁴⁾		2,019			12,586
FHLB SF stock		28,200			27,792
Other assets		183,918			168,244
Total	$	7,282,198		$	6,792,537
Liabilities:
Deposits	$	5,535,482		$	5,124,995
FHLB SF borrowings		600,000			550,000
Other liabilities		69,211			51,548
Total	$	6,204,693		$	5,726,543

⁽¹⁾	As of September 30, 2012 and December 31, 2011, the amounts include restricted cash of $49.5 million and $0.8 million, respectively.

⁽²⁾	Includes deferred loan fees and discounts.

⁽³⁾	Includes investments carried at cost, investments carried at fair value and investments accounted for under the equity method.

⁽⁴⁾	Includes short-term and long-term deferred income tax assets, net of related valuation allowance.

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 3, Cash and Cash Equivalents and Restricted Cash, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2012.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consists of Agency callable notes, Agency debt, Agency MBS, Non-agency MBS and U.S. Treasury and agency securities. CapitalSource Bank pledges a portion of its investment securities, available-for-sale, to the FHLB SF, the FRB and various state and local agencies as a source of borrowing capacity as of September 30, 2012. For additional information, see Note 5, Investments, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2012.


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Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity, consists of commercial mortgage-backed securities rated BBB or higher. CapitalSource Bank pledges a portion of its investment securities, held-to-maturity, to the FHLB SF and the FRB as a source of borrowing capacity. For additional information on our investment securities, held-to-maturity, see Note 5, Investments, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2012.

Loan Portfolio Composition

The CapitalSource Bank loan balances reflected in the portfolio statistics below exclude loans held for sale of $45.0 million and $129.9 million as of September 30, 2012 and December 31, 2011, respectively.

As of September 30, 2012 and December 31, 2011, the composition of the CapitalSource Bank loan portfolio by loan type was as follows:


	September 30, 2012				December 31, 2011
	($ in thousands except percentages)
Commercial	$	2,898,718	55	%	$	2,640,777	56	%
Real estate		2,280,493	44			2,082,130	43
Real estate — construction		35,361	1			11,563	1
Total⁽¹⁾	$	5,214,572	100	%	$	4,734,470	100	%

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

As of September 30, 2012, 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	$	222,073		2,463,299	$	258,971	$	2,944,343
Real estate		51,194		1,292,261		982,202		2,325,657
Real estate — construction		10,838		2,612		22,045		35,495
Total loans⁽¹⁾	$	284,105	$	3,758,172	$	1,263,218	$	5,305,495

⁽¹⁾	Includes loans held for sale carried at lower of cost or fair value. Excludes deferred loan fees and discounts.

As of September 30, 2012, approximately 82% of the CapitalSource Bank accruing adjustable rate portfolio was subject to an interest rate floor. Due to low market interest rates as of September 30, 2012, 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 1.06% as of September 30, 2012. 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.


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As of September 30, 2012, 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	$	1,083,232	$	928,825	$	12,651	$	2,024,708		38	%
2-Month LIBOR		49,019		695		—		49,714		1
3-Month LIBOR		645,313		90,359		—		735,672		14
6-Month LIBOR		139,520		70,531		—		210,051		4
6-Month EURIBOR		—		4,110		—		4,110		—
Prime		371,196		168,351		20,508		560,055		10
Other		25,578		58,318		—		83,896		2
Total adjustable rate loans		2,313,858		1,321,189		33,159		3,668,206		69
Fixed rate loans		578,013		992,692		2,337		1,573,042		30
Loans on non-accrual status		52,473		11,774		—		64,247		1
Total loans⁽¹⁾	$	2,944,344	$	2,325,655	$	35,496	$	5,305,495		100	%

⁽¹⁾	Includes loans held for sale carried at lower of cost or fair value. Excludes deferred loan fees and discounts.

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, 2012.

Deposits

As of September 30, 2012 and December 31, 2011, a summary of CapitalSource Bank’s deposits by product type and the maturities of the certificates of deposit were as follows:


	September 30, 2012					December 31, 2011
	Balance		Weighted Average Rate			Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	270,929		0.49	%	$	260,032		0.73	%
Savings		761,416		0.52			836,521		0.76
Certificates of deposit		4,503,137		1.00			4,028,442		1.14
Total interest-bearing deposits	$	5,535,482		0.91	%	$	5,124,995		1.06	%


	September 30, 2012
	Balance		Weighted Average Rate
	($ in thousands)
Remaining maturity of certificates of deposit:
0 to 3 months	$	1,813,724		0.97	%
4 to 6 months		759,043		0.80
7 to 9 months		340,162		0.97
10 to 12 months		721,839		1.02
Greater than 12 months		868,369		1.25
Total certificates of deposit	$	4,503,137		1.00	%


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FHLB SF Borrowings

FHLB SF borrowings increased to $600.0 million as of September 30, 2012 from $550.0 million as of December 31, 2011. 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 3.4 years and 3.7 years as of September 30, 2012 and December 31, 2011, respectively.

As of September 30, 2012, the remaining maturity and the weighted average interest rate of FHLB SF borrowings were as follows:


	Balance		Weighted Average Rate
	($ in thousands)
Less than 1 year	$	33,000		1.61	%
After 1 year through 2 years		85,000		1.57
After 2 years through 3 years		87,500		1.90
After 3 years through 4 years		199,000		2.08
After 4 years through 5 years		128,000		1.31
After 5 years		67,500		2.21
Total	$	600,000		1.81	%

Other Commercial Finance Segment

As of September 30, 2012 and December 31, 2011, the Other Commercial Finance segment included:


	September 30, 2012			December 31, 2011
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	178,045		$	206,577
Investment securities, available-for-sale		24,147			28,883
Loans held for sale		39,931			63,205
Loans held for investment, net⁽²⁾		680,153			955,677
Allowance for loan and lease losses		(28,195	)		(58,981	)
Interest receivable		7,926			9,836
Other investments⁽³⁾		43,773			57,472
Deferred tax asset, net⁽⁴⁾		368,559			32,858
Other assets		82,282			225,964
Total	$	1,396,621		$	1,521,491
Liabilities:
Borrowings	$	613,187		$	774,493
Other liabilities		120,580			240,534
Total	$	733,767		$	1,015,027

⁽¹⁾	As of September 30, 2012 and December 31, 2011, the amounts include restricted cash of $21.9 million and $64.6 million, respectively.

