12.31.13 10-K

10-K 1 a12311310-k.htm 10-K 12.31.13 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013

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)

Securities Registered Pursuant to Section 12(b) of the Act:



(Title of Each Class)		(Name of Exchange on Which Registered)
Common Stock, par value $0.01 per share		New York Stock Exchange

Securities Registered Pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. þ Yes o No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No

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. þ Yes o 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). þ Yes o No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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):



þ Large accelerated filer		o Accelerated filer

o Non-accelerated filer	(Do not check if a smaller reporting company)	o Smaller reporting company

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

The aggregate market value of the Registrant's Common Stock, par value $0.01 per share, held by nonaffiliates of the Registrant, as of June 30, 2013 was $1,825,859,491.

As of February 26, 2014, the number of shares of the Registrant's Common Stock, par value $0.01 per share, outstanding was 196,869,521.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of CapitalSource Inc.'s Proxy Statement for the 2014 annual meeting of shareholders, a definitive copy of which will be filed with the SEC within 120 days after the end of the year covered by this Form 10-K, are incorporated by reference herein as portions of Part III of this Form 10-K.



		Page
	PART I

Item 1.	Business	4

Item 1A.	Risk Factors	14

Item 1B.	Unresolved Staff Comments	23

Item 2.	Properties	23

Item 3.	Legal Proceedings	23

Item 4.	Mine Safety Disclosures	23

	PART II

Item 5.	Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	24

Item 6.	Selected Financial Data	27

Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations	30

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	78

	Management Report on Internal Controls Over Financial Reporting	79

	Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting	80

Item 8.	Financial Statements and Supplementary Data	81

Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	138

Item 9A.	Controls and Procedures	138

Item 9B.	Other Information	138

	PART III

Item 10.	Directors, Executive Officers and Corporate Governance	139

Item 11.	Executive Compensation	140

Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	140

Item 13.	Certain Relationships and Related Transactions, and Director Independence	140

Item 14.	Principal Accountant Fees and Services	140

	PART IV

Item 15.	Exhibits and Financial Statement Schedules	141

	Signatures	142

	Index to Exhibits	143

PART I

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K, including the footnotes to our audited 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 the pending merger between the Parent Company and PacWest Bancorp (“PacWest”), CapitalSource Bank net interest margin (“NIM”), loan repayments, credit trends, funding of unfunded loan commitments, CapitalSource Bank and Parent Company liquidity, CapitalSource Bank tax payment to the Parent Company, realizing the allowed portion of the deferred tax asset, and interest rate risk management, all which are subject to numerous assumptions, risks, and uncertainties. All statements contained in this Form 10-K 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: the ability to complete the pending merger between the Parent Company and PacWest, including obtaining regulatory approvals, or any future transaction, successfully integrating the companies following completion of the merger or achieving expected beneficial synergies and/or operating efficiencies, in each case, within expected time frames or at all; the possibility that regulatory approvals may not be received on expected time frames or at all; the possibility that personnel changes in connection with the merger may not proceed as planned; the possibility that the cost of additional capital may be more than expected; changes in the Company’s stock price before completion of the merger, including as a result of the financial performance of PacWest prior to closing; the reaction to the merger by each of the company’s customers, employees and counterparties; change in interest rates and lending spreads; compression of spreads on newly originated loans; unfavorable changes in asset mix; higher than anticipated payoff levels; changes in our loan product could further compress NIM; deteriorations in credit and other markets; higher than anticipated credit losses; reserves and delinquencies; loan loss provisions; a borrower’s lack of financial strength to repay loans; continued or worsening credit losses; changes in economic or market conditions or investment or lending opportunities; competitive and other market pressures on product pricing and services; reduced demand for our services; loan repayments higher than expected; charge-offs; our inability to grow deposits and access wholesale funding sources; regulatory safety and soundness considerations; the success and timing of other business strategies and asset sales; drawdown of Parent Company unfunded commitments substantially in excess of historical drawings; 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; higher than anticipated capital needs due to strategic or regulatory reasons; CapitalSource Bank dividend payment to the Parent Company is less than expected; changes in tax laws or regulations affecting our business; our inability to generate sufficient earnings; tax planning or disallowance of tax benefits by tax authorities; changes in the forward yield curve; increases or decreases in market interest rates; changes in the relationship between yields on investments and loans repaid and yields on assets reinvested; and other factors described in this Form 10-K and documents subsequently filed by CapitalSource with the Securities and Exchange Commission (the "SEC"). All forward-looking statements included in this Form 10-K 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 audited consolidated financial statements and related notes and the information contained elsewhere in this Form 10-K, including that set forth under Item 1A, Risk Factors.


ITEM 1.	BUSINESS

Overview

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

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. With a 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.

As of December 31, 2013, we had total assets of $8.9 billion, total loans of $6.8 billion, total deposits of $6.1 billion and stockholders' equity of $1.6 billion.

Our corporate headquarters is located in Los Angeles, California, and we have 21 retail bank branches located in southern and central California. Our loan origination efforts are conducted nationwide with key offices located in Chevy Chase, Maryland, Los Angeles, California, Denver, Colorado, Chicago, Illinois, and New York, New York. We also maintain a number of smaller lending offices throughout the country.

For the years ended December 31, 2013, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. The CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. For additional information, see Note 20, Segment Data.

Current Developments

On July 23, 2013, the Parent Company announced that it had entered into a Merger Agreement (the "Merger") with PacWest Bancorp ("PacWest") pursuant to which the Parent Company will merge with and into PacWest. Under the terms of the Merger, stockholders of the Parent Company will receive $2.47 in cash and 0.2837 shares of PacWest common stock for each share of CapitalSource common stock. The total value of the per share merger consideration, based on the closing price of PacWest shares on July 19, 2013, is $11.64. On January 13, 2014, the Company's shareholders approved the merger; however, the transaction continues to be subject to customary conditions, including the approval of bank regulatory authorities.

Our business focus includes operating CapitalSource Bank and liquidating our remaining Parent Company assets. As of December 31, 2013 and 2012, CapitalSource Bank had $8.1 billion and $7.4 billion of assets, respectively. During 2013, CapitalSource Bank's loan portfolio grew by approximately $1.1 billion or 19.2%, while the loan portfolio of the Parent Company decreased by $0.4 billion or 83.4%; resulting in net loan growth of $0.7 billion. During 2012, CapitalSource Bank's loan portfolio grew by approximately $0.9 billion or 18.6%, while the loan portfolio of the Parent Company decreased by $0.4 billion or 45.8%; resulting in net loan growth of $0.5 billion. CapitalSource Bank's non-performing assets as of December 31, 2013 were $48.6 million, or 0.6% of total assets, a decrease of $0.3 million from December 31, 2012. CapitalSource Bank's allowance for loan losses as of December 31, 2013 was $109.5 million or 1.6% of loans compared to $98.9 million or 1.8% of loans as of December 31, 2012.

CapitalSource Bank's net interest margin for the three months ended December 31, 2013 decreased to 4.76% from the previous quarter as the loan portfolio yields declined, however, the margin was partially offset by loan portfolio growth. We anticipate that the net interest margin will remain relatively flat as compared to the fourth quarter. Net interest margin was 4.86%, 4.79%, 5.08%, and 4.84% for the three months ended September 30, 2013, June 30, 2013, March 31, 2013, and December 31, 2012, respectively.

Loan Products and Service Offerings

Senior Secured Loans

We make senior secured real estate and asset-based loans which have a first priority lien in the collateral securing the loan. We also make cash flow loans which are secured by the enterprise value of the borrowing entity. Asset-based loans are collateralized by specified assets of the borrower, generally its accounts/notes receivable, inventory and/or machinery. Real estate loans are secured by senior mortgages on real property. We make cash flow loans based on our assessment of a client's ability to generate cash flows sufficient to repay the loan and to maintain or increase its enterprise value during the term of the loan. Our cash flow loans are generally secured by a security interest in all or substantially all of a borrower's assets.

Our lending activities are primarily focused on the following sectors:


•	Healthcare: real estate, asset-based and cash flow loans to healthcare providers;


•	Lender finance: loans to commercial finance companies with underlying portfolios of tax liens, loans secured by timeshare receivables, auto receivables, student loans and other consumer receivables;


•	Multifamily real estate: mortgage loans on multifamily properties;


•	Commercial real estate: mortgage loans on a variety of commercial property types;


•	Equipment leasing and finance: equipment loans and leases collateralized by the specific equipment financed;


•	Technology: loans to technology companies that provide critical product or service offerings, including wireless communication tower owner/operators, information technology hosting providers and managed service providers;


•	Security: asset-based and cash flow loans to companies in the physical security, government security, and public safety sectors;


•	Small business: loans guaranteed in part by the Small Business Administration (“SBA”) to small businesses; and


•	Premium finance: traditional life insurance premium finance loans secured by the cash surrender value of life insurance policies and other liquid assets.

Depository Products and Services

Through CapitalSource Bank's 21 branches in southern and central California, our website and our borrower relationships, we provide savings and money market accounts, individual retirement accounts and certificates of deposit. These products are insured up to the maximum amounts permitted by the FDIC. As an industrial bank, we are not permitted to offer demand deposit accounts.

Financing

We depend on deposits and external financing sources to fund our operations. We employ a variety of financing arrangements, including term debt, subordinated debt and equity. As a member of the Federal Home Loan Bank of San Francisco (“FHLB SF”), one of 12 regional banks in the Federal Home Loan Bank (“FHLB”) system, CapitalSource Bank had financing availability with the FHLB SF as of December 31, 2013 equal to 35% of CapitalSource Bank's total assets, subject to pledging adequate collateral.

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.

Competition

We offer a number of loan and deposit products with many of the loan product offerings focused on niche sectors, such as timeshare lending, security lending, technology and healthcare lending, among others. Generally, our loan products are marketed nationwide while our depository activities occur in California. The primary competition for each of our loan products varies by product type. Our markets are competitive and characterized by varying competitive factors. We compete with a large number of financial services companies, including:


•	commercial banks and thrifts that operate locally, regionally or nationally;


•	specialty and commercial finance companies;


•	private investment funds;


•	insurance companies; and


•	investment banks.

Competition is based on a number of factors, including: interest rates charged on loans and paid on deposits, the scope and type of banking and financial services offered, customer service and convenience, and regulatory constraints. Many of our competitors are large companies that have substantial capital, technological and marketing resources. Some of our competitors have substantial market positions and have access to a lower cost of capital or a less expensive source of funds. We believe we compete based on:


•	in-depth knowledge of our borrowers' industries and their business needs based upon information received from our borrowers' key decision-makers, analysis by our experienced professionals and interaction between our borrowers' decision-makers and our experienced professionals;


•	our breadth of loan product offerings and flexible and creative approach to structuring products that meet our borrowers' business and timing needs; and


•	our superior client service.

Supervision and Regulation

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 Federal Deposit Insurance Corporation ("FDIC") and the California Department of Business Oversight ("DBO"). 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 DBO, the FDIC, the Federal Reserve Board (“FRB”) or any other federal or state bank regulatory authority either as a bank holding company or otherwise, the Parent Company gave the FDIC authority pursuant to a contractual supervisory agreement (the “Parent Company Agreement”) to examine the Parent Company, the relationship and transactions between it and CapitalSource Bank and the effect of such relationship and transactions on CapitalSource Bank. The Parent Company is subject to regulation by other applicable federal and state agencies, such as the Securities and Exchange Commission ("SEC"). We are required to file periodic reports with these regulators and provide any additional information that they may require.

The following summary describes some of the more significant laws, regulations, and policies that affect our operations; it is not intended to be a complete listing of all laws that apply to us. From time to time, federal, state and foreign legislation is enacted and regulations are adopted which may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. We cannot predict whether or when potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.

General

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

While CapitalSource Bank completed its initial three-year de novo period in July 2011, certain conditions contained in the FDIC Order remain in place pursuant to the continued existence of the Parent Company Agreement and the Capital Maintenance and Liquidity Agreement (the “CMLA”) until such time as we apply for and are granted relief by the FDIC from the requirements of these agreements. Under the provisions of the CLMA, the Parent Company has provided, and is required to continue to provide, a $150.0 million unsecured revolving credit facility that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. This revolving credit facility has been in place since the formation of CapitalSource Bank and has not been drawn upon. Other remaining conditions are the requirement that CapitalSource Bank maintain a total risk-based capital ratio of not less than 15% and also maintain all other capital ratios of well-capitalized banks, to be supported by the Parent Company. CapitalSource Bank remains subject to bank safety and soundness requirements as well as to various regulatory capital requirements established by federal and state regulatory agencies, including any new conditions that our regulators may determine. Pursuant to the Parent Company Agreement, the Parent Company has consented to an examination of itself by the FDIC for purposes of monitoring compliance with the laws and regulations applicable to CapitalSource Bank and its affiliates.

In 2011, CapitalSource Bank filed a revised business plan pursuant to guidance issued by the FDIC for de novo institutions, with the plan covering the time period from July 1, 2011 through December 31, 2015. During this time period, CapitalSource Bank is subject to increased supervision that would otherwise not be applicable to a bank that has been in existence longer than three years, including enhanced FDIC supervision for compliance examinations and Community Reinvestment Act evaluations.

The FDIC and DBO conduct periodic examinations to evaluate CapitalSource Bank's safety and soundness and compliance with various regulatory requirements. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the regulators or Congress, could have a material adverse impact on our operations.

In addition, the investment, lending and branch operating authority of CapitalSource Bank is prescribed by state and federal laws, and CapitalSource Bank is prohibited from engaging in any activities not permitted by these laws.

California law provides limits on loans to one borrower. In general, a California bank may not make unsecured loans or extensions of credit to a single or related group of borrowers in excess of 15% of the sum of its shareholders' equity, allowance for loan losses, capital notes and debentures. An additional amount may be lent, equal to 10% of such sum of shareholders' equity and other amounts, if secured by specified readily marketable collateral. As of December 31, 2013, this limit on loans to one borrower was $202.0 million if unsecured and $337.0 million if secured by readily marketable collateral.

The FDIC and DBO, as well as the other federal banking agencies, have adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards may be subject to potential enforcement actions by the federal or state banking agencies for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance for deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, or the issuance of removal and prohibition orders against institution-affiliated parties.

The international Basel Committee on Banking Supervision published the final text of Basel III on December 16, 2010, which introduced new minimum capital requirements. On July 9, 2013, the federal banking agencies issued final rules (the “Basel III Capital Rules”), which become effective on January 1, 2015 (subject to phase-in periods for certain provisions), establishing a new comprehensive capital framework for U.S. banking organizations. The Basel III Capital Rules revise the definitions and components of regulatory capital, expand the scope of the deductions from and adjustments to capital, expand the number of risk-weighting categories and assign higher risk weights to certain assets and make other changes that affect the calculation of regulatory capital ratios. The Basel III Capital Rules also implement certain provisions of the Dodd-Frank Act, including the requirements to remove references to credit ratings from the federal agencies’ rules. These changes, and other regulatory initiatives in the United States, in the wake of the financial crisis, including provisions of the Dodd-Frank Act, are expected to result in higher regulatory capital standards and expectations for banking organizations.

The Basel III Capital Rules (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”) and related regulatory capital ratio of CET1 to risk-weighted assets, (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain revised requirements, and (iii) require that most deductions from and adjustments to capital be made to CET1 rather than to the other components of capital.

Under the Basel III Capital Rules, the minimum capital ratios as of January 1, 2015, will be: (1) 4.5% CET1 to risk-weighted assets; (2) 6.0% Tier 1 capital (i.e., CET1 plus Additional Tier 1 capital) to risk-weighted assets; (3) 8.0% total capital (i.e., Tier 1 capital plus Tier 2 capital ) to risk-weighted assets; and (4) 4.0% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (i.e., the “leverage ratio”). The Basel III Capital Rules also limit a banking organization’s ability to pay dividends, repurchase shares or pay discretionary bonus if a banking organization does not have a “capital conservation buffer,” comprised of CET1 capital, in an amount greater than 2.5% CET1 of risk-weighted assets in addition to the amount necessary to meet its minimum risk-based capital requirements. Phase-in of the capital conservation buffer requirements will begin on January 1, 2016 and must be fully phased-in by January 1, 2019.

Federal Home Loan Bank System

CapitalSource Bank is a member of the FHLB SF. Among other benefits, each FHLB serves its members within its assigned region and makes available loans to its members. Each FHLB is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. As a member, CapitalSource Bank is required to purchase and maintain stock in the FHLB SF. As of December 31, 2013, CapitalSource Bank owned $31.3 million in par value of FHLB SF stock, which was in compliance with this requirement.

Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), an initiative directed at the financial services industry, represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the “BCFP”), and will require the BCFP and other federal agencies, including the SEC, to undertake assessments and rulemaking. A number of the provisions in the Dodd-Frank Act are aimed at financial institutions that are larger than the Parent Company or CapitalSource Bank. Nonetheless, there are provisions with which we will have to comply both as a public company and a financial institution.

The Dodd-Frank Act imposes a number of significant regulatory and compliance changes in the banking and financial services industry. Many provisions of the Dodd-Frank Act must be implemented by regulations yet to be adopted by various government agencies. These regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that may impact us. Certain provisions of the Dodd-Frank Act and implementing regulations that may have a material effect on our business are noted below.

•

is eliminated, in order to continue to own CapitalSource Bank, the Parent Company would be required to register as a bank holding company, or BHC. If we were unsuccessful in registering as a BHC or another exception does not become available to us, our continued ownership of CapitalSource Bank would not be permissible.

•

The Dodd-Frank Act directs the federal banking agencies to issue regulations requiring that the parent company of any federally insured depository institution serve as a “source of financial strength” to its subsidiary depository institution. The source of strength requirement had historically applied only to BHCs and their subsidiary banks. Under the source of strength requirement, the Parent Company will be required to serve as a source of financial strength to CapitalSource Bank. The banking regulators could require the Parent Company to contribute additional capital to CapitalSource Bank or to take, or refrain from taking, other actions for the benefit of CapitalSource Bank.

•

The Dodd-Frank Act restricted the acquisition of control of an industrial bank by a non-financial firm. For a period of three years beginning on July 21, 2010, the Dodd-Frank Act generally prohibited the banking regulators from approving any proposed change in control of an industrial bank, such as CapitalSource Bank, if the proposed acquirer was a “commercial firm.” Although that three-year moratorium period has expired, there is no certainty that the FDIC would approve the direct or indirect acquisition of control of CapitalSource Bank by a commercial firm.

•

The Dodd-Frank Act requires the FRB to adopt regulations requiring increased capital requirements, minimum liquidity ratios, periodic stress testing and the establishment of board-level risk management committees for the largest banking institutions (those with assets greater than $50 billion or, in some case, greater than $10 billion), some or all of which requirements may become requirements, over time, for smaller institutions and for banking organizations not regulated by the FRB.

•

The Dodd-Frank Act requires the federal financial agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain “unregistered investment companies” (defined as hedge funds and private equity funds). This statutory provision is commonly referred to as the “Volcker Rule.” In December 2013, five financial regulatory agencies, including the FDIC, adopted final rules implementing the Volcker Rule (the “Final Rules"). The Final Rules prohibit banking entities from (i) engaging in short-term proprietary trading for their own accounts, or (ii) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). The Final Rules are intended to provide greater clarity with respect to the extent of those prohibitions and the related exemptions and exclusions. Each regulated entity, including the Parent Company and CapitalSource Bank, is also required to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule. The Final Rules also include certain regulatory reporting requirements. We intend to adopt the Final Rules by the mandated April 1, 2014 date and expect to be fully compliant with the Final Rules by the conformity period on July 21, 2015. We are currently analyzing the effects of the Volcker Rule.

•

Six financial regulatory federal agencies, including the FDIC, have proposed rules to implement the Dodd-Frank Act provisions requiring retention of credit risk by certain securitization participants through holding interests in securitization vehicles. The proposed rules would require a securitizer (or sponsor) to retain an economic interest equal to at least 5 percent of the aggregate credit risk of assets collateralizing an issuance of asset-backed securities, subject to certain exceptions for qualified residential mortgages and qualified commercial real estate mortgages, commercial loans and auto loans, which meet specified underwriting standards. Because these rules are not yet finalized or effective, the ultimate impact of these provisions on the CapitalSource Bank and the Parent Company are not known at this time. We will continue to monitor developments related to the implementation of these risk retention provisions of the Dodd-Frank Act.

Insurance of Accounts and Regulation by the FDIC

CapitalSource Bank's deposits are insured up to the maximum amounts permitted by the FDIC, currently $250,000. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. The FDIC may prohibit any FDIC insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against insured institutions.

On October 7, 2008, the FDIC established a Restoration Plan to return the Depositors Insurance Fund ("DIF") to its statutorily mandated minimum reserve ratio of 1.15% within five years. In 2009, the Restoration Plan was amended to extend the restoration period to seven years and Congress subsequently amended the statute to allow the FDIC up to eight years to return the DIF reserve ratio to 1.15%, absent extraordinary circumstances. To meet this reserve ratio by the end of 2016, the FDIC amended its Restoration Plan and adopted a uniform 3 basis point increase in the initial assessment rates effective January 1, 2011.

The Dodd-Frank Act establishes a minimum designated reserve ratio (“DRR”) of 1.35% of estimated insured deposits, provides discretion to the FDIC to develop a new assessment base, mandates the FDIC adopt a restoration plan should the fund balance fall below 1.35%, and authorizes payment of dividends to the industry should the fund balance exceed 1.50%. The Dodd-Frank Act requires the DRR to be achieved by September 30, 2020. On February 7, 2011, the FDIC adopted a final rule that revised the assessment base and assessment rate schedule effective April 1, 2011, and, in lieu of dividends, provides for reduced assessment

rates once the DRR exceeds 2.00% and again at 2.50%. Assessments generally will be calculated using an insured depository institution's average assets minus average tangible equity. The initial assessment rates range between 5 basis points for a low risk institution to 35 basis points for a high risk institution, with further rate adjustments for the level of unsecured debt and brokered deposits held by an institution.

A significant increase in FDIC assessment rates would have an adverse effect on the operating expenses and results of operations of CapitalSource Bank. We cannot predict what assessment rates will be in the future. Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Prompt Corrective Action

The FDIC is required to take certain supervisory actions against undercapitalized banks, the severity of which depends upon the institution's degree of undercapitalization. Generally, an institution is considered to be “undercapitalized” if it has a core capital ratio of less than 4.0% (3.0% or less for institutions with the highest examination rating), a ratio of total capital to risk-weighted assets of less than 8.0%, or a ratio of Tier 1 capital to risk-weighted assets of less than 4.0%. An institution that has a core capital ratio that is less than 3.0%, a total risk-based capital ratio less than 6.0%, and a Tier 1 risk-based capital ratio of less than 3.0% is considered to be “significantly undercapitalized” and an institution that has a tangible capital ratio equal to or less than 2.0% of total assets is deemed to be “critically undercapitalized.” Subject to a narrow exception, the FDIC is required to appoint a receiver or conservator for a bank that is “critically undercapitalized.” Regulations also require that a capital restoration plan be filed with the FDIC within 45 days of the date an institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. “Significantly undercapitalized” and “critically undercapitalized” institutions are subject to more extensive mandatory regulatory actions. The FDIC also could take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. Inadequate capital is also a basis for action, ultimately including receivership, by the FDIC.

The Basel III Capital Rules revise the prompt corrective action (“PCA”) regulations pursuant to section 38 of the Federal Deposit Insurance Act, which authorize and, under certain circumstances, require the federal banking agencies to take certain actions against banks that fail to meet their capital requirements, particularly those that are categorized as less than “adequately capitalized” (i.e., categorized as “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized”). The Basel III Capital rules revise the PCA regulations by: (1) introducing a CET1 ratio requirement at each PCA category (other than “critically undercapitalized”; (2) increasing the minimum Tier 1 capital ratio requirement for each category; and (3) eliminating the current provision that allows a bank with a composite supervisory rating of 1 to have a 3% leverage ratio and remain classified as “adequately capitalized.” The total risk-based capital ratio requirement for each PCA category remains unchanged. To qualify as “well capitalized” under the revised PCA regulations, a bank must meet the following capital ratio requirements: (1) 6.5% CET1 to risk-weighted assets; (2) 8.0% Tier 1 capital to risk-weighted assets; (3) 10.0% total capital to risk-weighted assets, and (4) 5.0% leverage ratio. The FDIC and other federal banking agencies have advised that they expect banking organizations to maintain capital ratios well above the minimum ratios necessary to be categorized as “well capitalized.”

To remain in compliance with the conditions imposed by the FDIC, CapitalSource Bank is required to maintain a total risk-based capital ratio of not less than 15% and must at all times be “well-capitalized,” which additionally requires CapitalSource Bank to have minimum Tier 1 risk-based capital ratio of 6% and Tier 1 leverage ratio of 5% in accordance with pre-Basel III Capital Rules. As of December 31, 2013, CapitalSource Bank had Tier 1 leverage, Tier 1 risked-based capital and total risk based capital ratios of 13.88%, 15.03%, and 16.29%, respectively, each in excess of the minimum percentage requirements for “well-capitalized” institutions. With regard to the Basel III Capital Rules, we are in the process of determining the impact of the new capital requirements on our capital ratios. For additional information, see Note 14, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

Limitations on Capital Distributions

The authority of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. Additionally, Enhanced Supervisory Procedures for Newly Insured FDIC-Supervised Institutions require the FDIC’s prior non-objection to material changes to a de novo institution’s business plan which includes the payment of dividends in excess of the CapitalSource Bank’s FDIC-approved Four Year Plan. For purposes of this guidance, CapitalSource Bank is still categorized as a de novo institution. The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") prohibits a bank from making capital distributions, including dividends, if, after such transaction, the bank would be undercapitalized.

In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank and the bank's net income for its

last three fiscal years (less any distributions to shareholders during this period). If a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with appropriate regulatory approval in an amount not exceeding the greatest of the bank's retained earnings, the bank's net income for its last fiscal year and the bank's net income for its current fiscal year. Simultaneously with the Merger with PacWest, CapitalSource Bank will pay a dividend to the Parent Company in an amount no more than CapitalSource Bank's retained earnings as of December 31, 2013.

The FDIC also has the authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.

Transactions with Affiliates

CapitalSource Bank's authority to engage in transactions with “affiliates” is limited by Sections 23A and 23B of the Federal Reserve Act as implemented by the Federal Reserve Board's Regulation W. The term “affiliates” for these purposes generally means any company that controls or is under common control with an institution, and includes the Parent Company as it relates to CapitalSource Bank. In general, transactions with affiliates must be on terms that are as favorable to the institution as comparable transactions with non-affiliates. In addition, specified types of transactions are restricted to an aggregate percentage of the institution's capital stock and surplus as defined by the regulators. Collateral in specified amounts must be provided by affiliates to receive extensions of credit from an institution. Federally insured banks are subject, with certain exceptions, to restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these institutions are prohibited from engaging in specified tying arrangements in connection with any extension of credit or the providing of any property or service.

Community Reinvestment Act

Under the Community Reinvestment Act ("CRA"), every FDIC-insured institution has a continuing and affirmative obligation consistent with safe and sound banking practices to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FDIC, in connection with the examination of CapitalSource Bank, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications, such as a merger or the establishment or closure of a branch, by CapitalSource Bank. The FDIC may use an unsatisfactory rating as the basis for the denial of an application. Due to the heightened attention being given to the CRA in the past few years, CapitalSource Bank may be required to devote additional funds for investment and lending in its local community, which comprises southern and central California. CapitalSource Bank received a rating of "Outstanding" from the FDIC on its most recent CRA evaluation.

Regulatory and Criminal Enforcement Provisions

The FDIC and DBO have primary enforcement responsibility over CapitalSource Bank and have the authority to bring action against all “institution-affiliated parties,” including stockholders, attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers or directors, receivership, conservatorship or termination of deposit insurance. The FDIC has the authority to assess civil money penalties for a wide range of violations, which can amount to $25,000 per day, or $1.1 million per day in especially egregious cases. Federal law also establishes criminal penalties for specific violations.

Environmental Issues Associated with Real Estate Lending

The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), a federal statute, generally imposes strict liability on all prior and current “owners and operators” of sites containing hazardous waste. However, Congress acted to protect secured creditors by providing that the term “owner and operator” excludes a person whose ownership is limited to protecting its security interest in the site. Since the enactment of the CERCLA, this “secured creditor exemption” has been the subject of judicial interpretations which have left open the possibility that lenders could be liable for clean-up costs on contaminated property that they hold as collateral for a loan. To the extent that legal uncertainty exists in this area, all creditors, including the Parent Company and CapitalSource Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs, which costs often substantially exceed the value of the collateral property.

Privacy Standards

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (“GLBA”) modernized the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. CapitalSource Bank is subject to regulations implementing the privacy

protection provisions of the GLBA. These regulations require CapitalSource Bank to disclose its privacy policy, including identifying with whom it shares “non-public personal information” to consumers at the time of establishing the customer relationship and annually thereafter. The State of California's Financial Information Privacy Act provides greater protection for consumer's rights under California Law to restrict affiliate data sharing.

Anti-Money Laundering and Customer Identification

As part of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”), Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLAFATA”). IMLAFATA amended the Bank Secrecy Act (“BSA”) and adopted additional measures that established or increased existing obligations of financial institutions, including CapitalSource Bank, to identify their customers, monitor and report suspicious transactions, respond to requests for information by federal banking regulatory authorities and law enforcement agencies, and, at the option of CapitalSource Bank, share information with other financial institutions. The U.S. Secretary of the Treasury has adopted several regulations to implement these provisions. Pursuant to these regulations, CapitalSource Bank is required to implement appropriate policies and procedures relating to anti-money laundering matters, including compliance with applicable regulations, suspicious activities, currency transaction reporting and customer due diligence. Our BSA compliance program is subject to federal regulatory review.

Other Laws and Regulations

We are subject to many other federal statutes and regulations, such as the Equal Credit Opportunity Act, the Truth in Savings Act, the Fair Credit Reporting Act, the Fair Housing Act, the National Flood Insurance Act and various federal and state privacy protection laws. These laws, rules and regulations, among other things, impose licensing obligations, limit the interest rates and fees that can be charged, mandate disclosures and notices to customers, mandate the collection and reporting of certain data regarding customers, regulate marketing practices and require the safeguarding of non-public information of customers. Violations of these laws could subject us to lawsuits and could also result in administrative penalties, including, fines and reimbursements. We are also subject to federal and state laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition.

In recent years, examination and enforcement by the state and federal banking agencies for non-compliance with the above-referenced laws and their implementing regulations have become more intense. Due to these heightened regulatory concerns, we may incur additional compliance costs or be required to expend additional funds for investments in our local community.

The federal government continues to evaluate possible new laws and regulations, which if enacted, could have a material impact on us, including among other things increased reporting obligations, restrictions on current lending activities, federal and state supervision and increased expenses to operate as a bank.

Regulation of Other Activities

Some other aspects of our operations are subject to supervision and regulation by governmental authorities and may be subject to various laws and judicial and administrative decisions imposing various requirements and restrictions, which, among other things:


•	regulate credit and lending activities, including establishing licensing requirements in some jurisdictions;


•	establish the maximum interest rates, finance charges and other fees we may charge our borrowers;


•	govern secured transactions;


•	require specified information disclosures to our borrowers;


•	set collection, foreclosure, repossession and claims handling procedures and other trade practices;


•	regulate our borrowers' insurance coverage;


•	prohibit discrimination in the extension of credit and administration of our loans; and


•	regulate the use and reporting of certain borrower information.

In addition, many of our healthcare borrowers receive significant funding from governmental sources and are subject to licensure, certification and other regulation and oversight under the applicable Medicare and Medicaid programs. These regulations and governmental oversight, both on federal and state levels, indirectly affect our business in several ways as discussed below.


•	Failure to comply with the applicable laws and regulation by our borrowers could result in loss of accreditation, denial of reimbursement, imposition of fines or corporate integrity agreements, suspension or decertification from federal and state health care programs, loss of license and closure of the facility.

•

With limited exceptions, the law prohibits payment of amounts owed to healthcare providers under the Medicare and Medicaid programs to be directed to any entity other than actual providers approved for participation in the applicable programs. Accordingly, while we lend money that is secured by pledges of Medicare and Medicaid receivables, if we were required to invoke our rights to the pledged receivables, we would be unable to collect receivables payable under these programs directly. We would need a court order to force collection directly against these governmental payers.

•

Hospitals, nursing facilities and other providers of healthcare services are not always assured of receiving adequate Medicare and Medicaid reimbursements to cover the actual costs of operating the facilities and providing care to patients. In addition, modifications to reimbursement payment mechanisms, statutory and regulatory changes, retroactive rate adjustments, administrative rulings, policy interpretations, payment delays, and government funding restrictions could result in payment delays or alterations in reimbursements affecting providers' cash flows with possible material adverse effect on a borrower's liquidity.

•

Many states are presently considering enacting, or have already enacted, reductions in the amount of funds appropriated to healthcare programs resulting in rate freezes or reductions to their Medicaid payment rates and often curtailments of coverage afforded to Medicaid enrollees. Most of our healthcare borrowers depend on Medicare and Medicaid reimbursements, and reductions in reimbursements, caused by modifications to reimbursement systems, payment cuts, census declines, staffing shortages, or other operational forces from these programs may have a negative impact on their ability to generate adequate revenues to satisfy their obligations to us. There are no assurances that payments from governmental payors will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to patients eligible for coverage under these programs.

•

The impacts of Congressional healthcare reform, federal fiscal cliff impacts and related budget deficit initiatives, impacts of medicaid expansion participation by individual states where we conduct business, as well as individual state budgetary shortfalls may initiate significant reforms and alterations to the United States healthcare system, including potential material changes to the delivery of healthcare services including anticipated shifts to a higher utilization of managed care coverage, and the level of reimbursements paid to providers and the mechanisms for such payments by the government and other third party payors.

•

For our borrowers to remain eligible to receive reimbursements under the Medicare and Medicaid programs, the borrowers must comply with a number of conditions of participation and other regulations imposed by these programs, and are subject to periodic federal and state surveys to ensure compliance with various clinical, life safety and operational covenants. A borrower's failure to comply with these covenants and regulations may cause the borrower to incur penalties and fines and other sanctions, or lose its eligibility to continue to receive reimbursements under the programs, which could result in the borrower's inability to make scheduled payments to us.

Employees

As of December 31, 2013, we employed 495 people. We believe that our relations with our employees are good.

Executive Officers

Our executive officers and their ages and positions are as follows:



Name	Age	Position
James J. Pieczynski	51	Chief Executive Officer
Douglas H. (Tad) Lowrey	61	Chief Executive Officer - CapitalSource Bank
Laird M. Boulden	56	President
John A. Bogler	48	Chief Financial Officer
Mike A. Smith	47	Senior Vice President and Chief Accounting Officer
Bryan M. Corsini	52	Executive Vice President and Chief Administrative Officer - CapitalSource Bank
Christopher A. Scardelletti	44	Executive Vice President and Chief Credit Officer - CapitalSource Bank

_________________________

Biographies for our executive officers are as follows:

James J. Pieczynski, 51, has served as a director since January 2010 and as Chief Executive Officer since January 2012. Mr. Pieczynski has also served as President of CapitalSource Bank since January 2012 and as a member of the board of directors of CapitalSource Bank since January 2013. Mr. Pieczynski previously served as Co-Chief Executive Officer from January 2010 through December 2011, our President - Healthcare Real Estate Business from November 2008 until January 2010, and our Co-President - Healthcare and Specialty Finance from January 2006 until November 2008. Mr. Pieczynski received his undergraduate degree from the University of Illinois, Urbana-Champaign in 1984.

Douglas H. (Tad) Lowrey, 61, has served as Chairman of the Board of CapitalSource Bank since July 2012, and as the Chief Executive Officer of CapitalSource Bank since its formation on July 25, 2008 and served as President of CapitalSource Bank from his appointment through December 2011. Prior to his appointment, Mr. Lowrey served as Executive Vice President of Wedbush, Inc., a private investment firm and holding company, from January 2006 until June 2008. Mr. Lowrey is an elected director of the Federal Home Loan Bank of San Francisco and the California Bankers Association. He received his undergraduate degree from Arkansas Tech University and was licensed in 1977 in the state of Arkansas as a certified public accountant.

Laird M. Boulden, 56, has served as President since October 2011 and as the Chief Lending Officer of CapitalSource Bank since January 1, 2012. Mr. Boulden previously served as the President of the Company's Corporate Finance Group from May 2011 to October 2011 and President of the Company's Corporate Asset Finance Group from February 2010 to May 2011. Before joining the Company, Mr. Boulden was co-founder of Tygris Commercial Finance where he served as President of Tygris Asset Finance from March 2008 to December 2010 and was the founder and President of RBS Asset Finance (f/k/a RBS Lombard) from October 2001 until March 2008. Mr. Boulden received his undergraduate degree from the University of South Florida in 1979.

John A. Bogler, 48, has served as Chief Financial Officer since January 2012 and as Chief Financial Officer of CapitalSource Bank since its formation on July 25, 2008. Prior to his appointment, Mr. Bogler served as Chief Financial Officer of Affinity Financial Corporation from January 2008 until July 2008. Mr. Bogler served as a financial consultant specializing in bank acquisition and de novo activities from February 2005 until January 2008. Mr. Bogler received his undergraduate degree from Missouri State University in 1988, became a certified public accountant in the state of Missouri in 1991 and became a chartered financial analyst in 1998.

Mike A. Smith, 47, has served as our Chief Accounting Officer since March 2012 and as Chief Accounting Officer of CapitalSource Bank since October 2009. Previously, Mr. Smith served as Senior Vice President, Finance of CapitalSource Bank since its formation from July 2008 until September 2009. Mr. Smith served as Chief Accounting Officer of Fremont Investment & Loan from May 2004 until July 2008. Mr. Smith received his masters and undergraduate degrees from Brigham Young University in 1992, became a certified public accountant in the state of California in 1996, became a certified management accountant in 1997 and became a chartered global management accountant in 2012.

Bryan M. Corsini, 52, has served as the Executive Vice President and Chief Administrative Officer of CapitalSource Bank since October 2011. Mr. Corsini previously served as President, Credit Administration of CapitalSource Bank from July 2008 to October 2011 and as our Chief Credit Officer from our inception in 2000 until July 2008. He received his undergraduate degree from Providence College, Rhode Island. Mr. Corsini was licensed in 1986 in the state of Connecticut as a certified public accountant.