⁽²⁾	Includes deferred loan fees and discounts.

⁽³⁾	Includes investments carried at cost, investments carried at fair value and investments accounted for under the equity method.

⁽⁴⁾	Includes short-term and long-term deferred income tax assets, net of related valuation allowance.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale consists of our interests in the 2006-A Trust of $24.1 million.


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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

As of September 30, 2012 and December 31, 2011, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:


	September 30, 2012				December 31, 2011
	($ in thousands except percentages)
Commercial	$	613,954	90	%	$	850,482	89	%
Real estate		54,170	8			51,080	5
Real estate — construction		11,516	2			54,115	6
Total⁽¹⁾	$	679,640	100	%	$	955,677	100	%

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

As of September 30, 2012, 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	$	202,906	$	457,554	$	—	$	660,460
Real estate		20,044		35,028		129		55,201
Real estate — construction		11,845		—		—		11,845
Total⁽¹⁾	$	234,795	$	492,582	$	129	$	727,506

⁽¹⁾	Includes loans held for sale carried at lower of cost or fair value. Excludes deferred loan fees and discounts.

As of September 30, 2012, approximately 94% of the Other Commercial Finance accruing adjustable rate loan portfolio was subject to an interest rate floor. Due to low market interest rates as of September 30, 2012, 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 1.58% as of September 30, 2012. 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, 2012, 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	$	226,425	$	—	$	—	$	226,425		31	%
3-Month LIBOR		131,543		—		—		131,543		18
Prime		233,784		—		—		233,784		32
Total adjustable rate loans		591,752		—		—		591,752		81
Fixed rate loans		1,938		35,098		—		37,036		5
Loans on non-accrual status		66,770		20,103		11,845		98,718		14
Total loans⁽¹⁾	$	660,460	$	55,201	$	11,845	$	727,506		100	%

⁽¹⁾	Includes loans held for sale carried at lower of cost or fair value. Excludes deferred loan fees and discounts.


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Credit Quality and Allowance for Loan and Lease Losses

Consolidated

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 within this section.

Real estate — construction loans

As real estate construction loans are typically considered to be a higher-risk loan type concentration, we are providing additional disclosure of the policies and procedures related to our real estate construction loan portfolio.

The objective of our servicing procedures for real estate construction loans is to maintain the proper relationship between the loan amount funded and the value of the collateral securing the loan. The primary 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, where applicable, the leasing or unit sales activity compared to market leasing or market unit sales and compared to the underwritten leasing or unit sales actively.

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.

Most of our $47.3 million of real estate construction loans as of September 30, 2012 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. Our risk assessment policies and procedures require that the assignment of a risk rating consider whether the capitalization of interest may be masking other performance related issues. We consider the status of the construction project securing our loan, including its leasing or sales activity (where applicable), relative to our expectations for the status of the project during our initial underwriting. 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.

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 (like the project’s progress compared to underwriting and the market in which the project is located) 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.

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.


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The following table presents the balance of non-performing real estate — construction loans and the cumulative capitalized interest on our real estate — construction loan portfolio as of the date of the balance sheet:


	September 30, 2012⁽¹⁾			December 31, 2011
	($ in thousands except percentages)
Total real estate — construction loans⁽²⁾	$	47,341		$	66,285
Non-performing		11,845			54,960
% of total real estate — construction		25	%		82.9	%
Cumulative capitalized interest	$	10,781		$	11,565

⁽¹⁾

As of September 30, 2012, 2 of the 22 loans that comprise our real estate construction portfolio have been extended, renewed or restructured since origination. These modifications have occurred for various reasons including, but not limited to, changes in business plans and/or work-out efforts that were best achieved via a restructuring.

⁽²⁾	We recognized interest income on the real estate construction loan portfolio of $0.6 million and $1.4 million for the three and nine months ended September 30, 2012, and $0.7 million and $3.4 million for the three and nine months ended September 30, 2011, respectively.

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in our consolidated loan portfolio as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	116,880	$	144,651
Real estate		30,391		101,453
Real estate — construction		11,516		24,087
Total loans on non-accrual	$	158,787	$	270,191
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		5,603
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	5,603
Total non-performing loans
Commercial	$	116,880	$	144,651
Real estate		30,391		107,056
Real estate — construction		11,516		24,087
Total non-performing loans⁽¹⁾	$	158,787	$	275,794

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

The decrease in the non-performing loan balance from December 31, 2011 to September 30, 2012 is primarily due to payoffs, charge offs, sales and foreclosures on those loans.

Additionally, certain loans within our portfolio have been identified as potential problem loans. Potential problem loans are loans that are not considered non-performing loans, as disclosed in the table above, or loans that have been restructured in a TDR, 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 borrower to comply with the loan repayment terms. Such credit problems could eventually result in the loans being reclassified as non-performing loans. As of September 30, 2012 and December 31, 2011, we had $1.1 million and $4.8 million, respectively, in potential problem loans related to 4 and 11 loans, respectively, 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.


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Delinquent loans

The following table presents the balance of the non-accrual and accruing loans that are delinquent as of the date of the balance sheet:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	30,006	$	4,317
90+ days delinquent		45,547		90,193
Total delinquent non-accrual loans	$	75,553	$	94,510
Accruing loans
30-89 days delinquent	$	228	$	8,396
90+ days delinquent		—		5,603
Total delinquent accruing loans	$	228	$	13,999

Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the three and nine months ended September 30, 2012 and 2011 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	133,359		$	199,138		$	153,631		$	329,122
Charge offs:
Commercial		(20,043	)		(15,715	)		(48,984	)		(132,612	)
Real estate		(2,548	)		(8,485	)		(10,264	)		(46,245	)
Real estate — construction		(499	)		(3,114	)		(9,784	)		(28,387	)
Total charge offs		(23,090	)		(27,314	)		(69,032	)		(207,244	)
Recoveries:
Commercial		2,818			1,198			7,865			4,656
Real estate		4,772			280			5,046			11,693
Real estate — construction		—			—			—			1,105
Total recoveries		7,590			1,478			12,911			17,454
Net charge offs		(15,500	)		(25,836	)		(56,121	)		(189,790	)
Charge offs upon transfer to held for sale		(188	)		(68	)		(1,447	)		(12,430	)
Provision for loan and lease losses:
General		(5,742	)		(2,356	)		(20,366	)		(71,231	)
Specific		14,701			37,474			50,933			152,681
Total provision for loan and lease losses		8,959			35,118			30,567			81,450
Balance as of end of period	$	126,630		$	208,352		$	126,630		$	208,352
Allowance for loan and lease losses ratio		2.15	%		3.58	%		2.15	%		3.58	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		0.60	%		2.39	%		0.68	%		1.87	%
Net charge offs as a percentage of average loans outstanding (annualized)		1.04	%		1.86	%		1.28	%		4.67	%


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Our allowance for loan and lease losses decreased by $27.0 million to $126.6 million as of September 30, 2012 from $153.6 million as of December 31, 2011. This decrease was attributable to a $20.4 million decrease in general reserves and a $6.6 million decrease in specific reserves on impaired loans as further described below.

The decrease in the general reserves was driven by the sale and repayment of loans with higher historical loss factors stemming from those loans having unfavorable credit ratings. This decrease was partially offset by additions to the general reserve from new loan originations that were comprised of loan types with lower historical loss factors and certain qualitative increases to the general reserves related to the slow economic recovery, global economic conditions and changing loan portfolio concentrations. The lower effective reserve percentage was attributable to the loan composition of the portfolio as of September 30, 2012 having more favorable credit loss characteristics based on historical experience than the loan portfolio as of December 31, 2011.

Impaired loans

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. 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. Each quarter, we determine each impaired loan’s fair value. The fair value is either i) the present value of payments expected to be received discounted at the loan’s effective interest rate, ii) the fair value of the collateral for collateral dependent loans, or iii), the impaired loan’s observable market price. Each impaired loan’s fair value is compared to the recorded investment in the impaired loan. If a shortfall exists, a specific reserve is established. The specific reserves in place at each period end are directly related to the population of impaired loans in place at each period end.

As of September 30, 2012 and December 31, 2011, our non-impaired and impaired loan balances was as follows:


	September 30, 2012			December 31, 2011
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	5,676,913		$	5,333,669
General reserves allocated		106,817			127,183
Effective reserve %		1.9	%		2.4	%
Impaired loans
Unpaid principal balance	$	271,206		$	425,321
Specific reserves allocated⁽¹⁾		19,813			26,448
Original legal balance previously charge off⁽²⁾		171,077			191,278
Total cumulative charge offs and specific reserves		190,890			217,726
Legal balance		490,859			654,642
Expected total loss of the legal balance (%)		38.9	%		33.3	%

⁽¹⁾

The decrease in specific reserves from December 31, 2011 to September 30, 2012 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $7.1 million, ii) reversals of specific reserves for loans impaired as of December 31, 2011 net of related reversals or charge offs of $14.1 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the nine months ended September 30, 2012 of $14.6 million. The specific reserves in place at September 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

⁽²⁾	The original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans.


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CapitalSource Bank Segment

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in the CapitalSource Bank loan portfolio as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	52,128	$	46,777
Real estate		12,129		69,509
Real estate — construction		—		—
Total loans on non-accrual	$	64,257	$	116,286
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		—
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	—
Total non-performing loans
Commercial	$	52,128	$	46,777
Real estate		12,129		69,509
Real estate — construction		—		—
Total non-performing loans⁽¹⁾	$	64,257	$	116,286

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

Certain loans within our portfolio have been identified as potential problem loans. Potential problem loans are loans that are not considered non-performing loans, as disclosed in the table above, or loans that have been restructured in a TDR, 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 borrower to comply with the loan repayment terms. Such credit problems could eventually result in the loans being reclassified as non-performing loans. We had four potential problem loans with an unpaid principal balance of $1.1 million as of September 30, 2012, and eleven potential problem loans with an unpaid principal balance of $4.8 million as of December 31, 2011.