Christopher A. Scardelletti, 44, has served as the Executive Vice President and Chief Credit Officer of CapitalSource Bank since July 2008. Previously, Mr. Scardelletti served as Director of Credit in our Lender Finance Group from March 2003 to June 2008. Mr. Scardelletti received his undergraduate degree from the University of Maryland, College Park and was licensed in 1993 in the state of Maryland as a certified public accountant.

Other Information

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website at www.capitalsource.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission or by contacting CapitalSource Investor Relations, at (866) 876-8723 or investor.relations@capitalsource.com.

We also provide access on our website to our Principles of Corporate Governance, Code of Business Conduct and Ethics, the charters of our Audit, Compensation, Asset / Liability Committee, Risk Committee and Nominating and Corporate Governance Committee and other corporate governance documents. Copies of these documents are available to any shareholder upon written request made to our corporate secretary at our Chevy Chase, Maryland address. In addition, we intend to disclose on our website any changes to or waivers for our executive officers or directors from, our Code of Business Conduct and Ethics.


ITEM 1A.	RISK FACTORS

Our business faces many risks. The risks described below may not be the only risks we face. Additional risks that we do not yet know of or that we currently believe are immaterial may also impair our business operations. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition or results of operations could suffer, and the trading price of our securities could decline. The U.S. economy is still in the process of recovering from an economic recession, and a slow recovery may adversely impact on our business and operations, including, without limitation, the credit quality of our loan portfolio, our liquidity and our earnings. You should know that many of the risks described may apply to more than just the subsection in which we grouped them for the purpose of this presentation. As a result, you should consider all of the following risks, together with all of the other information in this Annual Report on Form 10-K, before deciding to invest in our securities.

Risks Related to the Pending Merger

Regulatory approvals may not be received, may take longer than expected or may impose conditions that are not presently anticipated or that could have an adverse effect on the combined company following the merger.

Before the merger and the other transactions contemplated by the Merger Agreement may be completed, the Company and PacWest must obtain approvals from the FRB, the FDIC, and the California Department of Business Oversight. Other approvals, waivers or consents from regulators may also be required. These regulators may impose conditions on the completion of the merger or the other transactions contemplated by the Merger Agreement or require changes to the terms of the merger or the other transactions contemplated by the Merger Agreement. Such conditions or changes could have the effect of delaying or preventing completion of the merger or the other transactions contemplated by the Merger Agreement or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have an adverse effect on the combined company following the merger.

Combining the two companies may be more difficult, costly or time consuming than expected and the anticipated benefits and cost savings of the merger may not be realized.

PacWest and the Company have operated and, until the completion of the merger, will continue to operate, independently. The success of the merger, including anticipated benefits and cost savings, will depend, in part, on PacWest's ability to successfully combine the businesses of PacWest and the Company. To realize these anticipated benefits and cost savings, after the completion of the merger, PacWest expects to integrate the Company's business into its own. It is possible that the integration process could result in the loss of key employees, the disruption of each company's ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company's ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits and cost savings of the merger. The loss of key employees could have an adverse effect on PacWest's financial results and the value of its common stock, and therefore on the value of the merger consideration to be received by the Company's stockholders in the merger. If PacWest experiences difficulties with the integration process, the anticipated benefits of the merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause PacWest and/or the Company to lose customers or cause customers to remove their accounts from PacWest and/or the Company and move their business to competing financial institutions. Integration efforts between the two companies will also divert management attention and resources. These integration matters could have an adverse effect on each of PacWest and the Company during this transition period and for an undetermined period after completion of the merger on the combined company. In addition, the actual cost savings of the merger could be less than anticipated.

Termination of the Merger Agreement could negatively impact us.

If the Merger Agreement is terminated, there may be various consequences. For example, our businesses may have been impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger. Additionally, if the merger agreement is terminated, the market price of the Company's common stock could decline to the extent that the current market price reflects a market assumption that the merger will be completed. In addition, we have incurred and will incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the Merger Agreement. If the merger is not completed, we would have to recognize these expenses without realizing the expected benefits of the transaction.

The Company and PacWest will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on PacWest or the Company as well as the combined organization. These uncertainties may impair the Company's or PacWest's ability to attract, retain and motivate key personnel until the merger is completed, and could cause customers and others that deal with the Company or PacWest to seek to change existing business relationships with the Company or PacWest. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or PacWest, the Company's business or PacWest's business could be harmed. Subject to certain exceptions, each of PacWest and the Company has agreed to operate its business in the ordinary and usual course prior to closing.

The Merger Agreement limits PacWest's and the Company's ability to pursue acquisition proposals.

The Merger Agreement prohibits the Company from initiating, soliciting, encouraging or facilitating certain third party acquisition proposals. In addition, the Merger Agreement provides that the Company must pay to PacWest a termination fee in the amount of $91 million under certain limited circumstances relating to third party acquisition transactions involving the Company. This provision might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of the Company from considering or proposing such an acquisition.

Risks Related to Our Lending Activities

Our results of operations and financial condition would be adversely affected if our allowance for loan and lease losses is not sufficient to absorb actual losses.

Experience in the financial services industry indicates that a portion of our loans in all categories of our lending business will become delinquent or impaired, and some may only be partially repaid or may never be repaid at all. Our methodology for establishing the adequacy of the allowance for loan and lease losses depends in part on subjective determinations and judgments about our borrowers' ability to repay. Despite management's efforts to estimate future losses, ultimate resolutions of individual loans may result in actual losses that are greater than our allowance. Deterioration in general economic conditions and unforeseen risks affecting customers may have an adverse effect on our borrowers' capacity to repay their obligations, whether our risk ratings or valuation analyses reflect those changing conditions. Changes in economic and market conditions may increase the risk that our allowance for loan and lease losses would become inadequate if borrowers experience economic and other conditions adverse to their businesses. Maintaining the adequacy of our allowance for loan and lease losses may require that we make significant and unanticipated increases in our provisions for loan and lease losses, which would materially affect our results of operations and capital adequacy. Recognizing that many of our loans individually represent a significant percentage of our total allowance for loan and lease losses, adverse collection experience in a relatively small number of loans could require an increase in our allowance. Federal and State regulators, as an integral part of their respective supervisory functions, periodically review a portion of our loan portfolio. The regulatory agencies may require changes to our risk ratings on loans, which could lead to an increase in the allowance for loan and lease losses, increased provisions for loan and lease losses and as appropriate, recognition of further loan charge-offs based upon their judgments, which may be different from ours. Increases in the allowance for loan and lease losses required by these regulatory agencies could have a negative effect on our results of operations and financial condition.

We may not recover all amounts that are contractually owed to us by our borrowers.

The Parent Company is dependent primarily on loan collections and the proceeds of loan sales to fund its operations. A shortfall in loan proceeds may impair our ability to fund our operations or to repay our existing debt.

When we loan money, commit to loan money or enter into a letter of credit or other contract with a counterparty, we incur credit risk. The credit quality of our portfolio can have a significant impact on our earnings. We expect to experience charge-offs and delinquencies on our loans in the future. Our clients may experience operational or financial problems or may perform below

that which we expected when we originated a loan that, if not timely addressed, could result in a substantial impairment or loss of the value of our loan to the client. We may fail to identify problems because our client did not report them in a timely manner or, even if the client did report the problem, we may fail to address it quickly enough or at all. Even if clients provide us with full and accurate disclosure of all material information concerning their businesses, we may misinterpret or incorrectly analyze this information. Mistakes may cause us to make loans that we otherwise would not have made or, to fund advances that we otherwise would not have funded, or result in losses on one or more of our loans. As a result, we could suffer loan losses, which could have a material adverse effect on our revenues, net income and results of operations and financial condition, to the extent the losses exceed our allowance for loan and lease losses.

The collateral securing a loan may not be sufficient to protect us if we have not properly obtained or perfected a lien on such collateral or if the collateral value does not cover the loan.

Most of our loans are secured by a lien on specified collateral of the client and we may not obtain or properly perfect our liens or the value of the collateral securing any particular loan may not protect us from suffering a partial or complete loss if the loan becomes non-performing and we move to foreclose on the collateral. In such event, we could suffer loan losses, which could have a material adverse effect on our revenue, net income, financial condition and results of operations.

In particular, leveraged lending involves lending money to a client based primarily on the expected cash flow, profitability and enterprise value of a client rather than on the value of its assets. As of December 31, 2013, approximately 28% of the aggregate outstanding loan balance of our portfolio comprised leveraged loans. The value of the assets which we hold as collateral for these loans is typically substantially less than the amount of money we advance to a client under these loans. When a leveraged loan becomes non-performing, our primary recourse to recover some or all of the principal of our loan is to force the sale of the entire company as a going concern or restructure the company in a way we believe would enable it to generate sufficient cash flow over time to repay our loan. Neither of these alternatives may be an available or viable option or generate enough proceeds to repay the loan. Additionally, given recent and current economic conditions, many of our leveraged loan clients have and may continue to suffer decreases in revenues and net income, making them more likely to underperform and default on our loans and making it less likely that we could obtain sufficient proceeds from a restructuring or sale of the company.

Our concentration of loans to privately owned small and medium-sized companies and to a limited number of clients within particular industry or region could expose us to greater lending risk if the market sector, industry or region were to experience economic difficulties or changes in the regulatory environment.

Our portfolio consists primarily of commercial loans to small and medium-sized, privately owned businesses in a limited number of industries and regions primarily throughout the United States. In our normal course of business, we engage in lending activities with clients primarily throughout the United States. As of December 31, 2013, the single largest industry concentration in our outstanding loan balance was health care and social assistance, which represented approximately 22.2% of the outstanding loan portfolio. As of December 31, 2013, taken in the aggregate, lender finance (primarily timeshare) loans were our largest loan concentration by sector and represented approximately 16% of our loan portfolio. As of December 31, 2013, the largest loan to one borrower amounted to $83.7 million, or 1.2%, of our portfolio and the largest relationship with one borrower amounted to $104.1 million, or 1.5%, of our portfolio which was comprised of multiple loans.

Apart from the borrower industry concentrations, loans secured by real estate represented approximately 43% of our outstanding loan portfolio as of December 31, 2013. Within this area, the largest property type concentration was the multifamily category, comprising approximately 23% of total loans and 10% of loans secured by real estate. The largest geographical concentration was in California, comprising approximately 21% of total loans and 9% of loans secured by real estate.

If any particular industry or geographic region were to experience economic difficulties, the overall timing and amount of collections on our loans to clients operating in those industries or geographic regions may differ from what we expected, which could have a material adverse impact on our financial condition or results of operations.

Additionally, compared to larger, publicly owned firms, privately owned small and medium-sized companies generally have limited access to capital and higher funding costs, may be in a weaker financial position and may need more capital to expand or compete. These financial challenges may make it difficult for our clients to make scheduled payments of interest or principal on our loans. Accordingly, loans made to these types of clients entail higher risks than loans made to companies that are able to access a broader array of credit sources. The concentration of our portfolio in loans to these types of clients could amplify these risks.

Further, there is generally no publicly available information about the small and medium-sized privately owned companies to which we lend. Therefore, we underwrite our loans based on detailed financial information and projections provided to us by our clients and we must rely on our clients and the due diligence efforts of our employees to obtain the information relevant to

making our credit decisions. We rely upon the management of these companies to provide full and accurate disclosure of material information concerning their business, financial condition and prospects. We may not have access to all of the material information about a particular client's business, financial condition and prospects, or a client's accounting records may be poorly maintained or organized. The client's business, financial condition and prospects may also change rapidly in the current economic environment. In such instances, we may not make a fully informed credit decision which may lead, ultimately, to a failure or inability to recover our loan in its entirety.

We are in a competitive business and may not be able to take advantage of attractive opportunities.

Our markets are competitive and characterized by varying competitive factors. We compete with a large number of companies, including:


•	commercial banks and thrifts;


•	specialty and commercial finance companies;


•	private investment funds;


•	insurance companies; and


•	investment banks.

Some of our competitors have greater financial, technical, marketing and other resources and market positions than we do. They also have greater access to capital than we do and at a lower cost than is available to us. Furthermore, we would expect to face increased price competition on deposits if banks or other competitors seek to expand within or enter our target markets. Increased competition could cause us to reduce our pricing and lend greater amounts as a percentage of a client's eligible collateral or cash flows. Even with these changes, in an increasingly competitive market, we may not be able to attract and retain depositors or clients or maintain or grow our business and our market share and future revenues may decline. If our existing clients choose to use competing sources of credit to refinance their loans, the rate at which loans are repaid may increase, which could change the characteristics of our loan portfolio as well as cause our anticipated return on our existing loans to vary.

Risks Impacting Funding our Operations

Our ability to operate our business depends on our ability to raise sufficient deposits and in some cases other sources of funding.

CapitalSource Bank's ability to maintain or raise sufficient deposits may be limited by several factors, including:


•	competition from a variety of competitors, many of which offer a greater selection of products and services have greater financial resources;


•	as a California state-chartered bank, CapitalSource Bank is permitted to offer only savings, money market, and time deposit products, which limitations may adversely impact its ability to compete effectively; and


•	depositors’ negative views of the Company could cause those depositors to withdraw their deposits or seek higher rates.

While we expect to maintain and continue to raise deposits at a reasonable rate of interest, there is no assurance that we will be able to do so successfully. If the ability of CapitalSource Bank to attract and retain suitable levels of deposits weakens, it would have a negative impact on our business, financial condition, results of operations and the market price of our common stock.

In addition, given the short average maturity of CapitalSource Bank's deposits relative to the maturity of its loans, the inability of CapitalSource Bank to raise or maintain deposits could compromise our ability to operate our business, impair our liquidity and threaten our solvency.

Aside from deposit funding, CapitalSource Bank may obtain back-up liquidity from the Parent Company pursuant to the $150.0 million revolving credit facility it has established with the Parent Company. The Parent Company may not have or maintain sufficient liquidity, in which case CapitalSource Bank may not be able to draw on the $150.0 million revolving credit facility.

CapitalSource Bank has borrowing facilities established with the FHLB SF and the FRB. Our access to borrowing from FHLB SF may be materially impacted should Congress alter or dissolve the Federal Home Loan Bank system. Our access to the FRB primary credit program may be materially impacted should the FRB modify its credit program and limit CapitalSource Bank's access to the program. The ability to borrow from each of the FHLB SF and the FRB is dependent upon the value of collateral pledged to these entities. These lenders could reduce the borrowing capacity of CapitalSource Bank, eliminate certain types of

eligible collateral or could otherwise modify or even terminate their respective loan programs. Such changes or termination could have an adverse affect on our liquidity and profitability.

Our commitments to lend additional amounts to existing clients exceed our resources available to fund these commitments.

As of December 31, 2013, we had $1.1 billion of unfunded commitments to extend credit to our clients, of which $1.0 billion were commitments of CapitalSource Bank and $28.0 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 funding, 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 to future funding by us, and our clients may draw on these unfunded commitments at any time. Clients may seek to draw on our unfunded commitments to improve their cash positions. We expect that these unfunded commitments will continue to exceed the Parent Company's available funds. Our failure to satisfy our full contractual funding commitment to one or more of our clients could create breach of contract and lender liability for us and irreparably damage our reputation in the marketplace, which would have a material adverse effect on our ability to continue to operate our business.

Fluctuating interest rates could adversely affect our net interest margins.

We raise short-term deposits at prevailing rates in our local retail consumer markets. We generally lend money at variable rates based on either prime or LIBOR indices. Our operating results and cash flow depend on the difference between the interest rates at which we borrow funds and raise deposits and the interest rates at which we lend these funds. Because prevailing interest rates are below many of the rate floors in our loans, upward movements in interest rates will not immediately result in additional interest income, although these movements would increase our cost of funds. Therefore, any upward movement in rates may result in a reduction of our net interest income. For additional information about interest rate risk, see Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk Management.

In addition, changes in market interest rates, or in the relationships between short-term and long-term market interest rates, or between different interest rate indices, could affect the interest rates charged on interest earning assets differently than the interest rates paid on interest bearing liabilities, which could result in an increase in interest expense relative to our interest income. Additionally, changes in interest rates could adversely influence the growth rate of loans and deposits and the quality of our loan portfolio.

Risks Related to Our Operations

We are subject to extensive government regulation and supervision, which limit our flexibility and could result in adverse actions by regulatory agencies against us.

We are subject to extensive federal and state regulation and supervision that govern, limit or otherwise affect almost all aspects of our operations. Such regulation and supervision is intended primarily to protect customers, depositors and the FDIC Deposit Insurance Fund - not our shareholders. The laws and regulations to which we are subject, among other matters, establish minimum capital requirements, limit the business activities we can conduct, prohibit various business practices, limit the dividends or distributions CapitalSource Bank can pay, establish reporting requirements, require approvals or consent for many types of transactions or business changes, and establish standards for financial and managerial safety and soundness. Our state and federal regulators periodically conduct examinations of our business, including examination of our compliance with laws and regulations as well as the safety and soundness of our banking operations. Failure to comply with laws, regulations or policies pursuant to which we operate, or any regulatory order to which we are or may become subject, even if unintentional or inadvertent, could result in adverse actions by regulatory agencies against us. Such actions could result in higher capital requirements, higher deposit insurance premiums, additional limitations on our activities, civil monetary penalties and fines or, ultimately, termination of deposit insurance, or appointment of the FDIC as conservator or receiver for CapitalSource Bank. See the Supervision and Regulation section of Item 1, Business, above and, Item 8, Financial Statements and Supplementary Data, including Note 14, Bank Regulatory Capital, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

Changes in laws and regulations, including the enactment of the Dodd-Frank Act, may have a material effect on our operations.

We are currently facing increased regulation and supervision of our industry as a result of the financial crisis in the banking and financial markets. In addition, federal and state legislatures and regulatory agencies continually review banking laws, regulations and policies for possible changes for other reasons, including perceived needs for improvements in the provision of

financial services, the elimination of inappropriate practices or a strengthening of risk management practices. Changes to banking laws or regulations, including changes in their interpretation or implementation, could materially affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit or restrict our ability to use capital for business purposes, limit the types of financial services and products we may offer or increase the ability of companies not subject to banking regulations to offer competing financial services and products, among other things, which may have a material adverse effect on our business, financial condition, results of operations or reputation.

•

The Dodd-Frank Act required a study regarding the continued exemption of industrial banks from the Bank Holding Company Act of 1956, as amended, or BHC Act. As a state-chartered industrial bank, CapitalSource Bank is currently exempt from the definition of “bank” under the BHC Act. The required study, which has been completed by the General Accounting Office, did not state a definitive conclusion on this question but did report that the Treasury Department and the Federal Reserve Board believe that the current exemption poses risks to the financial system. If the current exemption is eliminated, in order to continue to own CapitalSource Bank, the Parent Company would be required to register as a bank holding company, or BHC. If we were unsuccessful in registering as a BHC or another exception does not become available to us, our continued ownership of CapitalSource Bank would not be permissible.

•

The Dodd-Frank Act requires the federal financial agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain “unregistered investment companies” (defined as hedge funds and private equity funds). This statutory provision is commonly referred to as the “Volcker Rule.” In December 2013, five financial regulatory agencies, including the FDIC, adopted final rules implementing the Volcker Rule (the “Final Rules”). The Final Rules prohibit banking entities from (i) engaging in short-term proprietary trading for their own accounts, or (ii) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). The Final Rules are intended to provide greater clarity with respect to the extent of those prohibitions and the related exemptions and exclusions. Each regulated entity, including the Parent Company and CapitalSource Bank, is also required to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule. The Final Rules also include certain regulatory reporting requirements. We intend to adopt the Final Rules by the mandated April 1, 2014 date and expect to be fully compliant with the Final Rules by the conformity period on July 21, 2015. We are currently analyzing the impact of the Final Rule.

Six financial regulatory federal agencies, including the FDIC, have proposed rules to implement the Dodd-Frank Act provisions requiring retention of credit risk by certain securitization participants through holding interests in securitization vehicles. The proposed rules would require a securitizer (or sponsor) to retain an economic interest equal to at least 5 percent of the aggregate credit risk of assets collateralizing an issuance of asset-backed securities, subject to certain exceptions for qualified residential mortgages and qualified commercial real estate mortgages, commercial loans and auto loans, which meet specified underwriting standards. Because these rules are not yet finalized or effective, the ultimate effect of these provisions on the CapitalSource Bank and the Parent Company are not known at this time. We will continue to monitor developments related to the implementation of these risk retention provisions of the Dodd-Frank Act.

These rules and regulations, and other changes in the regulatory regime, may include additional requirements, conditions, and limitations that could increase our compliance costs and materially adversely affect our business, operations, financial results and the price of our common stock.

Federal bank regulators have adopted increased capital standards for banking organizations, including under the Basel III framework, which may have a material effect on our operations.

We are required to satisfy minimum regulatory capital standards. On December 16, 2010, the Basel Committee on Banking Supervision announced an international agreement among member country bank regulatory authorities to a heightened set of capital and liquidity standards, referred to as Basel III, for banking organizations around the world. On July 9, 2013, the federal banking agencies issued final rules (the “Basel III Capital Rules”), which will become effective on January 1, 2015 (subject to phase-in periods for certain provisions), establishing a new comprehensive capital framework for U.S. banking organizations. The Basel III Capital Rules revise the definitions and components of regulatory capital, expand the scope of the deductions from and adjustments to capital, expand the number of risk-weighting categories and assign higher risk weights to certain assets and make other changes that affect the calculation of regulatory capital ratios. The Basel III Capital Rules also implement certain provisions of the Dodd-Frank Act, including the requirements to remove references to credit ratings from the federal agencies’ rules. These changes and other regulatory initiatives in the United States in the wake of the financial crisis, including provisions of the Dodd-Frank Act, are expected to result in higher regulatory capital standards and expectations for banking organizations.

In addition, the Basel III Capital Rules revise the prompt corrective action (“PCA”) regulations pursuant to section 38 of the Federal Deposit Insurance Act, which authorize and, under certain circumstances, require the federal banking agencies to take certain actions against banks that fail to meet their capital requirements, particularly those that are categorized as less than “adequately capitalized” (i.e., categorized as “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized”). The Basel III Capital rules revise the PCA regulations by: (1) introducing a CET1 ratio requirement at each PCA category (other than “critically undercapitalized”; (2) increasing the minimum Tier 1 capital ratio requirement for each category; and (3) eliminating the current provision that allows a bank with a composite supervisory rating of 1 to have a 3% leverage ratio and remain classified as “adequately capitalized.” The total risk-based capital ratio requirement for each PCA category remains unchanged. To qualify as “well capitalized” under the revised PCA regulations, a bank must meet the following capital ratio requirements: (1) 6.5% CET1 to risk-weighted assets; (2) 8.0% Tier 1 capital to risk-weighted assets; (3) 10.0% total capital to risk-weighted assets, and (4) 5.0% leverage ratio. The FDIC and other federal banking agencies have advised that they expect banking organizations to maintain capital ratios well above the minimum ratios necessary to be categorized as “well capitalized.”

We are in the process of determining the impact of the new capital requirements on our capital ratios.

In general, however, increased regulatory capital and liquidity standards, or changes in the manner in which such standards are implemented, could adversely affect our financial results. We will continue to monitor developments relating to the implementation of the Basel III Capital Rules, the issuance of any additional capital and liquidity requirements and their potential impact on our operations.

We face risks in connection with our strategic undertakings and new businesses, products or services.

If appropriate opportunities present themselves, we may engage in strategic activities, which could include acquisitions, joint ventures, or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.

In order to finance future strategic undertakings, we might obtain additional equity or debt financing. Such financing might not be available on terms favorable to us, or at all. If obtained, equity financing could be dilutive and the incurrence of debt and contingent liabilities could have material adverse effect on our business, results of operations and financial condition.

Our ability to execute strategic activities successfully will depend on a variety of factors. These factors likely will vary on the nature of the activity but may include our success in integrating the operations, services, products, personnel and systems of an acquired company into our business, operating effectively with any partner with whom we elect to do business, retaining key employees, achieving anticipated synergies, meeting expectations and otherwise realizing the undertaking's anticipated benefits. Our ability to address these matters successfully cannot be assured. In addition, our strategic efforts may divert resources or management's attention from ongoing business operations and may subject us to additional regulatory scrutiny. If we do not successfully execute a strategic undertaking, it could adversely affect our business, financial condition, results of operations, reputation and growth prospects. In addition, if we were able to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations.

In addition, from time to time, we may develop and grow new lines of business or offer new products and services, within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.

Our risk management framework may not be effective in mitigating risks and/or losses to us.

We have implemented a risk management framework to manage our risk exposure. This framework is comprised of various processes, systems and strategies, and is designed to manage the types of risk to which we are subject, including, among others, credit, market, liquidity, operational, financial, interest rate, legal and regulatory, compliance, strategic, reputation, fiduciary, and general economic risks. Our framework also includes financial or other modeling methodologies, which involves management assumptions and judgment. There is no assurance that our risk management framework will be effective under all circumstances or that it will adequately mitigate any risk or loss to us. If our framework is not effective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially adversely affected. We may also be subject to potentially adverse regulatory consequences.

The change of control rules under Section 382 of the Internal Revenue Code may limit our ability to use net operating loss carryovers and other tax attributes to reduce future tax payments or our willingness to issue equity.

We have net operating loss carryforwards for federal and state income tax purposes that can be utilized to offset future taxable income. If we were to undergo a change in ownership of more than 50% of our capital stock over a three-year period as measured under Section 382 of the Internal Revenue Code, our ability to utilize our net operating loss carryforwards, certain built-in losses and other tax attributes recognized in years after the ownership change generally would be limited. The annual limit would equal the product of the applicable long term tax exempt rate and the value of the relevant taxable entity's capital stock immediately before the ownership change. These change of ownership rules generally focus on ownership changes involving stockholders owning directly or indirectly 5% or more (the "5-Percent Shareholders") of a company's outstanding stock, including certain public groups of stockholders as set forth under Section 382, and those arising from new stock issuances and other equity transactions, which may limit our willingness and ability to issue new equity. The determination of whether an ownership change occurs is complex and not entirely within our control. No assurance can be given as to whether we have undergone, or in the future will undergo, an ownership change under Section 382 of the Internal Revenue Code.

In July 2013, the Board of Directors adopted a tax benefit preservation plan which was designed to preserve the net operating loss carryforwards and other tax attributes of the Company. The plan is intended to discourage persons from becoming 5-Percent Shareholders and existing 5-Percent Shareholders from increasing their beneficial ownership of shares.

We are subject to claims and litigation which could adversely affect our cash flows, financial condition and results of operations, or cause significant reputational harm to us.

We may be involved, from time to time, in litigation pertaining to our lending activities. If such claims and legal actions, whether founded or unfounded, are not resolved in a manner favorable to us they may result in significant financial liability. Although we establish accruals for legal matters according to accounting requirements, the amount of loss ultimately incurred in relation to those matters may be substantially higher than the amounts accrued. Substantial legal liability could adversely affect our business, financial condition or results of operations or cause significant reputational harm, which could seriously harm our business.

Our systems may experience an interruption or breach in security which could subject us to increased operating costs as well as litigation and other liabilities.

We rely on the computer and telephone systems and network infrastructure that we use to conduct our business. These systems and infrastructure could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer and telephone equipment against damage from fire, power loss, telecommunications failure or a similar catastrophic event. Any damage or failure that causes an interruption in our operations could have an adverse effect on our clients. In addition, we must be able to protect the computer systems and network infrastructure utilized by us against physical damage, security breaches and service disruption caused by the internet or other users. Such break-ins and other disruptions would jeopardize the security of information stored in and transmitted through our systems and network infrastructure, which may result in significant liability to us and deter potential clients. While we have systems, policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our systems and infrastructure, there can be no assurance that these measures will be successful and that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. In addition, the failure of our clients to maintain appropriate security for their systems also may increase our risk of loss in connection with business transactions with them. The occurrence of any failures, interruptions or security breaches of systems and infrastructure could damage our reputation, result in a loss of business and/or clients, result in losses to us or our clients, subject us to additional regulatory scrutiny, cause us to incur additional expenses, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.

Our controls and procedures may fail or be circumvented.

We review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition. In addition, if we identify material weaknesses in our internal control over financial reporting or are otherwise required to restate our financial statements, we could be required to implement expensive and time-consuming remedial measures and could lose investor confidence in the accuracy and completeness of our financial reports. This could have an adverse effect on our business, financial condition, results of operations and common stock price, and could potentially subject us to litigation.

Risks Related to Income Taxes

The Company and its subsidiaries are subject to examinations and challenges by taxing authorities.

In the normal course of business, the Company and its subsidiaries are routinely subjected to examinations and challenges from federal and state taxing authorities regarding tax positions taken by the Company and the determination of the amount of tax due. These examinations may relate to income, franchise, gross receipts, payroll, property, sales and use, or other tax returns filed, or not filed, by the Company. The challenges made by taxing authorities may result in adjustments to the amount of taxes due, and may result in the imposition of penalties and interest. If any such challenges are not resolved in the Company's favor, they could have a material adverse effect on the Company's financial condition, results of operations, and liquidity.

The Company and its subsidiaries are subject to changes in federal and state tax laws and changes in interpretation of existing laws.

The Company's financial performance is impacted by federal and state tax laws. Given the current economic and political environment, and ongoing budgetary pressures, the enactment of new federal or state tax legislation may occur. The enactment of such legislation, or changes in the interpretation of existing law, including provisions impacting income tax rates, apportionment, consolidation or combination, income, expenses, and credits, may have a material adverse effect on the Company's financial condition, results of operations, and liquidity.

Risks Related to Our Common Stock

We may not pay dividends on our common stock.

Our board of directors, in its sole discretion, will determine the amount and frequency of dividends to our shareholders based on a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, regulatory stress tests, economic conditions, tax considerations, and other factors. If we change our dividend policy, our common stock price could be adversely affected.

Some provisions of Delaware law and our certificate of incorporation and bylaws as well as certain banking laws may deter third parties from acquiring us.

Our certificate of incorporation and bylaws provide for, among other things:


•	a classified board of directors;


•	restrictions on the ability of our shareholders to fill a vacancy on the board of directors;


•	the authorization of undesignated preferred stock, the terms of which may be established and shares of which may be issued without shareholder approval; and


•	advance notice requirements for shareholder proposals.

We also are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which restricts the ability of any shareholder that at any time holds more than 15% of our voting shares to acquire us without the approval of shareholders holding at least 66 2/3% of the shares held by all other shareholders that are eligible to vote on the matter.

Federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, which could inhibit a business combination and adversely affect the market price of our common stock.

These laws and anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors of your choosing and cause us to take other corporate actions than you desire.


ITEM 1B.	UNRESOLVED STAFF COMMENTS

None.


ITEM 2.	PROPERTIES

We lease office space in Los Angeles, California and Chevy Chase, Maryland, a suburb of Washington, D.C., under long-term operating leases. We also maintain smaller offices under operating leases in Arizona, California, Colorado, Connecticut, Georgia, Florida, Illinois, Massachusetts, Missouri, New York, North Carolina, Pennsylvania, Tennessee, Texas and Utah. We believe our leased facilities are adequate for us to conduct our business.


ITEM 3.	LEGAL PROCEEDINGS

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.


ITEM 4.	MINE SAFETY DISCLOSURES

Not applicable.

PART II


ITEM 5.	MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Price Range of Common Stock

Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “CSE.” The high and low sales prices for our common stock as reported by the NYSE for the quarterly periods during 2013 and 2012 were as follows:



	High		Low
2013:
Fourth Quarter	$	14.72	$	12.98
Third Quarter	13.23		11.37
Second Quarter	12.26		8.85
First Quarter	9.86		8.03
2012:
Fourth Quarter	$	8.15	$	7.26
Third Quarter	7.93		6.56
Second Quarter	6.99		5.96
First Quarter	7.26		6.30

On February 26, 2014, the last reported sale price of our common stock on the NYSE was $14.41 per share.

Holders

As of February 26, 2014, there were 384 holders of record of our common stock. The number of holders does not include individuals or entities who beneficially own shares, but whose shares are held of record by a broker or clearing agency, and each such broker or clearing agency is included as one record holder. American Stock Transfer & Trust Company serves as transfer agent for our shares of common stock.

Dividend Policy

For the years ended December 31, 2013 and 2012, we declared and paid dividends as follows:



	Dividends Declared and Paid per Share
	2013		2012
Fourth Quarter	$	0.01	$	0.51
Third Quarter	0.01		0.01
Second Quarter	0.01		0.01
First Quarter	0.01		0.01
Total dividends declared and paid	$	0.04	$	0.54

For shareholders who held our shares for the entire year, the dividends declared and paid in 2013 and 2012 were classified for tax reporting purposes as dividend income.

Our Board of Directors (the "Board"), in its sole discretion, will determine the amount and frequency of dividends to be provided to our shareholders based on a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations, and other factors. Per the Merger Agreement, our dividend is limited to $0.01 per share per quarter.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

A summary of our common stock share repurchases for the three months ended December 31, 2013, was as follows:



	Total Number of Shares Purchased⁽¹⁾	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs⁽²⁾	Maximum Number of Shares (or Approximate Dollar Value) that May Yet be Purchased Under the Plans⁽²⁾
October 1 - October 31, 2013	22,206	$	12.89	—
November 1 - November 30, 2013	33,588	13.45		—
December 1 - December 31, 2013	102,741	14.16		—
Total	158,535	$	13.83	—	$	—

_________________________


(1)	Represents 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 authorized the repurchase of $150.0 million of our common stock over a period of up to 2 years. Subsequently, an additional $635.0 million was also authorized during the same period. In October 2012, the Board extended the program to include the period through December 31, 2013 and reset the authorization at $250.0 million. Collectively, we refer to these authorizations as the “Stock Repurchase Program.” All shares repurchased under the Stock Repurchase Program were retired upon settlement. As a result of entering into the Merger Agreement, the Stock Repurchase Program was suspended as of July 23, 2013. The Stock Repurchase Program was terminated as of December 31, 2013.

Performance Graph

The following graph compares the performance of our common stock during the five-year period beginning on December 31, 2008 to December 31, 2013, with the S&P 500 Index and the S&P 500 Financials Index. The graph depicts the results of investing $100 in our common stock, the S&P 500 Index, and the S&P 500 Financials Index at closing prices on December 31, 2008, assuming all dividends were reinvested. Historical stock performance during this period may not be indicative of future stock performance.

Comparison of Cumulative Total Return

Source: SNL Financial LC, Charlottesville, VA



Company/Index	Base Period 12/31/08		Year Ended December 31,
Company/Index	Base Period 12/31/08		2009		2010		2011		2012		2013
CapitalSource Inc.	$	100	$	87.1	$	156.9	$	149.0	$	180.8	$	344.1
S&P 500 Index	100		126.5		145.5		148.6		172.4		228.2
S&P 500 Financials Index	100		117.2		131.4		109.0		140.4		190.5


ITEM 6.	SELECTED FINANCIAL DATA

You should read the data set forth below in conjunction with our audited consolidated financial statements and related notes, Management's Discussion and Analysis of Financial Condition and Results of Operations and other financial information appearing elsewhere in this report. The following tables show selected portions of historical consolidated financial data as of and for the five years ended December 31, 2013. We derived our selected consolidated financial data as of and for the five years ended December 31, 2013, from our audited consolidated financial statements, which have been audited by Ernst & Young LLP, an independent registered public accounting firm.



	Year Ended December 31,
	2013		2012			2011			2010			2009
	($ in thousands, except per share and share data)
Results of operations:
Interest income	$	447,476	$	468,214		$	510,390		$	639,641		$	871,946
Interest expense	74,088		79,407			150,010			232,096			427,312
Net interest income	373,388		388,807			360,380			407,545			444,634
Provision for loan and lease losses	20,531		39,442			92,985			307,080			845,986
Net interest income (loss) after provision for loan and lease losses	352,857		349,365			267,395			100,465			(401,352		)
Non-interest income	82,550		49,846			92,694			71,662			(8,667		)
Non-interest expense	189,078		193,682			375,170			333,451			364,511
Net income (loss) from continuing operations before income taxes	246,329		205,529			(15,081		)	(161,324		)	(774,530		)
Income tax expense (benefit) ⁽¹⁾	82,037		(285,081		)	36,942			(20,802		)	136,314
Net income (loss) from continuing operations	164,292		490,610			(52,023		)	(140,522		)	(910,844		)
Net income from discontinued operations, net of taxes	—		—			—			9,489			49,868
Gain (loss) from sale of discontinued operations, net of taxes	—		—			—			21,696			(8,071		)
Net income (loss)	164,292		490,610			(52,023		)	(109,337		)	(869,047		)
Net loss attributable to noncontrolling interests	—		—			—			(83		)	(28		)
Net income (loss) attributable to CapitalSource Inc.	$	164,292	$	490,610		$	(52,023	)	$	(109,254	)	$	(869,019	)
Basic income (loss) per share:
From continuing operations	$	0.84	$	2.19		$	(0.17	)	$	(0.44	)	$	(2.97	)
From discontinued operations	—		—			—			0.10			0.14
Attributable to CapitalSource Inc.	$	0.84	$	2.19		$	(0.17	)	$	(0.34	)	$	(2.84	)
Diluted income (loss) per share:
From continuing operations	$	0.82	$	2.13		$	(0.17	)	$	(0.44	)	$	(2.97	)
From discontinued operations	—		—			—			0.10			0.14
Attributable to CapitalSource Inc.	$	0.82	$	2.13		$	(0.17	)	$	(0.34	)	$	(2.84	)
Average shares outstanding:
Basic	195,189,983		223,928,583			302,998,615			320,836,867			306,417,394
Diluted	200,451,899		230,154,989			302,998,615			320,836,867			306,417,394
Cash dividends declared per share	$	0.04	$	0.54		$	0.04		$	0.04		$	0.04
Dividend payout ratio attributable to CapitalSource Inc.	0.05		0.25			(0.24		)	(0.12		)	(0.01		)

________________________


(1)	We provided for income tax expense (benefit) on the consolidated income earned or loss incurred based on effective tax rates of 33.3%, (138.7)%, (245)%, 12.9%, and (17.6)% in 2013, 2012, 2011, 2010 and 2009, respectively.