Delinquent loans

The following table presents the balance of the non-accrual and accruing loans that are delinquent as of the date of the balance sheet:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	29,948	$	1,910
90+ days delinquent		7,462		17,645
Total delinquent non-accrual loans	$	37,410	$	19,555
Accruing loans
30-89 days delinquent	$	228	$	7,974
90+ days delinquent		—		—
Total delinquent accruing loans	$	228	$	7,974


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Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the three and nine months ended September 30, 2012 and 2011 was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	101,784		$	108,592		$	94,650		$	124,878
Charge offs:
Commercial		(7,687	)		—			(9,786	)		(1,177	)
Real estate		(874	)		(3,965	)		(7,091	)		(29,885	)
Real estate — construction		—			—			—			(11,530	)
Total charge offs		(8,561	)		(3,965	)		(16,877	)		(42,592	)
Recoveries:
Commercial		188			75			955			160
Real estate		4,751			257			4,962			11,626
Real estate — construction		—			—			—			1,019
Total recoveries		4,939			332			5,917			12,805
Net charge offs		(3,622	)		(3,633	)		(10,960	)		(29,787	)
Charge offs upon transfer to held for sale		—			—			—			(43	)
Provision for loan losses:
General		2,242			1,605			5,567			(14,081	)
Specific		(1,969	)		12,120			9,178			37,717
Total provision for loan losses		273			13,725			14,745			23,636
Balance as of end of period	$	98,435		$	118,684		$	98,435		$	118,684
Allowance for loan and lease losses ratio		1.89	%		2.62	%		1.89	%		2.62	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		0.02	%		1.20	%		0.39	%		0.70	%
Net charge offs as a percentage of average loans outstanding (annualized)		0.28	%		0.34	%		0.29	%		0.99	%

Our allowance for loan and lease losses increased by $3.7 million to $98.4 million as of September 30, 2012 from $94.7 million as of December 31, 2011. This increase was attributable to a $5.5 million increase in general reserves and a $1.8 million decrease in specific reserves.

The increases in the general reserves was driven by additions to the general reserve from new loan originations and certain qualitative increases to the general reserves related to the slow economic recovery, global economic conditions and changing loan portfolio concentrations that were only partially offset by loans paying off or paying down. The reduction in the effective reserve percentage was attributable to the loan composition of the portfolio as of September 30, 2012 having more favorable credit loss characteristics based on historical experience than the loan portfolio as of December 31, 2011.

Impaired loans

We employ a formal quarterly process to both identify impaired loans and record specific reserves in accordance with the Company policy. For additional information, see Credit Quality and Allowance for Loan and Lease Losses — Consolidated within this section.


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As of September 30, 2012 and December 31, 2011, our non-impaired and impaired loan balances was as follows:


	September 30, 2012			December 31, 2011
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	5,174,914		$	4,787,389
General reserves allocated		90,156			84,588
Effective reserve %		1.7	%		1.8	%
Impaired loans
Unpaid principal balance	$	85,629		$	124,138
Specific reserves allocated⁽¹⁾		8,279			10,063
Original legal balance previously charge off⁽²⁾		34,802			46,959
Total cumulative charge offs and specific reserves		43,081			57,022
Legal balance		128,384			179,100
Expected total loss of the legal balance (%)		33.6	%		31.8	%

⁽¹⁾

The decrease in specific reserves from December 31, 2011 to September 30, 2012 stems from the net effect of i) reversals of specific reserves for loans impaired as of December 31, 2011 net of related reversals or charge offs of $7.2 million, and ii) new specific reserves net of related charge offs for loans new to impairment status during the nine months ended September 30, 2012 of $5.4 million. The specific reserves in place at September 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

⁽²⁾	The original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans.

We believe the origination strategy and underwriting practices in place support a loan portfolio with normal, acceptable degrees of credit risk. We acknowledge, however, that some of our lending products have greater credit risk than others. The categories with more credit risk than others are those that have comprised a greater degree of our historical charge offs. For the years ended December 31, 2011 and 2010 commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception comprised 71% and 93%, respectively, of those years’ charge offs. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. As of September 30, 2012 and December 31, 2011, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception totaled $59.3 million and $202.6 million, respectively, or 1.1% and 4.1% of total loans, respectively.

Troubled Debt Restructurings

During the three and nine months ended September 30, 2012, loans with an aggregate carrying value of $70.4 million and $135.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. 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. 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. There were $6.2 million and $1.6 million of specific reserves allocated to loans that were involved in TDRs as of September 30, 2012 and December 31, 2011, respectively.

During 2010, CapitalSource Bank restructured, in TDRs, three commercial real estate loans into new loans using an “A note / B note” structure in which the B note component was 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 $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 $9.6 million B note. As of December 31, 2011, the aggregate carrying value of the remaining two A notes was $35.7 million and the remaining two B notes had no aggregate carrying value. In January 2012, one of the remaining two A/B note arrangements with an aggregate carrying value of $12.0 million as of December 31, 2011 was repaid in full. The $2.3 million B note of this arrangement was forgiven as part of the TDR restructure. In September 2012, the last remaining A/B note arrangement with an aggregate carrying value of $22.8 million as of June 30, 2012 was repaid in a discounted payoff that resulted on a recovery of $4.7 million.

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


69

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.

In January 2012, Capital Source Bank restructured, as a TDR, a commercial real estate loan into new loans using an A note / B note / C note structure similar to the A note / B note structure described above. The contractual principal balance of the loan prior to the restructure totaled $61.0 million, of which $11.2 million was previously charged off during the year ended December 31, 2011. The January 2012 restructure resulted in a $47.4 million A note, a $2.4 million B note and a $11.2 million C note, in which the C note represents the amount of the loan previously charged off. During January 2012, the B note was repaid in full. As of September 30, 2012, the carrying value of the A note was $5.1 million and the C note had no carrying value.

Other Commercial Finance Segment

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in Other Commercial Finance loan portfolio as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	64,752	$	97,874
Real estate		18,262		31,944
Real estate — construction		11,516		24,087
Total loans on non-accrual	$	94,530	$	153,905
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		5,603
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	5,603
Total non-performing loans
Commercial	$	64,752	$	97,874
Real estate		18,262		37,547
Real estate — construction		11,516		24,087
Total non-performing loans⁽¹⁾	$	94,530	$	159,508

⁽¹⁾	Includes deferred loan fees and discounts. Excludes loans held for sale carried at lower of cost or fair value.