	Year Ended December 31,
	2013		2012		2011		2010		2009
	($ in thousands)
Balance sheet data:
Investment securities, available-for-sale	$	870,482	$	1,079,025	$	1,188,002	$	1,522,911	$	960,591
Investment securities, held-to-maturity	74,369		108,233		111,706		184,473		242,078
Commercial real estate “A” Participation Interest, net	—		—		—		—		530,560
Total loans⁽¹⁾	6,663,969		6,044,676		5,729,537		5,922,650		7,549,215
Assets of discontinued operations, held for sale	—		—		—		—		624,650
Total assets	8,905,490		8,549,005		8,300,068		9,445,407		12,261,050
Deposits	6,127,690		5,579,270		5,124,995		4,621,273		4,483,879
Credit facilities	—		—		—		67,508		542,781
Term debt	—		177,188		309,394		979,254		2,956,536
Other borrowings	1,037,156		1,005,738		1,015,099		1,375,884		1,204,074
Total borrowings	1,037,156		1,182,926		1,324,493		2,422,646		4,703,391
Liabilities of discontinued operations	—		—		—		—		363,293
Total shareholders' equity	1,636,627		1,625,172		1,575,146		2,053,942		2,183,259
Total loan commitments	8,028,407		7,448,235		7,558,327		8,592,968		11,600,297
Average outstanding loan size	3,511		3,643		3,779		4,538		7,720
Average balance of loans⁽²⁾	6,369,520		6,013,799		5,816,760		7,375,775		9,028,580
Employees as of year end	495		543		564		625		665

________________________


(1)	Includes loans held for sale and loans held for investment, net of deferred loan fees and discounts and the allowance for loan and lease losses.


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



	Year Ended December 31,
	2013		2012		2011		2010		2009
Performance ratios:
Return on average assets:
Income (loss) from continuing operations	1.90	%	5.80	%	(0.58	)%	(1.36	)%	(6.41	)%
Net income (loss)	1.90	%	5.80	%	(0.58	)%	(1.06	)%	(5.69	)%
Return on average equity:
Income (loss) from continuing operations	10.41	%	30.25	%	(2.64	)%	(6.97	)%	(43.86	)%
Net income (loss)	10.41	%	30.25	%	(2.64	)%	(5.42	)%	(31.96	)%
Yield on average interest-earning assets⁽¹⁾	5.79	%	6.16	%	6.28	%	6.65	%	6.42	%
Cost of funds⁽¹⁾	1.07	%	1.19	%	2.23	%	2.90	%	3.60	%
Net interest margin⁽¹⁾	4.83	%	5.12	%	4.43	%	4.24	%	3.27	%
Operating expenses as a percentage of average total assets⁽²⁾	1.96	%	2.21	%	2.37	%	2.15	%	1.91	%
Core lending spread⁽¹⁾	6.33	%	6.77	%	7.67	%	7.51	%	7.41	%
Efficiency ratio⁽³⁾	38.44	%	43.50	%	47.18	%	46.41	%	62.39	%
Credit quality ratios⁽⁴⁾:
Loans 30-89 days contractually delinquent as a percentage of average loans (as of year end)	0.03	%	0.39	%	0.21	%	0.44	%	3.33	%
Loans 90 or more days delinquent as a percentage of average loans (as of year end)	0.41	%	0.66	%	1.61	%	5.03	%	5.50	%
Loans on non-accrual status as a percentage of average loans (as of year end)	1.49	%	1.98	%	4.72	%	10.99	%	12.89	%
Impaired loans as a percentage of average loans (as of year end)	1.49	%	3.32	%	7.15	%	14.65	%	15.10	%
Net charge offs (as a percentage of average loans)	0.27	%	1.27	%	4.62	%	5.78	%	7.30	%
Allowance for loan and lease losses as a percentage of loans receivable (as of year end)	1.78	%	1.91	%	2.67	%	5.35	%	7.08	%
Capital and leverage ratios:
Average equity to average assets⁽¹⁾	18.25	%	19.18	%	22.01	%	19.49	%	14.61	%
Equity to total assets (as of year end)⁽¹⁾	18.38	%	19.01	%	18.98	%	21.75	%	17.93	%

________________________


(1)	Ratios calculated based on continuing operations.


(2)	Operating expenses included compensation and benefits, professional fees, occupancy expense, FDIC fees and assessments, general depreciation and amortization and other administrative expenses.


(3)	Efficiency ratio is defined as operating expense divided by net interest and non-interest income, less leased equipment depreciation.


(4)	Credit ratios calculated based on average gross loans, which excludes deferred loan fees and discounts and the allowance for loan and lease losses.


ITEM 7.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

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

As of December 31, 2013, we had total assets of $8.9 billion, total loans of $6.8 billion, total deposits of $6.1 billion and stockholders' equity of $1.6 billion.

For the years ended December 31, 2013, 2012 and 2011, we operated as two reportable segments: the Bank and Other Commercial Finance. The Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. For additional information, see Note 20, Segment Data.

Results of Operations

Consolidated

The significant factors influencing our consolidated results of operations for the year ended December 31, 2013, compared to the year ended December 31, 2012 include an increase in net income tax expense, a decrease in interest income, offset by an increase in non-interest income and a decrease in loan and lease loss provision. Consolidated income tax expense (benefit) for the year ended December 31, 2013 and 2012 was $82.0 million and $(285.1) million, respectively. The $367.1 million increase in income tax expense was primarily the result of the release of the deferred tax valuation allowance during the year ended December 31, 2012. Interest income decreased from $468.2 million during year ended December 31, 2012 to $447.5 million during the year ended December 31, 2013 due to lower yields on both our loan portfolio and investment securities available-for-sale portfolio. Non-interest income increased during the year ended December 31, 2013 primarily due to gains on investments arising from the sale of investment securities. The loan and lease loss provision decreased from $39.4 million for the year ended December 31, 2012 to $20.5 million for the year ended December 31, 2013 due to an improvement in our overall portfolio credit profile with reserve releases related to loans at the Parent Company.

For the years ended December 31, 2013, 2012 and 2011, our consolidated average balances and the resulting average interest yields and rates were as follows:



	2013						2012						2011
	Average Balance		Interest Income / (Expense)		Yield / Rate		Average Balance		Interest Income / (Expense)		Yield / Rate		Average Balance		Interest Income / (Expense)		Yield / Rate
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	263,771	$	648	0.25	%	$	372,581	$	1,304	0.35	%	$	809,946	$	2,195	0.27	%
Investment securities	1,067,571		30,242		2.83	%	1,247,084		38,230		3.07	%	1,562,768		55,524		3.55	%
Loans⁽¹⁾	6,369,520		415,375		6.52	%	5,952,699		428,397		7.20	%	5,732,172		452,607		7.90	%
Other assets	29,542		1,211		4.10	%	25,978		283		1.01	%	23,742		64		0.27	%
Total interest-earning assets	$	7,730,404	$	447,476	5.79	%	$	7,598,342	$	468,214	6.16	%	$	8,128,628	$	510,390	6.28	%
Interest-bearing liabilities:
Deposits	$	5,870,561	$	51,941	0.88	%	$	5,400,247	$	51,035	0.95	%	$	4,808,141	$	53,609	1.11	%
Other borrowings	1,051,639		22,147		2.11	%	1,253,237		28,372		2.26	%	1,911,613		96,401		5.04	%
Total interest-bearing liabilities	$	6,922,200	$	74,088	1.07	%	$	6,653,484	$	79,407	1.19	%	$	6,719,754	$	150,010	2.23	%
Net interest income/spread⁽²⁾			$	373,388	4.72	%			$	388,807	4.97	%			$	360,380	4.05	%
Net interest margin					4.83	%					5.12	%					4.43	%

_______________________


(1)	Average loan balances are net of deferred fees and discounts on loans. Non-accrual loans have been included in the average loan balances for the purpose of this analysis.


(2)	Net interest income is defined as the difference between total interest income and total interest expense which is calculated on a continuing operations basis. Net yield on interest-earning assets is defined as net interest-earnings divided by average total interest-earning assets.

For the years ended December 31, 2013 and 2012, changes in interest income, interest expense and net interest income as a result of changes in volume, changes in interest rates or both were as follows:



	2013 Compared to 2012									2012 Compared to 2011
	Due to Change in:⁽¹⁾						Net Change			Due to Change in:⁽¹⁾						Net Change
	Rate			Volume			Net Change			Rate			Volume			Net Change
	($ in thousands)
(Decrease) increase in interest income:
Cash and cash equivalents	(336		)	(321		)	(657		)	518			(1,409		)	(891		)
Investment securities, available-for-sale	(2,717		)	(5,204		)	(7,921		)	(865		)	(8,553		)	(9,418		)
Investment securities, held-to-maturity	(288		)	220			(68		)	(5,709		)	(2,166		)	(7,875		)
Loans	(41,816		)	28,794			(13,022		)	(41,156		)	16,946			(24,210		)
Other assets	911			17			928			207			13			220
Total (decrease) increase in interest income	(44,246		)	23,506			(20,740		)	(47,005		)	4,831			(42,174		)
(Decrease) increase in interest expense:
Deposits	(3,374		)	4,282			908			(8,726		)	6,153			(2,573		)
Credit facilities	—			—			—			(1,783		)	(1,783		)	(3,566		)
Long-term debt	2,555			(6,172		)	(3,617		)	(18,360		)	(18,154		)	(36,514		)
Other borrowings	(2,495		)	(115		)	(2,610		)	(19,806		)	(8,143		)	(27,949		)
Total decrease in interest expense	$	(3,314	)	$	(2,005	)	$	(5,319	)	$	(48,675	)	$	(21,927	)	$	(70,602	)
Net increase (decrease) in net interest income	$	(40,932	)	$	25,511		$	(15,421	)	$	1,670		$	26,758		$	28,428

_________________


(1)	The change in interest due to both volume and rates has been allocated in proportion to the relationship of the absolute dollar amounts of the change in each.

Our consolidated operating results for the year ended December 31, 2013, compared to the year ended December 31, 2012, and for the year ended December 31, 2012, compared to the year ended December 31, 2011, were as follows:



	Year Ended December 31,								2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013		2012			2011			2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Interest income	$	447,476	$	468,214		$	510,390		(4.4	)%	(8.3	)%
Interest expense	74,088		79,407			150,010			(6.7	)%	(47.1	)%
Provision for loan and lease losses	20,531		39,442			92,985			(47.9	)%	(57.6	)%
Non-interest income	82,550		49,846			92,694			65.6	%	(46.2	)%
Non-interest expense	189,078		193,682			375,170			(2.4	)%	(48.4	)%
Income tax expense (benefit)	82,037		(285,081		)	36,942			128.8	%	(871.7	)%
Net income (loss)	164,292		490,610			(52,023		)	(66.5	)%	1,043.1	%

Income Taxes

We provide for income taxes as a “C” corporation on income earned from operations. We are subject to federal, foreign, state and local taxation in various jurisdictions.

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

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 December 31, 2013 and 2012, the valuation allowance was $152.0 million and $128.6 million, respectively.

During 2012, we reversed $358.1 million of the valuation allowance, and such reversal was recorded as a benefit in our income tax expenses. 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. 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, significant positive evidence had developed which overcame this negative evidence such that, during the year ended December 31, 2012, management determined that it is more likely than not that a portion of 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 a recent history of positive earnings at the Bank, improved 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 are no longer in a cumulative pre-tax loss position since the end of 2012.

A valuation allowance of $152.0 million remains in effect as of December 31, 2013 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 these deferred tax assets subject to a valuation allowance will not be realized primarily due to their character and/or the expiration of the carryforward periods.

2013 vs. 2012. Consolidated income tax expense for the year ended December 31, 2013 was $82.0 million, compared to an income tax benefit of $(285.1) million for the year ended December 31, 2012. The income tax expense of $82.0 million for the year ended December 31, 2013 was primarily due to the tax on pre-tax book income offset by the resolution of the 2006-2008 audit and the sale of capital assets. The income tax benefit of $(285.1) million for the year ended December 31, 2012 was primarily due to the release of valuation allowance.

2012 vs. 2011. Consolidated income tax benefit for the year ended December 31, 2012 was $(285.1) million, compared to income tax expense of $36.9 million for the year ended December 31, 2011. The income tax benefit of $(285.1) million for the

year ended December 31, 2012 was primarily due to the release of the valuation allowance. The tax expense of $36.9 million for the year ended December 31, 2011 was primarily due to the decrease in the net deferred tax assets of one of our corporate entities.

Comparison of the Years Ended December 31, 2013, 2012 and 2011

Certain amounts in the prior year's audited consolidated financial statements have been reclassified to conform to the current year presentation, including modifying the presentation of our audited consolidated statements of operations to include the caption of total operating expenses and the new line item of other administrative expenses being split apart from other non-interest expense. Accordingly, the reclassifications have been appropriately reflected throughout our audited consolidated financial statements. The discussion that follows differentiates our results of operations between our segments.

CapitalSource Bank Segment

Our CapitalSource Bank operating results for the year ended December 31, 2013, compared to December 31, 2012, and for the year ended December 31, 2012, compared to December 31, 2011, were as follows:



	Year Ended December 31,						2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013		2012		2011		2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Interest income	$	418,885	$	393,083	$	368,964	6.6	%	6.5	%
Interest expense	62,685		62,096		62,802		0.9	%	(1.1	)%
Provision for loan and lease losses	16,866		16,192		27,539		4.2	%	(41.2	)%
Non-interest income	66,184		60,495		41,697		9.4	%	45.1	%
Non-interest expense	168,249		168,569		149,710		(0.2	)%	12.6	%
Income tax expense	96,593		84,054		57,996		14.9	%	44.9	%
Net income	140,676		122,667		112,614		14.7	%	8.9	%

Interest Income

2013 vs. 2012. Total interest income increased to $418.9 million for the year ended December 31, 2013 from $393.1 million for the year ended December 31, 2012, with an average yield on interest-earning assets of 5.72% and 5.90%, respectively. During the years ended December 31, 2013 and 2012, interest income on loans was $390.9 million and $359.2 million, respectively, yielding 6.41% and 7.01% on average loan balances of $6.1 billion and $5.1 billion, respectively. The 60 basis point decrease in loan yield is due to a 46 basis point decrease from lower loan and lease yields, a 17 basis point decrease due to amortization of premiums on purchased loans, a 15 basis point decrease due to the amortization of deferred loan fees, offset by a 15 basis point increase due to changes in prepayment speeds on loans, a 3 basis point increase due to changes in non-accrual interest and other factors.

Included in the lower loan yield analysis above, interest income of $4.7 million and $8.8 million during the years ended December 31, 2013 and 2012, respectively, was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.08% and 0.17%, respectively. During the years ended December 31, 2013 and 2012, $0.4 million and $1.4 million of interest was collected on loans previously on non-accrual status and recognized in interest income, respectively.

During the years ended December 31, 2013 and 2012, interest income from our investments, including available-for-sale and held-to-maturity securities, was $26.4 million and $32.4 million, yielding 2.53% and 2.65% on average balances of $1.0 billion and $1.2 billion, respectively. The average balances of investment securities available-for-sale and held-to-maturity decreased as a result of sales and maturities of securities which we did not fully replace due to loan growth and associated liquidity needs. The investment yield change is primarily due to a 36 basis point decrease resulting from relatively higher yielding securities paying down, purchasing new securities at lower yields and adjustable rate bonds' coupons resetting lower, offset by an 8 basis point increase resulting from accelerated discount amortization of a held-to-maturity commercial mortgage-backed security ("CMBS") from its prepayment and a 16 basis point increase due to lower premium amortization attributable to slower projected prepayment speeds on our available-for-sale MBS. As a result, total interest income on investments decreased $6.0 million attributed to a $5.9 million and $0.1 million decrease in interest income from available-for-sale securities and held-to-maturity securities, respectively.

During the year ended December 31, 2013, we purchased $117.6 million of investment securities, available-for-sale and $47.9 million of held-to-maturity securities, while $318.8 million and $35.5 million of principal repayments and sales were made on our investment securities, available-for-sale and held-to-maturity, respectively. During the year ended December 31, 2012, we

purchased $287.1 million of investment securities, available-for-sale and no investment securities, held-to-maturity while $385.3 million and $5.1 million, respectively, of principal repayments were received.

During the years ended December 31, 2013 and 2012, interest income on cash and cash equivalents was $0.4 million and $1.2 million, respectively, yielding 0.29% and 0.40% on average balances of $150.1 million and $294.2 million, respectively.

2012 vs. 2011. Total interest income increased to $393.1 million for the year ended December 31, 2012 from $369.0 million for the year ended December 31, 2011, with an average yield on interest-earning assets of 5.90% for the year ended December 31, 2012 compared to 6.13% for the year ended December 31, 2011. During the years ended December 31, 2012 and 2011, interest income on loans was $359.2 million and $319.5 million, respectively, yielding 7.01% on average loan balances of $5.1 billion and $4.1 billion, respectively. Interest income of $15.7 million was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.38% during the year ended December 31, 2011. In addition, $0.1 million of interest income was not recognized for loans on non-accrual status during the year ended December 31, 2011.

During the years ended December 31, 2012 and 2011, interest income from our investments, including available-for-sale and held-to-maturity securities, was $32.4 million and $48.4 million, yielding 2.65% and 3.14% on average balances of $1.2 billion and $1.5 billion, respectively. The average balances of investment securities available-for-sale and held-to-maturity decreased as a result of principal paydowns and maturities of securities which we did not fully replace due to loan growth and associated liquidity needs. Additionally, the overall yield of the portfolio decreased in the declining interest rate environment experienced in 2012. As a result, during the year ended December 31, 2012, total interest income on investments decreased $16.0 million attributed to an $8.1 million decrease in interest income from available-for-sale securities and a $7.9 million decrease in interest income from held-to-maturity securities.

During the year ended December 31, 2011, we purchased $591.9 million of investment securities, available-for-sale, and $10.6 million of investment securities, held-to-maturity, while $702.9 million and $92.6 million of principal repayments were received, respectively.

During the years ended December 31, 2012 and 2011, interest income on cash and cash equivalents was $1.2 million and $1.1 million, yielding 0.40% and 0.35% on average balances of $294.2 million and $306.2 million, respectively.

Interest Expense

2013 vs. 2012. Total interest expense increased to $62.7 million for the year ended December 31, 2013 from $62.1 million for the year ended December 31, 2012. However, the cost of interest-bearing liabilities decreased from 1.04% for the year ended December 31, 2012 to 0.97% the year ended December 31, 2013. Average balances of interest-bearing liabilities were $6.5 billion and $6.0 billion as of December 31, 2013 and 2012, respectively, which consisted of deposits and borrowings. The lower cost of interest-bearing liabilities was the result of a lower interest rate environment as higher interest bearing rate liabilities were replaced at lower interest rates.

Our interest expense on deposits for the years ended December 31, 2013 and 2012 was $51.9 million and $51.0 million with an average cost of deposits of 0.88% and 0.95% on average balances of $5.9 billion and $5.4 billion, respectively. During the year ended December 31, 2013, $4.8 billion of our time deposits matured with a weighted average interest rate of 0.85% and $5.4 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.90%. During the year ended December 31, 2012, $5.1 billion of our time deposits matured with a weighted average interest rate of 0.99%, and $5.8 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.86%. Additionally, for the year ended December 31, 2013, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, declined from 0.51% at the beginning of the year to 0.46% at the end of the year.

During the year ended December 31, 2013, our interest expense on borrowings, consisting of FHLB SF borrowings, was $10.7 million with an average cost of 1.77% on an average balance of $606.1 million. The primary reason for using FHLB SF borrowings as a funding source is to manage interest rate risk and the secondary is to provide a source of liquidity. For the year ended December 31, 2013, there were $23.0 million term advances taken with a weighted average rate of 0.87% and $43.0 million term maturities with a weighted average rate of 1.35%. We maintained an average overnight advances balance of $12.1 million with a weighted average rate of 0.12%. For the year ended December 31, 2013, the weighted average rates for FHLB SF borrowings maturing within one year, one to five years, and greater than five years were 1.12%, 1.81% and 1.62%, respectively. Overall, the FHLB SF borrowing balance had a weighted-average-life of 2.3 years. For the year ended December 31, 2012, our interest expense on FHLB SF borrowings was $11.1 million with an average cost of 1.88% on an average balance of $587.3 million. For the year ended December 31, 2012, there were term advances of $98.0 million with related maturities of $53.0 million and no overnight advances and maturities.

2012 vs. 2011. Total interest expense decreased to $62.1 million for the year ended December 31, 2012 from $62.8 million for the year ended December 31, 2011. The decrease was primarily due to a decrease in the average cost of interest-bearing liabilities which was 1.04% and 1.19% for the years ended December 31, 2012 and 2011, respectively. The lower cost of interest-bearing

liabilities was the result of a lower interest rate environment as higher interest bearing rate liabilities were replaced at lower interest rates. Interest expense decreased despite an increase in average balances of interest-bearing liabilities of $6.0 billion and $5.3 billion as of December 31, 2012 and 2011, respectively which consisted of deposits and borrowings.

Our interest expense on deposits for the years ended December 31, 2012 and 2011 was $51.0 million and $53.6 million with an average cost of deposits of 0.95% and 1.11% on average balances of $5.4 billion and $4.8 billion, respectively. During the year ended December 31, 2012, $5.1 billion of our time deposits matured with a weighted average interest rate of 0.99%, and $5.8 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.86%. During the year ended December 31, 2011, $3.8 billion of our time deposits matured with a weighted average interest rate of 1.04%, and $4.2 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.94%. During the year ended December 31, 2012, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, declined from 0.75% at the beginning of the year to 0.51% at the end of the year.

For the year ended December 31, 2012, our interest expense on borrowings, consisting of FHLB SF borrowings, was $11.1 million with an average cost of 1.88% on an average balance of $587.3 million. During December 31, 2011, our interest expense on FHLB SF borrowings was $9.2 million with an average cost of 2.02% on an average balance of $455.1 million.

Net Interest Margin

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the years ended December 31, 2013, 2012 and 2011 were as follows:



	Year Ended December 31,
	2013						2012						2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost		Weighted Average Balance		Net Interest Income		Average Yield/Cost		Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	150,105	$	430	0.29	%	$	294,242	$	1,174	0.40	%	$	306,229	$	1,058	0.35	%
Investment securities	1,041,187		26,389		2.53	%	1,220,212		32,396		2.65	%	1,541,511		48,359		3.14	%
Loans (1)	6,096,284		390,858		6.41	%	5,121,261		359,233		7.01	%	4,145,130		319,485		7.71	%
Other assets	29,543		1,208		4.09	%	27,985		280		1.00	%	23,741		62		0.26	%
Total interest-earning assets⁽¹⁾	7,317,119		418,885		5.72	%	6,663,700		393,083		5.90	%	6,016,611		368,964		6.13	%
Interest-bearing liabilities:
Deposits	5,870,561		51,941		0.88	%	5,400,247		51,035		0.95	%	4,808,141		53,609		1.11	%
Other borrowings	606,110		10,744		1.77	%	587,301		11,061		1.88	%	455,055		9,193		2.02	%
Total interest-bearing liabilities⁽²⁾	6,476,671		62,685		0.97	%	5,987,548		62,096		1.04	%	5,263,196		62,802		1.19	%
Net interest income/spread (2)			$	356,200	4.75	%			$	330,987	4.86	%			$	306,162	4.94	%
Net interest margin					4.87	%					4.97	%					5.09	%

________________________


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


(2)	Interest-bearing liabilities include deposits and 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.

Non-Interest Income

CapitalSource Bank services loans and other assets, which are owned by the Parent Company and third parties, for which it receives fees based on the number of loans or other assets serviced. Loans serviced by CapitalSource Bank for the benefit of others were $0.9 billion, $1.4 billion, and $2.5 billion as of December 31, 2013, 2012 and 2011, respectively, of which $87.0 million, $549.0 million, 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.



	Year Ended December 31,								2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013		2012			2011			2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Loan fees	$	22,772	$	16,089		$	8,678		41.5	%	85.4	%
Leased equipment income	20,590		14,113			3,748			45.9	%	276.5	%
Gain (loss) on investments, net	208		(1		)	4,713			20,900.0	%	(100.0	)%
Gain (loss) on derivatives	1,068		(1,162		)	(312		)	191.9	%	(272.4	)%
Bank fees	187		193			203			(3.1	)%	(4.9	)%
Gain (loss) on sale of assets	2,402		516			(128		)	365.5	%	503.1	%
Loan servicing revenue	5,345		10,362			12,588			(48.4	)%	(17.7	)%
Intercompany shared service revenue	10,366		14,904			6,340			(30.4	)%	135.1	%
Other	3,246		5,481			5,867			(40.8	)%	(6.6	)%
Total	$	66,184	$	60,495		$	41,697		9.4	%	45.1	%

2013 vs. 2012


•	Loan fees increased $6.7 million, or 41.5%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to increased termination fees due to early pay offs on loans and increased miscellaneous loans fees, such as late fees, penalties, unused line fees, and recurring fees.

•

Leased equipment income increased $6.5 million, or 45.9%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to an increase in equipment on operating leases of $114.4 million as of December 31, 2012 to $132.1 million as of December 31, 2013. In addition, average balances on our leased equipment increased $39.2 million, or 43.4%, from $90.4 million as of December 31, 2012 to $129.6 million as of December 31, 2013, respectively.


•	Gain on derivatives increased $2.2 million, or 191.9%, from the year ended December 31, 2012 to the year ended December 31, 2013 due to valuation changes in our foreign exchange rate contracts at December 31, 2013.


•	Gain on sale of assets increased $1.9 million, or 365.5%, from the year ended December 31, 2012 to the year ended December 31, 2013 due to loan sales resulting in larger realized gains during the year ended December 31, 2013.


•	Loan servicing revenue decreased $5.0 million, or 48.4%, from the year ended December 31, 2012 to the year ended December 31, 2013 as the number of Parent Company loans serviced by CapitalSource Bank declined with the runoff of the Parent Company loan portfolio.


•	Intercompany shared service revenue decreased $4.5 million, or 30.4%, from the year ended December 31, 2012 to the year ended December 31, 2013 as the general services provided to the Parent Company decreased with the reduction in Parent Company operations and activities.


•	Other income decreased $2.2 million, or 40.8%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to foreign currency translation adjustments on our loans denominated in a foreign currencies.

2012 vs. 2011


•	Loan fees increased $7.4 million, or 85.4%, from the year ended December 31, 2011 to the year ended December 31, 2012 primarily due to increased termination fees due to early pay offs on loans and increased miscellaneous loans fees, such as late fees, penalties, unused line fees, and recurring fees.

•

Leased equipment income increased $10.4 million from the year ended December 31, 2011 to the year ended December 31, 2012 primarily due to an increase in equipment on operating leases of $83.1 million as of December 31, 2011 to $114.4 million as of December 31, 2012. In addition, average balances on our leased equipment increased $65.5 million, or 380.2%, from $17.2 million as of December 31, 2011 to $82.7 million as of December 31, 2012, respectively.


•	Gain on investments, net, decreased $4.7 million from the year ended December 31, 2011 to the year ended December 31, 2012 due to less sale activity of securities during the year ended December 31, 2012.


•	Loan servicing revenue decreased $2.2 million, or 17.7%, from the year ended December 31, 2011 to the year ended December 31, 2012 primarily due to decreases of Parent Company and third party loans serviced by CapitalSourceBank.

•

Intercompany shared service revenue increased $8.6 million, or 135.1%, from the year ended December 31, 2011 to the year ended December 31, 2012 as CapitalSource Bank charges the Parent Company for shared services. Nearly all of the Parent Company employees were transferred to CapitalSource Bank beginning January 2012, resulting in an increase in services provided to the Parent Company and related shared services revenue.

Non-Interest Expense

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. At the start of 2012, the origination function, and all related personnel, were transferred to CapitalSource Bank, as a result of which the loan referral fee ceased being paid while other operating expenses of CapitalSource Bank increased. There were no such fees in operating expense for the years ended December 31, 2013 and 2012; and $51.2 million for the year ended December 31, 2011. These fees have been eliminated in consolidation.



	Year Ended December 31,								2013 vs. 2012 % Change		2012 vs. 2011 % Change
	December 31, 2013			December 31, 2012			December 31, 2011		2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Compensation and benefits	$	107,619		$	102,417		$	49,941	5.1	%	105.1	%
Professional fees	4,214			5,628			4,054		(25.1	)	38.8
Occupancy expenses	9,568			10,139			7,106		(5.6	)	42.7
FDIC fees and assessments	5,067			5,958			6,091		(15.0	)	(2.2	)
General depreciation and amortization	4,908			3,884			4,198		26.4		(7.5	)
Intercompany loan referral expense	—			—			45,078		—		(100.0	)
Loan servicing expense	1,504			5,903			6,167		(74.5	)	(4.3	)
Other administrative expenses	20,702			22,886			11,308		(9.5	)	102.4
Total operating expenses	153,582			156,815			133,943		(2.1	)	17.1
Leased equipment depreciation	14,427			9,919			2,720		45.4		264.7
Expense of real estate owned and other foreclosed assets, net	1,203			2,169			12,756		(44.5	)	(83.0	)
Other non-operating (gains) expenses	(963		)	(334		)	291		188.3		(214.8	)
Total	$	168,249		$	168,569		$	149,710	(0.2	)	12.6

2013 vs. 2012


•	Compensation and benefits increased $5.2 million, or 5.1%, from the year ended December 31, 2012 to the year ended December 31, 2013, due to increases in base compensation, bonuses, and stock compensation.


•	Professional fees decreased $1.4 million, or 25.1%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to decreases in other miscellaneous professional service accruals for the year ended December 31, 2013.


•	Loan servicing expense decreased $4.4 million from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to a lower level of problem loans that required third party professional fees or special servicing, and increased reimbursements from borrowers on newly originated loans or performing loans.


•	Other administrative expenses decreased $2.2 million, or 9.5%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to decreases in travel and franchise tax expenses.

•

Leased equipment depreciation increased $4.5 million, or 45.4%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to an increase in equipment subject to operating leases issued by CapitalSource Bank. The equipment subject to operating leases increased $39.2 million, or 43.4%, from $90.4 million as of December 31, 2012 to $129.6 million as of December 31, 2013, respectively.


•	Expense of real estate owned and other foreclosed assets, net decreased $1.0 million, or 44.5%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to a $1.6 million reduction in impairment losses offset by greater realized gains of $0.6 million.

2012 vs. 2011


•	Compensation and benefits increased $52.5 million, or 105.1%, from the year ended December 31, 2011 to the year ended December 31, 2012, due to increases in base compensation, bonuses, and stock compensation which resulted from the transfer of Parent Company employees to the Bank on January 1, 2012.


•	Professional fees increased $1.6 million, or 38.8%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to increases in audit, accounting fees and legal fees.


•	Occupancy expenses increased $3.0 million, or 42.7%, from the year ended December 31, 2011 to the year ended December 31, 2012, as a result of transferring Parent Company employees to CapitalSource Bank.


•	Intercompany loan referral fee decreased $45.1 million, or 100.0%, from the year ended December 31, 2011 to the year ended December 31, 2012, as the loan referral fees were no longer paid to the Parent Company as the Parent Company employees transferred to CapitalSource Bank.

•

Leased equipment depreciation increased $7.2 million, or 264.7%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to an increase in equipment subject to operating leases issued by the Bank. The equipment subject to operating leases increased $31.3 million, or 37.6%, from $83.1 million as of December 31, 2011 to $114.4 million as of December 31, 2012. In addition, average balances on our leased equipment increased $70.9 million, or 230.4%, from $30.8 million as of December 31, 2011 to $101.7 million as of December 31, 2012, respectively.

•

Expense of real estate owned and other foreclosed assets, net decreased $10.6 million, or 83.0%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to a $6.6 million decrease in realized losses on the sale of real estate owned during 2011, a $1.7 million decrease in unrealized impairment losses, and a $2.3 million overall decrease in related net operating expenses during 2012 as a result of our ongoing efforts to resolve real estate owned and other foreclosed assets.

Other Commercial Finance Segment

Our Other Commercial Finance operating results for the year ended December 31, 2013, compared to December 31, 2012, and for the year ended December 31, 2012, compared to December 31, 2011, were as follows:



	Year Ended December 31,									2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013			2012			2011			2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Interest income	$	26,551		$	78,629		$	141,056		(66.2	)%	(44.3	)%
Interest expense	11,403			17,311			87,208			(34.1	)%	(80.1	)%
Provision for loan and lease losses	3,665			23,250			65,446			(84.2	)%	(64.5	)%
Non-interest income	33,263			14,522			123,951			129.1	%	(88.3	)%
Non-interest expense	37,470			51,344			300,652			(27.0	)%	(82.9	)%
Income tax benefit	(15,237		)	(370,209		)	(21,054		)	(95.9	)%	1,658.4	%
Net income (loss)	22,513			371,455			(167,245		)	(93.9	)%	322.1	%

Interest Income

2013 vs. 2012. Interest income decreased to $26.6 million for the year ended December 31, 2013 from $78.6 million for the year ended December 31, 2012, primarily due to a 55.7% decrease in average total interest-earning assets. During the year ended December 31, 2013, our average balance of interest-earning assets decreased by $0.5 billion, compared to the year ended December 31, 2012, due to the runoff of Parent Company loans. Additionally, since the Merger announcement, the Parent Company has been retaining all excess cash generated from operations, and investing those funds in short-term investments, thereby depressing the yield on the average interest-earning assets. During the years ended December 31, 2013 and 2012, the yield on average interest-earning assets was 6.43% and 8.42%, respectively.

2012 vs. 2011. Total interest income decreased to $78.6 million for the year ended December 31, 2012 from $141.1 million for the year ended December 31, 2011, primarily due to a 55.7% decrease in average total interest-earning assets. During the year ended December 31, 2012, the average balance of interest-earning assets decreased by $1.2 billion, compared to the year ended

December 31, 2011, due to the continued runoff of Parent Company loans. During the years ended December 31, 2012 and 2011, the yield on average interest-earning assets was 8.42% and 6.69%, respectively.

Interest Expense

2013 vs. 2012. Interest expense decreased to $11.4 million for the year ended December 31, 2013 from $17.3 million for the year ended December 31, 2012, primarily due to a decrease of $220.4 million, or 33.1%, in average interest-bearing liabilities from $0.7 billion as of December 31, 2012 to $0.4 billion as of December 31, 2013. The decrease in interest-bearing liabilities was primarily driven by the early retirement of our term debt securitizations.

2012 vs. 2011. Interest expense decreased to $17.3 million for the year ended December 31, 2012 from $87.2 million for the year ended December 31, 2011, primarily due to a decrease in average interest-bearing liabilities from $1.5 billion as of December 31, 2011 to $0.7 billion as of December 31, 2012. The decrease in interest-bearing liabilities was primarily driven by the early retirement of our 12.75% Senior Secured Notes of $298.1 million.

Net Interest Margin

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the years ended December 31, 2013, 2012 and 2011 were as follows:



	Year Ended December 31,
	2013						2012						2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost		Weighted Average Balance		Net Interest Income		Average Yield/Cost		Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	113,666	$	221	0.19	%	$	76,333	$	133	0.17	%	$	503,717	$	72	0.01	%
Investment securities	26,384		3,853		14.60	%	26,872		5,834		21.71	%	21,257		7,165		33.71	%
Loans	273,102		22,477		8.23	%	830,316		72,662		8.75	%	1,583,594		132,752		8.38	%
Other assets	—		—		—	%	—		—		—	%	—		1,067		—	%
Total interest-earning assets⁽¹⁾	413,152		26,551		6.43	%	933,521		78,629		8.42	%	2,108,568		141,056		6.69	%
Interest-bearing liabilities:
Borrowings	445,530		11,403		2.56	%	665,937		17,311		2.60	%	1,456,558		87,208		5.99	%
Total interest-bearing liabilities⁽²⁾	445,530		11,403		2.56	%	665,937		17,311		2.60	%	1,456,558		87,208		5.99	%
Net interest income/spread			$	15,148	3.87	%			$	61,318	5.82	%			$	53,848	0.70	%
Net interest margin					3.67	%					6.57	%					2.55	%

_________________________


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


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

Non-Interest Income

Prior to 2012, the Parent Company referred loans to CapitalSource Bank and provided loan origination due diligence services to CapitalSource Bank. 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. At the start of 2012, the origination function, and all related personnel, were transferred into CapitalSource Bank, and as a result, the loan fees received by the Parent Company decreased.



	Year Ended December 31,								2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013			2012		2011			2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Loan fees	$	774		$	2,472	$	7,556		(68.7	)%	(67.3	)%
Gain on investments, net	28,757			7,383		53,868			289.5		(86.3	)
(Loss) gain on derivatives	(7		)	338		(6,501		)	102.1		(105.2	)
Bank fees	—			—		63			—		(100.0	)
Gain on sale of assets	5,893			3,159		12,003			86.5		(73.7	)
Intercompany loan referral revenue	—			—		49,034			—		(100.0	)
Loan servicing revenue	14			121		6,167			(88.4	)	(98.0	)
Other	(2,168		)	1,049		1,761			(306.7	)	(40.4	)
Total	$	33,263		$	14,522	$	123,951		129.1		(88.3	)

2013 vs. 2012


•	Loan fees decreased $1.7 million, or 68.7%, from the year ended December 31, 2012 to the year ended December 31, 2013, due to decreased unused line fees and letter of credit fees with the runoff of the Parent Company loan portfolio.


•	Gains on investments, net increased $21.4 million, or 289.5%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to the sale of investment securities during the year ended December 31, 2013 resulting in a $23.0 million realized gain.


•	Gain on sale of assets increased $2.7 million, or 86.5%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to gains on intercompany loan sales and third party commercial loan sales.


•	All other non-interest income decreased $3.2 million, or 306.7%, from the year ended December 31, 2012 to the year ended December 31, 2013 primarily due to foreign currency translation losses on debt and decreases in other miscellaneous income.

2012 vs. 2011

•

Loan fees decreased $5.1 million, or 67.3%, from the year ended December 31, 2011 to the year ended December 31, 2012, due to a $2.3 million decrease in due diligence fees, $2.0 million decrease in line of credit fees, and a $2.2 million decrease in unused line fees. The overall decrease in loan fees is primarily a result of transferring loan administration functions to CapitalSource Bank in early 2012, which was partially offset by a $1.4 million increase in legal, wire and late fees.

•

Gains on investments, net decreased $46.5 million, or 86.3%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to a $19.6 million decrease in income related to investment securities measured on a cost-basis, a $14.4 million decrease from a combination of dividends and gains on disposal of equity investments, and a $12.5 million decrease related to valuation adjustments on available-for-sale securities.


•	Loss on derivatives decreased $6.8 million, or 105.2%, from a loss of $6.5 million for the year ended December 31, 2011 to a gain of $0.3 million for the year ended December 31, 2012. This decrease is primarily due to a reduction in the total notional balance outstanding as $1.0 billion notional derivatives which were terminated in the first quarter 2012.


•	Gain on sale of assets decreased $8.8 million, or 73.7%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to lower gains on sales of loans offset by valuation adjustments to existing loans held for sale.


•	Intercompany loan referral revenue decreased $49.0 million from the year ended December 31, 2011 to the year ended December 31, 2012, due to loan origination and other administrative functions moving from the Parent Company to CapitalSource Bank.


•	Loan servicing revenue decreased $6.0 million, or 98.0%, from the year ended December 31, 2011 to the year ended December 31, 2012, as the Parent Company had previously provided loan services to CapitalSource Bank and was compensated for those services.

Non-Interest Expense



	Year Ended December 31,								2013 vs. 2012 % Change		2012 vs. 2011 % Change
	2013			2012			2011		2013 vs. 2012 % Change		2012 vs. 2011 % Change
	($ in thousands)
Compensation and benefits	$	57		$	3,013		$	79,680	(98.1	)%	(96.2	)%
Professional fees	610			7,186			27,128		(91.5	)	(73.5	)
Occupancy expenses	5,580			7,274			8,947		(23.3	)	(18.7	)
General depreciation and amortization	1,913			2,539			3,171		(24.7	)	(19.9	)
Loan servicing expense	10,205			18,325			12,647		(44.3	)	44.9
Other administrative expenses	14,420			17,564			22,156		(17.9	)	(20.7	)
Total operating expenses	32,785			55,901			153,729		(41.4	)	(63.6	)
(Gain) expense of real estate owned and other foreclosed assets, net	(382		)	4,621			26,591		108.3		82.6
(Gain) loss on extinguishment of debt	—			(8,059		)	119,007		(100.0	)	106.8
Other non-operating expenses (income)	5,067			(1,119		)	1,325		552.8		(184.5	)
Total	$	37,470		$	51,344		$	300,652	(27.0	)	(82.9	)

2013 vs. 2012


•	Compensation and benefits decreased $3.0 million, or 98.1%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to the transfer of Parent Company employees to CapitalSource Bank on January 1, 2012.


•	Professional fees decreased $6.6 million, or 91.5%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to decreases in audit, accounting and legal fees as a result of the simplification and runoff of the Parent Company loan portfolio.


•	Occupancy expense decreased $1.7 million, or 23.3%, from the year ended December 31, 2012 to the year ended December 31, 2013 due to the reduction in Parent Company operations.


•	Loan servicing expenses decreased $8.1 million, or 44.3%, from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to a lower level of problem loans that required third party professional fees or special servicing, and increased reimbursements from borrowers on performing loans.


•	Other administrative expenses decreased $3.1 million from the year ended December 31, 2012 to the year ended December 31, 2013, primarily due to certain loan administrative functions moving from the Parent Company to CapitalSource Bank and the runoff of the Parent Company loan portfolio.


•	(Gain) expense of real estate owned and other foreclosed assets, net, increased $5.0 million, or 108.3%, from $(4.6) million for the year ended December 31, 2012 to $0.4 million for the year ended December 31, 2013, primarily due to a $2.0 million increase in realized gains, a $1.8 million reduction in impairment losses, and a $1.2 million reduction in related operating expenses.


•	We had no gains on extinguishment of debt for the year ended December 31, 2013 compared to gains of $8.1 million during December 31, 2012. The gains during 2012 were attributable to the repurchase of debt related to our TP Trusts 2005-1 and 2006-4 which resulted in a $8.2 million gain offset by a $0.1 million loss related to the repurchase of our 7.25% Convertible Debentures.


•	The increase in non-operating expense of $6.2 million, or 552.8% from the year ended December 31, 2012 to the year ended December 31, 2013 was primarily due to merger-related costs.

2012 vs. 2011


•	Compensation and benefits decreased $76.7 million, or 96.2%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to the transfer of Parent Company employees to CapitalSource Bank on January 1, 2012.

•

Professional fees decreased $19.9 million, or 73.5%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to an $11.1 million decrease in cost of services for loans, as a result of the servicing functions being transferred to CapitalSource Bank in early 2012. Audit, accounting, legal fees, and other such administrative fees decreased by approximately $8.8 million as the associated functions were transferred to CapitalSource Bank.


•	Loan servicing expenses increased $5.7 million, or 44.9%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to increased loan servicing expenses reimbursable to CapitalSource Bank.


•	Other administrative expenses decreased $4.6 million, or 20.7%, from the year ended December 31, 2011 to the year ended December 31, 2012, primarily due to certain loan administrative functions moving from the Parent Company to CapitalSource Bank.

•

Expense of real estate owned and other foreclosed assets, net, decreased from $26.6 million for the year ended December 31, 2011 to $4.6 million for the year ended December 31, 2012, primarily due to a $14.9 million decrease in provision charge-offs and expenses related to foreclosed assets, $10.1 million decreases in unrealized losses and a $3.3 million decrease in operations and administrative expenses related to real estate owned properties. The overall decrease was partially offset by a $6.4 million increase in realized gains from real estate owned sales.

•

Losses on extinguishment of debt were $119.0 million for the year ended December 31, 2011 compared to gains of $8.1 million for the year ended December 31, 2012. The gains during 2012 were attributable to the repurchase of debt related to our TP Trusts 2005-1 and 2006-4 which resulted in a $8.2 million gain offset by a $0.1 million loss related to the repurchase of our 7.25% Convertible Debentures. The losses during 2011 included a $111.8 million loss related to the repurchase of our 12.75% Senior Secured Notes and a $7.2 million loss related to the repurchase of our 7.25% Convertible Debentures.


•	The decrease in non-operating expense of $2.4 million, or 184.5% from the year ended December 31, 2011 to the year ended December 31, 2012 was primarily due to a change in the allowance for unfunded commitments.

Financial Condition

Consolidated

As of December 31, 2013 and 2012, our consolidated balance sheet included:



	December 31,
	2013			2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	514,452		$	403,130
Investment securities, available-for-sale	870,482			1,079,025
Investment securities, held-to-maturity	74,369			108,233
Loans held for sale	—			22,719
Loans held for investment, net⁽²⁾	6,784,489			6,139,230
Allowance for loan and lease losses	(120,520		)	(117,273		)
Interest receivable	26,068			29,112
Other investments⁽³⁾	52,124			60,363
Goodwill	173,135			173,135
Deferred tax assets, net	252,268			362,283
Other assets	278,623			289,048
Total	$	8,905,490		$	8,549,005
Liabilities:
Deposits	$	6,127,690		$	5,579,270
Borrowings	1,037,156			1,182,926
Other liabilities	104,017			161,637
Total	$	7,268,863		$	6,923,833

________________________


(1)	As of December 31, 2013 and 2012, the amounts include restricted cash of $58.7 million and $104.0 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.

Cash and Cash Equivalents

Cash and cash equivalents consist of amounts due from banks, short-term investments and commercial paper with an initial maturity of three months or less.

Investment Securities, Available-for-Sale and Held-to-Maturity

Included in investment securities, available-for-sale, were agency securities which included commercial and residential mortgage pass through securities and collateralized mortgage obligations issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae ("Agency MBS"); asset-backed securities; investments in collateralized loan obligations ("CLOs"); residential mortgage-backed securities issued by non-government agencies (“Non-agency MBS”) and agency asset-backed securities issued by the Small Business Administration (“SBA ABS”). CapitalSource Bank pledges a portion of its investment securities, available-for-sale, as collateral to the Federal Reserve Bank of San Francisco Discount Window and to the State of California for deposits the state has with CapitalSource Bank as of December 31, 2013.

Investment securities, held-to-maturity, consists of non-agency commercial mortgage-backed securities rated AA+ or higher. CapitalSource Bank pledges a portion of its investment securities, held-to-maturity, to the FHLB SF and the FRB as collateral for current or future borrowings.

During 2013, we transferred certain investment securities, held-to-maturity, which consisted of collateralized loan obligations, to investment securities, available-for-sale. The CLOs were reclassified to available-for-sale due to the provisions of the Volcker Rule which prohibit banking entities from having ownership interests in "covered funds." As such, CapitalSource Bank would not be permitted to hold the CLOs to their contractual maturity.

For additional information on our investment securities, available-for-sale and held-to-maturity, see Note 4, Investments, in our accompanying consolidated financial statements for the year ended December 31, 2013.



	December 31,
	2013		2012
	($ in thousands)
Investment securities, available-for-sale:
Agency debt securities	$	784,240	$	983,521
Asset-backed securities	3,169		9,592
Collateralized loan obligations	47,337		26,250
Non-agency MBS	20,203		41,347
SBA asset-backed securities	15,533		18,315
Total investment securities, available-for-sale	$	870,482	$	1,079,025
Investment securities, held-to-maturity:
Commercial mortgage-backed securities	$	74,369	$	108,233

Investments by Maturity Dates

As of December 31, 2013, the carrying amounts, contractual maturities and weighted average yields of our investment securities were as follows:



	Due in One Year or Less			Due Between One and Five Years			Due Between Five and Ten Years⁽¹⁾			Due after Ten Years⁽²⁾			Total
	($ in thousands)
Investment securities, available-for-sale:
Agency debt securities	$	—		$	5,009		$	16,860		$	762,371		$	784,240
Asset-backed securities	—			—			3,169			—			3,169
Collateralized loan obligations	—			—			24,662			22,675			47,337
Non-agency MBS	—			8,321			193			11,689			20,203
SBA asset-backed securities	—			—			—			15,533			15,533
Total investment securities, available-for-sale	$	—		$	13,330		$	44,884		$	812,268		$	870,482
Weighted average yield	—		%	4.60		%	3.43		%	2.31		%	2.40		%
Investment securities, held-to-maturity:
Commercial mortgage-backed securities	$	—		$	—		$	60,396		$	13,973		$	74,369
Weighted average yield⁽³⁾	—		%	—		%	1.63		%	5.17		%	2.30		%

________________________


(1)	Includes Agency debt securities, Non-agency MBS, Non-agency ABS, Non-agency CMBS and CLO's with fair values of $16.9 million, $0.2 million, $3.2 million, $60.6 million and $24.7 million, respectively, and weighted average expected maturities of approximately 1.94, 1.83, 1.59, 0.41, and 4.43 years, respectively, based on interest rates and expected prepayment speeds as of December 31, 2013.

(2)

Includes Agency debt securities, SBA asset-backed securities, Non-agency MBS, Non-agency CMBS and CLO's with fair values of $762.4 million, $15.5 million, $11.7 million, $14.9 million, and $22.7 million, respectively, and weighted average expected maturities of approximately 4.06, 6.70, 2.01, 2.66, and 7.07 years, respectively, based on interest rates and expected prepayment speeds as of December 31, 2013.

Actual maturities of these securities may differ from contractual maturity dates because issuers may have the right to call or prepay obligations.

Loan Portfolio Composition

The outstanding unpaid principal balance of loans in our loan portfolio by category as of December 31, 2013, 2012, 2011, 2010 and 2009 was as follows:



	December 31,
	2013		2012		2011		2010		2009
	($ in thousands)
Commercial	$	3,852,537	$	3,594,643	$	3,491,259	$	4,159,831	$	4,919,196
Real estate	2,865,976		2,499,567		2,133,210		1,804,087		2,005,247
Real estate - construction	65,976		45,020		65,678		287,854		1,211,468
Total loans⁽¹⁾	$	6,784,489	$	6,139,230	$	5,690,147	$	6,251,772	$	8,135,911

_________________________________


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

As of December 31, 2013, the largest loan to one borrower amounted to $83.7 million, or 1.2%, of our portfolio and the largest relationship with one borrower amounted to $104.1 million, or 1.5%, of our portfolio which was comprised of multiple loans.

As of December 31, 2013, we had a concentration of over 10% of our loan balances in two industries (as defined by the North American Industry Classification System, not underlying collateral). These industries and their respective percentage to total loans were as follows:



	Percentage of Total Loans
Health care and social assistance	22.2%
Real estate and rental and leasing	21.2%

The loans within these industries are to approximately 830 borrowers located throughout the United States (47 states and the District of Columbia).

Loan Balances by Maturities

As of December 31, 2013, the contractual maturities of our loan portfolio were as follows:



	Due in One Year or Less		Due After One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	195,357	$	2,779,565	$	877,615	$	3,852,537
Real estate	196,855		1,722,799		946,322		2,865,976
Real estate - construction	10,069		28,755		27,152		65,976
Total⁽¹⁾	$	402,281	$	4,531,119	$	1,851,089	$	6,784,489

_________________________


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

Sensitivity in Loans to Changes in Interest Rates

As of December 31, 2013, the total amount of loans due after one year with predetermined interest rates and floating or adjustable interest rates were as follows:



	Loans with Predetermined Rates⁽¹⁾		Loans with Floating or Adjustable Rates		Total
	($ in thousands)
Commercial	$	705,346	$	2,928,614	$	3,633,960
Real estate	803,109		1,857,184		2,660,293
Real estate - construction	—		55,905		55,905
Total loans⁽²⁾	$	1,508,455	$	4,841,703	$	6,350,158

________________________


(1)	Represents loans for which the interest rate is fixed.


(2)	Includes deferred loan fees and discounts. Excludes loans held for sale at lower of cost or fair value and loans on non-accrual status.

As of December 31, 2013, approximately 78% of our accruing adjustable rate portfolio was subject to an interest rate floor. Due to low market interest rates as of December 31, 2013, 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 accruing loans was 0.94% as of December 31, 2013. To the extent the underlying indices subsequently increase, our interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.

As of December 31, 2013, the composition of our loan balances by adjustable rate index and by loan type was as follows:



	Loan Type						Total		Percentage
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	1,556,521	$	1,434,731	$	28,754	$	3,020,006	45	%
2-Month LIBOR	32,942		—		—		32,942		—
3-Month LIBOR	1,068,742		167,167		—		1,235,909		19
6-Month LIBOR	50,182		79,786		—		129,968		2
6-Month EURIBOR	—		4,010		—		4,010		—
Prime	325,404		228,337		27,152		580,893		9
Other	49,000		44,679		—		93,679		1
Treasuries	708		20,020		—		20,728		—
Total adjustable rate loans	3,083,499		1,978,730		55,906		5,118,135		76
Fixed rate loans⁽¹⁾	715,832		849,682		—		1,565,514		23
Loans on non-accrual status	53,206		37,564		10,070		100,840		1
Total loans⁽²⁾	$	3,852,537	$	2,865,976	$	65,976	$	6,784,489	100	%

________________________


(1)	Includes $655.9 million of loans that are in their introductory fixed rate period. For the majority of these loans, the fixed interest rate is higher than the fully indexed rate at December 31, 2013.


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

Credit Quality and Allowance for Loan and Lease Losses

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 DBO. 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

In prior years, real estate construction loans comprised a greater portion of our loan portfolio. At December 31, 2013, real estate construction loans were $66.6 million, or 1.0% of total loans. By comparison, at the end of 2010, real estate construction loans were $1.4 billion, or 14.8% of total loans. Loans secured by real estate construction projects generally have a greater degree of risk than real estate loans secured by improved property with in-place cash flows, and as such, loans secured by construction projects require an increased level of loan servicing and monitoring. Because of this, 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 of real estate construction loans include an interest reserve that is established upon origination of the loan. We recognize interest income from the reserve during the construction period as long as the interest is deemed collectible. 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 TDR, 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 (for example, 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 market conditions for 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.

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:



	December 31,
	2013⁽¹⁾			2012
	($ in thousands, except percentages)
Total real estate - construction loans⁽²⁾⁽³⁾	$	66,646		$	45,315
Non-performing	10,400			11,317
% of total real estate - construction	15.6		%	25.0		%
Cumulative capitalized interest	$	11,086		$	10,890

_______________________________________


(1)	As of December 31, 2013, three of the 30 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 $2.9 million and $1.9 million for the years ended December 31, 2013 and 2012, respectively.


(3)	Excludes deferred loan fees and discounts of $0.7 million and $0.3 million as of December 31, 2013 and 2012, respectively.

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in our consolidated loan portfolio as of December 31, 2013, 2012, 2011, 2010 and 2009 were as follows:



	December 31,
	2013		2012		2011		2010		2009
	($ in thousands)
Non-accrual loans
Commercial	$	53,206	$	79,400	$	144,651	$	353,673	$	393,774
Real estate	37,564		26,875		101,453		129,700		202,476
Real estate - construction	10,070		10,987		24,087		181,762		446,601
Total loans on non-accrual	$	100,840	$	117,262	$	270,191	$	665,135	$	1,042,851
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—	$	—	$	3,244	$	42,968
Real estate	—		—		5,603		6,238		—
Real estate - construction	—		—		—		39,606		23,701
Total accruing loans contractually past-due 90 days or more	$	—	$	—	$	5,603	$	49,088	$	66,669
Total non-performing loans
Commercial	$	53,206	$	79,400	$	144,651	$	356,917	$	436,742
Real estate	37,564		26,875		107,056		135,938		202,476
Real estate - construction	10,070		10,987		24,087		221,368		470,302
Total non-performing loans⁽¹⁾	$	100,840	$	117,262	$	275,794	$	714,223	$	1,109,520

_______________________________________


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

The decrease in the non-performing loan balance from December 31, 2012 to December 31, 2013 is primarily due to payoffs and sales of non-performing loans.

Additionally, certain loans within our portfolio have been identified as potential problem loans. Potential problem loans are impaired loans that have not been restructured in a TDR and are currently considered performing loans. Potential problem loans are 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 December 31, 2013 we had no potential problem loans. As of December 31, 2012, we had $1.9 million in potential problem loans related to six loans for which we have determined that it is probable that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreements, 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.

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:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	1,417	$	20,313
90+ days delinquent	27,635		39,094
Total delinquent non-accrual loans⁽¹⁾	$	29,052	$	59,407
Accruing loans
30-89 days delinquent	$	944	$	4,153
90+ days delinquent	—		—
Total delinquent accruing loans⁽¹⁾	$	944	$	4,153

_______________________________________


(1)	Includes deferred loan fees and discounts.

Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the years ended December 31, 2013, 2012, 2011, 2010 and 2009 was as follows:



	Year Ended December 31,
	2013			2012			2011			2010			2009
	($ in thousands)
Balance as of beginning of year	$	117,273		$	153,631		$	329,122		$	586,696		$	423,844
Charge offs:
Commercial	(5,631		)	(74,827		)	(162,577		)	(145,681		)	(308,554		)
Real estate	(2,576		)	(11,765		)	(50,878		)	(112,504		)	(76,919		)
Real estate - construction	(229		)	(9,784		)	(32,787		)	(126,912		)	(204,381		)
Total charge offs	(8,436		)	(96,376		)	(246,242		)	(385,097		)	(589,854		)
Recoveries
Commercial	5,533			9,145			5,693			827			11,299
Real estate	367			13,075			12,128			97			16
Real estate - construction	—			—			1,105			6			46
Total recoveries	5,900			22,220			18,926			930			11,361
Net charge offs	(2,536		)	(74,156		)	(227,316		)	(384,167		)	(578,493		)
Charge offs upon transfer to held for sale	(14,748		)	(1,644		)	(41,160		)	(42,353		)	(33,907		)
Deconsolidation of 2006-A Trust	—			—			—			(138,134		)	—
Loan and lease loss provision (recovery):
General	5,520			(16,393		)	(122,970		)	(128,164		)	775,252
Specific	15,011			55,835			215,955			435,244			—
Total loan and lease loss provisions	20,531			39,442			92,985			307,080			775,252
Balance as of end of year	$	120,520		$	117,273		$	153,631		$	329,122		$	586,696
Allowance for loan and lease losses ratio	1.8		%	1.9		%	2.7		%	5.3		%	7.2		%
Loan and lease loss provision as a percentage of average loans outstanding	0.3		%	0.7		%	1.6		%	4.2		%	9.4		%
Net charge offs as a percentage of average loans outstanding	0.3		%	1.3		%	4.6		%	5.8		%	7.3		%

The allowance for loan and lease losses allocated to each category of loans and the percentage of each category to our total loan portfolio as of December 31, 2013, 2012, 2011, 2010 and 2009 was as follows:



	December 31,
	2013			2012			2011			2010			2009
	($ in thousands)
Allocation by Category
Commercial	$	67,438		$	64,494		$	103,327		$	229,144		$	261,392
Real estate	46,852			50,526			50,103			78,572			138,575
Real estate - construction	6,230			2,253			201			21,406			186,729
Total allowance for loan and lease losses	$	120,520		$	117,273		$	153,631		$	329,122		$	586,696
Percentage of ALLL to Total Loan Portfolio by Category
Commercial	1.8		%	1.8		%	3.0		%	5.5		%	5.3		%
Real estate	1.6		%	2.0		%	2.3		%	4.4		%	6.9		%
Real estate - construction	9.4		%	5.0		%	0.3		%	7.4		%	15.4		%
Total	1.8		%	1.9		%	2.7		%	5.3		%	7.2		%

Our allowance for loan and lease losses increased by $3.2 million to $120.5 million as of December 31, 2013 from $117.3 million as of December 31, 2012. This increase consisted of a $5.5 million increase in general reserves and a $2.3 million decrease in specific reserves on impaired loans. The increase in the general reserve is due to additional provisions relating to net loan growth. The decrease in the specific reserve resulted from charged off specific reserves that were previously in place exceeding new specific provisions for loan losses. The primary factors that influence increases and decreases in general reserves are the net loan portfolio increases or decreases from period to period and qualitative adjustments to the general reserve based on economic circumstances and our loan portfolio performance and composition trends.

Impaired loans

We employ a 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 December 31, 2013 and 2012, our non-impaired and impaired loan balances was as follows:



	December 31,
	2013			2012
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	6,728,314		$	5,986,768
General reserves allocated	116,309			110,790
Effective reserve %	1.7		%	1.9		%
Impaired loans
Unpaid principal balance	$	102,205		$	206,090
Specific reserves allocated⁽¹⁾	4,211			6,483
Original legal balance previously charged off⁽²⁾	85,392			162,462
Total cumulative charge offs and specific reserves	89,603			168,945
Legal balance	223,226			407,147
Expected total loss of the legal balance (%)	40.1		%	41.5		%

_______________________________________

(1)

The decrease in specific reserves from December 31, 2012 to December 31, 2013 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $4.5 million, ii) reversals of specific reserves for loans impaired as of December 31, 2012 net of related charge offs of $1.0 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the year ended December 31, 2013 for $3.2 million. The specific reserves in place at December 31, 2013 and at December 31, 2012 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.

Adversely Classified Items Coverage Ratio

The Adversely Classified Items Coverage Ratio is a common regulatory metric used to assess the credit risk profile of a bank. The ratio compares the sum of the loans rated Substandard or Doubtful (plus any associated unfunded commitments, REO, foreclosed assets and investments rated Substandard) to the sum of the Tier 1 regulatory capital plus the allowance for loan and lease losses. As of December 31, 2013 and 2012, the ratio was 15.7% and 32.1%, respectively.



	December 31,
	2013			2012
	($ in thousands)

Substandard loans and associated unfunded commitments	$	225,340		$	355,884
REO and foreclosed assets	12,824			11,796
Substandard investment securities	—			39,105
Total classified items	$	238,164		$	406,785

Tier 1 capital	$	1,391,726		$	1,150,770
Allowance for loan and lease losses	120,520			117,273
Total Tier 1 capital plus allowance for loan and lease losses	$	1,512,246		$	1,268,043

Adversely classified items coverage ratio	15.7		%	32.1		%

CapitalSource Bank Segment

As of December 31, 2013 and 2012, the CapitalSource Bank segment included:



	December 31,
	2013			2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	87,312		$	230,305
Investment securities, available-for-sale	870,482			1,052,775
Investment securities, held-to-maturity	74,369			108,233
Loans held for investment, net⁽²⁾	6,698,093			5,618,810
Allowance for loan and lease losses	(109,469		)	(98,905		)
Interest receivable	25,787			24,598
Other investments⁽³⁾	21,913			22,795
Goodwill	173,135			173,135
Deferred tax assets, net	—			3,492
FHLB SF stock	31,255			28,200
Other assets	203,752			206,463
Total	$	8,076,629		$	7,369,901
Liabilities:
Deposits	$	6,127,690		$	5,579,270
FHLB SF borrowings	625,000			595,000
Other borrowings	81,877			85,179
Total	$	6,834,567		$	6,259,449

_______________________________________


(1)	As of December 31, 2013 and 2012, the amounts include restricted cash of $42.6 million and $48.2 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.

Cash and Cash Equivalents

Cash and cash equivalents consist of amounts due from banks, short-term investments and commercial paper with an initial maturity of three months or less.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consists of Agency MBS, Non-agency MBS and U.S. non-agency MBS, U.S. agency securities, and collateralized loan obligations. CapitalSource Bank pledges a portion of its investment securities, available-for-sale, to the Federal Reserve Bank of San Francisco's Discount Window and to the State of California as collateral for deposits the state has with CapitalSource Bank as of December 31, 2013. For additional information, see Note 4, Investments, in our accompanying consolidated financial statements for the year ended December 31, 2013.

Investment Securities, Held-to-Maturity

For additional information on our investment securities, held-to-maturity, see Note 4 Investments, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

CapitalSource Bank Loan Portfolio Composition

As of December 31, 2013 and 2012, the composition of CapitalSource Bank loan portfolio by loan type was as follows:



	December 31,
	2013				2012
	($ in thousands)
Commercial	$	3,792,844	57	%	$	3,137,863	56	%
Real estate	2,849,344		42	%	2,446,914		43	%
Real estate - construction	55,905		1	%	34,033		1	%
Total⁽¹⁾	$	6,698,093	100	%	$	5,618,810	100	%

_______________________________________


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

CapitalSource Bank Loan Balances by Maturities

As of December 31, 2013, the contractual maturities of CapitalSource Bank loan portfolio by loan type were as follows:



	Due in One Year or Less		Due After One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	151,919	$	2,763,360	$	877,565	$	3,792,844
Real estate	181,192		1,721,948		946,204		2,849,344
Real estate - construction	—		28,754		27,151		55,905
Total loans⁽¹⁾	$	333,111	$	4,514,062	$	1,850,920	$	6,698,093

_______________________________________


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

CapitalSource Bank Sensitivity in Loans to Changes in Interest Rates

As of December 31, 2013, approximately 78% of CapitalSource Bank's accruing adjustable rate portfolio was subject to an interest rate floor. Due to low market interest rates as of December 31, 2013, 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 accruing loans was 0.93% as of December 31, 2013. To the extent the underlying indices subsequently increase, CapitalSource Bank's interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.

As of December 31, 2013, the composition of CapitalSource Bank's loan balances by adjustable rate index and by loan type was as follows:



	Loan Type						Total		Percentage
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	1,541,550	$	1,434,695	$	28,754	$	3,004,999	45	%
2-Month LIBOR	32,941		—		—		32,941		—	%
3-Month LIBOR	1,068,742		166,319		—		1,235,061		20	%
6-Month LIBOR	50,182		79,767		—		129,949		2	%
6-Month EURIBOR	—		4,010		—		4,010		—	%
Prime	309,188		228,328		27,151		564,667		8	%
Other	48,968		44,679		—		93,647		1	%
Treasuries	708		20,020		—		20,728		—	%
Total adjustable rate loans	3,052,279		1,977,818		55,905		5,086,002		76	%
Fixed rate loans⁽¹⁾	715,815		849,682		—		1,565,497		23	%
Loans on non-accrual status	24,750		21,844		—		46,594		1	%
Total loans⁽²⁾	$	3,792,844	$	2,849,344	$	55,905	$	6,698,093	100	%

_______________________________________


(1)	Includes $655.9 million of loans that are in their introductory fixed rate period. For the majority of these loans, the fixed interest rate is higher than the fully indexed rate at December 31, 2013.


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

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 December 31, 2013.

Deposits

As of December 31, 2013 and 2012, a summary of CapitalSource Bank's deposits by product type and the maturities of the certificates of deposit were as follows:



	December 31,
	2013				2012
	Balance		Weighted Average Rate		Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	253,357	0.45	%	$	257,961	0.49	%
Savings	623,430		0.47	%	704,890		0.52	%
Certificates of deposit	5,250,903		0.97	%	4,616,419		0.94	%
Total interest-bearing deposits	$	6,127,690	0.90	%	$	5,579,270	0.87	%



	December 31, 2013
	Balance		Weighted Average Rate
	($ in thousands)
Remaining maturity of certificates of deposit:
0 to 3 months	$	997,709	0.86	%
4 to 6 months	1,039,969		0.88	%
7 to 9 months	1,747,035		0.99	%
10 to 12 months	909,687		1.00	%
Greater than 12 months	556,503		1.23	%
Total certificates of deposit	$	5,250,903	0.97	%

For the years ended December 31, 2013 and 2012, the average balances and the weighted average interest rates on deposit categories in excess of 10% of average total deposits were as follows:



	Year Ended December 31,
	2013				2012
	Average Balance		Weighted Average Rate		Average Balance		Weighted Average Rate
	($ in thousands)
Savings deposits	$	918,442	0.50	%	$	1,053,480	0.58	%
Time deposits	4,876,831		0.96	%	4,310,974		1.03	%
Total deposits	$	5,795,273	0.89	%	$	5,364,454	0.95	%

As of December 31, 2013, the composition of certificates of deposit in the amount of $100,000 or more and categorized by time remaining to maturity was as follows ($ in thousands):



0 to 3 months	$	561,420
4 to 6 months	585,091
7 to 12 months	1,670,324
Greater than 12 months	331,853
Total certificates of deposit in the amount of $100,000 or more	3,148,688
All other certificates of deposit	2,102,215
Total certificates of deposit	$	5,250,903

FHLB SF Borrowings

FHLB SF borrowings increased to $625.0 million as of December 31, 2013 from $595.0 million as of December 31, 2012. The primary reason for using FHLB borrowings as a funding source is to manage rate risk and the secondary reason is to provide a source of liquidly. The weighted-average remaining maturities of the borrowings were approximately 2.3 and 3.2 years as of December 31, 2013 and 2012, respectively.

As of December 31, 2013, 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	$	135,000	1.12	%
After 1 year through 2 years	112,500		1.85	%
After 2 years through 3 years	204,000		1.93	%
After 3 years through 4 years	88,000		1.33	%
After 4 years through 5 years	78,000		1.74	%
After 5 years	7,500		1.62	%
Total	$	625,000	1.66	%

Credit Quality and Allowance for Loan and Lease Losses

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in the CapitalSource Bank loan portfolio as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual loans
Commercial	$	24,750	$	32,187
Real estate	21,844		9,814
Real estate - construction	—		—
Total loans on non-accrual	$	46,594	$	42,001
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	$	24,750	$	32,187
Real estate	21,844		9,814
Real estate - construction	—		—
Total non-performing loans	$	46,594	$	42,001

__________________________________


(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 impaired loans that have not been restructured in a TDR and are currently considered performing loans. Potential problem loans are 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 December 31, 2013, we had no potential problem loans. As of December 31, 2012, we had $1.9 million in potential problem loans related to six loans for which we have determined that it is probable that we would be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreements, 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.

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:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	1,363	$	20,253
90+ days delinquent	1,899		6,907
Total delinquent non-accrual loans	$	3,262	$	27,160
Accruing loans
30-89 days delinquent	$	944	$	4,153
90+ days delinquent	—		—
Total delinquent accruing loans⁽¹⁾	$	944	$	4,153

__________________________________


(1)	Includes deferred loan fees and discounts.

Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the years ended December 31, 2013, 2012 and 2011 was as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Balance as of beginning of year	$	98,905		$	94,650		$	124,878
Charge offs:
Commercial	(1,890		)	(17,349		)	(5,237		)
Real estate	(2,562		)	(8,592		)	(33,959		)
Real estate - construction	—			—			(11,530		)
Total charge offs	(4,452		)	(25,941		)	(50,726		)
Recoveries:
Commercial	392			1,081			604
Real estate	366			12,923			11,670
Real estate - construction	—			—			1,019
Total recoveries	758			14,004			13,293
Net charge offs	(3,694		)	(11,937		)	(37,433		)
Charge offs upon transfer to held for sale	(2,608		)	—			(20,334		)
Loan and lease loss provisions (recovery):
General	9,139			12,486			(38,410		)
Specific	7,727			3,706			65,949
Total loan and lease loss provisions	16,866			16,192			27,539
Balance as of end of year	$	109,469		$	98,905		$	94,650
Allowance for loan and lease losses ratio	1.6		%	1.8		%	2.0		%
Provision for loan and lease losses as a percentage of average loans outstanding	0.3		%	0.3		%	0.7		%
Net charge offs as a percentage of average loans outstanding	0.1		%	0.2		%	1.4		%

Our allowance for loan and lease losses increased by $10.6 million to $109.5 million as of December 31, 2013 from $98.9 million as of December 31, 2012. This increase was comprised of a $9.1 million increase in general reserves and a $1.5 million increase in specific reserves on impaired loans. The increase in the general reserve is due to additional provisions relating to net loan growth. The increase in the specific reserve is due to specific provisions for impaired loans during the period. The primary factors that influence increases and decreases in general reserves are the net loan portfolio increases or decreases from period to period and qualitative adjustments to the general reserve based on economic circumstances and our loan portfolio performance and composition trends.

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.

As of December 31, 2013 and 2012, our non-impaired and impaired loan balances was as follows:



	December 31,
	2013			2012
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	6,696,369		$	5,607,591
General reserves allocated	106,213			97,074
Effective reserve %	1.6		%	1.7		%
Impaired loans
Unpaid principal balance	$	47,176		$	58,947
Specific reserves allocated⁽¹⁾	3,256			1,831
Original legal balance previously charge off⁽²⁾	33,518			39,941
Total cumulative charge offs and specific reserves	36,774			41,772
Legal balance	84,321			103,936
Expected total loss of the legal balance (%)	43.6		%	40.2		%

__________________________________

(1)

The increase in specific reserves from December 31, 2012 to December 31, 2013 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $0.8 million, ii) reversals of specific reserves for loans impaired as of December 31, 2012 net of related charge offs of $1.0 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the year ended December 31, 2013 for $3.2 million. The specific reserves in place at December 31, 2013 and at December 31, 2012 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. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to CapitalSource Bank's July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. For the years ended December 31, 2011 and 2010, charge offs of commercial real estate loans, excluding healthcare real estate loans, originated prior to CapitalSource Bank's July 2008 inception comprised 71.0% and 93.0%, respectively, of those years' charge offs. There were no charge offs of commercial real estate loans, excluding healthcare real estate loans, originated prior to CapitalSource Bank's July 2008 inception during the years ended December 31, 2013 and December 31, 2012 primarily because of loan resolutions resulting in a small remaining balance of loans in this category. As of December 31, 2013 and 2012, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception totaled $46.6 million and $53.7 million, respectively, or 0.7% and 1.0% of total loans, respectively.

Troubled Debt Restructurings

During the years ended December 31, 2013 and 2012, loans with an aggregate carrying value of $7.0 million and $135.7 million, respectively, as of their respective restructuring dates, were involved in troubled debt restructurings (“TDRs”). 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. There were $0.7 million of specific reserves allocated to loans that were involved in TDRs as of December 31, 2013 and 2012, respectively.

Adversely Classified Items Coverage Ratio



	December 31,
	2013			2012
	($ in thousands)

Substandard loans and associated unfunded commitments	$	164,103		$	113,682
REO and foreclosed assets	1,988			6,255
Total classified items	$	166,091		$	119,937

Tier 1 capital	$	1,088,870		$	933,837
Allowance for loan and lease losses	109,469			98,905
Total Tier 1 capital plus allowance for loan and lease losses	$	1,198,339		$	1,032,742

Adversely classified items coverage ratio	13.9		%	11.6		%

Other Commercial Finance Segment

As of December 31, 2013 and 2012, our consolidated balance sheet included:



	December 31,
	2013			2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	427,140		$	172,825
Investment securities, available-for-sale	—			26,250
Loans held for sale	—			22,719
Loans held for investment, net⁽²⁾	86,396			520,420
Allowance for loan and lease losses	(11,051		)	(18,368		)
Interest receivable	281			4,514
Other investments⁽³⁾	30,211			37,568
Deferred tax assets, net	255,909			359,864
Other assets	48,834			52,719
Total	$	837,720		$	1,178,511
Liabilities and Shareholder's equity:
Borrowings	$	412,156		$	587,926
Other liabilities	34,256			78,672
Shareholders' equity	397,003			521,704
Total	$	843,415		$	1,188,302

_______________________________________


(1)	As of December 31, 2013 and 2012, the amounts include restricted cash of $16.0 million and $55.9 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.

Cash and Cash Equivalents

Cash and cash equivalents consist of amounts due from banks, short-term investments and commercial paper with an initial maturity of three months or less. As a result of entering into the Merger Agreement, the Parent Company has been building its cash position to settle the cash payout due upon the closing of the Merger.

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. Such equity interests are typically acquired on substantially similar terms as the private equity sponsors that invested in the borrower in part with our loan proceeds. The Parent Company has also made investments in private equity funds which are managed by firms that typically invested in one or more of our borrowers.

In December 2013, as a result of a change in regulatory requirements due to the issuance of the Final Rules of the Dodd-Frank Act, known as the Volcker Rule, banking entities became limited to the types and amounts of investments they may hold. Banking entities may need to dispose of or seek exemption for certain investments by July 21, 2015. As such, the Company is evaluating which of its investments are impacted.