Certain loans within our portfolio have been identified as potential problem loans. Potential problem loans are loans that are not considered non-performing loans, as disclosed in the table above, or loans that have been restructured in a TDR, 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 borrower to comply with the loan repayment terms. Such credit problems could eventually result in the loans being reclassified as non-performing loans. We had no potential problem loans as of September 30, 2012 and December 31, 2011.


70

Delinquent loans

The following table presents the balance of the non-accrual and accruing loans that are delinquent as of the date of the balance sheet:


	September 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	58	$	2,407
90+ days delinquent		38,035		72,548
Total delinquent non-accrual loans	$	38,093	$	74,955
Accruing loans
30-89 days delinquent	$	—	$	422
90+ days delinquent		—		5,603
Total delinquent accruing loans	$	—	$	6,025

Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the three and nine months ended September 30, 2012 and 2011 was as follows


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	31,575		$	90,546		$	58,981		$	204,244
Charge offs:
Commercial		(12,356	)		(15,715	)		(39,198	)		(131,435	)
Real estate		(1,674	)		(4,520	)		(3,173	)		(16,360	)
Real estate — construction		(499	)		(3,114	)		(9,784	)		(16,857	)
Total charge offs		(14,529	)		(23,349	)		(52,155	)		(164,652	)
Recoveries:
Commercial		2,630			1,123			6,911			4,496
Real estate		21			23			83			67
Real estate — construction		—			—			—			86
Total recoveries		2,651			1,146			6,994			4,649
Net charge offs		(11,878	)		(22,203	)		(45,161	)		(160,003	)
Charge offs upon transfer to held for sale		(188	)		(68	)		(1,447	)		(12,387	)
Provision for loan and lease losses:
General		(7,984	)		(3,961	)		(25,934	)		(57,150	)
Specific		16,670			25,354			41,756			114,964
Total provision for loan and lease losses		8,686			21,393			15,822			57,814
Balance as of end of period	$	28,195		$	89,668		$	28,195		$	89,668
Allowance for loan and lease losses ratio		4.15	%		6.97	%		4.15	%		6.97	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		4.53	%		6.59	%		2.36	%		6.00	%
Net charge offs as a percentage of average loans outstanding (annualized)		6.29	%		6.90	%		6.96	%		13.18	%


71

Our allowance for loan and lease losses decreased by $30.8 million to $28.2 million as of September 30, 2012 from $59.0 million as of December 31, 2011. This decrease was attributable to a $25.9 million decrease in general reserves and a $4.9 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.

Impaired loans

As of September 30, 2012 and September 30, 2011, our non-impaired and impaired loan balances was as follows:


	September 30, 2012			December 31, 2011
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	501,998		$	670,417
General reserves allocated		16,661			42,596
Effective reserve %		3.3	%		6.4	%
Impaired loans
Unpaid principal balance	$	185,578		$	301,183
Specific reserves allocated⁽¹⁾		11,534			16,385
Original legal balance previously charge off⁽²⁾		136,276			144,319
Total cumulative charge offs and specific reserves		147,810			160,704
Legal balance		362,514			475,500
Expected total loss of the legal balance (%)		40.8	%		33.8	%

⁽¹⁾

The decrease in specific reserves from December 31, 2011 to September 30, 2012 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $7.1 million, ii) new specific reserves net of related charge offs for loans new to impairment status during the nine months ended September 30, 2012 of $9.2 million and iii) reversals of reserves of $7.0 million on existing impaired. The specific reserves in place at September 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

⁽²⁾	The original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans.

In the Other Commercial Finance portfolio, the areas with more credit risk than others are those that have comprised a greater degree of our historical charge offs. For the years ended December 31, 2011 and 2010, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception comprised 22% and 48%, respectively, of those years’ charge offs. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. As of September 30, 2012 and December 31, 2011, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception totaled $50.5 million and $101.1 million, respectively, or 7.0% and 9.8% of total loans, respectively. Additionally, cash flow based commercial loans originated prior to the Bank’s July 2008 inception are considered to be higher risk based on historical charge offs. For the years ended December 31, 2011 and 2010, cash flow based commercial loans originated prior to the Bank’s July 2008 inception comprised 55% and 40%, respectively, of those years’ charge offs. As of September 30, 2012 and December 31, 2011, cash flow based commercial loans originated prior to the Bank’s July 2008 inception totaled $434.1 million and $588.7 million, respectively, or 59.7% and 56.9% of total loans, respectively.

Troubled Debt Restructurings

During the three and nine months ended September 30, 2012, loans with an aggregate carrying value of $2.4 million and $29.2 million, respectively, as of their respective restructuring dates, were involved in TDRs. 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. 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 $1.9 million and $5.8 million as of September 30, 2012 and December 31, 2011, respectively.


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Liquidity and Capital Resources

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

As of September 30, 2012, we had $1.2 billion of unfunded commitments to extend credit to our clients, of which $1.0 billion were commitments of CapitalSource Bank and $186.2 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 regarding our future funding obligations, and our borrowers may draw on these unfunded commitments at any time. We forecast adequate liquidity to fund the expected borrower draws under these commitments.

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

CapitalSource Bank’s liquidity sources and uses are as follows:

Liquidity Sources

Deposits;

Payments of principal and interest on loans and securities;

Cash equivalents;

Borrowings from the FHLB SF⁽¹⁾;

State and Local Agency Deposits⁽¹⁾;

Brokered Certificates of Deposits⁽¹⁾;

Capital contributions⁽¹⁾;

Borrowings from the Parent Company⁽¹⁾;

Borrowings from banks or the FRB⁽¹⁾;

Loan sales⁽¹⁾; and

Issuance of debt securities.⁽¹⁾

Liquidity Uses

Funding new and existing loans;

Purchasing investment securities;

Funding net deposit outflows;

Operating expenses;

Income taxes⁽²⁾; and

Dividends.