Other Commercial Finance Loan Portfolio Composition

As of December 31, 2013 and 2012, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:



	December 31,
	2013				2012
	($ in thousands)
Commercial	$	59,693	69	%	$	456,780	88	%
Real estate	16,632		19		52,653		10
Real estate - construction	10,071		12		10,987		2
Total⁽¹⁾	$	86,396	100	%	$	520,420	100	%

_______________________________________


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

Other Commercial Finance Loan Balances by Maturities

As of December 31, 2013, the contractual maturities of the Other Commercial Finance loan portfolio by loan type were as follows:



	Due in One Year or Less		Due After One Year to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	43,438	$	16,205	$	50	$	59,693
Real estate	15,663		851		118		16,632
Real estate - construction	10,069		1		1		10,071
Total⁽¹⁾	$	69,170	$	17,057	$	169	$	86,396

_______________________________________


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

Other Commercial Finance Sensitivity in Loans to Changes in Interest Rates

As of December 31, 2013, approximately 88% of the adjustable rate loan portfolio comprised loans that are subject to an interest rate floor and were accruing interest. Due to low market interest rates as of December 31, 2013, 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 accruing loans was 1.76% as of December 31, 2013. 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 December 31, 2013, the composition of Other Commercial Finance loan balances by adjustable rate index and by loan type was as follows:



	Loan Type						Total		Percentage
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	14,971	$	36	$	—	$	15,007	17	%
2-Month LIBOR	1		—		—		1		—
3-Month LIBOR	—		848		—		848		1
6-Month LIBOR	—		19		—		19		—
Prime	16,216		9		1		16,226		19
Other	32		—		—		32		—
Total adjustable rate loans	31,220		912		1		32,133		37
Fixed rate loans	17		—		—		17		—
Loans on non-accrual status	28,456		15,720		10,070		54,246		63
Total loans⁽¹⁾	$	59,693	$	16,632	$	10,071	$	86,396	100	%

_______________________________________


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

Shareholders' Equity

Shareholders' equity decreased by $124.7 million from December 31, 2012 to December 31, 2013, primarily due to the repurchase of 15.0 million shares of our common stock pursuant to the Stock Repurchase Program at an average price of $9.18 per share for a total purchase price of $137.7 million during the year ended December 31, 2013. As a result of entering into the Merger Agreement, the Stock Repurchase Program was suspended as of July 23, 2013. The Stock Repurchase Program was later terminated as of December 31, 2013.

Credit Quality and Allowance for Loan and Lease Losses

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in Other Commercial Finance loan portfolio as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual loans
Commercial	$	28,456	$	47,213
Real estate	15,720		17,061
Real estate - construction	10,070		10,987
Total loans on non-accrual	$	54,246	$	75,261
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	$	28,456	$	47,213
Real estate	15,720		17,061
Real estate - construction	10,070		10,987
Total non-performing loans	$	54,246	$	75,261

_______________________________


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

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:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	54	$	60
90+ days delinquent	25,736		32,187
Total delinquent non-accrual loans	$	25,790	$	32,247
Accruing loans
30-89 days delinquent	$	—	$	—
90+ days delinquent	—		—
Total delinquent accruing loans	$	—	$	—

_______________________________________


(1)	Includes deferred loan fees and discounts.

Allowance for loan and lease losses

The activity in the allowance for loan and lease losses for the years ended December 31, 2013, 2012 and 2011 was as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Balance as of beginning of year	$	18,368		$	58,981		$	204,244
Charge offs:
Commercial	(3,741		)	(57,478		)	(157,340		)
Real estate	(14		)	(3,173		)	(16,919		)
Real estate - construction	(229		)	(9,784		)	(21,257		)
Total charge offs	(3,984		)	(70,435		)	(195,516		)
Recoveries:
Commercial	5,141			8,064			5,089
Real estate	1			152			458
Real estate - construction	—			—			86
Total recoveries	5,142			8,216			5,633
Net recovery (charge offs)	1,158			(62,219		)	(189,883		)
Charge offs upon transfer to held for sale	(12,140		)	(1,644		)	(20,826		)
Loan and lease loss provisions (recovery):
General	(3,619		)	(28,879		)	(84,560		)
Specific	7,284			52,129			150,006
Total loan and lease loss provisions	3,665			23,250			65,446
Balance as of end of year	$	11,051		$	18,368		$	58,981
Allowance for loan and lease losses ratio	12.9		%	3.5		%	6.1		%
Provision for loan and lease losses as a percentage of average loans outstanding	1.3		%	2.8		%	4.1		%
Net charge offs as a percentage of average loans outstanding	4.0		%	7.7		%	13.1		%

Our allowance for loan and lease losses decreased by $7.3 million to $11.1 million as of December 31, 2013 from $18.4 million as of December 31, 2012. This decrease comprised a $3.6 million decrease in general reserves and a $3.7 million decrease in specific reserves on impaired loans as further described below. The decrease in the general reserve resulted from having a lower amount of unimpaired loans at December 31, 2013 than at December 31, 2012. The decrease in the specific reserve is due to previously recorded specific provisions being charged off or reversed and a lower amount of new specific provisions.

Impaired loans

We employ a 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.

As of December 31, 2013, our non-impaired and impaired loan balances were $31.9 million and $55.0 million, respectively, and total reserves were $11.1 million resulting in an effective reserve percent of 12.7%. Including legal balances previously charged off of $51.9 million, the expected total loss of the legal balance of non-impaired and impaired loans as of December 31, 2013 was 38.0%. As of December 31, 2012, our non-impaired and impaired loan balances were $379.2 million and $147.1 million, respectively, and total reserves were $18.4 million resulting in an effective reserve percent of 3.5%. Including legal balances previously charged off of $122.5 million, the expected total loss of the legal balance of non-impaired and impaired loans as of December 31, 2012 was 41.9%.

Troubled Debt Restructurings

During the years ended December 31, 2013 and 2012, loans with an aggregate carrying value of $87.0 million and $34.8 million, respectively, as of their respective restructuring dates, were involved in TDRs. 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. The specific reserves allocated to loans that were involved in TDRs were $0.9 million as of December 31, 2013 and 2012.

Liquidity and Capital Resources

The information contained in this section should be read in conjunction with, and is subject to and qualified by the information set forth under Item 1A, Risk Factors, and the Cautionary Note Regarding Forward Looking Statements in this Annual Report on Form 10-K.

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 that we believe are reasonable. These include our assumption that substantially all newly originated loans will be funded by CapitalSource Bank.

As of December 31, 2013, we had $1.1 billion of unfunded commitments to extend credit to our clients, of which $1.0 billion were commitments of CapitalSource Bank and $28.0 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 borrowers' ability to provide collateral to secure the requested additional funding, the collateral's satisfaction of eligibility requirements, our borrowers' ability to meet specified preconditions to borrowing, including compliance with the loan agreements, and/or our discretion pursuant to the terms of the loan agreements. In other cases, however, there are no such prerequisites or discretion to future funding by us, 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.

CapitalSource Bank Liquidity

CapitalSource Bank's sources and uses of liquidity 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 Deposit⁽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 is required to maintain a total risk-based capital ratio of not less than 15%, capital levels required for a bank to be considered “well- capitalized” under relevant banking regulations. In addition, we have a policy to maintain 7.5% of CapitalSource Bank's assets in unencumbered cash, cash equivalents and available-for-sale investments. In accordance with regulatory guidance, we have identified, modeled and planned for the financial, capital and liquidity impact of various events, including stress scenarios that would cause a large outflow of deposits, a reduction in borrowing capacity, a material increase in loan funding obligations, a material increase in credit costs or any combination of these events. We anticipate that CapitalSource Bank would be able to maintain sufficient liquidity and ratios in excess of its required minimum ratios in these events and scenarios. 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 December 31, 2013, deposits at CapitalSource Bank were $6.1 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 6, Deposits, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

CapitalSource Bank supplements its liquidity with borrowings from the FHLB SF. As of December 31, 2013, CapitalSource Bank had financing availability with the FHLB SF equal to 35.0% of CapitalSource Bank's total assets. The maximum financing available under this formula was $2.8 billion and $2.6 billion as of December 31, 2013 and 2012, 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 December 31, 2013, securities collateral with an estimated fair value of $3.7 million and loans with an unpaid principal balance of $1.2 billion 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 December 31, 2013 and 2012, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:



	December 31,
	2013			2012
	($ in thousands)
Borrowing capacity	$	1,012,361		$	841,309
Less: outstanding principal	(625,000		)	(595,000		)
Less: outstanding letters of credit	(150		)	(300		)
Unused borrowing capacity	$	387,211		$	246,009

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 December 31, 2013, investment securities with an estimated fair value of $70.6 million had been pledged to the FRB San Francisco and there were no borrowings outstanding. Additionally, CapitalSource Bank participates in the Borrower-In-Custody program at the FRB of San Francisco which allows the Bank to pledge qualifying loans and borrow against them. As of December 31, 2013, there were no loans pledged.

CapitalSource Bank also maintains a portfolio of investment securities. As of December 31, 2013, CapitalSource Bank had $44.7 million of unrestricted cash and cash equivalents and $843.0 million in unrestricted investment securities, available-for-sale. The investment portfolio primarily comprises 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.

Liquidity Uses


•	Interest and principal payments on subordinated debt;


•	Tax payments;


•	Operating expenses;


•	Subordinated debt repurchases and repayments;


•	Dividends; and


•	Funding unfunded commitments.

__________________________________

(1) Pursuant to our intercompany tax allocation arrangement.

(2) As permitted by banking regulations and guidelines.

(3) Represents secondary sources of funding.

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 December 31, 2013, there were no amounts outstanding under this facility.

Between 2010 and 2013, the Company repurchased $930.6 million of its common stock at weighted average prices of $7.01 per share in 2010, $6.22 per share in 2011, $6.97 per share in 2012 and $9.18 per share in 2013. All shares purchased during this period were retired upon settlement. Currently, the Company is not authorized by the Board of Directors to purchase its common stock. Pursuant to the Merger Agreement, the Company is prohibited from purchasing it shares prior to the consummation of the transaction.

Special Purpose Entities

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.

Commitments, Guarantees and Contingencies

As of December 31, 2013 and 2012, we had committed lending arrangements to our borrowers of approximately $8.0 billion and $7.4 billion of which approximately $1.1 billion and $1.0 billion, respectively were unfunded. As of December 31, 2013 and 2012, $1.0 billion and $0.9 billion of the total unfunded commitments were extended by the CapitalSource Bank, respectively. As of December 31, 2013 and 2012, $28.0 million and $88.5 million, of the total unfunded commitments were extended by the Parent Company, respectively. Our failure to satisfy our full contractual funding commitment to one or more of our borrower's could

create a breach of contract and lender liability for us and damage our reputation in the marketplace, which could have a material adverse effect on our business.

We have non-cancelable operating leases for office space and office equipment, which expire over the next eleven years and contain provisions for certain annual rental escalations. We have committed to contribute up to an additional $3.8 million to 14 private equity funds.

We provide standby letters of credit in conjunction with several of our lending arrangements and property lease obligations. As of December 31, 2013 and 2012, we had issued $43.4 million and $54.2 million, respectively, in standby letters of credit which expire at various dates over the next six years. If a borrower defaults on its commitments subject to any letter of credit issued under these arrangements, we would be required to meet the borrower's financial obligation but would seek repayment of that financial obligation from the borrower. In some cases, borrowers have posted cash and investment securities as collateral with us under these arrangements.

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.

Additional information, see Note 15, Commitments and Contingencies, in our accompanying audited consolidated financial statements for the year ended December 31, 2013, and Liquidity and Capital Resources herein.

Contractual Obligations

In addition to our scheduled maturities on our debt, we have future cash obligations under various types of contracts. We lease office space and office equipment under long-term operating leases and we have committed to contribute up to an additional $3.8 million to 14 private equity funds. The contractual obligations under our debt are included in our audited consolidated balance sheet as of December 31, 2013. The expected contractual obligations under our certificates of deposit, debt, operating leases and commitments under non-cancelable contracts as of December 31, 2013, were as follows:



	Certificates of Deposit		Subordinated Debt⁽¹⁾		FHLB Borrowings		Other⁽²⁾		Total
	($ in thousands)
2014	$	4,694,400	$	—	$	135,000	$	11,715	$	4,841,115
2015	432,770		—		112,500		9,154		554,424
2016	69,602		—		204,000		7,660		281,262
2017	26,459		—		88,000		6,738		121,197
2018	27,672		—		78,000		6,025		111,697
Thereafter	—		412,156		7,500		33,831		453,487
Total	$	5,250,903	$	412,156	$	625,000	$	75,123	$	6,363,182

______________________


(1)	The contractual obligations for subordinated debt are computed based on the legal maturities, which are between 2035 and 2037.


(2)	Includes operating leases and non-cancelable contracts.

We enter into derivative contracts under which we either receive cash or are required to pay cash to counterparties depending on changes in interest rates or foreign currency exchange rates. Derivative contracts are carried at fair value on our audited consolidated balance sheet as of December 31, 2013, with the fair value representing the net present value of expected future cash receipts or payments based on market rates as of the balance sheet date. The fair values of the contracts change daily as market interest rates change. Further discussion of derivative instruments is included in Note 2, Summary of Significant Accounting Policies and Note 17, Derivative Instruments, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

Enterprise Risk Management

We take an enterprise-wide approach to risk management designed to support our organizational and strategic objectives and to enhance shareholder value. Global risk oversight is conducted by senior management and overseen by the Board of Directors (the "Board"). As part of its oversight responsibilities, the Board monitors how management operates the Company and manages strategic, credit, liquidity, financial, market, regulatory, compliance, legal, fraud, reputation, compensation and operational risks. The involvement of the full Board in setting our business strategy is a fundamental part of its assessment and oversight of appropriate risk tolerances for the Company.

Board Level Risk Oversight

While the full Board is responsible for risk oversight, the Risk Committee, the Audit Committee, the Asset/Liability Committee, the Compensation Committee and the CapitalSource Bank Credit Policy Committee provide direct oversight of risks arising from specific activities.

The Risk Committee monitors the organization's compliance with the Board-approved risk appetite statement and risk tolerance threshold as well as the organization's ongoing and potential exposure to other risks. Additionally, the Risk Committee oversees and approves company-wide risk management policies that assist the Board in (1) overseeing the executive team's identification and assessment of significant risks that the organization faces and establishment of a risk management infrastructure capable of addressing those risks; (2) overseeing and reviewing the risk-related responsibilities allocated among Board committees, while reviewing management's risk management practices to determine management's appropriate oversight of strategic, financial, credit, market, liquidity, security, property, IT, legal, regulatory, compliance, reputational and other emerging risks; and (3) approving the Company's enterprise wide risk management framework. In carrying out its duties and responsibilities, the Risk Committee has the authority to meet with and seek any information it requires from employees, officers, directors, or external parties.

As part of the Board's risk oversight responsibility, it periodically reviews management's capital and liquidity stress tests to evaluate possible outcomes in the event of adverse economic or market events. These stress tests have become a regular part of the Company's risk management and capital planning process.

The Audit Committee oversees financial and accounting risk, including internal controls. The Audit Committee reviews periodic risk assessment reports from our internal audit department assessing the primary accounting and financial risks facing CapitalSource and management's considerations for mitigating these risks. The Audit Committee also assesses the guidelines and policies that govern the processes for identifying and assessing significant financial and accounting risks and formulating and implementing steps to minimize such risks and exposures. The Audit Committee considers risks in the financial reporting and disclosure process and review policies on financial risk control assessment and accounting risk exposure. The Audit Committee meets with management, including our Chief Executive Officer, Chief Financial Officer, our internal audit department and our independent registered public accounting firm in executive sessions at least quarterly, and with our General Counsel as necessary from time to time.

The Audit Committee also supervises the internal audit function, which provides the Audit Committee with periodic assessments of our risk management processes and internal quality-control procedures. The Audit Committee periodically reviews our internal audit department, including its independence and reporting authority and obligations and the development and coordination of proposed audit plans for coming years. The Audit Committee receives notification of material adverse findings from internal audits and a progress report at least quarterly on the proposed internal audit plan, as appropriate, with explanations for changes from the original plan. The Audit Committee reviews with management and the internal audit department the adequacy of our internal control structure and procedures for financial reporting and the resolution of any identified material weaknesses or significant deficiencies in such internal control structure and procedures.

The Asset/Liability Committee meets periodically but no less frequently than quarterly and assists the Board in overseeing and reviewing our asset and liability strategies, including the significant policies, procedures and practices employed to manage these risks. The Asset/Liability Committee periodically reviews our liquidity and cash management.

The Compensation Committee monitors all of our compensation policies and practices, including our incentive compensation policies and practices, to ensure they are consistent with the Company's business strategies and in compliance with applicable laws and regulatory guidance. Management regularly assesses our compensation policies and practices to identify and mitigate compensation-related risks as appropriate.

The CapitalSource Bank Credit Policy Committee primarily oversees credit policy and credit risk management. The Credit Policy Committee of the CapitalSource Bank regularly assesses the effectiveness of credit policies and administration, reviews the methodology for determining the appropriate amount of allowance for loan losses, and monitors the performance of the credit portfolio.

Management Level Risk Oversight

While the Board has ultimate oversight responsibility for our risk management, we have utilized management level committees to actively assess and manage risks across the Company. The Board has established an enterprise-wide management level Enterprise Risk Management (“ERM”) infrastructure that aligns with bank regulatory guidance. The ERM infrastructure is governed by a Board approved ERM Policy and Plan and administered by a management ERM Committee (“ERMC”) chaired by our Chief Risk Officer. The ERMC comprises executive and senior level management and reports to the Board Risk Committee through the Chief Risk Officer on enterprise-wide risks and risk management. The ERMC is responsible for implementing risk identification, assessment and monitoring systems, where applicable, and has oversight responsibility for the processes that identify,

measure, mitigate and report on the Company's risk categories, including strategic, credit, liquidity, financial, market, regulatory compliance, legal, fraud, reputation, compensation and operational risks.

Credit Risk Management

Credit risk 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. Credit risk exists primarily in our loan, lease and derivative portfolios and certain portions of our investment portfolio that may include investments such as non-agency MBS, non-agency ABS, CMBS and CLOs. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the borrower, 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 borrower, 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. These committees' 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 clients' financial condition and performance.

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

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


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


•	Collateral descriptions and appropriate valuation methods;


•	Underwriting considerations which include recommended 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 percentages for real estate loans, maximum advance rates for asset-based loans and minimum debt service coverage ratios for most 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, 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 or upon modification is maintained and is reported to the CapitalSource Bank Board of Director's Credit Policy Committee.

We continuously monitor a borrower'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 borrower's financial condition, cash flow or financial position. We use loan aggregations by risk rating as one measure of 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 borrowers primarily throughout the United States. As of December 31, 2013, borrowers in the following industries comprised the following concentrations by loan balance: health care and social assistance; and real estate and rental and leasing, which represented approximately 22.2% and 21.2% of the outstanding loan portfolio, respectively. As of December 31, 2013 lender finance (primarily timeshare) loans were our largest loan concentration by sector and represented approximately 16% of our loan portfolio.

We consider multiple loans as one borrower or one credit relationship when borrowers are under common majority ownership,

have a common guarantor, or may depend on each other to service our loans. Selected information pertaining to our largest credit relationship as of December 31, 2013 was as follows:



Loan Balance		% of Total Portfolio		Loan Type	Industry	Loan Commitment		Performing	Specific Reserves	Underlying Collateral⁽¹⁾	Date of Last Collateral Appraisal	Amount of Last Appraisal
($ in thousands)
$	104,140	1.5	%	Commercial and Industrial and Real Estate	Health Care and Social Assistance	$	105,147	Yes	—	Senior care facilities	n/a	(2)
83,723		1.2	%	Commercial and Industrial	Finance and Insurance	85,000		Yes	—	Consumer receivables	n/a	(3)
$	187,863	2.7	%			$	190,147

______________________


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


(2)	The collateral that secures our loan balance of $104.1 million as of December 31, 2013 primarily consisted of real estate loans to senior care facility owners and operators and senior care facilities that had a total value of $181.0 million as of December 31, 2013. Total senior debt, including our loan balance, secured by the collateral was $134.9 million as of December 31, 2013.


(3)	The collateral that secures our loan balance of $83.7 million as of December 31, 2013 consisted of consumer receivables that had an unpaid principal balance of $132.0 million as of December 31, 2013. Total senior debt, including our loan balance, secured by the collateral was $83.7 million as of December 31, 2013.

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 99 credit relationships in the non-performing portfolio as of December 31, 2013, and our largest non-performing credit relationship totaled $28.0 million and comprised 27.8% of our total non-performing loans.

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. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from certain counterparties and monitor all exposure and collateral requirements daily. We continually monitor the fair value of collateral received from counterparties and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. Our agreements generally include master netting agreements whereby the counterparties are entitled to settle their derivative positions "net." As of December 31, 2013, the gross positive fair values of derivative financial instruments was $1.4 million, offset through master netting agreements by gross negative fair value of $0.5 million. As such, we had $0.9 million net exposure to counterparty risk as of December 31, 2013. As of December 31, 2012, our financial instruments had no gross positive fair values, and as such, we had no exposure to counterparty risk.

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 ("NII") 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 analysis below 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 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.

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 December 31, 2013, were as follows ($ in thousands):



	Estimated Change in NII
Change in Market Interest Rate (basis points)	Amount			%
+200	$	47,655		13.3	%
+100	15,777			4.4	%
-100	(1,634		)	(0.5	)%
-200	(2,976		)	(0.8	)%

In addition to NII simulation, the Company measures the impact of market interest rate changes on our economic value of equity (“EVE”). EVE is defined as the market value of assets, less the market value of liabilities, adjusted for any off-balance sheet items.

The estimated changes in EVE in the following table are based on a discounted cash flow analysis which incorporates the impacts of changes in market interest rates. The model simulations and calculations are highly assumption-dependent and will change regularly as our asset/liability structure changes, as interest rate environments evolve, and as we change our assumptions in response to relevant market or business circumstances. These calculations do not reflect the changes that we anticipate or may make to reduce our EVE exposure in response to a change in market interest rates as a part of our overall interest rate risk management strategy. As with any method of measuring interest rate risk, certain limitations are inherent in the method of analysis presented in the preceding table. We are exposed to yield curve risk, prepayment risk and basis risk, which cannot be fully modeled and expressed using the above methodology. Accordingly, the results in the following table should not be relied upon as a precise indicator of actual results in the event of changing market interest rates. Additionally, the resulting changes in EVE and NII estimates are not intended to represent, and should not be construed to represent the underlying value.

The estimated changes in EVE based on interest rates applied to the combined portfolio of our segments as of December 31, 2013, were as follows ($ in thousands):



	Estimated Change in EVE
Change in Market Interest Rate (basis points)	Amount			%
+200	$	(31,777	)	(2.5	)%
+100	(24,480		)	(1.9	)%
-100	43,239			3.4	%
-200	54,953			4.3	%

We develop remediation plans that would maintain residual risk within acceptable tolerances if our analysis indicates the NII or EVE will decrease by more than the Asset Liability Management Policy limits in response to an immediate increase or decrease in interest rates.

As of December 31, 2013, approximately 59% 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 93% 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 December 31, 2013 were as follows:



	Amount Outstanding		Percentage of Total Portfolio
	($ in thousands)
Loans with contractual interest rates:
Below the interest rate floor	$	3,721,082	54.8	%
Exceeding the interest rate floor	1,185		—
At the interest rate floor	279,363		4.1
Loans with no interest rate floors	1,116,505		16.5
Total adjustable rate loans	5,118,135		75.4
Loans on non-accrual	100,840		1.5
Fixed rate loans⁽¹⁾	1,565,514		23.1
Total	$	6,784,489	100.0	%

________________________


(1)	Includes $655.9 million of loans that are in their introductory fixed rate period. For the majority of these loans, the fixed interest rate is higher than the fully indexed rate at December 31, 2013.

As of December 31, 2013, the outstanding unpaid principal balance of loans subject to interest rate floors by adjustable rate index and by the spread between the floor rate and the fully indexed rate were as follows:



	Above Floor		Basis Points								Total
	Above Floor		0-100		101-200		201-300		300+		Total
	($ in thousands)
1-Month LIBOR	$	—	$	1,859,965	$	399,000	$	55,050	$	97,917	$	2,411,932
2-Month LIBOR	—		5,108		27,834		—		—		32,942
3-Month LIBOR	—		653,143		437,377		—		—		1,090,520
6-Month LIBOR	—		34,948		18,039		52,058		12,278		117,323
6-Month EURIBOR	—		—		2,758		1,251		—		4,009
Prime	1,144		62,231		102,498		83,873		14,534		264,280
Other	41		36,559		23,297		—		—		59,897
Treasuries	—		708		5,071		4,444		10,504		20,727
Total accruing adjustable rate loans	1,185		2,652,662		1,015,874		196,676		135,233		4,001,630
Non-accrual loans subject to interest rate floors	—		28,020		22,737		897		10,838		62,492
Total loans subject to interest rate floors	$	1,185	$	2,680,682	$	1,038,611	$	197,573	$	146,071	4,064,122
Loans not subject to interest rate floors⁽¹⁾											2,720,367
Total loans											$	6,784,489

________________________


(1)	Includes $655.9 million of loans that are in their introductory fixed rate period. For the majority of these loans, the fixed interest rate is higher than the fully indexed rate at December 31, 2013.

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 and the Audit Committee has reviewed our disclosures related to these estimates.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is management's estimate of probable losses inherent in the loan and lease portfolio. Management performs detailed reviews of the portfolio quarterly to determine if impairment has occurred and to assess the adequacy of the allowance for loan and lease losses, based on historical and current trends and other factors affecting loan and lease losses. Additions to the allowance for loan and lease losses are charged to current period earnings through the provision for loan and lease losses. Amounts determined to be uncollectible are charged directly against the allowance for loan and lease losses, while amounts recovered on previously charged-off accounts increase the allowance.

The loan portfolio includes balances with non-homogeneous exposures. These loans are evaluated individually, and are risk-rated based upon borrower, collateral and industry-specific information that management believes is relevant to determining the

occurrence of a loss event and measuring impairment. Loans are then segregated by risk according to our internal risk rating scale. Higher risk loans are individually analyzed for impairment. Management establishes specific allowances for loans determined to be individually impaired. All impaired loans are valued to determine if a specific allowance is warranted. The valuation analysis for the specific allowance is based upon one of the three valuation methods (i) the present value of expected future cash flows discounted at the loan's initially contracted effective yield; (ii) the loan's observable market price; or (iii) the fair value of the collateral. The appropriate valuation methodology generally reflects the chosen loan resolution strategy being pursued to maximize the recovery of the loan. Estimated costs to sell are considered in the impairment valuation when such costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. Any guarantees provided by the borrower are typically not considered when determining our potential for specific loss.

In addition to the specific allowances for impaired loans, we maintain allowances that are based on an evaluation of inherent losses in our commercial loan portfolio. These allowances are based on an analysis of historical loss experience, current economic conditions and performance trends and any other pertinent information within specific portfolio segments.

As set forth in detail below, the process for determining the reserve factors and the related level of loan loss reserves is subject to numerous estimates and assumptions that require judgment about the timing, frequency and severity of credit losses that could materially affect the provision for loan and lease losses and, therefore, net income. Within this process, management is required to make judgments related, but not limited, to: (i) risk ratings for loans; (ii) market and collateral values and discount rates for individually evaluated loans; (iii) loss rates used for commercial loans; and (iv) adjustments made to assess certain factors, including overall credit and economic conditions.

Our allowance for loan and lease losses is sensitive to the risk ratings assigned to loans and to corresponding reserve factors that we use to estimate the allowance and that are reflective of historical losses. We assign reserve factors to the loans in our portfolio, which dictate the percentage of the total outstanding loan balance that we reserve. We review the loan portfolio information regularly to determine whether it is necessary for us to further revise our reserve factors. The reserve factors used in the calculation are determined by analyzing the following elements:


•	the types of loans, for example, land, commercial real estate, healthcare receivables or cash flow;


•	our historical losses with regard to the loan types;


•	borrower industry;


•	the relative seniority of our security interest;


•	our expected losses with regard to the loan types; and


•	the internal risk rating assigned to the loans.

We update these reserve factors periodically to capture actual and recent behavioral characteristics of the portfolios. We estimate the allowance by applying historical loss factors derived from loss tracking mechanisms associated with actual portfolio activity over a specified period of time. These estimates are adjusted when necessary based on additional analysis of long-term average loss experience, external loan loss data and other risks identified from current and expected credit market conditions and trends, including management's judgment for estimated inaccuracy and uncertainty.

We also consider the need for qualitative factors which we use to provide for uncertainties surrounding our estimation process including changes in the volume of our problem loans, changes in the value of collateral for our collateral dependent loans, and the existence of certain loan concentrations.

The sensitivity of our allowance for loan and lease losses to potential changes in our reserve factors (in terms of basis points) applied to our overall loan portfolio as of December 31, 2013, was as follows:



Change in Reserve Factors	Estimated Increase (Decrease) in the Allowance for Loan and Lease Losses
	($ in thousands)
+ 25	$	10,975
+ 10	4,390
- 10	(4,390		)
- 25	(10,975		)

These sensitivity analyses do not represent management's expectations of the deterioration, or improvement, in risk ratings, but are provided as hypothetical scenarios to assess the sensitivity of the allowance for loan and lease losses to changes in key

inputs. We believe the reserve factors currently in use are appropriate. The process of determining the level of allowance for loan and lease losses involves a high degree of judgment. If our internal risk ratings, reserve factors or specific reserves for impaired loans are not accurate, our allowance for loan and lease losses may be misstated. In addition, our operating results are sensitive to changes in the reserve factors utilized to determine our related provision for loan and lease losses.

We also consider whether losses might be incurred in connection with unfunded commitments to lend although, 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. Any such allowance for unfunded commitments is included in other liabilities.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.

In accordance with GAAP, we prioritize the inputs into valuation techniques used to measure fair value. This hierarchy, consisting of three levels of inputs, prioritizes observable data from active markets and gives the lowest priority to unobservable inputs. Assets and liabilities that are actively traded in the marketplace or that have values based on readily available market value data require little, if any, subjectivity to be applied when determining the fair value. These are classified as either Level 1 or Level 2. Whether an asset or liability is classified as Level 1 or Level 2 depends largely on its similarity with other items in the marketplace and our ability to obtain corroborative data regarding whether the market in which the instrument trades is active. Fair value measurements on assets and liabilities that are based on prices or valuation techniques that require inputs that are both unobservable and are significant to the overall measurement are classified as level 3.

As of December 31, 2013, 9.8% and 0.01% of total assets and total liabilities, respectively, were recorded at fair value on a recurring basis. As of December 31, 2013, $870.5 million (99.8% of total assets measured on a recurring basis) were classified as Level 2 within the fair value hierarchy, while no assets were classified as Level 1 or Level 3 within the fair value hierarchy. From a liability perspective, $510.0 thousand (all of total liabilities measured on a recurring basis) were classified as Level 2, while no liabilities were classified as Level 1 or Level 3 within the fair value hierarchy.

It is our policy to maximize the use of observable market based inputs, when appropriate, to value our assets and liabilities carried at fair value on a recurring basis or to determine whether an adjustment to fair value is needed for assets and liabilities carried at fair value on a non-recurring basis. Given the nature of some of our assets carried at fair value, whether on a recurring or nonrecurring basis, clearly determinable market based valuation inputs are often not available. Therefore, the fair value measurements of these instruments utilize unobservable inputs and are classified as Level 3 within the fair value hierarchy. We may be required to apply significant judgments in determining our fair value estimates for these assets.

Due to the unavailability of observable inputs for our Level 3 assets, management assumptions used in the valuation models play a significant role in these fair value estimates. In times of severe market volatility and illiquidity, there may be more uncertainty and variability with lack of market data to use in the valuation process. An illiquid market is one in which little or no observable activity has occurred or one that lacks willing buyers. To factor in market illiquidity, management makes adjustments to certain inputs in the valuation models and makes other assumptions to ensure fair values are reasonable and reflect current market conditions.

Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measurement. Therefore, even when market assumptions are not readily available, management's own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. For additional information, see Note 19, Fair Value Measurements, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

The estimates of fair values reflect our best judgments regarding the appropriate valuation methods and assumptions that market participants would use in determining fair value. The amount of judgment involved in estimating the fair value of an asset or liability is affected by a number of factors, such as the type of instrument, the liquidity of the markets for the instrument and the contractual characteristics of the instrument. The selection of a method to estimate fair value for each type of financial instrument depends on the reliability and availability of relevant market data. Judgments in these cases include, but are not limited to:


•	Selection of third-party market data sources;


•	Evaluation of the expected reliability of the estimate;


•	Reliability, timeliness and cost of alternative valuation methodologies; and


•	Selection of proxy instruments, as necessary.

Due to the lack of observability of significant inputs, we must make assumptions in deriving our valuation inputs based on relevant empirical data surrounding interest rates, asset prices, timing of future cash flows and credit performance. In addition,

assumptions must be made to reflect constraints on liquidity, counterparty credit quality and other unobservable factors. Imprecision surrounding our assumptions related to unobservable market inputs may impact the fair value of our assets and liabilities. Furthermore, use of different methods to derive the fair value of our assets and liabilities could result in different fair value estimates at the measurement date.

We record fair value adjustments on our loans held for investment when we have determined that it is necessary to record a specific reserve against the loans, and we measure impairment using the fair value of the loan collateral. During the year ended December 31, 2013, we recognized losses of $2.0 million related to our loans held for investment measured at fair value on a nonrecurring basis. These losses were attributable to an increased number of loans requiring a specific reserve during the year, as well as declines in the fair value of collateral for these loans.

Income Taxes

We are subject to the income tax laws of the United States, its states and municipalities and the foreign jurisdictions in which we operate. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of these inherently complex tax laws. We must also make estimates about when, in the future, certain items will affect taxable income in the various tax jurisdictions, both domestic and foreign.

Disputes over interpretations of the tax laws may be subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority upon examination or audit.

We provide for income taxes as a “C” corporation on income earned from operations. We are subject to federal, foreign, state and local taxation in various jurisdictions.

During 2012, we reversed $358.1 million of the valuation allowance, and such reversal was recorded as a benefit in our income tax expenses. 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 year ended December 31, 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, improved 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 are no longer in a cumulative loss position at the end of 2012.

We have net operating loss carryforwards for federal and state income tax purposes that can be utilized to offset future taxable income. If we were to undergo a change in ownership of more than 50% of our capital stock over a three-year period as measured under Section 382 of the Internal Revenue Code (the “Code”), our ability to utilize our net operating loss carryforwards, certain built-in losses and other tax attributes recognized in years after the ownership change generally would be limited. The annual limit would equal the product of (a) the applicable long term tax exempt rate and (b) the value of the relevant taxable entity's capital stock immediately before the ownership change. These change of ownership rules generally focus on ownership changes involving stockholders owning directly or indirectly 5% or more (the "5-Percent Shareholders") of a company's outstanding stock, including certain public groups of stockholders as set forth under Section 382 of the Code, and those arising from new stock issuances and other equity transactions. The determination of whether an ownership change occurs is complex and not entirely

within our control. No assurance can be given as to whether in the future we will undergo an ownership change under Section 382 of the Code.

During the years ended December 31, 2013 and 2012, we recorded $82.0 million of income tax expense and $285.1 million of income tax benefit, respectively, with respect to our income from continuing operations. The effective income tax rate for these periods was 33.3% and (138.7)%, 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 2009 through 2012. We are currently under examination by certain state jurisdictions for the tax years 2006 to 2011.


ITEM 7A.	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. In addition, for a detailed discussion of our derivatives, see Note 17, Derivative Instruments and Note 18, Credit Risk, in our accompanying audited consolidated financial statements for the year ended December 31, 2013.

MANAGEMENT REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING

The management of CapitalSource Inc. (“CapitalSource”) is responsible for establishing and maintaining adequate internal control over financial reporting. CapitalSource's internal control system was designed to provide reasonable assurance to CapitalSource's management and Board of Directors regarding the preparation and fair presentation of published financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

CapitalSource's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2013. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission 1992 framework (COSO) in Internal Control - Integrated Framework. Based on such assessment management believes that, as of December 31, 2013, the Company's internal control over financial reporting is effective based on those criteria. CapitalSource's independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the effectiveness of the Company's internal control over financial reporting. This report appears on page 80.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING

FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Board of Directors and Shareholders of CapitalSource Inc.

We have audited CapitalSource Inc.'s (“CapitalSource” or the "Company") internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 1992 framework (the COSO criteria). CapitalSource's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Controls over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, CapitalSource Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of CapitalSource Inc. as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013 of CapitalSource Inc. and our report dated February 28, 2014 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

Los Angeles, California

February 28, 2014


ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

For the Years Ended December 31, 2013, 2012 and 2011



Report of Independent Registered Public Accounting Firm	82

Consolidated Balance Sheets as of December 31, 2013 and 2012	83

Consolidated Statements of Operations for the years ended December 31, 2013, 2012 and 2011	84

Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2013, 2012 and 2011	85

Consolidated Statements of Shareholders' Equity for the years ended December 31, 2013, 2012 and 2011	86

Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012 and 2011	87

Notes to the Consolidated Financial Statements	88

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of CapitalSource Inc.

We have audited the accompanying consolidated balance sheets of CapitalSource Inc. (“CapitalSource”) as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013. These financial statements are the responsibility of CapitalSource's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CapitalSource Inc. at December 31, 2013 and 2012, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), CapitalSource's internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission 1992 framework and our report dated February 28, 2014 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

Los Angeles, California

February 28, 2014

CapitalSource Inc.