⁽¹⁾	Represents secondary sources of funding.

⁽²⁾	Paying income taxes is pursuant to our intercompany tax allocation arrangement.

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 operates in accordance with the remaining 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% and capital levels required for a bank to be “well-capitalized” under relevant banking regulations. CapitalSource Bank has a policy to maintain 7.5% of CapitalSource Bank’s assets in unencumbered cash, cash equivalents and investment securities, available-for-sale. In accordance with regulatory guidance, we have identified, modeled and planned for the liquidity impact of various hypothetical events and scenarios that would cause a large outflow of deposits, a reduction in borrowing capacity, and a material increase in loan funding obligations. We anticipate that CapitalSource Bank would be able to maintain sufficient liquidity and ratios in excess of its required minimums in these events and scenarios. CapitalSource Bank has a contingency funding plan which contains the steps the Company would take to mitigate a liquidity crisis.

CapitalSource Bank’s primary source of liquidity is deposits, most of which are in the form of certificates of deposit. As of September 30, 2012, deposits at CapitalSource Bank were $5.5 billion. We utilize various product, pricing and promotional strategies in our deposit business, so that we are able to obtain and maintain sufficient deposits to meet our liquidity needs. For additional information, see Note 9, Deposits, in our audited consolidated financial statements for the year ended December 31, 2011, in our Form 10-K.

CapitalSource Bank supplements its liquidity with borrowings from the FHLB SF. As of September 30, 2012, CapitalSource Bank


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had financing availability with the FHLB SF equal to 35% of CapitalSource Bank’s total assets. The maximum financing available under this formula was $2.6 billion and $2.3 billion as of September 30, 2012 and December 31, 2011, respectively. The financing is subject to various terms and conditions including pledging acceptable collateral, satisfaction of the FHLB SF stock ownership requirement and certain limits regarding the maximum term of debt. As of September 30, 2012, securities collateral with an estimated fair value of $222.7 million and loans with an unpaid principal balance of $738.7 million were pledged to the FHLB SF. Securities and loans pledged to the FHLB SF are subject to an advance rate in determining borrowing capacity.

As of September 30, 2012 and December 31, 2011, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:


	September 30, 2012			December 31, 2011
	($ in thousands)
Borrowing capacity	$	808,163		$	838,531
Less: outstanding principal		(600,000	)		(550,000	)
Less: outstanding letters of credit		(300	)		(600	)
Unused borrowing capacity	$	207,863		$	287,931

CapitalSource Bank participates in the primary credit program of the FRB of San Francisco’s discount window under which approved depository institutions are eligible to borrow from the FRB for periods of up to 90 days. As of September 30, 2012, collateral with an estimated fair value of $88.7 million had been pledged under this program, and there were no borrowings outstanding under this program.

CapitalSource Bank also maintains a portfolio of available-for-sale investment securities. As of September 30, 2012, CapitalSource Bank had $459.4 million of unrestricted cash and cash equivalents and $840.5 million of unrestricted investment securities, available-for-sale. The available-for-sale investment portfolio comprises primarily highly liquid securities that can be sold and converted to cash if additional liquidity needs arise.

Parent Company Liquidity

The Parent Company’s liquidity sources and uses are as follows:

Liquidity Sources

Cash and cash equivalents;

Income tax payments from CapitalSource Bank⁽¹⁾;

Payments of principal and interest on loans and securities;

Asset sales;

Dividends from CapitalSource Bank⁽²⁾;

Bank borrowings⁽³⁾; and

Issuance of debt and equity securities⁽³⁾.

Liquidity Uses

Interest and principal payments on existing debt;

Tax payments;

Operating expenses;

Share repurchases⁽⁴⁾;

Debt repurchases;

Dividends; and

Funding unfunded commitments.


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⁽¹⁾	Pursuant to our intercompany tax allocation arrangement.

⁽²⁾	As permitted by banking regulations and guidelines.

⁽³⁾	Represents secondary sources of funding.

⁽⁴⁾	Pursuant to our Stock Repurchase Program.

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, 2012, there were no amounts outstanding under this facility.

While share buybacks have been the primary means of returning excess capital to shareholders to date, we are also considering additional mechanisms to return excess capital in the near term. In this regard, our Board has been actively considering (i) modifying our dividend policy to pay a regular quarterly dividend more commensurate with our banking industry peers and (ii) possibly paying one or more special dividends, if appropriate in light of buyback and regular dividend levels. Our Board intends to further consider these alternatives in the near term, and it is possible that the board could determine to take further action in 2012. However, our Board has not yet made a decision on these specific actions, and we cannot assure you that any such action(s) will be taken. Any such determinations will be subject to market conditions and other developments, the level of available cash, and other factors.

Any share repurchases 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 this program were retired upon settlement.

Special Purpose Entities

We use special purpose entities (“SPEs”) as part of our funding activities, and we service loans that we have transferred to these entities. The use of these special purpose entities is generally required in connection with our non-recourse secured term debt financings to legally isolate from us loans that we transfer to these entities if we were to enter into a bankruptcy proceeding.

We evaluate all SPEs with which we are affiliated to determine whether such entities must be consolidated for financial statement purposes. If we determine that such entities represent variable interest entities, we consolidate these entities if we also determine that we are the primary beneficiary of the entity. For special purpose entities for which we determine we are not the primary beneficiary, we account for our economic interests in these entities in accordance with the nature of our investments. The assets and related liabilities of all special purpose entities that we use to issue our term debt are recognized in our accompanying audited consolidated balance sheets as of September 30, 2012 and December 31, 2011.

Commitments, Guarantees & Contingencies

As of September 30, 2012 and December 31, 2011, we had unfunded commitments to extend credit to our clients of $1.2 billion and $1.4 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, 2011, included in our Form 10-K, and Liquidity and Capital Resources herein.