Consolidated Balance Sheets



	December 31,
	2013			2012
	($ in thousands, except share amounts)
ASSETS
Cash and due from banks	$	176,889		$	180,803
Interest-bearing deposits in other banks	15,391			108,285
Other short-term investments	263,519			9,998
Restricted cash (including $0 and $36.4 million, respectively, of cash that can only be used to settle obligations of consolidated VIEs)	58,653			104,044
Investment securities:
Available-for-sale, at fair value	870,482			1,079,025
Held-to-maturity, at amortized cost	74,369			108,233
Total investment securities	944,851			1,187,258
Loans held for sale	—			22,719
Loans held for investment, gross	6,830,519			6,192,858
Less net deferred loan fees and discounts	(46,030		)	(53,628		)
Loans held for investment, net (including $0 and $340.0 million, respectively, of loans that can only be used to settle obligations of consolidated VIEs)	6,784,489			6,139,230
Less allowance for loan and lease losses	(120,520		)	(117,273		)
Total loans held for investment, net	6,663,969			6,021,957
Interest receivable	26,068			29,112
Other investments	52,124			60,363
Goodwill	173,135			173,135
Deferred tax assets, net	252,268			362,283
Other assets	278,623			289,048
Total assets	$	8,905,490		$	8,549,005
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits	$	6,127,690		$	5,579,270
Term debt - obligations of consolidated VIEs for which there is no recourse to the general credit of CapitalSource Inc.	—			177,188
Other borrowings	1,037,156			1,005,738
Other liabilities	104,017			161,637
Total liabilities	7,268,863			6,923,833
Commitments and contingencies (Note 15)
Shareholders' equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)	—			—
Common stock ($0.01 par value, 1,200,000,000 shares authorized; issued and outstanding 196,855,283 and 209,551,674 shares issued/outstanding, respectively)	1,969			2,096
Additional paid-in capital	3,038,218			3,157,533
Accumulated deficit	(1,402,690		)	(1,559,107		)
Accumulated other comprehensive (loss) income, net	(870		)	24,650
Total shareholders' equity	1,636,627			1,625,172
Total liabilities and shareholders' equity	$	8,905,490		$	8,549,005

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Operations



	Year Ended December 31,
	2013		2012			2011
	($ in thousands, except per share data)
Net interest income:
Interest income:
Loans and leases	$	415,375	$	428,397		$	452,607
Investment securities	30,242		38,230			55,524
Other	1,859		1,587			2,259
Total interest income	447,476		468,214			510,390
Interest expense:
Deposits	51,941		51,035			53,609
Borrowings	22,147		28,372			96,401
Total interest expense	74,088		79,407			150,010
Net interest income	373,388		388,807			360,380
Loan and lease loss provision	20,531		39,442			92,985
Net interest income after loan and lease loss provision	352,857		349,365			267,395
Non-interest income:
Loan fees	23,546		18,561			16,234
Leased equipment income	20,590		14,113			3,748
Gain on investments, net	28,965		7,382			58,581
Gain (loss) on derivatives, net	1,061		(823		)	(6,813		)
Other non-interest income, net	8,388		10,613			20,944
Total non-interest income	82,550		49,846			92,694
Non-interest expense:
Compensation and benefits	107,676		105,430			125,665
Professional fees	4,824		12,814			31,182
Occupancy expenses	14,577		16,840			15,480
FDIC fees and assessments	5,068		5,957			6,091
General depreciation and amortization	6,261		5,934			6,879
Loan servicing expense	6,566		13,011			2,285
Other administrative expenses	24,754		26,499			24,898
Total operating expenses	169,726		186,485			212,480
Leased equipment depreciation	14,427		9,919			2,720
Expense of real estate owned and other foreclosed assets, net	821		6,790			39,347
(Gain) loss on extinguishment of debt	—		(8,059		)	119,007
Other non-interest expense, net	4,104		(1,453		)	1,616
Total non-interest expense	189,078		193,682			375,170
Net income (loss) before income taxes	246,329		205,529			(15,081		)
Income tax expense (benefit)	82,037		(285,081		)	36,942
Net income (loss)	$	164,292	$	490,610		$	(52,023	)
Basic income (loss) per share	$	0.84	$	2.19		$	(0.17	)
Diluted income (loss) per share	$	0.82	$	2.13		$	(0.17	)
Average shares outstanding:
Basic	195,189,983		223,928,583			302,998,615
Diluted	200,451,899		230,154,989			302,998,615

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Comprehensive Income (Loss)



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Net income (loss)	$	164,292		$	490,610		$	(52,023	)
Other comprehensive (loss) income, net of tax:
Unrealized (loss) gain on available-for-sale securities, net of tax	(25,520		)	5,595			13,292
Unrealized loss on foreign currency translation, net of tax	—			(351		)	(3,827		)
Other comprehensive (loss) income, net of tax	(25,520		)	5,244			9,465
Comprehensive income (loss)	$	138,772		$	495,854		$	(42,558	)

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Shareholders' Equity



	Common Stock			Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
	($ in thousands)
Total shareholders' equity as of December 31, 2010	$	3,232		$	3,911,341		$	(1,870,572	)	$	9,941		$	2,053,942
Net loss							(52,023		)				(52,023		)
Other comprehensive income										9,465			9,465
Repurchase of common stock	(702		)	(438,125		)							(438,827		)
Dividends paid ($0.04 per share)				114			(12,137		)				(12,023		)
Stock option expense				5,933									5,933
Exercise of options	5			1,643									1,648
Restricted stock activity	26			7,005									7,031
Total shareholders' equity as of December 31, 2011	2,561			3,487,911			(1,934,732		)	19,406			1,575,146
Net income							490,610						490,610
Other comprehensive income										5,244			5,244
Repurchase of common stock	(491		)	(343,668		)							(344,159		)
Dividends paid ($0.54 per share)	2			1,679			(114,985		)				(113,304		)
Stock option expense				1,931									1,931
Exercise of options	16			6,337									6,353
Restricted stock activity	8			3,343									3,351
Total shareholders' equity as of December 31, 2012	2,096			3,157,533			(1,559,107		)	24,650			1,625,172
Net income							164,292						164,292
Other comprehensive loss										(25,520		)	(25,520		)
Repurchase of common stock	(150		)	(137,839		)							(137,989		)
Dividends paid ($0.04 per share)				95			(7,875		)				(7,780		)
Stock option expense				1,702									1,702
Exercise of options	18			5,851									5,869
Restricted stock activity	5			10,876									10,881
Total shareholders' equity as of December 31, 2013	$	1,969		$	3,038,218		$	(1,402,690	)	$	(870	)	$	1,636,627

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Cash Flows



	For the Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Operating activities:
Net income (loss)	$	164,292		$	490,610		$	(52,023	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Stock option expense	1,702			1,931			5,933
Restricted stock expense	12,039			11,835			9,722
(Gain) loss on extinguishment of debt	—			(8,059		)	119,007
Amortization of deferred loan fees and discounts	(31,370		)	(40,398		)	(64,260		)
Paid-in-kind interest on loans	5,951			10,109			31,941
Loan and lease loss provision	20,531			39,442			92,985
Amortization of deferred financing fees and discounts	1,089			1,633			18,473
Depreciation and amortization	22,452			20,319			6,944
Provision (benefit) for deferred income taxes	122,551			(316,382		)	56,940
Gain on investments, net	(28,412		)	(5,055		)	(55,630		)
(Gain) loss on foreclosed assets and other property and equipment disposals	(4,096		)	(3,455		)	24,232
Unrealized loss on derivatives and foreign currencies, net	2,463			349			7,850
Decrease in interest receivable	3,044			9,684			18,597
Decrease in loans held for sale, net	—			21,493			188,854
Decrease in other assets	28,990			165,286			100,260
Decrease in other liabilities	(58,122		)	(127,216		)	(102,117		)
Cash provided by operating activities	263,104			272,126			407,708
Investing activities:
Decrease (increase) in restricted cash	45,391			(38,560		)	63,102
Increase in loans held for investment, net	(615,775		)	(356,570		)	(73,390		)
Purchase of investment securities, available-for-sale	(117,580		)	(293,899		)	(591,863		)
Sale and maturity of investment securities, available-for-sale	358,742			383,597			976,300
Purchase of investment securities, held-to-maturity	(47,855		)	—			(10,631		)
Sale and maturity of investment securities, held-to-maturity	35,736			5,149			92,583
Reduction of other investments	8,627			22,655			2,317
Acquisition of property and equipment, net	(34,988		)	(45,243		)	(89,505		)
Cash (used in) provided by investing activities	(367,702		)	(322,871		)	368,913
Financing activities:
Deposits accepted, net of repayments	548,420			454,275			503,722
Repayments on credit facilities, net	—			—			(68,792		)
Repayments and extinguishment of term debt	(177,209		)	(132,247		)	(763,022		)
Proceeds (repayments) of other borrowings	30,000			15,931			(372,825		)
Repurchase of common stock	(137,989		)	(339,725		)	(427,231		)
Proceeds from exercise of options	5,869			6,353			1,648
Payment of dividends	(7,780		)	(113,304		)	(12,023		)
Cash provided by (used in) financing activities	261,311			(108,717		)	(1,138,523		)
Increase (decrease) in cash and cash equivalents	156,713			(159,462		)	(361,902		)
Cash and cash equivalents as of beginning of year	299,086			458,548			820,450
Cash and cash equivalents as of end of year	$	455,799		$	299,086		$	458,548
Supplemental information:
Cash paid during the year:
Interest	$	73,304		$	80,841		$	181,175
Income taxes, net	9,476			8,976			64,083
Noncash transactions from investing and financing activities:
Assets acquired through foreclosure	845			15,494			28,281

See accompanying notes.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization

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

For the years ended December 31, 2013 and 2012, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. The CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. For additional information, see Note 20, Segment Data.

Note 2. Summary of Significant Accounting Policies

Our financial reporting and accounting policies conform to U.S. generally accepted accounting principles (“GAAP”).

Use of Estimates

The preparation of our audited consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Management has made significant estimates in certain areas, including valuing certain financial instruments and other assets, assessing financial instruments and other assets for impairment, assessing the realization of deferred tax assets and determining the allowance for loan and lease losses. Actual results could differ from those estimates.

Principles of Consolidation

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.

Fair Value Measurements

In accordance with GAAP, we prioritize the inputs into valuation techniques used to measure fair value. This hierarchy prioritizes observable data from active markets, placing measurements using those inputs in Level 1 of the fair value hierarchy, and gives the lowest priority to unobservable inputs and classifies these as Level 3 measurements. The three levels of the fair value hierarchy are described below:

Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access at the measurement date;

Level 2 - Valuations based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active or models for which all significant inputs are observable in the market either directly or indirectly; and

Level 3 - Valuations based on models that use inputs that are unobservable in the market and significant to the overall fair value measurement.

A financial instrument's level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Fair value hierarchy classifications are reviewed on a quarterly basis. Changes related to the observability of inputs to a fair value measurement may result in a reclassification between hierarchy levels.

Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measurement. Therefore, even when market assumptions are not readily available, management's own assumptions attempt to reflect those that market participants would use in pricing the asset or liability at the measurement date.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Cash and Cash Equivalents

We consider all highly liquid investments with original maturities of three months or less upon acquisition to be cash equivalents. Cash and cash equivalents include amounts due from banks, U.S. Treasury securities, short-term investments and commercial paper with an original maturity of three months or less. The cash is classified as unrestricted or restricted cash.

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).

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.

Loans

Loans held for investment in our portfolio are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts received or premiums paid on purchased loans. Deferred costs or fees, discounts and premiums are amortized over the contractual term of the loan.

Loans held for sale are accounted for at the lower of cost or fair value, which is determined on an individual loan basis, and include loans we originated or purchased that we intend to sell, in whole or in part, in the secondary market. Direct loan origination costs or fees, discounts and premiums are deferred at origination of the loan and not amortized into income.

As part of our management of the loans held in our portfolio, we will occasionally transfer loans from held for investment to held for sale. Upon transfer, any associated allowance for loan and lease loss is charged off and the carrying value of the loans is adjusted to the estimated fair value. The loans are subsequently accounted for at the lower of cost or fair value, with valuation changes recorded in other non-interest income, net. Gains or losses on the sale of these loans are also recorded in other non-interest income, net. In certain circumstances, loans designated as held for sale may later be transferred back to the loan portfolio based upon our intent and ability to hold the loans for the foreseeable future. We transfer these loans to loans held for investment at the lower of cost or fair value.

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 including the size of the asset or transaction, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral.

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

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

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

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 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.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

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

A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the agreement. Impairment on individual loans is measured based on the present value of payments expected to be received, observable market prices for the loan, or the estimated fair value of the collateral. If the recorded investment in an impaired loan exceeds the present value of payments expected to be received or the fair value of the collateral, 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 amounts previously charged off, we will recognize a recovery by increasing 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 client or other terms and conditions. Reserves for losses related to unfunded commitments are charged to other non-interest expense, net and included within other liabilities.

Foreclosed Assets

Foreclosed assets, includes foreclosed property and other assets received in full or partial satisfaction of a loan. We recognize foreclosed assets upon the earlier of the loan foreclosure event or when we take physical possession of the assets (i.e., through a deed in lieu of foreclosure transaction). Foreclosed assets are initially measured at their fair value less estimated costs to sell. We treat any excess of our recorded investment in the loan over the fair value less estimated cost to sell the asset as a charge off to the loan.

Real estate owned (“REO”) represents real property obtained through foreclosure. REO that we do not intend to sell is classified separately as held for use, depreciated and recorded in other assets. We report REO that we intend to sell, are actively marketing and that are available for immediate sale in their current condition as held for sale. These REO are reported at the lower of their carrying amount or fair value less estimated selling costs and are not depreciated. The fair value of our REO is determined by third party appraisals, when available. When third party appraisals are not available, we estimate fair value based on factors such as prices for similar properties in similar geographical areas and/or assessment through observation of such properties. We recognize any subsequent decline in the REO's fair value less its estimated costs to sell through a valuation allowance with an offsetting charge to expense of real estate owned and other foreclosed asset, net. A recovery is recognized for any subsequent increase in fair value less estimated costs to sell up to the cumulative loss previously recognized through the valuation allowance. We recognize REO operating costs and gains or losses on sales of REO through expense of real estate owned and other foreclosed assets, net.

Goodwill Impairment

Goodwill must be allocated to reporting units and tested for impairment. We test goodwill for impairment at least annually, and more frequently if events or circumstances, such as adverse changes in the business climate, indicate there may be justification for conducting an interim test. Impairment testing is performed at the reporting unit level.

In testing goodwill for impairment, we first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In making this assessment, we consider all relevant events and circumstances. These include, but are not limited to, macroeconomic conditions, industry and market considerations and the reporting unit's overall financial performance. If we conclude, based on our qualitative assessment, that it is more likely than not that the fair value of the reporting unit is at least equal to its carrying amount, then we presume that the goodwill of the reporting unit is not impaired and no further testing is performed. However, if we conclude, based on our qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we proceed with a two-step method to assess and measure impairment of the reporting unit's goodwill. At our option, we may, in any given period, bypass the qualitative assessment and proceed directly to the two step approach.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

The two-step method begins with a comparison of the fair value of a reporting unit to its carrying amount, including goodwill. If the fair value of the reporting unit is less than its carrying amount, we then compare the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. The implied fair value of a reporting unit's goodwill is measured as the excess of the fair value of the reporting unit over the aggregate fair values of all the reporting unit's assets and liabilities. If the implied fair value of the reporting unit's goodwill is less than its carrying amount, we record an impairment loss equal to that difference. If the fair value of the reporting unit exceeds its carrying amount or if the fair value of the reporting unit's goodwill exceeds the carrying amount of that goodwill, no impairment loss is recognized.

The balance of goodwill of $173.1 million as of both December 31, 2013 and 2012 was attributable to the formation of CapitalSource Bank. During the years ended December 31, 2013, 2012 and 2011, we did not record any goodwill impairment.

Investments in Debt Securities and Equity Securities That Have Readily Determinable Fair Values

All debt securities, as well as equity securities that have readily determinable fair values, are classified based on management's intention on the date of purchase. Debt securities which management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities not classified as held-to-maturity or trading, as well as equity investments in publicly traded entities, are classified as available-for-sale and carried at fair value with net unrealized gains and losses included in accumulated other comprehensive income (loss) on an after-tax basis.

Investments in Equity Securities That Do Not Have Readily Determinable Fair Values

Investments in common stock or preferred stock that are not publicly traded and/or do not have a readily determinable fair value are accounted for pursuant to the equity method of accounting if we have the ability to significantly influence the operating and financial policies of an investee. This is generally presumed to exist when we own between 20% and 50% of a corporation, or when we own greater than 5% of a limited partnership or similarly structured entity. Our share of earnings and losses in equity method investees is included in other non-interest income, net. If we do not have significant influence over the investee, the cost method is used to account for the equity interest.

For investments accounted for using the cost or equity method of accounting, management evaluates information such as budgets, business plans, and financial statements of the investee in addition to quoted market prices, if any, in determining whether an other-than-temporary decline in value exists. Factors indicative of an other-than-temporary decline in value include, but are not limited to, recurring operating losses and credit defaults. We compare the estimated fair value of each investment to its carrying value quarterly. For any of our investments in which the estimated fair value is less than its carrying value, we consider whether the impairment of that investment is other-than-temporary.

If we determine that an investment has sustained an other-than-temporary decline in its value, the equity interest is written down to its fair value through gain on investments, net and a new carrying value for the investment is established.

Realized gains or losses resulting from the sale of investments are calculated using the specific identification method and are included in gain on investments, net.

If we hold both a loan and an equity method investment in an investee, we will continue to apply our pro rata share of losses in the investee to the balance of the loan once the equity investment has been fully written down.

Transfers of Financial Assets

We account for transfers of loans and other financial assets to third parties or special purpose entities (“SPEs”) that we establish as sales if we determine that we have relinquished effective control over the transferred assets. In such transactions, we derecognize the transferred assets, recognize and measure at fair value any assets obtained and liabilities assumed, including servicing assets and liabilities and record a gain or loss on the sale based upon the difference between the fair value of the assets obtained and liabilities assumed and the carrying amount of the transferred assets. If we transfer a portion of a financial asset that qualifies as a participating interest, we allocate the previous carrying amount of the entire financial asset between the participating interests sold and the interest that we continue to hold based on their relative fair values at the transfer date.

We account for transfers of financial assets in which we receive cash consideration, but for which we determine that we have not relinquished control, as secured borrowings.

Deferred Financing Fees

Deferred financing fees represent fees and other direct incremental costs incurred in connection with our borrowings. These amounts are amortized into income as interest expense over the estimated life of the borrowing using the interest method.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Property and Equipment

Property and equipment are stated at cost and depreciated or amortized using the straight-line method over the following estimated useful lives (equipment leased to others is depreciated on a straight-line basis over the term of the lease to its estimated salvage value):



Buildings and improvements	10 to 40 years
Leasehold improvements	Lesser of remaining lease term or estimated useful life
Computer software	3 years
Equipment	5 years
Furniture	7 years

Income Recognition on Loans

Interest income, including income on impaired loans, fees due at maturity and paid-in-kind (“PIK”) interest, is recorded on an accrual basis to the extent that such amounts are expected to be collected. Carrying value adjustments of revolving lines of credit are amortized into interest and fee income over the contractual life of a loan on a straight line basis, while carrying value adjustments of all other loans are amortized into earnings over the contractual life of a loan using the interest method. In applying the interest method, the effective yield on a loan is determined based on its contractual payment terms, adjusted for actual prepayments.

Loan origination fees are deferred and amortized as adjustments to the related loan's yield over the contractual life of the loan. In connection with the prepayment of a loan, any remaining unamortized deferred fees for that loan are accelerated and, depending upon the terms of the loan, there may be an additional fee that is charged based upon the prepayment and recognized in the period of the prepayment.

We accrete any discount from purchased loans into interest income in accordance with our policies up to the amount of contractual interest and principal payments expected to be collected. Upon acquisition, if management assesses that a portion of contractual interest and principal payments are not expected to be collected, a portion of the discount will be deemed non-accretable (non-accretable difference).

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

We continue to recognize interest income on loans that have been identified as impaired, but that have not been placed on non-accrual status. If the loan is placed on non-accrual status, accrued and unpaid interest is reversed and the recognition of interest and fee income on that loan will stop until factors indicating doubtful collection no longer exist and the loan has been brought current.

Income Recognition and Impairment Recognition on Securities

For our investments in debt securities, we use the interest method to amortize deferred items, including premiums, discounts and other basis adjustments, into interest income. For debt securities representing non-investment grade beneficial interests in securitizations, the effective yield is determined based on the estimated cash flows of the security. Changes in the effective yield of these securities due to changes in estimated cash flows are recognized on a prospective basis as adjustments to interest income in future periods. The effective yield on all other debt securities that have not experienced an other-than-temporary impairment is based on the contractual cash flows of the security.

Declines in the fair value of debt securities classified as available-for-sale or held-to-maturity are reviewed to determine whether the impairment is other-than-temporary. This review considers a number of factors, including the severity of the decline in fair value, current market conditions, historical performance of the security, risk ratings and the length of time the investment has been in an unrealized loss position. If we do not expect to recover the entire amortized cost basis of the security, an other-than-temporary impairment is considered to have occurred. In assessing whether the entire amortized cost basis of the security will be recovered, we compare the present value of cash flows expected to be collected from the security with its amortized cost. The present value of cash flows is determined using a discount rate equal to the effective yield on the security. If the present value of cash flows expected to be collected is less than the amortized cost basis of the security, then the impairment is considered to

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

be other-than-temporary. Determination of whether an impairment is other-than-temporary requires significant judgment surrounding the collectability of the investment including such factors as the financial condition of the issuer, expected prepayments and expected defaults.

When we have determined that an other-than-temporary impairment has occurred, we separate the impairment amount into a component representing the credit loss and a component representing all other factors. The credit loss component is recognized in earnings and is determined by discounting the expected future cash flows of the security by the effective yield of the security. The previous amortized cost basis less the credit component of the impairment becomes the new amortized cost basis of the security. Any remaining impairment, representing the difference between the new amortized cost of the security and its fair value is recognized through other comprehensive income. We also consider impairment of a security to be other-than-temporary if we have the intent to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. In these situations, the entire amount of the impairment represents the credit component and is recognized through earnings.

In periods following the recognition of an other-than-temporary impairment, the difference between the new amortized cost basis and the cash flows expected to be collected on the security are accreted as interest income. Any subsequent changes to estimated cash flows are recognized as prospective adjustments to the effective yield of the security.

Derivative Instruments

We enter into derivative contracts primarily to manage the interest rate and foreign currency risk associated with certain assets, liabilities, or probable forecasted transactions. As of December 31, 2013 and 2012, all of our derivatives were held for risk management purposes, and none were designated as accounting hedges.

Our derivatives are recorded in other assets or other liabilities, as appropriate. The changes in fair value of our derivatives and the related interest accrued are recognized in gain (loss) on derivatives, net.

Income Taxes

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

Net Income (Loss) per Share

Basic net income (loss) per share loss is based on the weighted average number of common shares outstanding during each period, plus common share equivalents computed for stock options, stock units, stock dividends declared, restricted stock and convertible debt. Diluted net income (loss) per share is adjusted for the effects of other potentially dilutive financial instruments only in the periods in which such effect is dilutive.

Bonuses

Bonuses are accrued ratably, pursuant to the underlying bonus plans over the annual performance period. On an annual basis, management recommends a bonus accrual based on the Company's bonus plans to the Compensation Committee of our Board of Directors.

Segment Reporting

We present financial and descriptive information about our reportable operating segments including a measure of segment profit or loss, certain specific revenue and expense items and segment assets. We designate components of our business as reportable operating segments if the component a) engages in business activities from which it may earn revenues and incur expenses, b) has operating results that are regularly reviewed by executive management to make business decisions about resources to be allocated to the segment and assess its performance and c) has available discrete financial information. We currently operate 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 loan portfolio and other business activities in the Parent Company.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

New Accounting Pronouncements

In February 2013, the FASB amended its guidance on the presentation of comprehensive income to improve the transparency of reporting amounts reclassified out of accumulated other comprehensive income. For significant items reclassified out of accumulated other comprehensive income in their entirety in the same reporting period, entities are required to present the effects on the line items of net income. For items that are not reclassified to net income in their entirety in the same reporting period, entities are required to cross-reference to other disclosures currently required. This guidance was effective for interim and annual periods beginning after December 15, 2012. We adopted this guidance on January 1, 2013 and it did not have a material impact on our consolidated financial statements.

Reclassifications

Certain amounts in the prior year's consolidated financial statements have been reclassified to conform to the current year presentation.

Note 3. Loans and Credit Quality

As of December 31, 2013 and 2012, our outstanding loan balance was $6.8 billion and $6.2 billion, respectively. These amounts include loans held for sale and loans held for investment. As of December 31, 2013 and 2012, interest and fee receivables relating to loans totaled $23.7 million and $26.0 million, respectively.

Loans held for sale are recorded at the lower of cost or fair value. We determine when to sell a loan on a loan-by-loan basis and consider several factors, including the credit quality of the loan, 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 held for investment in our loan portfolio.

During the years ended December 31, 2013, 2012 and 2011, we transferred loans with a carrying value of $188.9 million, $323.8 million and $374.4 million, respectively, which included $56.8 million, $57.4 million and $173.3 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 our overall portfolio management and workout strategies. We did not incur any losses due to lower of cost or fair value adjustments during the year ended December 31, 2013. We incurred $0.4 million and $1.4 million of losses due to lower of cost or fair value adjustments at the time of transfer during the years ended December 31, 2012 and 2011, respectively, which is recorded within other non-interest expense, net on the Consolidated Statements of Operations. We did not reclassify any loans from held for sale to held for investment during the years ended December 31, 2013. We reclassified $5.5 million and $28.4 million of loans from held for sale to held for investment during the years ended December 31, 2012 and 2011, respectively.

During the years ended December 31, 2013, 2012 and 2011, we recognized net gains on the sale of loans of $6.9 million, $4.7 million and $16.4 million, respectively. Included in these amounts, we sold a participating interest in two loans to Pacific Western Bank, a wholly-owned subsidiary of PacWest, with a carrying value $35.0 million and recognized a net gain of $84 thousand.

As of December 31, 2013, we had no loans held for sale. As of December 31, 2012 and 2011, loans held for sale with an outstanding balance of $2.5 million, and $2.9 million, respectively, were classified as non-accrual. We did not record any fair value write-downs on non-accrual loans held for sale during the years ended December 31, 2013, 2012 and 2011.

During the years ended December 31, 2013, 2012 and 2011, we purchased loans held for investment with an outstanding principal balance at the time of purchase of $368.9 million, $487.9 million and $620.3 million, respectively.

As of December 31, 2013 and 2012, the Bank pledged loans held for investment with an unpaid principal balance of $1.2 billion and $0.7 billion, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, the outstanding carrying value of loans, by type of loan, was as follows:



	December 31,
	2013				2012
	($ in thousands)
Commercial	$	3,852,537	57	%	$	3,594,643	58	%
Real estate	2,865,976		42		2,499,567		41
Real estate - construction	65,976		1		45,020		1
Total⁽¹⁾⁽²⁾	$	6,784,489	100	%	$	6,139,230	100	%

______________________


(1)	Includes deferred loan fees and discounts.


(2)	As of December 31, 2013, includes deferred loans fees and discounts of $29.1 million, $16.2 million and $0.7 million for commercial, real estate and real estate - construction loans, respectively. As of December 31, 2012, includes deferred loans fees and discounts of $38.4 million, $14.9 million and $0.3 million for commercial, real estate and real estate - construction loans, respectively.

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 December 31, 2013 and 2012, the carrying value of each class of loans held for investment, separated by performing and non-performing categories, was as follows:



	December 31,
	2013						2012
Class	Performing		Non-Performing		Total		Performing		Non-Performing		Total
	($ in thousands)
Asset-based	$	1,642,937	$	12,459	$	1,655,396	$	1,409,837	$	27,759	$	1,437,596
Cash flow	1,966,599		40,801		2,007,400		1,916,042		51,700		1,967,742
Healthcare asset-based	168,238		—		168,238		179,617		—		179,617
Healthcare real estate	765,246		15,666		780,912		665,058		17,001		682,059
Multi-family	776,320		1,052		777,372		899,963		1,961		901,924
Real estate	1,069,610		24,776		1,094,386		717,798		12,593		730,391
Small business	294,699		6,086		300,785		233,653		6,248		239,901
Total⁽¹⁾	$	6,683,649	$	100,840	$	6,784,489	$	6,021,968	$	117,262	$	6,139,230

________________________


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

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 borrower, the contractual terms of the agreement and the availability and quality of collateral. We continuously

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

monitor a borrower'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 borrower'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).

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 a credit classification 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 worth and paying capacity of the obliger or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected; and


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

As of December 31, 2013 and 2012, 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 December 31, 2013:
Asset-based	$	1,602,564	$	25,420	$	15,261	$	12,151	$	1,655,396
Cash flow	1,823,926		108,242		64,996		10,236		2,007,400
Healthcare asset-based	108,196		45,911		14,131		—		168,238
Healthcare real estate	682,942		67,235		30,735		—		780,912
Multi-family	761,270		14,473		1,629		—		777,372
Real estate	1,011,565		25,521		57,300		—		1,094,386
Small business	293,630		1,066		6,089		—		300,785
Total⁽¹⁾	$	6,284,093	$	287,868	$	190,141	$	22,387	$	6,784,489
As of December 31, 2012:
Asset-based	$	1,352,729	$	36,535	$	29,185	$	19,147	$	1,437,596
Cash flow	1,684,107		67,629		191,582		24,424		1,967,742
Healthcare asset-based	114,889		64,728		—		—		179,617
Healthcare real estate	607,382		57,676		17,001		—		682,059
Multi-family	857,667		41,709		2,548		—		901,924
Real estate	673,783		38,139		18,389		80		730,391
Small business	228,071		2,860		8,443		527		239,901
Total⁽¹⁾	$	5,518,628	$	309,276	$	267,148	$	44,178	$	6,139,230

_________________________


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

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Non-Accrual and Past Due Loans

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

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 $17.6 million, $32.6 million and $62.0 million higher for the years ending December 31, 2013, 2012 and 2011, respectively.

As of December 31, 2013 and 2012, the carrying value of non-accrual loans was as follows:



	December 31,
	2013		2012
	($ in thousands)
Asset-based	$	12,459	$	27,759
Cash flow	40,801		51,700
Healthcare real estate	15,666		17,001
Multi-family	1,052		1,961
Real estate	24,776		12,593
Small business	6,086		6,248
Total⁽¹⁾	$	100,840	$	117,262

______________________


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

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, the delinquency status of loans in our loan portfolio was as follows:



	30-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current		Total Loans		Greater Than 90 Days Past Due and Accruing
	($ in thousands)
As of December 31, 2013:
Asset-based	$	54	$	—	$	54	$	1,655,342	$	1,655,396	$	—
Cash flow	878		99		977		2,006,423		2,007,400		—
Healthcare asset-based	—		—		—		168,238		168,238		—
Healthcare real estate	—		15,666		15,666		765,246		780,912		—
Multi-family	591		188		779		776,593		777,372		—
Real estate	—		10,326		10,326		1,084,060		1,094,386		—
Small business	839		1,356		2,195		298,590		300,785		—
Total⁽¹⁾	$	2,362	$	27,635	$	29,997	$	6,754,492	$	6,784,489	$	—
As of December 31, 2012:
Asset-based	$	19,207	$	391	$	19,598	$	1,417,998	$	1,437,596	$	—
Cash flow	578		3,486		4,064		1,963,678		1,967,742		—
Healthcare asset-based	—		—		—		179,617		179,617		—
Healthcare real estate	—		17,001		17,001		665,058		682,059		—
Multi-family	656		999		1,655		900,269		901,924		—
Real estate	1,032		12,284		13,316		717,075		730,391		—
Small business	2,994		3,932		6,926		232,975		239,901		—
Total⁽¹⁾	$	24,467	$	38,093	$	62,560	$	6,076,670	$	6,139,230	$	—

__________________________


(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 borrower;


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


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


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

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

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

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, information pertaining to our impaired loans was as follows:



	December 31,
	2013							2012
	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	$	12,459	$	19,724				$	40,655	$	75,547
Cash flow	279		21,486					48,796		118,440
Healthcare asset-based	—		—					—		12,246
Healthcare real estate	15,666		21,668					17,001		18,286
Multi-family	1,052		1,414					1,961		2,108
Real estate	24,776		100,374					12,711		83,363
Small business	6,086		14,046					8,112		15,976
Total	60,318		178,712					129,236		325,966
With allowance recorded:
Asset-based	—		—		$	—		867		859		$	(412	)
Cash flow	40,522		44,513		(4,211		)	71,609		80,322		(6,072		)
Total	40,522		44,513		(4,211		)	72,476		81,181		(6,484		)
Total impaired loans	$	100,840	$	223,225	$	(4,211	)	$	201,712	$	407,147	$	(6,484	)

______________________


(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.

As of December 31, 2013 and 2012, the carrying value of impaired loans with no related allowance recorded was $60.3 million and $129.2 million, respectively. Of these amounts, $29.7 million and $41.6 million, respectively, related to loans that were charged off to their carrying values. These charge offs were primarily the result of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $30.6 million and $87.6 million related to loans that had no recorded charge offs or specific reserves as of December 31, 2013 and 2012, respectively, based on our estimate that we ultimately will collect all principal and interest amounts due.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Average balances and interest income recognized on impaired loans, by loan class, for the years ended December 31, 2013, 2012 and 2011, were as follows:



	Year Ended December 31,
	2013				2012				2011
	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	$	26,106	$	489	$	65,805	$	3,246	$	67,521	$	2,899
Cash flow	25,628		5,867		68,549		5,534		110,466		7,456
Healthcare asset-based	—		—		1,002		233		1,827		177
Healthcare real estate	16,717		—		24,118		—		23,010		165
Multi-family	1,583		161		1,432		17		5,770		—
Real estate	18,897		5		54,800		3,735		185,104		3,410
Small business	6,766		242		11,983		20		10,158		—
Total	95,697		6,764		227,689		12,785		403,856		14,107
With allowance recorded:
Asset-based	743		—		8,222		74		47,572		—
Cash flow	43,156		1,622		95,442		3,094		111,637		3,405
Healthcare asset-based	—		—		—		—		787		—
Healthcare real estate	—		—		604		—		5,006		—
Multi-family	—		—		—		—		414		—
Real estate	—		—		—		—		32,964		—
Small business	—		—		—		—		733		—
Total	43,899		1,622		104,268		3,168		199,113		3,405
Total impaired loans	$	139,596	$	8,386	$	331,957	$	15,953	$	602,969	$	17,512

_________________________


(1)	We recognized no cash basis interest income on impaired loans during the years ended December 31, 2013 and 2012. We recognized $0.1 million cash basis interest income on impaired loans during the year ended December 31, 2011.

Allowance for Loan and Lease Losses

Our allowance for loan and lease losses represents management's estimate of incurred losses inherent in our loan and lease portfolio as of the balance sheet date. The estimation of the allowance for losses is based on a variety of factors, including past 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 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 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 or published industry data if our lending history for a particular loan type is limited.

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 borrower's financial condition, cash flow or financial position. We use risk rating aggregations to measure credit risk within the loan portfolio. In addition, we consider the market trend of collateral values and loan concentrations by borrower industries and real estate property types.

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.

100

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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 losses.

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

Activity in the allowance for loan and lease losses related to our loans held for investment for the years ended December 31, 2013, 2012 and 2011, respectively, was as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Allowance for loan and lease losses as of beginning of year	$	117,273		$	153,631		$	329,122
Charge offs	(8,436		)	(96,376		)	(246,242		)
Recoveries	5,900			22,220			18,926
Net charge offs	(2,536		)	(74,156		)	(227,316		)
Charge offs upon transfer to held for sale	(14,748		)	(1,644		)	(41,160		)
Loan and lease loss provision	20,531			39,442			92,985
Balance as of end of year	120,520			117,273			153,631
Allowance for credit losses on unfunded lending commitments at beginning of year	3,424			4,877			3,261
(Release) provision for unfunded lending commitments	(1,124		)	(1,453		)	1,616
Allowance for credit losses on unfunded lending commitments at end of year⁽¹⁾	2,300			3,424			4,877
Total allowance for loan, lease and unfunded lending commitments	$	122,820		$	120,697		$	158,508

_________________________


(1)	Represents additional credit loss reserves for unfunded lending commitments and letters of credit recorded in Other Liabilities. Unfunded lending commitments totaled $1.1 billion, $1.0 billion and $1.4 billion at December 31, 2013, 2012 and 2011, respectively.

As of December 31, 2013 and 2012, 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:



	December 31,
	2013					2012
	Loans		Allowance for Loan and Lease Losses			Loans		Allowance for Loan and Lease Losses
	($ in thousands)
Individually evaluated for impairment⁽¹⁾	$	99,091	$	(4,211	)	$	198,856	$	(6,484	)
Other loans groups with unidentified incurred losses	6,683,649		(116,309		)	5,937,518		(110,789		)
Acquired loans with deteriorated credit quality	1,749		—			2,856		—
Total	$	6,784,489	$	(120,520	)	$	6,139,230	$	(117,273	)

_______________________________


(1)	Loans individually evaluated for impairment are net of charge offs of $85.4 million and $162.5 million at December 31, 2013 and 2012, respectively.

Troubled Debt Restructurings

The types of concessions that are assessed to determine if modifications to our loans should be classified 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.

101

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

During the years ended December 31, 2013 and 2012, the aggregate carrying value of loans involved in TDRs were $94.0 million and $170.5 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 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 borrower and our assessment of the borrower's ability and intent to repay in accordance with the revised loan terms. We generally consider such factors as historical operating performance and payment history of the borrower, indications of support by sponsors and other interest holders, the terms of the TDR, the value of any collateral securing the loan and projections of future performance of the borrower 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 borrower. However, if the charged off portion of the loan is legally forgiven through concessions to the borrower, then the restructured loan may be placed on accrual status if the remaining contractual amounts due on the loan are reasonably assured of collection. In addition, for certain TDRs, especially those involving a commercial real estate loan, we may split the loan into an A note and a B note, placing the performing A note on accrual status and charging off the B note. For 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.

The aggregate carrying values of loans that had been restructured in TDRs as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013		2012
	($ in thousands)
Non-accrual	$	55,460	$	62,815
Accruing	—		83,367
Total	$	55,460	$	146,182

The specific reserves related to these loans were $1.6 million as of December 31, 2013 and 2012. We had unfunded commitments related to these restructured loans of $7.6 million and $21.1 million as of December 31, 2013 and 2012, respectively.

The following table rolls forward the balance of loans modified in TDRs for the years ended December 31, 2013, 2012 and 2011:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Beginning balance of TDRs	$	146,182		$	309,003		$	555,113
New TDRs	3,896			45,353			143,963
Draws and pay downs on existing TDRs, net	(16,934		)	(18,087		)	(27,305		)
Loan sales and payoffs	(74,360		)	(157,954		)	(267,168		)
Charge offs post modification	(3,324		)	(32,133		)	(95,600		)
Ending balance of TDRs	$	55,460		$	146,182		$	309,003

102

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

The number and aggregate carrying values of loans involved in TDRs that occurred during the year ended December 31, 2013 were as follows:



	Year Ended December 31, 2013
	Number of Loans	Carrying Value Prior to TDR		Carrying Value Subsequent to TDR⁽²⁾
	($ in thousands)
Asset-based
Maturity extension	1	$	2,985	$	2,985
Discounted payoffs	2	10,006		—
Multiple concessions	2	9,398		9,398
	5	22,389		12,383
Cash flow
Maturity extension	2	32,547		32,547
Payment deferral	1	571		571
Discounted payoffs	3	16,942		—
Multiple concessions	7	17,840		17,840
	13	67,900		50,958
Multi-family
Discounted payoffs	1	425		—
Small business
Discounted payoffs	2	565		—
Foreclosures	3	786		—
Multiple concessions	4	1,955		1,955
	9	3,306		1,955
Total⁽¹⁾	28	$	94,020	$	65,296

__________________________


(1)	Includes deferred loan fees and discounts.


(2)	Represents the carrying value immediately following the modification of the loan; does not represent the carrying value as of December 31, 2013.

During the year ending December 31, 2013, one small business loan experienced default after its initial restructuring within the previous 12 months. As of December 31, 2013, the carrying value of this loan was $38 thousand.

103

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

A summary of concession types granted by loan type, including the accrual status of the loans as of December 31, 2013 and 2012, respectively, was as follows:



	December 31,
	2013						2012
	Non-accrual		Accrual		Total		Non-accrual		Accrual		Total
	($ in thousands)
Commercial
Maturity extension	$	—	$	—	$	—	$	14,166	$	59,513	$	73,679
Payment deferral	529		—		529		—		—		—
Multiple concessions	42,340		—		42,340		36,786		23,711		60,497
	42,869		—		42,869		50,952		83,224		134,176
Real estate
Interest rate and fee reduction	—		—		—		—		—		—
Maturity extension	54		—		54		59		—		59
Payment deferral	529		—		529		617		—		617
Multiple concessions	1,938		—		1,938		200		143		343
	2,521		—		2,521		876		143		1,019
Real estate - construction
Maturity extension	10,070		—		10,070		10,758		—		10,758
Multiple concessions	—		—		—		229		—		229
	10,070		—		10,070		10,987		—		10,987
Total	$	55,460	$	—	$	55,460	$	62,815	$	83,367	$	146,182

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. A majority of such losses has been incurred on our commercial loans and are 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.

104

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Losses incurred on TDRs since their initial restructuring by concession and loan type as of December 31, 2013, 2012 and 2011, respectively, was as follows:



	Year Ended December 31,
	2013		2012		2011
	($ in thousands)
Commercial
Interest rate and fee reduction	$	—	$	—	$	18,727
Maturity extension	727		5,440		11,310
Payment deferral	144		252		10,968
Multiple concessions	6,360		20,281		48,912
	7,231		25,973		89,917
Real estate
Interest rate and fee reduction	—		—		9
Maturity extension	—		950		—
Payment deferral	—		—		11,162
Multiple concessions	363		23		402
	363		973		11,573
Real estate - construction
Maturity extension	—		4,709		19,408
Multiple concessions	229		958		—
	229		5,667		19,408
Total	$	7,823	$	32,613	$	120,898

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the years ended December 31, 2013, 2012 and 2011, 65.3%, 92.9% and 83.9%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status. We recognized approximately $0.3 million, $0.1 million and $0.2 million of interest income for the years ended December 31, 2013, 2012 and 2011, respectively, on the commercial loans that experienced losses during those years.

Real Estate Owned and Other Foreclosed Assets ("REO")

When we foreclose on an asset that collateralizes a loan, we record the acquired asset at its estimated fair value less costs to sell at the time of foreclosure. Upon foreclosure, we evaluate the asset's fair value as compared to the loan's carrying amount and record a charge off when the carrying amount of the loan exceeds fair value less costs to sell. We may also write down or record allowances on the acquired asset subsequent to foreclosure if such assets experience additional deterioration. Any subsequent valuation adjustments are recorded as a component of net expense of real estate owned and other foreclosed assets.

Activity related to REO for the years ended December 31, 2013, 2012 and 2011 was as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Balance as of beginning of year	$	23,791		$	69,698		$	163,329
Transfers from loans held for investment and other assets	845			15,494			28,281
Fair value adjustments	(2,025		)	(10,174		)	(28,274		)
Real estate sold	(9,787		)	(51,227		)	(93,638		)
Balance as of end of year	$	12,824		$	23,791		$	69,698

During the years ended December 31, 2013, 2012 and 2011, we recognized gains (losses) of $4.0 million, $2.7 million and $(0.7) million, respectively, on the sales of REO as a component of expense of real estate owned and other foreclosed assets, net.

105

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 4. Investments

Investment Securities, Available-for-Sale

As of December 31, 2013 and 2012, our investment securities, available-for-sale were as follows:



	December 31,
	2013									2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	($ in thousands)
Agency securities	$	785,511	$	10,909	$	(12,180	)	$	784,240	$	960,864	$	23,464	$	(807	)	$	983,521
Asset-backed securities	3,031		138		—			3,169		9,280		312		—			9,592
Collateralized loan obligations	47,863		—		(526		)	47,337		13,418		12,832		—			26,250
Non-agency MBS	19,897		329		(23		)	20,203		40,937		689		(279		)	41,347
SBA asset-backed securities	15,640		—		(107		)	15,533		17,632		683		—			18,315
Total	$	871,942	$	11,376	$	(12,836	)	$	870,482	$	1,042,131	$	37,980	$	(1,086	)	$	1,079,025

Realized gains or losses resulting from the sale and maturities of investments are calculated using the specific identification method and included in gain on sales or calls of investments, net. During the year ended December 31, 2013, we had repayments on investment securities, available-for-sale of $358.7 million and $117.6 million in purchases, with a net amortized discount of $3.4 million. During the year ended December 31, 2012, we had repayments on investment securities, available-for-sale of $383.6 million and $293.9 million in purchases, with a net amortized discount of $6.1 million.

During the years ended December 31, 2013, 2012, and 2011, we recognized $(25.5) million, $5.6 million, and $13.3 million, respectively, of net unrealized after-tax (loss) gains as a component of accumulated other comprehensive income, net.

Other-than-temporary impairments (“OTTI”) on our investment securities, available-for-sale are included as a component of gain on investments, net. We recorded OTTI of $0.2 million, $1.4 million and $1.5 million relating to a decline in the fair value of our investment securities, available-for-sale on our collateralized loan obligations and municipal bond during the years ended December 31, 2013, 2012 and 2011, respectively.

The amortized cost and fair value of investment securities, available-for-sale pledged as collateral to the FHLB SF and government agencies as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013				2012
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB SF	$	—	$	—	$	190,113	$	197,911
FRB	9,988		9,975		—		—
Government agencies⁽¹⁾	17,246		17,436		5,390		5,439
Total	$	27,234	$	27,411	$	195,503	$	203,350

____________________________


(1)	Represents the amounts pledged as collateral to secure funds deposited by government agencies.

106

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Investment Securities, Held-to-Maturity

As of December 31, 2013 and 2012, investment securities, held-to-maturity consisted of non-agency commercial mortgage-backed securities rated AA+ or higher. The amortized cost, gross unrealized gains and losses, and estimated fair value of held-to-maturity securities were as follows:



	December 31,
	2013		2012
	($ in thousands)
Amortized Cost	$	74,369	$	108,233
Unrealized Gains	1,166		3,531
Unrealized Losses	—		(376		)
Fair Value	$	75,535	$	111,388

During the years ended December 31, 2013 and 2012, we recorded $4.3 million and $4.4 million, respectively, of interest income on investment securities, held-to-maturity which were recorded as a component of interest income in investment securities.

During the year ended December 31, 2013, we had repayments and purchases on investment securities, held-to-maturity of $35.7 million and $47.9 million, respectively, with a net amortized premium of $1.7 million.

During the year ended December 31, 2013, we transferred $47.9 million in investment securities, held-to-maturity, which consisted of collateralized loan obligations, with a fair value of $47.3 million and net unrealized losses of $526 thousand, to investment securities, available-for-sale. The CLOs were reclassified to available-for-sale due to the provisions of the Volcker Rule that prohibit banking entities from having ownership interests in "covered funds." As such, the Company would not be permitted to hold the CLOs to their contractual maturity. In addition, we sold one CMBS with a net carrying value of $6.2 million and realized a net gain of $0.2 million during the year ended December 31, 2013. We decided to sell the security as a result of evidence of significant deterioration in the issuer's creditworthiness.

During the year ended December 31, 2012, we had $5.1 million of principal repayments on investment securities, held-to-maturity with a net amortized premium of $1.7 million, and no purchases of investment securities, held-to-maturity.

The investment securities, held-to-maturity pledged as collateral as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013				2012
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB SF	$	3,582	$	3,745	$	4,060	$	4,497
FRB	60,396		60,593		87,038		88,381
Total	$	63,978	$	64,338	$	91,098	$	92,878

107

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Unrealized Losses on Investment Securities

As of December 31, 2013 and 2012, the gross unrealized losses and fair values of investment securities that were in unrealized loss positions, for which other-than-temporary impairments have not been recognized in earnings, 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 December 31, 2013
Investment Securities, Available-for-Sale:
Agency securities	$	(8,974	)	$	332,996	$	(3,206	)	$	59,738	$	(12,180	)	$	392,734
Collateralized loan obligations	(526		)	47,337		—			—		(526		)	47,337
SBA asset-backed securities	(107		)	15,533		—			—		(107		)	15,533
Non-agency MBS	(14		)	1,463		(9		)	690		(23		)	2,153
Total Investment Securities, Available-for-Sale	$	(9,621	)	$	397,329	$	(3,215	)	$	60,428	$	(12,836	)	$	457,757
Total Investment Securities, Held-to-Maturity	$	—		$	—	$	—		$	—	$	—		$	—
As of December 31, 2012
Investment Securities, Available-for-Sale:
Agency securities	$	(807	)	$	115,447	$	—		$	—	$	(807	)	$	115,447
Non-agency MBS	(245		)	8,651		(34		)	1,175		(279		)	9,826
Total Investment Securities, Available-for-Sale	$	(1,052	)	$	124,098	$	(34	)	$	1,175	$	(1,086	)	$	125,273
Total Investment Securities, Held-to-Maturity	$	—		$	—	$	(376	)	$	59,284	$	(376	)	59,284

Investment securities in unrealized loss positions are analyzed individually as part of our ongoing assessment of OTTI. As of December 31, 2013 and 2012, we do not believe that any unrealized losses included in the table above represent an OTTI. The unrealized 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 December 31, 2013, each of the agency, Non-agency MBS, and CLOs with unrealized losses were well supported. Based on our analysis of each security in an unrealized loss position, we have the intent, ability to hold and no requirement to sell these securities, so we can expect to recover the entire amortized cost basis of the impaired securities.

Contractual Maturities

As of December 31, 2013, 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	$	—	$	—	$	—	$	—
Due after one year through five years	12,889		13,330		—		—
Due after five years through ten years⁽¹⁾	44,241		44,884		60,396		60,593
Due after ten years⁽²⁾⁽³⁾	814,812		812,268		13,973		14,943
Total	$	871,942	$	870,482	$	74,369	$	75,536

__________________________________


(1)	Includes Agency MBS, Non-agency MBS, Non-agency ABS, Non-agency CMBS, and CLOs with fair values of $16.9 million, $0.2 million, $3.2 million, $60.6 million and $24.7 million, respectively, and weighted average expected maturities of approximately 1.94, 1.83, 1.59, 0.41 and 4.43 years, respectively, based on interest rates and expected prepayment speeds as of December 31, 2013.


(2)	Includes Agency MBS, SBA ABS, Non-agency MBS, Non-agency CMBS, and CLOs with fair values of $762.4 million, $15.5 million, $11.7 million, $14.9 million, and $22.7 million, respectively, and weighted average expected maturities of approximately 4.06, 6.70, 2.01, 2.66 and 7.07 years, respectively, based on interest rates and expected prepayment speeds as of December 31, 2013.


(3)	Includes securities with no stated maturity.

108

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Other Investments

As of December 31, 2013 and 2012, our other investments were as follows:



	December 31,
	2013		2012
	($ in thousands)
Investments carried at cost	$	17,797	$	23,963
Investments accounted for under the equity method	34,327		36,400
Total	$	52,124	$	60,363

Proceeds and gains from sales of other investments for the years ended December 31, 2013, 2012 and 2011 were as follows:



	Year Ended December 31,
	2013		2012		2011
	($ in thousands)
Proceeds from sales	$	3,407	$	11,478	$	30,468
Gain from sales	3,385		5,874		22,915

During the years ended December 31, 2013 and 2012, we recorded $3.6 million and $7.1 million, respectively, of dividends which were recorded as a component of gain on investments, net.

During the years ended December 31, 2013, 2012 and 2011, we recorded OTTI of $1.6 million, $5.2 million and $1.4 million, respectively, relating to our investments carried at cost.

Note 5. Property and Equipment

We own property and equipment for use in our operations as well as equipment leased to others subject to operating lease agreements. As of December 31, 2013 and 2012, property and equipment included in other assets consisted of the following:



	December 31,
	2013			2012
	($ in thousands)
Land	$	125		$	125
Buildings	470			470
Equipment	179,544			149,345
Furniture and related equipment	10,479			10,266
Leasehold improvements	26,266			24,498
Accumulated depreciation and amortization	(63,809		)	(46,190		)
Total	$	153,075		$	138,514

During the years ended December 31, 2013 and 2012, we acquired $31.9 million and $40.8 million of equipment, respectively, which we lease to others for their use subject to operating lease agreements. During the years ended December 31, 2013 and 2012, income from these leases was $1.7 million and $1.1 million, respectively.

Depreciation of property and equipment totaled $14.4 million, $12.7 million and $9.2 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Note 6. Deposits

As of December 31, 2013 and 2012, the Bank had $6.1 billion and $5.6 billion, respectively, in deposits insured up to the maximum limit by the FDIC. As of December 31, 2013 and 2012, the Bank had $816.3 million and $597.8 million, respectively, of certificates of deposit in the amount of $250,000 or more and $3.1 billion and $2.6 billion, respectively, of certificates of deposit in the amount of $100,000 or more.

As of December 31, 2013 and 2012, the weighted average interest rates for savings and money market deposit accounts were 0.46% and 0.51%, respectively, and for certificates of deposit were 0.97% and 0.94%, respectively. The weighted average interest rates for all deposits as of December 31, 2013 and 2012 were 0.90% and 0.87%, respectively.

109

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, interest-bearing deposits at the Bank were as follows:



	December 31,
	2013				2012
	Balance		Weighted Average Rate		Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	253,357	0.45	%	$	257,961	0.49	%
Savings	623,430		0.47	%	704,890		0.52	%
Certificates of deposit	5,250,903		0.97	%	4,616,419		0.94	%
Total interest-bearing deposits	$	6,127,690	0.90	%	$	5,579,270	0.87	%

As of December 31, 2013, certificates of deposit at the Bank detailed by maturity were as follows:



	Amount		Weighted Average Rate
	($ in thousands)
Maturing by:
December 31, 2014	$	4,694,400	0.94	%
December 31, 2015	432,770		1.16	%
December 31, 2016	69,602		1.67	%
December 31, 2017	26,459		1.19	%
December 31, 2018	27,672		1.25	%
Total	$	5,250,903	0.97	%

For the years ended December 31, 2013, 2012 and 2011, interest expense on deposits was as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Savings and money market	$	4,584		$	6,086		$	8,289
Certificates of deposit	47,591			45,165			45,547
Fees for early withdrawal	(234		)	(216		)	(227		)
Total interest expense on deposits	$	51,941		$	51,035		$	53,609

Note 7. Variable Interest Entities

Troubled Debt Restructurings

Certain of our loan modifications qualify as events that require reconsideration of our borrowers as VIEs. 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 in these borrowers. 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 be significant. As a result, we have determined that the equity investors should continue to have a controlling financial interest in the borrowers subsequent to the restructuring.

Our interest in borrowers qualifying as VIEs was $44.6 million and $115.4 million as of December 31, 2013 and 2012, respectively, and is included in loans held for investment. For certain of these borrowers, we have had obligations to fund additional amounts through either unfunded commitments or letters of credit issued to or on behalf of these borrowers. Consequently, our

110

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

maximum exposure to loss as a result of our involvement with these entities was $69.4 million and $151.9 million as of December 31, 2013 and 2012, 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 were structured to be legally isolated, bankruptcy remote entities. The Issuers issued notes and certificates that were collateralized by their underlying assets, which primarily comprised loans contributed to the securitizations. We serviced the underlying loans contributed to the Issuers and earned 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. During the year ended December 31, 2013, we called all of our remaining term debt securitizations and repaid the outstanding third-party debt of $177.2 million. We recognized no gain or loss on the extinguishment of debt. As a result, as of December 31, 2013, we had no remaining term debt securitizations. As of December 31, 2012, the total outstanding balance of the securitizations was $398.9 million. This amount included $221.7 million of notes and certificates that we held as of December 31, 2012.

Prior to the call and extinguishment of our term debt securitizations, we had determined that the Issuers were VIEs, subject to applicable consolidation guidance and 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 had concluded that we were the primary beneficiary of each of the Issuers. Consequently, except as set forth below, we had been reporting 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. Upon the extinguishment of our securitizations, we have no consolidated assets and liabilities related to the Issuers as of December 31, 2013. As of December 31, 2012, the carrying amount of the consolidated liabilities related to the Issuers was $177.4 million. This amount included term debt and represented obligations for which there was only legal recourse to the Issuers. As of December 31, 2012, the carrying amount of the consolidated assets related to the Issuers was $345.4 million. This amount primarily included loans held for investment, net and related assets that can only be used to settle obligations of the Issuers.

As of December 31, 2012, we held an interest in a term debt securitization trust (the "2006-A Trust"). As of December 31, 2013, we had no remaining interest in the 2006-A Trust. Due to the sale of our interest during the fourth quarter of 2013, we had $19.8 million in realized gains which was included as component of gains on investments, net. As of December 31, 2012, 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 was $26.3 million, and was classified as investment securities, available-for-sale. We had no material commitments or other obligations related to these interests. Except for a guarantee provided to a swap counterparty of the 2006-A Trust, we did 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 $9.2 million and $13.5 million as of December 31, 2013 and 2012. During the years ended December 31, 2013 and December 31, 2012, we recorded no unrealized gains or losses and $12.8 million in unrealized gains, respectively, which was included as a component of other comprehensive income, on the securities that we had held in the 2006-A Trust.

Note 8. Borrowings

As of December 31, 2013 and 2012, the composition of our outstanding borrowings was as follows:



	December 31,
	2013		2012
	($ in thousands)
Term debt - obligations of consolidated VIEs for which there was no recourse to the general credit of CapitalSource Inc ⁽¹⁾	$	—	$	177,188
Other borrowings:
Subordinated debt	412,156		410,738
FHLB SF borrowings	625,000		595,000
Total other borrowings	1,037,156		1,005,738
Total borrowings	$	1,037,156	$	1,182,926

______________________________


(1)	Amount presented is net of debt discounts of $21 thousand as of December 31, 2012.

Term Debt

In conjunction with each of our commercial term debt securitizations, we established and contributed commercial loans to separate Issuers. The Issuers were structured to be legally isolated, bankruptcy remote entities. The Issuers issued notes and

111

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

certificates that were collateralized by the underlying assets of the Issuers, primarily comprising contributed loans. We serviced the underlying commercial loans contributed to the Issuers and earned periodic servicing fees paid from the cash flows of the underlying commercial loans. During the year ended December 31, 2013, we called the 2006-1, 2006-2 and 2007-1 term debt securitizations and repaid the outstanding third-party debt of $177.2 million; we recognized no gain or loss on the extinguishment of debt. As a result, as of December 31, 2013, we had no outstanding term debt securitizations.

Our outstanding term debt transactions in the form of asset securitizations held by third parties as of December 31, 2013 and 2012, were as follows:



	Amounts Issued	Outstanding Third Party Held Debt Balance as of December 31,				Interest Rate Spread⁽¹⁾	Original Expected Maturity Date
	Amounts Issued	2013		2012		Interest Rate Spread⁽¹⁾	Original Expected Maturity Date
	($ in thousands)
2006-1
Class C	68,447	—		1,119		0.55%	September 20, 2010
Class D	52,803	—		24,371		1.30%	December 20, 2010
	121,250	—		25,490
2006-2
Class D⁽²⁾	101,250	—		84,597		1.52%	June 20, 2013
Class E	56,250	—		20,000		2.50%	June 20, 2013
	157,500	—		104,597
2007-1
Class C	84,000	—		19,448		0.65%	February 20, 2013
Class D	48,000	—		27,674		1.50%	September 20, 2013
	132,000	—		47,122
Total		$	—	$	177,209

____________________


(1)	All of our term debt securitizations incurred interest based on one-month LIBOR, which was 0.21% as of December 31, 2012.


(2)	We repurchased certain bonds from third party investors at fair market value. The tables reflect outstanding debt to third party investors, and therefore,

eliminate the portions of debt owned by us.

Convertible Debt

We have issued convertible debentures as part of our financing activities. Our 7.25% senior subordinated convertible debentures due 2037 (originally issued in July 2007) were repurchased in full during 2012 and extinguished, leaving no remaining convertible debentures.

For the years ended December 31, 2013, 2012 and 2011, the interest expense recognized on our Convertible Debentures and the effective interest rates on the liability components were as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Interest expense recognized on:
Contractual interest coupon	$	—		$	1,006		$	21,112
Amortization of deferred financing fees	—			7			692
Amortization of debt discount	—			66			6,033
Total interest expense recognized	$	—		$	1,079		$	27,837
Effective interest rate on the liability component:
3.5% Senior Debentures due 2034⁽¹⁾	—		%	—		%	7.25		%
4.0% Senior Subordinated Debentures due 2034⁽¹⁾	—		%	—		%	7.68		%
7.25% Senior Subordinated Debentures due 2037⁽²⁾	—		%	7.79		%	7.79		%

____________________


(1)	Repurchased in 2011.


(2)	Repurchased in 2012.

112

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Subordinated Debt

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, in June 2012, the related subordinated debt was exchanged and cancelled, and we recognized a related gain of $8.2 million on the extinguishment.

The carrying value of our subordinated debt was $412.2 million and $410.7 million as of December 31, 2013 and 2012, respectively.



TPS Series	Trust Formation Date	Debt Outstanding			Maturity Date	Date Callable⁽¹⁾	Interest Rate as of December 31, 2013
		($ in thousands)
2005-1	November 2005	$	82,475		December 15, 2035	December 15, 2010	2.19	%	⁽²⁾
2005-2	December 2005	$	128,866		January 30, 2036	January 30, 2011	2.19	%	⁽²⁾
2006-1	February 2006	$	51,545		April 30, 2036	April 30, 2011	2.19	%	⁽²⁾
2006-2	September 2006	$	51,550		October 30, 2036	October 30, 2011	2.19	%	⁽²⁾
2006-3	September 2006	$	35,423	⁽⁴⁾	October 30, 2036	October 30, 2011	2.28	%	⁽³⁾
2006-4	December 2006	$	16,470		January 30, 2037	January 30, 2012	2.19	%	⁽²⁾
2006-5	December 2006	$	6,650		January 30, 2037	January 30, 2012	2.19	%	⁽²⁾
2007-2	June 2007	$	39,177		July 30, 2037	July 30, 2012	2.19	%	⁽²⁾

______________________


(1)	The subordinated debt is callable by us in whole or in part at par at any time after the stated date.


(2)	Bears interest at a floating interest rate equal to three-month LIBOR plus 1.95%, resetting quarterly at various dates.


(3)	Bears interest at a floating interest rate equal to three-month EURIBOR plus 2.05%, resetting quarterly.


(4)	Denomination is in Euros with a value of €25.8 million.

The subordinated debt described above is unsecured and ranks subordinate and junior in right of payment to all of the Parent Company's indebtedness.

FHLB SF Borrowings and FRB Credit Program

As a member of the FHLB SF, CapitalSource Bank had financing availability with the FHLB SF as of December 31, 2013 equal to 35% of the Bank's total assets. The maximum financing available under this formula was $2.8 billion and $2.6 billion as of December 31, 2013 and 2012, 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 December 31, 2013, securities collateral with an estimated fair value of $3.7 million and loans with an unpaid principal balance of $1.2 billion were pledged to the FHLB SF.

As of December 31, 2013 and 2012, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:



	December 31,
	2013			2012
	($ in thousands)
Borrowing capacity	$	1,012,361		$	841,309
Less: outstanding principal	(625,000		)	(595,000		)
Less: outstanding letters of credit	(150		)	(300		)
Unused borrowing capacity	$	387,211		$	246,009

The Bank is an approved depository institution under the primary credit program of the FRB of San Francisco's discount window eligible to borrow from the FRB for short periods, generally overnight. As of December 31, 2013 and 2012, investment

113

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

securities with amortized costs of $70.4 million and $87.0 million, respectively, and fair values of $70.6 million and $88.4 million, respectively, had been pledged as collateral this program. As of December 31, 2013 and 2012, there were no borrowings outstanding. Additionally, the Bank participates in the Borrower-In-Custody program at the FRB of San Francisco, which allows the Bank to pledge qualifying loans. As of December 31, 2013, there were no loans pledged.

Debt Maturities

The contractual maturities of our obligations under the subordinated debt and FHLB SF borrowings as of December 31, 2013, were as follows:



	Other Borrowings				Total
	Subordinated Debt⁽¹⁾		FHLB SF Borrowings		Total
	($ in thousands)
2014	$	—	$	135,000	$	135,000
2015	—		112,500		112,500
2016	—		204,000		204,000
2017	—		88,000		88,000
2018	—		78,000		78,000
Thereafter	412,156		7,500		419,656
Total	$	412,156	$	625,000	$	1,037,156

______________________


(1)	The contractual obligations for subordinated debt are computed based on the legal maturities, which are between 2035 and 2037.

Interest Expense

The weighted average interest rates on all of our borrowings, including amortization of deferred financing costs, for the years ended December 31, 2013, 2012 and 2011 were 1.1%, 1.2% and 2.2%, respectively.

Deferred Financing Fees

As of December 31, 2013 and 2012, deferred financing fees of $10.7 million and $11.8 million, respectively, net of accumulated amortization of $3.2 million and $31.3 million, respectively, were included in other assets.

Debt Covenants

The Parent Company is subject to financial and non-financial covenants under our indebtedness, including, those with respect to engaging in a merger, sale or consolidation. If we were to default under our indebtedness by violating these covenants or otherwise, our investors' remedies would include the ability to, among other things, foreclose on collateral, and/or accelerate payment of all amounts payable under such indebtedness. We believe that we are in compliance with all covenants under our indebtedness.

114

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 9. Shareholders' Equity

Common Stock Shares Outstanding

Common stock share activity for the years ended December 31, 2013, 2012 and 2011 was as follows:



Outstanding as of December 31, 2010	323,225,355
Repurchase of common stock	(70,208,500	)
Exercise of options	475,709
Restricted stock and other stock activities	2,619,641
Outstanding as of December 31, 2011	256,112,205
Repurchase of common stock	(49,270,260	)
Exercise of options	1,694,429
Restricted stock and other stock activities	1,015,300
Outstanding as of December 31, 2012	209,551,674
Repurchase of common stock	(15,002,800	)
Exercise of options	1,774,824
Restricted stock and other stock activities	531,585
Outstanding as of December 31, 2013	196,855,283

Stock Repurchase Program

Between 2010 and 2013, the Company repurchased $930.6 million of its common stock at weighted average prices of $7.01 per share in 2010, $6.22 per share in 2011, $6.97 per share in 2012 and $9.18 per share in 2013. All shares purchased during this period were retired upon settlement. As a result of entering into the Merger Agreement, the Stock Repurchase Program was suspended as of July 23, 2013. The Stock Repurchase Program was later terminated as of December 31, 2013.

115

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Accumulated other comprehensive loss, net

Accumulated other comprehensive loss, net, as of December 31, 2013 and 2012 was as follows:



	December 31, 2013
	Unrealized Loss on Investment Securities, Available-for-Sale, net of tax			Unrealized Gain on Foreign Currency Translation, net of tax		Accumulated Other Comprehensive Loss, Net
	($ in thousands)
Beginning balance as of January 1, 2013	$	24,650		$	—	$	24,650
Other comprehensive loss before reclassifications, net of tax benefit of $10.2 million ⁽¹⁾	(10,367		)	—		(10,367		)
Amounts reclassified from accumulated other comprehensive income, net of tax benefit of $2.3 million ⁽²⁾	(15,153		)	—		(15,153		)
Other comprehensive loss, net of tax benefit of $12.5 million	(25,520		)	—		(25,520		)
Ending balance as of December 31, 2013	$	(870	)	$	—	$	(870	)

____________________


(1)	Gross amount included in Investment securities interest income, with related tax impact included in Deferred tax assets, net.


(2)	Gross amounts included in Gain on investments, net, and Other non-interest income, net, respectively. Related tax impact amounts are included in Income tax (benefit) expense and Other non-interest income, net, respectively.



	December 31, 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 as of January 1, 2012	$	19,055		$	351		$	19,406
Other comprehensive income before reclassifications, net of tax benefit of $1.5 million ⁽¹⁾	7,303			—			7,303
Amounts reclassified from accumulated other comprehensive income, net of tax (benefit) expense of $(0.7) million and $350.5 thousand, respectively ⁽²⁾	(1,708		)	(351		)	(2,059		)
Other comprehensive income (loss), net of tax (benefit) expense of $(2.2) million and $350.5 thousand, respectively	5,595			(351		)	5,244
Ending balance as of December 31, 2012	$	24,650		$	—		$	24,650

____________________


(1)	Gross amount included in Investment securities interest income, with related tax impact included in Deferred tax assets, net.


(2)	Gross amounts included in Gain on investments, net, and Other non-interest income, net, respectively. Related tax impact amounts are included in Income tax (benefit) expense and Other non-interest income, net, respectively.

Note 10. Employee Benefit Plan

Our employees are eligible to participate in the CapitalSource 401(k) Plan (“401(k) Plan”), a defined contribution plan in accordance with Section 401(k) of the Internal Revenue Code of 1986, as amended. During the years ended December 31, 2013, 2012 and 2011, we contributed $1.8 million, $2.1 million and $1.8 million, respectively, in matching contributions to the 401(k) Plan.

Note 11. Income Taxes

We provide for income taxes as a “C” corporation on income earned from operations. We are subject to federal, foreign, state and local taxation in various jurisdictions.

116

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

The components of income tax expense (benefit) from continuing operations for the years ended December 31, 2013, 2012 and 2011 were as follows:



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Current:
Federal	$	(52,836	)	$	21,467		$	(8,844	)
State	5,575			5,501			4,916
Foreign	22			237			(2,482		)
Total current	(47,239		)	27,205			(6,410		)
Deferred:
Federal	123,150			(306,065		)	32,785
State	6,126			(6,221		)	5,053
Foreign	—			—			5,514
Total deferred	129,276			(312,286		)	43,352
Income tax expense (benefit)	$	82,037		$	(285,081	)	$	36,942

For the year ended December 31, 2013 and 2012, we had $246.3 million and $205.5 million, respectively, of pre-tax income relating to our domestic operations. For the year ended December 31, 2011, we had $16.9 million of pre-tax income and $32.0 million of pre-tax loss that was attributable to foreign and domestic operations, respectively.

The reconciliations of the effective income tax rate and the federal statutory corporate income tax rate for the years ended December 31, 2013, 2012 and 2011, were as follows:



	Year Ended December 31,
	2013		2012		2011
Federal statutory rate	35.0	%	35.0	%	35.0	%
State income taxes, net of federal tax benefit	4.5		4.1		7.1
Foreign income/Repatriation	—		—		93.4
Valuation allowance	8.4		(186.8	)	(672.9	)
State rate change	(12.6	)	8.1		180.9
Other	(2.0	)	0.9		111.5
Effective income tax rate	33.3	%	(138.7	)%	(245.0	)%

117

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Deferred income taxes are recorded when revenues and expenses are recognized in different periods for financial statement and income tax purposes. The components of deferred tax assets and liabilities as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013			2012
	($ in thousands)
Deferred tax assets:
Allowance for loan and lease losses	$	47,314		$	38,922
Net unrealized losses on investments	30,274			62,557
Net unrealized losses on other real estate owned	5,608			7,720
Net operating losses - federal	187,733			166,624
Net operating losses - state, net of federal tax benefit	65,844			46,094
Capital losses - federal and state	38,649			23,813
Foreign tax credit	28,616			28,616
Share-based compensation awards	7,841			7,915
Non-accrual interest	8,832			50,899
Other	18,174			114,046
Total deferred tax assets	438,885			547,206
Valuation allowance	(151,980		)	(128,568		)
Total deferred tax assets, net of valuation allowance	286,905			418,638
Deferred tax liabilities:
Mark-to-market on loans	4,649			16,074
Other	29,988			40,281
Total deferred tax liabilities	34,637			56,355
Net deferred tax assets	$	252,268		$	362,283

We have net operating loss carryforwards for federal and state income tax purposes that can be utilized to offset future taxable income. If we were to undergo a change in ownership of more than 50% of our capital stock over a three-year period as measured under Section 382 of the Internal Revenue Code (the “Code”), our ability to utilize our net operating loss carryforwards, certain built-in losses and other tax attributes recognized in years after the ownership change generally would be limited. The annual limit would equal the product of (a) the applicable long term tax exempt rate and (b) the value of the relevant taxable entity's capital stock immediately before the ownership change. These change of ownership rules generally focus on ownership changes involving stockholders owning directly or indirectly 5% or more (the "5-Percent Shareholders") of a company's outstanding stock, including certain public groups of stockholders as set forth under Section 382 of the Code, and those arising from new stock issuances and other equity transactions. The determination of whether an ownership change occurs is complex and not entirely within our control. No assurance can be given as to whether in the future we will undergo an ownership change under Section 382 of the Code.

As of December 31, 2013 and 2012, we had net operating loss carryforwards of $546.2 million and $487.8 million, respectively, for federal tax purposes, which are available to offset future taxable income. If not used, these carryforwards will begin to expire in 2029 and would fully expire in 2031. To the extent net operating loss carryforwards, when realized, relate to non-qualified stock option and restricted stock deductions, the resulting benefits will be credited to stockholders' equity. As of December 31, 2013 and 2012, we had state net operating loss carryforwards of $1.2 billion and $0.7 billion, respectively, which will expire in varying amounts beginning in 2013 through 2033.

118

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, we had capital loss carryforwards of $94.1 million and $60.7 million, respectively, for federal tax purposes which are available to offset future capital gains. If not used, these carryforwards will begin to expire in 2015 and will fully expire in 2018.

As of December 31, 2013 and 2012, we have foreign tax credit carryforwards of $28.6 million for federal tax purposes, which are available to offset future federal income tax. If not used, these carryforwards will begin to expire in 2016 and would fully expire in 2021.

A reconciliation of the beginning and ending amount of unrecognized tax benefits for the years ended December 31, 2013 and 2012, are as follows:



	Year Ended December 31,
	2013			2012
	($ in thousands)
Balance as of the beginning of year	$	108,101		$	75,445
Additions for tax positions of prior years	13,715			34,698
Reductions for tax positions of prior years	(31,985		)	(97		)
Reductions for tax positions as a result of a lapse of the applicable statute of limitations	(557		)	(1,945		)
Reductions for tax positions as a result of settlements	(71,588		)	—
Balance as of the end of year	$	17,686		$	108,101

As of December 31, 2013 and 2012, our unrecognized tax benefit that may affect the effective tax rate was $2.1 million and $2.7 million, respectively, in each period. Due to potential for resolution of federal and state examinations and the expiration of various statutes of limitations, it is reasonably possible that our gross unrecognized tax benefits may decrease within the next twelve months by as much as $1.8 million; however, we have sufficient net operating losses and other adjustments to offset these potential tax liabilities.

We recognize interest and penalties accrued related to unrecognized tax benefits as a component of income taxes. For the years ended December 31, 2013, 2012 and 2011, we recognized $(1.0) million, $1.8 million and $0.5 million in interest (benefit) expense and penalties, respectively. We had $2.6 million and $3.6 million accrued for the payment of interest and penalties as of December 31, 2013 and 2012, respectively.

Note 12. Net Income (Loss) Per Share

The computations of basic and diluted net income (loss) per share attributable to CapitalSource Inc. for the years ended December 31, 2013, 2012 and 2011, respectively, were as follows:



	Year Ended December 31,
	2013	2012	2011
	($ in thousands, except per share data)
Net income (loss):
Net income (loss)	164,292	490,610	(52,023	)
Average shares - basic	195,189,983	223,928,583	302,998,615
Effect of dilutive securities:
Option shares	2,565,037	2,465,061	—
Stock units and unvested restricted stock	2,696,879	3,761,345	—
Average shares - diluted	200,451,899	230,154,989	302,998,615
Basic net income (loss) per share	0.84	2.19	(0.17	)
Diluted net income (loss) per share	0.82	2.13	(0.17	)

119

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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



	Year Ended December 31,
	2013	2012	2011
Stock units	—	1,858	2,956,796
Stock options	473,666	1,256,195	7,242,390
Shares issuable upon conversion of convertible debt	—	—	1,069,517
Unvested restricted stock	—	52,552	4,781,650

Note 13. Stock-Based Compensation

Equity Incentive Plan

A total of 66.0 million shares of common stock have been reserved for issuance under the CapitalSource Inc. Third Amended and Restated Equity Incentive Plan (the “Plan”). Any shares that may be issued under the Plan to any person pursuant to an option or stock appreciation right (an “SAR”) are counted against this limit as one share for every one share granted. Any shares that may be issued under the Plan to any person, other than pursuant to an option or SAR, are counted against this limit as one and one-half shares for every one share granted.

As of December 31, 2013, there were 7.7 million shares subject to outstanding grants and 23.2 million shares remaining available for future grants under the Plan. The Plan will expire on the earliest of (1) the date as of which the Board, in its sole discretion, determines that the Plan shall terminate, (2) following certain corporate transactions such as a merger or sale of our assets if the Plan is not assumed by the surviving entity, (3) at such time as all shares of common stock that may be available for purchase under the Plan have been issued or (4) April 29, 2020. The Plan is intended to give eligible employees, members of the Board, and our consultants and advisors awards that are linked to the performance of our common stock.