We have non-cancelable operating leases for office space and office equipment, which expire over the next twelve years and contain provisions for certain annual rental escalations. For additional information, see Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2011, in our Form 10-K.

We provide standby letters of credit in conjunction with several of our lending arrangements. As of September 30, 2012 and December 31, 2011, we had issued $58.0 million and $79.4 million, respectively, in letters of credit which expire at various dates over the next 5 years. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be responsible to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. We also provide standby letters of credit under certain of our property leases.

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


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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.

During the years ended December 31, 2010 and 2009, we sold all of our remaining 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, 2012, 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.

Credit Risk Management

Credit risk within our loan portfolio is the risk of loss arising from adverse changes in a borrower’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, 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.

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, lease and derivative portfolios and the portion of our investment portfolio comprised of non-agency MBS, non-agency ABS, Collateralized Loan Obligations 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, various committees evaluate and approve credit standards and oversee the credit risk management function related to our loans and other investments. Its 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 and supplemental 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 are broadly categorized as asset-based loans, cash flow loans and real estate loans (commercial real estate and real estate construction 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. Upon the amendment of any loan agreement,


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we also measure a loan’s compliance with our specific risk acceptance criteria. A record of which loans have exceptions to our specific risk acceptance criteria at underwriting is maintained.

We continuously monitor a client’s ability to perform under its obligations. Additionally, we manage the size and risk profile of our loan portfolio by syndicating loan exposure to other lenders and selling loans.

Under our credit risk management process, each loan is assigned an internal risk rating that is based on defined credit review standards. While rating criteria vary by product, each loan rating focuses on: the borrower’s financial performance and financial standing, the borrower’s ability to repay the loan, and the adequacy of the collateral securing the loan. Subsequent to loan origination, risk ratings are monitored and reassessed 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 credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by borrower industries and real estate property types (where applicable).

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, 2012, the largest borrower industry concentrations in our outstanding loan balance were real estate, rental and leasing; health care and social assistance; and information processing which represented approximately 20.9%, 18.9 % and 9.5% of the outstanding loan portfolio, respectively.

Apart from the borrower industry concentrations, loans secured by real estate represented approximately 40% of our outstanding loan portfolio as of September 30, 2012. Within this area, the largest property type concentration was the multifamily category, comprising approximately 31% and the largest geographical concentration was in California, comprising approximately 25% of this loan portfolio.

Selected information pertaining to our largest credit relationships as of September 30, 2012 was as follows:


Loan Balance		% of Total Portfolio			Loan Type	Industry	Amount of Loan(s) at Origination		Loan Commitment		Performing		Specific Reserves		Underlying Collateral⁽¹⁾	Date of Last Collateral Appraisal	Amount of Last Appraisal
($ in thousands)
	$177,070		2.9	%	Commercial	Timeshare	$	173,663	$	209,627		Yes	$	—	Timeshare receivables	N/A		N/A	⁽²⁾

	88,824		1.5		Real Estate	Resort Vacation Club		93,972		96,995		Yes		—	Portfolio of vacation properties	Various ranging from May 2012 to September 2012		461,030	⁽³⁾

	85,199		1.4		Commercial	Security Systems Services		31,496		99,200		Yes		—	Security alarm contracts	N/A		N/A	⁽⁴⁾
	$351,093		5.8	%			$	299,131	$	405,822			$	—

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

⁽²⁾

The collateral that secures our loan balance of $177.1 million as of September 30, 2012 primarily consists of timeshare receivables and timeshare real estate that had a total value of $276.1 million as of September 30, 2012. Total senior debt, including our loan balance, secured by the collateral was $233.0 million as of September 30, 2012. $39.9 million of our loan balance of $177.1 million is classified as held for sale at September 30, 2012.

⁽³⁾	Total senior debt, including our loan balance, was $240.3 million as of September 30, 2012.

⁽⁴⁾	Total senior debt, including our loan balance, was $214.8 million as of September 30, 2012.

Non-performing loans include all loans on non-accrual status and accruing loans which are contractually past due 90 days or more as to principal or interest payments. There were 106 credit relationships in the non-performing portfolio as of September 30, 2012, and our largest non-performing credit relationship totaled $29.6 million and comprised 18.7% of our total non-performing loans.


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Derivative Counterparty Credit Risk

Derivative financial instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where we are in a favorable position. Credit risk related to derivative financial instruments is considered and provided for separately from the allowance for loan and lease losses. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from all counterparties based on terms stipulated in the collateral support annex. We also monitor all exposure and collateral requirements daily on a per counterparty basis. 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. Our agreements generally include master netting agreements whereby the counterparties are entitled to settle their derivative positions “net.” As of December 31, 2011, the gross positive fair value of our derivative financial instruments was $59.1 million. Our master netting agreements reduced the exposure to this gross positive fair value by $40.3 million as of December 31, 2011. We held $18.8 million of collateral against derivative financial instruments as of December 31, 2011. We held no derivative instruments that were in an asset position as of September 30, 2012. For derivatives that were in a liability position, we had posted collateral of $1.5 million as of September 30, 2012.

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, 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 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 refers to the timing and volume differences in the re-pricing of our rate-sensitive assets and liabilities, changes in the general level of market interest rates and changes in the shape and level of various indices, including LIBOR-based indices and the prime rate. We attempt to mitigate exposure to the earnings impact of the interest rate changes by conducting the majority of our loan and deposit activity using interest rate structures that resets on a periodic basis. 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 the deposit portfolio is comprised of certificates of deposits that generally have an initial term between 3 and 18 months. Our investment and borrowings portfolios are used to offset a portion of the remaining re-pricing risk that exists between our loans and deposits.

The Company measures interest rate risk and the effect of changes in market interest rates using a net interest income simulation analysis. The analysis incorporates forecasted changes in the balance sheet and assumptions that reflect the current interest rate environment. The analysis estimates the interest rate impact of parallel increases in interest rates over a twelve-month horizon.

The estimated changes in net interest income for a twelve-month period based on changes in the interest rates applied to the combined portfolios of our segments as of September 30, 2012, were as follows ($ in thousands):


Rate Change (Basis Points)
+ 200	$	17,319
+ 100		2,588
- 100		414
- 200		(59	)

The analysis above incorporates the Company’s assumptions for the market yield curve, pricing sensitivities on loans and deposits, reinvestment of asset and liability cash flows, and prepayments on loans and securities. The simulation analysis includes management’s projection for loan originations, investment and funding strategies. The new loans, investment securities, borrowings 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


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below 0% for loans and borrowings. Parent Company loans, investment securities and borrowings are assumed to convert to cash as they run off. Actual results may differ from forecasted results due to changes in market conditions as well as changes in management strategies.

As of September 30, 2012, approximately 57% 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 96% 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, 2012 were as follows:


	Amount Outstanding		Percentage of Total Portfolio
	($ in thousands)
Loans with contractual interest rates:
Below the interest rate floor	$	3,412,368		57	%
Exceeding the interest rate floor		72,597		1
At the interest rate floor		86,695		1
Loans with interest rate floors on non-accrual		61,217		1
Loans with no interest rate floor		2,400,124		40
Total	$	6,033,001		100	%

We enter into 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 prime rate loans to one-month LIBOR. Our basis swap agreements partially protect us from the risk that interest collected under prime rate loans will not be sufficient to service the interest due under the one-month LIBOR-based term debt.

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

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. This preparation requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. These policies relate to the allowance for loan and lease losses, fair value measurements, and income taxes. 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 disclosures related to these estimates.

There have been no significant changes during the nine months ended September 30, 2012 to the items that we disclosed as our critical accounting policies and estimates 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, 2011.

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, 2011. Together with the discussion of supervision and regulation matters in our Form 10-K for the year ended December 31, 2011, 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


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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 FRB 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.

The international Basel Committee on Banking Supervision published the final text of Basel III on December 16, 2010 with revisions to update capital rules on June 1, 2011. The Basel III requirements will be implemented starting January 1, 2013 and its adoption will be phased-in over an extended period of time from 2013 through 2019. From January 1, 2013 onwards, banks will have to meet the following minimum capital requirements expressed in risk-weighted assets: 3.5% share capital, 4.5% Tier-1 capital and 8% total capital. During the transition period, these ratios will gradually be stepped up to 4.5% share capital, 6% Tier-1 capital and 8% total capital. The total capital ratio will be built-up with increases along gradual lines from 0.625% at January 1, 2016 to 2.5% at January 1, 2019. As a result, banks will ultimately have to hold 10.5% of their total capital expressed in risk-weighted assets as of January 1, 2019.

In addition, the international Basel Committee on Banking Supervision will begin to introduce minimum standards over bank leverage, liquidity coverage and net stable funding ratios after specified monitoring and observation periods. The Basel Committee on Banking Supervision will introduce the leverage ratio after an initial phase-in period starting January 1, 2013 with complete migration in effect by January 1, 2018. The liquidity coverage ratio and net stable funding ratio minimum standards will be in effect by January 1, 2015 and January 1, 2018, respectively.

We will continue to monitor developments relating to Basel III adoption in the U.S. and its potential impact on our operations.

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 14, Derivative Instruments, in our consolidated financial statements for the three and nine months ended September 30, 2012, and Note 22, Credit Risk, in our audited consolidated financial statements for the year ended December 31, 2011 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 Chief Executive Officer 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 Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2012. There have been no changes in our internal control over financial reporting during the three and nine months ended September 30, 2012, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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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, 2012 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⁽²⁾		Maximum Number of Shares (or Approximate Dollar Value) that May Yet be Purchased Under the Plans⁽²⁾
July 1 – July 31, 2012		34,980	$	6.51		—
August 1 – August 31, 2012		448,494		6.98		300,000
September 1 – September 30, 2012		5,859,319		7.27		5,740,200
Total		6,342,793		7.24		6,040,200	$	337,450,595

⁽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 through December 31, 2012, our Board of Directors authorized the repurchase of an additional $635.0 million of our common stock during such period. In November 2012, a new strategy to repurchase up to $250.0 million of our common stock through December 31, 2013 was authorized (in aggregate, the “Stock Repurchase Program”). In September, we repurchased 9.9 million shares of our common stock under the Stock Repurchase Program at an average price of $7.35 per share for a total purchase price of $72.8 million. Of these purchases, purchases of 4,165,100 shares at an average price of $7.47 per share were settled in October 2012 which, for accounting purposes, were recorded in September 2012. 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 30, 2012, 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, 2012 (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.


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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 6, 2012		/s/ JAMES J. PIECZYNSKI
		James J. Pieczynski
		Director and Chief Executive Officer (Principal Executive Officer)

Date: November 6, 2012		/s/ JOHN A. BOGLER
		John A. Bogler
		Chief Financial Officer (Principal Financial Officer)

Date: November 6, 2012		/s/ MICHAEL A. SMITH
		Michael A. Smith
		Senior Vice President and Chief Accounting Officer (Principal Accounting Officer)


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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		Sublease of Office Lease Agreement dated as of July 17, 2012, by and between CapitalSource Finance LLC and DANAC, LLC.†
12.1		Ratio of Earnings to Fixed Charges.†
31.1		Rule 13a — 14(a) Certification of Chief Executive Officer.†
31.2		Rule 13a — 14(a) Certification of Chief Financial Officer.†
32		Section 1350 certifications.†
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.


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