Total compensation cost recognized in income pursuant to the Plan was $38.3 million, $34.1 million and $15.7 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Stock Options

Stock option activity for the year ended December 31, 2013 was as follows:



	Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)	Aggregate Intrinsic Value
						($ in thousands)
Outstanding as of December 31, 2012	6,364,661		$	5.41	5.67	$	19,626
Granted	—		—
Exercised	(1,774,824	)	3.31
Expired	(154,686	)	15.59
Forfeited	—		—
Outstanding as of December 31, 2013	4,435,151		5.90		6.23	39,606
Vested as of December 31, 2013	3,673,901		5.78		5.85	33,582
Exercisable as of December 31, 2013	3,673,901		5.78		5.85	33,582

For the years ended December 31, 2013, no options were granted. For the years ended December 31, 2012 and 2011, the weighted average grant date fair values of options granted were $7.58 and $4.18, respectively. The total intrinsic values of options exercised during the years ended December 31, 2013, 2012 and 2011, were $11.4 million, $6.1 million and $1.5 million, respectively. As of December 31, 2013 and 2012, the total unrecognized compensation cost related to unvested options granted pursuant to the Plan was $0.9 million and $2.7 million, respectively. This cost is expected to be recognized over a weighted average period of 0.63 and 1.56 years, respectively.

120

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

For awards containing only service and/or performance based vesting conditions, we use the Black-Scholes option-pricing model to estimate the fair value of each option grant on its grant date. The assumptions used in this model for the years ended December 31, 2013, 2012 and 2011, were as follows:



	Year Ended December 31,
	2013	2012	2011
Dividend yield	0.28%	0.53%	0.57%
Expected volatility	33.06%	63.83%	87.80%
Risk-free interest rate	1.18%	0.52%	1.50%
Expected life	3.8 years	3.9 years	4.0 years

The dividend yield is computed based on annualized ordinary dividends and the average share price for the period. The expected volatility is based on the historical volatility of CapitalSource Inc.'s stock price in the most recent period that is equal to the expected term of the options being valued. The risk-free interest rate is the U.S. Treasury yield curve in effect at the time of grant based on the expected life of the options. The expected life of our options granted represents the period of time the options are expected to be outstanding.

Restricted Stock Awards and Restricted Stock Units

Restricted stock awards for the year ended December 31, 2013, were as follows:



	Shares		Weighted Average Grant Date Fair Value
Outstanding as of December 31, 2012	3,781,731		$6.44
Granted	1,294,388		9.68
Vested	(1,699,284	)	6.37
Forfeited	(77,514	)	6.67
Outstanding as of December 31, 2013⁽¹⁾	3,299,321		7.74

______________________


(1)	Includes 0.8 million and 0.2 million vested and unvested restricted stock units, respectively.

The fair value of unvested restricted stock awards and restricted stock units is determined based on the closing trading price of our common stock on the grant date, in accordance with the Plan. The weighted average grant date fair value of restricted stock awards and restricted stock units granted during the years ended December 31, 2013, 2012 and 2011 was $9.68, $6.99 and $6.30, respectively.

The total fair value of restricted stock awards and restricted stock units that vested during the years ended December 31, 2013, 2012 and 2011 was $20.3 million, $30.4 million and $8.9 million, respectively. As of December 31, 2013 and 2012, the total unrecognized compensation cost related to unvested restricted stock awards and restricted stock units granted pursuant to the Plan was $13.7 million and $18.0 million, respectively, which is expected to be recognized over a weighted average period of 1.42 and 1.80 years, respectively.

Note 14. Bank Regulatory Capital

The 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, the Bank must meet specific capital guidelines that involve quantitative measures of its assets and liabilities as calculated under regulatory accounting practices. The Bank's capital amounts and other requirements are also subject to qualitative judgments by its regulators about risk weightings and other factors.

121

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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, the 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%. the Bank's ratios and the minimum requirements as of December 31, 2013 and 2012 were as follows:



	December 31,
	2013								2012
	Actual				Minimum Required				Actual				Minimum Required
	Amount		Ratio		Amount		Ratio		Amount		Ratio		Amount		Ratio
	($ in thousands)
Tier-1 Leverage	$	1,088,870	13.88	%	$	393,342	5.00	%	$	933,837	13.06	%	$	357,443	5.00	%
Tier-1 Risk-Based Capital	1,088,870		15.03		434,562		6.00		933,837		15.24		367,651		6.00
Total Risk-Based Capital	1,179,666		16.29		1,086,405		15.00		1,010,746		16.50		919,128		15.00

Note 15. Commitments and Contingencies

We have non-cancelable operating leases for office space and office equipment. The leases expire over the next eleven years and contain provisions for certain annual rental escalations.

As of December 31, 2013, future minimum lease payments under non-cancelable operating leases, including leases held at the Bank, were as follows ($ in thousands):



2014	$	11,715
2015	9,154
2016	7,660
2017	6,738
2018	6,025
Thereafter	33,831
Total⁽¹⁾	$	75,123

______________________


(1)	Minimum lease payments have not been reduced by minimum sublease rentals of $16.1 million due in the future under non-cancelable subleases.

Occupancy expense was $14.6 million, $16.8 million and $15.5 million for the years ended December 31, 2013, 2012 and 2011, respectively.

As of December 31, 2013 and 2012, we had committed credit facilities to our borrowers of approximately $8.0 billion and $7.4 billion of which approximately $1.1 billion and $1.0 billion were unfunded, respectively. As of December 31, 2013 and 2012, $1.0 billion and $0.9 billion of the total unfunded commitments were extended by the Bank, respectively. As of December 31, 2013 and 2012, $28.0 million and $88.5 million, of the total unfunded commitments were extended by the Parent Company, respectively. Our failure to satisfy our full contractual funding commitment to one or more of our borrower's could create a breach of contract and lender liability for us and damage our reputation in the marketplace, which could have a material adverse effect on our business.

We provide standby letters of credit in conjunction with several of our lending arrangements and property lease obligations. As of December 31, 2013 and 2012, we had issued $43.4 million and $54.2 million, respectively, in stand-by letters of credit which expire at various dates over the next six years. If a borrower defaults on its commitments 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, and we have posted cash and investments securities as collateral under these arrangements.

Note 16. Related Party Transactions

We have from time to time in the past, and expect that we may from time to time in the future, enter into transactions with companies in which our directors, executive officers, nominees for directors, 5% or more beneficial owners or certain of their affiliates have material interests. Our Board, or a committee of disinterested directors, is charged with considering and approving

122

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

these types of transactions. Management believes that each of our related party loans have been, and will continue to be, subject to the same due diligence, underwriting and rating standards as the loans that we make to unrelated third parties.

As of December 31, 2013 and 2012, we had no loans committed or outstanding to such entities. For the year ended December 31, 2013, we recognized no interest and fees from these loans. For the years ended December 31, 2012 and 2011, we recognized $0.1 million and $0.6 million, respectively, in interest and fees from these loans.

Note 17. Derivative Instruments

We are exposed to certain risks related to our ongoing business operations. The primary risks managed through the use of derivative instruments are interest rate risk and foreign exchange risk. We do not enter into derivative instruments for speculative purposes. As of December 31, 2013 and 2012, none of our derivatives were designated as hedging instruments pursuant to GAAP.

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.

In connection with our term debt securitizations which were extinguished as of September 30, 2013, we had entered into basis swaps to eliminate risk between our LIBOR-based securitizations and the prime-based loans pledged as collateral for that debt. Those basis swaps modified our exposure to interest rate risk by converting our prime rate loans to a one-month LIBOR rate. The objective of that swap activity was to protect us from risk that interest collected under the prime rate loans was not sufficient to service the interest due under the one-month LIBOR-based term debt.

Derivative instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk exposure consists primarily of the termination value of agreements where we are in a favorable position. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from certain counterparties and monitor all exposure and collateral requirements daily. We continually monitor the fair value of collateral received from counterparties and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. 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 December 31, 2013, the gross positive fair value of derivative financial instruments was $1.4 million. As a result of our master netting arrangements, our exposure was reduced to $0.9 million as of December 31, 2013.

We report our derivatives at fair value on a gross basis irrespective of our master netting arrangements. We held no collateral against our derivatives in asset positions as of December 31, 2013 and 2012. For derivatives that were in a liability position, we had posted no collateral as of December 31, 2013 and $1.5 million collateral as of December 31, 2012. As of December 31, 2013, we also posted collateral of $10.0 million related to counterparty requirements for foreign exchange contracts at the Bank.

During the year ended December 31, 2013, we had $4.7 million of interest rate swaps that were terminated in conjunction with calling the two remaining securitizations.

123

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2013 and 2012, the notional amounts and fair values of our various derivative instruments as well as their locations in our consolidated balance sheets were as follows:



	December 31,
	2013						2012
	Notional Amount		Fair Value				Notional Amount		Fair Value
	Notional Amount		Other Assets		Other Liabilities		Notional Amount		Other Assets		Other Liabilities
	($ in thousands)						($ in thousands)
Interest rate contracts	$	—	$	—	$	—	$	6,712	$	—	$	11
Foreign exchange contracts	54,121		1,379		510		34,553		—		471
Total	$	54,121	$	1,379	$	510	$	41,265	$	—	$	482

The gains and losses on our derivative instruments recognized during the years ended December 31, 2013, 2012 and 2011 as well as the locations of such gains and losses in our audited consolidated statements of operations were as follows:



	Location	Gain (Loss) Recognized in Income in Year Ended December 31,
	Location	2013			2012			2011
		($ in thousands)
Interest rate contracts	Gain (loss) on derivatives, net	$	(10	)	$	338		$	(6,120	)
Foreign exchange contracts	Gain (loss) on derivatives, net	(286		)	(1,162		)	(693		)
Total		$	(296	)	$	(824	)	$	(6,813	)

Note 18. Credit Risk

In the normal course of business, we utilize various financial instruments to manage our exposure to interest rate and other market risks. These financial instruments, which consist of derivatives and credit-related arrangements, involve, to varying degrees, elements of credit and market risk in excess of the amounts recorded on our audited consolidated balance sheets in accordance with applicable accounting standards.

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. Market risk is the possibility that a change in market prices may cause the value of a financial instrument to decrease or become more costly to settle. The contract or notional amounts of financial instruments, which are not included in our audited consolidated balance sheets, do not necessarily represent credit or market risk. However, they can be used to measure the extent of involvement in various types of financial instruments.

We manage credit risk of our derivatives and credit-related arrangements by limiting the total amount of arrangements outstanding by an individual counterparty, by obtaining collateral based on management's assessment of the client and by applying uniform credit standards maintained for all activities with credit risk.

124

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Contract or notional amounts and the credit risk amounts for derivatives and credit-related arrangements as of December 31, 2013 and 2012, were as follows:



	December 31,
	2013				2012
	Contract or Notional Amount		Credit Risk Amount		Contract or Notional Amount		Credit Risk Amount
			($ in thousands)
Derivatives:
Interest rate contracts	$	—	$	—	$	6,712	$	—
Foreign exchange contracts	54,121		870		34,553		—
Total derivatives	$	54,121	$	870	$	41,265	$	—
Credit-related arrangements:
Commitments to extend credit	$	1,062,669	$	17,938	$	1,019,920	$	14,153
Commitments to extend letters of credit	59,926		7,433		95,927		8,737
Total credit-related arrangements	$	1,122,595	$	25,371	$	1,115,847	$	22,890

Derivatives

We report our derivatives at fair value on a gross basis irrespective of our master netting arrangements. We held no collateral against our derivatives in asset positions as of December 31, 2013 and 2012, respectively. We posted no collateral for derivatives that were in a liability position as of December 31, 2013. For derivatives that were in a liability position, we posted collateral of $1.5 million as of December 31, 2012. As of December 31, 2013, we also posted collateral of $10.0 million related to counterparty requirements for foreign exchange contracts at the Bank.

During the year ended December 31, 2013, we terminated interest rate swaps of $9.8 million which were in a liability position. As a result of these terminations, we received $0.3 million, net of collateral held and posted.

Credit-Related Arrangements

In our normal course of business, we engage in lending activities with borrowers primarily throughout the United States. As of December 31, 2013, the single largest industry concentration in our outstanding loan balance was health care and social assistance, which represented approximately 22.2% of the outstanding loan portfolio. As of December 31, 2013, taken in the aggregate, lender finance (primarily timeshare) loans were our largest loan concentration by sector and represented approximately 16% of our loan portfolio.

As of December 31, 2013, real estate and real estate - construction loans represented approximately 43% of our outstanding loan portfolio. Among real estate and real estate - construction loans, the largest property type concentration was the multifamily category, comprising approximately 10%, and the largest geographical concentration was in California, comprising approximately 9% of this loan portfolio.

Note 19. Fair Value Measurements

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

Fair value 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.

125

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

Assets and Liabilities

Cash

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

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consist of Agency MBS, Non-agency MBS, agency asset-backed securities, non-agency asset-backed securities and CLOs 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. No other available-for-sale securities were transferred from or into Level 3 during the years ending December 31, 2013 or 2012.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists of CMBS. 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 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.

126

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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 the appraisal being outdated. As of December 31, 2013 and 2012, we charged off an additional $30.2 million, net, and $32.2 million, net, respectively, in loan balances compared with amounts that would have been charged off based on the most recent 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 December 31, 2013, $31.9 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 Earnings Before Interest Taxes Depreciation and Amortization ("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 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.

127

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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 December 31, 2013.

Derivative Assets and Liabilities

Derivatives are carried at fair value on a recurring basis and primarily relate to interest rate swaps, caps, floors 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 and Other Foreclosed Assets ("REO")

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.

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.

Term Debt

Term debt comprised our term debt securitizations as of December 31, 2012. For disclosure purposes, the fair values of our securitizations were 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 subordinated debt and FHLB borrowings. For disclosure purposes, 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. The carrying value of our FHLB borrowings is deemed to approximate fair value.

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.

128

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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 December 31, 2013 were as follows:



	Fair Value Measurement		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	$	784,240	$	—	$	784,240	$	—
Assets-backed securities	3,169		—		3,169		—
Collateralized loan obligation	47,337		—		47,337		—
Non-agency MBS	20,203		—		20,203		—
SBA asset-backed securities	15,533		—		15,533		—
Total Investment securities, available-for-sale	870,482		—		870,482		—
Derivative assets	1,380		—		1,380		—
Total assets	$	871,862	$	—	$	871,862	$	—
Liabilities
Derivative liabilities	$	510	$	—	$	510	$	—

Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of December 31, 2012 were as follows:



	Fair Value Measurement		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	$	983,521	$	—	$	983,521	$	—
Asset-backed securities	9,592		—		9,592		—
Collateralized loan obligation	26,250		—		—		26,250
Non-agency MBS	41,347		—		41,347		—
SBA asset-backed securities	18,315		—		18,315		—
Total assets	$	1,079,025	$	—	$	1,052,775	$	26,250
Liabilities
Derivative liabilities	$	482	$	—	$	482	$	—

129

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

A summary of the changes in the fair values of assets carried at fair value for the year ended December 31, 2013 that have been classified in Level 3 of the fair value hierarchy was as follows:



	Investment Securities, Available-for-Sale
	Corporate Debt		Collateralized Loan Obligation			Municipal Bonds		Non-agency MBS		Total			Warrants		Total Assets
	($ in thousands)
Balance as of January 1, 2013	$	—	$	26,250		$	—	$	—	$	26,250		$	—	$	26,250
Realized and unrealized gains (losses):
Included in income	—		56,242			—		—		56,242			—		56,242
Included in other comprehensive income, net	—		(12,832		)	—		—		(12,832		)	—		(12,832		)
Total realized and unrealized gains (losses)	—		43,410			—		—		43,410			—		43,410
Transfers to/from Level 3:
Transfers into Level 3	—		—			—		—		—			—		—
Transfers out of Level 3	—		—			—		—		—			—		—
Total Level 3 transfers	—		—			—		—		—			—		—
Sales and settlements:
Sales	—		(66,673		)	—		—		(66,673		)	—		(66,673		)
Settlements	—		(2,987		)	—		—		(2,987		)	—		(2,987		)
Total sales and settlements	—		(69,660		)	—		—		(69,660		)	—		(69,660		)
Balance as of December 31, 2013	$	—	$	—		$	—	$	—	$	—		$	—	$	—

A summary of the changes in the fair values of assets carried fair value for the year ended December 31, 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 Bonds ⁽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			2,954			(1,246		)	1,353			3,072			5			3,077
Included in other comprehensive income, net	(45		)	6,985			—			—			6,940			—			6,940
Total realized and unrealized gains (losses)	(34		)	9,939			(1,246		)	1,353			10,012			5			10,017
Transfers to/from Level 3
Transfers into Level 3	—			—			—			—			—			—			—
Transfers out of Level 3	(666		)	—			—			—			(666		)	—			(666		)
Total Level 3 transfers	(666		)	—			—			—			(666		)	—			(666		)
Sales and issuances:
Sales	—			—			—			—			—			(198		)	(198		)
Settlements	—			(1,452		)	(1,989		)	(1,353		)	(4,794		)	—			(4,794		)
Total sales and issuances	—			(1,452		)	(1,989		)	(1,353		)	(4,794		)	(198		)	(4,992		)
Balance as of December 31, 2012	$	—		$	26,250		$	—		$	—		$	26,250		$	—		$	26,250

______________________


(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.

130

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the year ended December 31, 2013 and 2012, reported in interest income and (loss) gain on investments, net were as follows:



	Interest Income				(Loss) Gain on Investments, Net
	Year Ended December 31,
	2013		2012		2013		2012
	($ in thousands)
Total gains (losses) included in earnings for the period	$	3,036	$	4,498	$	53,205	$	(1,421	)
Unrealized gains (losses) relating to assets still held at reporting date	—		3,134		—		(180		)

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 December 31, 2013 and 2012, classified by their position in the fair value hierarchy.



	December 31,
	2013								2012
	Fair Value Measurement as of December 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Fair Value Measurement as of December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)								($ in thousands)
Assets
Loans held for sale	$	—	$	—	$	—	$	—	$	1,000	$	—	$	1,000	$	—
Loans held for investment	1,883		—		—		1,883		9,287		—		—		9,287
Investments carried at cost	1,311		—		1,311		—		597		—		571		26
Real estate owned	1,793		—		1,315		478		6,178		—		1,844		4,334
Total assets	$	4,987	$	—	$	2,626	$	2,361	$	17,062	$	—	$	3,415	$	13,647

The following table presents the net losses of the above assets resulting from nonrecurring fair value adjustments for the year ended December 31, 2013 and 2012:



	December 31,
	2013		2012
	($ in thousands)
Assets
Loans held for sale	$	—	$	198
Loans held for investment	2,041		25,981
Investments carried at cost	189		5,486
Real estate owned	1,365		5,681
Total net loss from nonrecurring measurements	$	3,595	$	37,346

131

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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 December 31, 2013 a summary of the significant unobservable inputs and valuation techniques is as follows:



	Fair Value Measurement as of December 31, 2013		Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
	($ in thousands)
Assets

Loans held for investment
Services	754		Income Approach	Capitalization Rate	40.0%

Commercial Real Estate	1,129		Market and Income Approach	Price Per Square Foot	$22 - $195 ($41)
				Room Revenue Multiple	2.00x - 2.25x (2.05x)
				Marketability Discount	10% - 51% (21%)
				Capitalization Rate	9.0%

Total loans held for investment	1,883

Real estate owned	478		Market Approach	Marketability Discount	18% - 44% (42%)
				Price Per Square Foot	$47.50
				Room Revenue Multiple	1.75x

Total assets as of December 31, 2013	$	2,361

132

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Fair Value of Financial Instruments

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

The table below provides fair value estimates for our financial instruments as of December 31, 2013 and 2012, excluding financial assets and liabilities which are recorded at fair value on a recurring basis.



	December 31,
	2013										2012
	Carrying Value		Fair Value								Carrying Value		Fair Value
			Level 1		Level 2		Level 3		Total				Level 1		Level 2		Level 3		Total
	($ in thousands)
Assets:
Cash and cash equivalents	$	455,799	$	455,799	$	—	$	—	$	455,799	$	299,086	$	299,086	$	—	$	—	$	299,086
Restricted cash	58,653		58,653		—		—		58,653		104,044		104,044		—		—		104,044
Loans held for sale	—		—		—		—		—		22,719		—		22,723		—		22,723
Loans held for investment, net	6,663,969		—		—		6,654,877		6,654,877		6,021,957		—		—		5,953,226		5,953,226
Investments carried at cost	17,797		—		2,375		40,599		42,974		23,963		—		—		61,742		61,742
Investments accounted for under the equity method	34,327		—		12,414		22,500		34,914		36,400		1,087		12,372		24,055		37,514
Investment securities, held-to-maturity	74,369		—		75,535		—		75,535		108,233		—		111,388		—		111,388
Liabilities:
Deposits	6,127,690		876,788		5,257,729		—		6,134,517		5,579,270		962,851		4,626,715		—		5,589,566
Term debt	—		—		—		—		—		177,188		—		—		146,548		146,548
FHLB Borrowings	625,000		—		634,438		—		634,438		595,000		—		614,063		—		614,063
Subordinated debt	412,156		—		308,262		—		308,262		410,738		—		273,141		—		273,141
Loan commitments and letters of credit	—		—		—		24,359		24,359		—		—		—		21,559		21,559

133

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 20. Segment Data

For the years ended December 31, 2013 and 2012, we operated as two reportable segments: the Bank and Other Commercial Finance. Our the Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company.

The financial results of our operating segments as of and for the years ended December 31, 2013, 2012 and 2011, were as follows:



	Year Ended December 31, 2013
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	418,885	$	26,551		$	2,040		$	447,476
Interest expense	62,685		11,403			—			74,088
Loan and lease loss provision	16,866		3,665			—			20,531
Non-interest income	66,184		33,263			(16,897		)	82,550
Non-interest expense	168,249		37,470			(16,641		)	189,078
Income tax expense (benefit)	96,593		(15,237		)	681			82,037
Net income	$	140,676	$	22,513		$	1,103		$	164,292
Total assets as of December 31, 2013	$	8,078,746	$	845,532		$	(18,788	)	$	8,905,490



	Year Ended December 31, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	393,083	$	78,629		$	(3,498	)	$	468,214
Interest expense	62,096		17,311			—			79,407
Loan and lease loss provision	16,192		23,250			—			39,442
Non-interest income	60,495		14,522			(25,171		)	49,846
Non-interest expense	168,569		51,344			(26,231		)	193,682
Income tax expense (benefit)	84,055		(370,209		)	1,073			(285,081		)
Net income	$	122,666	$	371,455		$	(3,511	)	$	490,610
Total assets as of December 31, 2012	$	7,371,643	$	1,190,044		$	(12,682	)	$	8,549,005



	Year Ended December 31, 2011
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	368,964	$	141,056		$	370		$	510,390
Interest expense	62,802		87,208			—			150,010
Loan and lease loss provision	27,539		65,446			—			92,985
Non-interest income	41,697		123,951			(72,954		)	92,694
Non-interest expense	149,710		300,652			(75,192		)	375,170
Income tax expense (benefit)	57,996		(21,054		)	—			36,942
Net income (loss)	$	112,614	$	(167,245	)	$	2,608		$	(52,023	)
Total assets as of December 31, 2011	$	6,793,496	$	1,534,698		$	(28,126	)	$	8,300,068

The accounting policies of each of the individual operating segments are the same as those described in Note 2, Summary of Significant Accounting Policies. Currently, substantially all of our business activities occur within the United States of America; therefore, no additional geographic disclosures are necessary.

134

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Intercompany Eliminations

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

Note 21. Parent Company Information

As of December 31, 2013 and 2012, the Parent Company condensed financial information was as follows:

Condensed Balance Sheets



	December 31,
	2013			2012
	($ in thousands)
Assets:
Cash and cash equivalents	$	675		$	1,698
Investment in subsidiaries:
Bank subsidiary	1,235,903			1,100,847
Non-Bank subsidiaries	153,971			326,811
Total investment in subsidiaries	1,389,874			1,427,658
Other assets	246,712			200,577
Total assets	$	1,637,261		$	1,629,933
Liabilities and Shareholders' Equity:
Other liabilities	$	634		$	4,761
Shareholders' Equity:
Common stock	1,969			2,096
Additional paid-in capital	3,038,218			3,157,533
Accumulated deficit	(1,402,690		)	(1,559,107		)
Accumulated other comprehensive income, net	(870		)	24,650
Total shareholders' equity	1,636,627			1,625,172
Total liabilities and shareholders' equity	$	1,637,261		$	1,629,933

135

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Condensed Statements of Operations



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Net interest loss:
Interest income	$	—		$	—		$	28,850
Interest expense	69			1,190			65,077
Net interest loss	(69		)	(1,190		)	(36,227		)
Non-interest income:
Loan fees	—			—			(363		)
Earnings in Bank subsidiary	140,677			122,666			112,091
Earnings (loss) in non-Bank subsidiaries	(4,986		)	107,012			(20,002		)
Other non-interest income	—			60			89
Total non-interest income	135,691			229,738			91,815
Non-interest expense:
Compensation and benefits	849			752			1,352
Professional fees	54			1,606			7,140
Other non-interest expenses	8,779			4,075			123,749
Total non-interest expense	9,682			6,433			132,241
Net income (loss) before income taxes	125,940			222,115			(76,653		)
Income tax expense (benefit)	(37,607		)	(268,495		)	(24,630		)
Net income (loss)	$	163,547		$	490,610		$	(52,023	)

Condensed Statements of Cash Flows



	Year Ended December 31,
	2013			2012			2011
	($ in thousands)
Cash provided by operating activities:	$	138,877		$	464,825		$	863,487
Cash provided by investing activities:	—			—			—
Financing activities:
Repurchase of common stock	(137,989		)	(339,725		)	(427,231		)
Payment of dividends	(7,780		)	(113,304		)	(12,023		)
Repayments of other borrowings	—			(29,069		)	(507,877		)
Other	5,869			6,353			1,648
Cash used in financing activities:	(139,900		)	(475,745		)	(945,483		)
Decrease in cash and cash equivalents	(1,023		)	(10,920		)	(81,996		)
Cash and cash equivalents as of beginning of year	1,698			12,618			94,614
Cash and cash equivalents as of end of year	$	675		$	1,698		$	12,618

The Parent Company did not receive a dividend from the Bank during 2013. Simultaneously with the Merger with PacWest, CapitalSource Bank will pay a dividend to the Parent Company in an amount no more than CapitalSource Bank's retained earnings as of December 31, 2013.

136

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

Note 22. Unaudited Quarterly Information

Unaudited quarterly information for each of the three months in the years ended December 31, 2013 and 2012, was as follows:



	Three Months Ended
	December 31,		September 30,			June 30,		March 31,
	2013		2013			2013		2013
	($ in thousands, except per share data)
Interest income	$	113,258	$	112,718		$	108,405	$	113,095
Interest expense	18,807		18,644			18,474		18,163
Net interest income	94,451		94,074			89,931		94,932
Loan and lease loss provision (recovery)	4,263		(1,069		)	4,832		12,505
Net interest income after provision for loan and lease losses	90,188		95,143			85,099		82,427
Non-interest income	42,076		15,708			11,548		13,218
Non-interest expense	46,114		47,614			50,695		44,655
Income tax expense	28,227		14,839			17,329		21,642
Net income	$	57,923	$	48,398		$	28,623	$	29,348
Basic income per share	$	0.30	$	0.25		$	0.15	$	0.15
Diluted income per share	$	0.29	$	0.24		$	0.15	$	0.14



	Three Months Ended
	December 31,		September 30,		June 30,			March 31,
	2012		2012		2012			2012
	($ in thousands, except per share data)
Interest income	$	114,921	$	115,234	$	117,982		$	120,077
Interest expense	18,872		19,513		20,164			20,858
Net interest income	96,049		95,721		97,818			99,219
Loan and lease loss provision	8,875		8,959		10,536			11,072
Net interest income after provision for loan and lease losses	87,174		86,762		87,282			88,147
Non-interest income	20,549		9,297		8,450			11,550
Non-interest expense	49,423		47,009		48,200			49,050
Income tax expense (benefit)	11,224		18,003		(340,017		)	25,709
Net income	$	47,076	$	31,047	$	387,549		$	24,938
Basic income per share	$	0.23	$	0.14	$	1.71		$	0.10
Diluted income per share	$	0.23	$	0.14	$	1.66		$	0.10

137


ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.


ITEM 9A.	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 December 31, 2013. There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2013, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Reference is made to the Management Report on Internal Controls over Financial Reporting on page 79.


ITEM 9B.	OTHER INFORMATION

None.

138

PART III


ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

A listing of our executive officers and their biographies are included under Item 1, Business, in the section entitled “Executive Officers” on page 13 of this Form 10-K.

The members of our Board of Directors, their principal occupations and the Board committees on which they serve are as follows:

William G. Byrnes

Chairman

Andrew B. Fremder^(1)(3)(4)(5)

President, East Bay College Fund

Sara Grootwassink Lewis^(1)(2)(3)

Private Investor

C. William Hosler^(1)(2)(4)

Chief Financial Officer, Catellus Development Corp.

Timothy M. Hurd⁽²⁾⁽³⁾

President and CIO, BlueSpruce Investments, LP

Joseph C. Mello^(2)(3)(5)

Private Investor and Management Consultant

Steven A. Museles⁽⁵⁾

Executive Officer, Alliance Partners LLC

James J. Pieczynski⁽⁴⁾

Chief Executive Officer

____________________


(1)	Audit Committee


(2)	Compensation Committee


(3)	Nominating and Corporate Governance Committee


(4)	Asset / Liability Committee


(5)	Risk Committee

Biographies for our non-management directors and additional information pertaining to directors and executive officers and our corporate governance as well as the remaining information called for by this item are incorporated herein by reference to Election of Directors, Corporate Governance, Board of Directors and Other Matters - Section 16(a) Beneficial Ownership Reporting Compliance and other sections in our definitive proxy statement for our 2014 Annual Meeting of Stockholders which will be filed within 120 days of the end of our fiscal year ended December 31, 2013 (the “2013 Proxy Statement”).

Our Chief Executive Officer and Chief Financial Officer have delivered, and we have filed with this Form 10-K, all certifications required by rules of the SEC and relating to, among other things, the Company's financial statements, internal controls and the public disclosures contained in this Form 10-K. In addition, on May 21, 2013, our Chief Executive Officer certified to the New York Stock Exchange (the “NYSE”) that he was not aware of any violations by the Company of the NYSE's corporate governance listing standards and, as required by the rules of the NYSE. We expect our Chief Executive Officer to provide a similar certification following the 2014 Annual Meeting of Stockholders.

139


ITEM 11.	EXECUTIVE COMPENSATION

Information pertaining to executive compensation is incorporated herein by reference to Executive Compensation in the 2013 Proxy Statement with respect to our 2014 Annual Meeting of Stockholders.


ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATERS

Information pertaining to security ownership of management and certain beneficial owners of the registrant's Common Stock is incorporated herein by reference to Voting Securities and Principal Holders Thereof and other sections of the 2013 Proxy Statement with respect to our 2014 Annual Meeting of Stockholders.


ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Information pertaining to certain relationships and related transactions and director independence is incorporated herein by reference to Corporate Governance and Compensation Committee Interlocks and Insider Participation and other sections of the 2013 Proxy Statement with respect to our 2014 Annual Meeting of Stockholders.


ITEM 14.	PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information pertaining to principal accounting fees and services is incorporated herein by reference to Report of the Audit Committee of the 2013 Proxy Statement with respect to our 2014 Annual Meeting of Stockholders.

140

PART IV


ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

15(a)(1) Financial Statements

The audited consolidated financial statements of the registrant as listed in the “Index to Consolidated Financial Statements” included in Item 8, Financial Statements and Supplementary Data, on page 81 of this report, are filed as part of this report.

15(a)(2) Financial Statement Schedules

Consolidated financial statement schedules have been omitted because the required information is not present, or not present in amounts sufficient to require submission of the schedules, or because the required information is provided in our audited consolidated financial statements or notes thereto.

15(a)(3) Exhibits

The exhibits listed in the accompanying Index to Exhibits are filed as part of this report.

141

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: February 28, 2014	/s/ JAMES J. PIECZYNSKI
	James J. Pieczynski Director and Chief Executive Officer (Principal Executive Officer)


Date: February 28, 2014	/s/ JOHN A. BOGLER
	John A. Bogler Chief Financial Officer (Principal Financial Officer)


Date: February 28, 2014	/s/ Mike A. Smith
	Mike A. Smith Senior Vice President and Chief Accounting Officer (Principal Accounting Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on February 28, 2014.



/ s/ WILLIAM G. BYRNES		/s/ STEVEN A. MUSELES
William G. Byrnes, Chairman of the Board of Directors		Steven A. Museles, Director


/s/ C. WILLIAM HOSLER		/s/ ANDREW B. FREMDER
C. William Hosler, Director		Andrew B. Fremder, Director


/s/ TIMOTHY M. HURD		/s/ SARA GROOTWASSINK LEWIS
Timothy M. Hurd, Director		Sara Grootwassink Lewis, Director


/s/ JOSEPH C. MELLO
Joseph C. Mello, Director

142

INDEX TO EXHIBITS



Exhibit No.	Description

2.1	Agreement and Plan of Merger, dated as of July 22, 2013, by and between PacWest Bancorp and CapitalSource Inc. (incorporated by reference to Exhibit 2.1 to the Form 8-K filed by CapitalSource on July 26, 2013).

2.1.1	Amendment No. 1 to Agreement and Plan of Merger, dated as of December 20, 2013, by and between PacWest Bancorp and CapitalSource Inc. (incorporated by referenced to Exhibit 2.1 to the Form 8-K filed by CapitalSource on December 20, 2013).

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).

3.3	Certificate of Designations of Series A Junior Participating Preferred Stock of CapitalSource Inc. (incorporated by reference to Exhibit 3.1 to the Form 8-K filed by CapitalSource on July 23, 2013).

4.1	Tax Benefit Preservation Plan, dated as of July 22, 2013, between CapitalSource Inc. and American Stock Transfer and Trust Company, LLC (incorporated by referenced to Exhibit 4.1 to the Form 8-K filed by CapitalSource on July 23, 2013).

10.1	Capital Maintenance and Liquidity Agreement dated as of July 25, 2008, among CapitalSource Inc., CapitalSource TRS LLC (formerly CapitalSource TRS Inc.), CapitalSource Finance LLC, CapitalSource Bank and the FDIC (incorporated by reference to exhibit 10.1 to the Form 8-K filed by CapitalSource on July 28, 2008).

10.2	Parent Company Agreement dated as of July 25, 2008, among CapitalSource Inc., CapitalSource TRS LLC (formerly CapitalSource TRS Inc.), CapitalSource Finance LLC, CapitalSource Bank and the FDIC (incorporated by reference to exhibit 10.2 to the Form 8-K filed by CapitalSource on July 28, 2008).

10.3	Office Lease Agreement dated April 27, 2007 by and between Wisconsin Place Office LLC and CapitalSource Finance LLC (incorporated by reference to exhibit 10.4 to the Form 10-K filed by CapitalSource on March 2, 2009).

10.3.1	Amendment No. 1 to Lease dated August 25, 2008 by and between Wisconsin Place Office LLC and CapitalSource Finance LLC (incorporated by reference to exhibit 10.6 to the Form 10-Q filed by CapitalSource on August 10, 2009).

10.3.2	Amendment No. 2 to Lease dated February 17, 2009 by and between Wisconsin Place Office LLC and CapitalSource Finance LLC (incorporated by reference to exhibit 10.7 to the Form 10-Q filed by CapitalSource on August 10, 2009).

10.3.3	Amendment No. 3 to Lease dated April 8, 2010 by and between Wisconsin Place Office LLC and CapitalSource Finance LLC (incorporated by reference to exhibit 10.3.3 to the Form 10-K filed by CapitalSource on February 28, 2012).

10.3.4	Sublease of Office Lease Agreement dated as of September 1, 2010 by and between CapitalSource Finance LLC and Brown Investment Advisory and Trust Company (incorporated by reference to exhibit 10.1 to the Form 10-Q filed by CapitalSource on November 4, 2010).

10.3.5	Sublease of Office Lease Agreement dated as of August 24, 2011 by and between CapitalSource Finance LLC and Manchester United LTD (incorporated by reference to exhibit 10.3.5 to the Form 10-K filed by CapitalSource on February 28, 2012).

10.3.6	Sublease of Office Lease Agreement dated as of July 17, 2012, by and between CapitalSource Finance LLC and DANAC, LLC (incorporated by reference to exhibit 10.1 to the Form 10-Q filed by CapitalSource on November 6, 2012).

10.3.7	Sublease of office lease agreement dated as of July 29, 2013 by and between CapitalSource Finance LLC and PKH Enterprises, LLC.†

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10.3.8	Sublease of office lease agreement dated of November 15, 2013 by and between CapitalSource Finance LLC and Abacus Technology Corporation.†

10.3.9	Sublease of office lease agreement dated as of December 11, 2013 by and between CapitalSource Finance LLC and Battle Resources Management, Inc.†

10.4	Office Lease dated November 5, 2008, by and between Providence 130 State College Brea, LLC and CapitalSource Bank (incorporated by reference to exhibit 10.1 to the Form 10-Q filed by CapitalSource on May 11, 2009).

10.5*	Third Amended and Restated Equity Incentive Plan (composite version; reflects all amendments through April 29, 2010) (incorporated by reference to exhibit 10.1 to the Registration Statement on Form S-8 filed by CapitalSource on May 3, 2010).

10.6.1	Form of Non-Qualified Option Agreement (2005) (incorporated by reference to exhibit 10.1 to the Form 8-K filed by CapitalSource on January 31, 2005).

10.6.2	Form of Non-Qualified Option Agreement (2007) (incorporated by reference to exhibit 10.81 to the Form 10-Q filed by CapitalSource on August 8, 2007).

10.6.3	Form of Non-Qualified Option Agreement (2008) (incorporated by reference to exhibit 10.8 to the Form 10-Q filed by CapitalSource on August 11, 2008).

10.6.4	Form of Non-Qualified Option Agreement (2010) (incorporated by reference to exhibit 10.32.4 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.6.5	Form of Non-Qualified Option Agreement (July 2010) (incorporated by reference to exhibit 10.5 to the Form 10-Q filed by CapitalSource on August 3, 2010).

10.7.1	Form of Non-Qualified Option Agreement for Directors (2005) (incorporated by reference to exhibit 10.2 to the Form 8-K filed by CapitalSource on January 31, 2005).

10.7.2	Form of Non-Qualified Option Agreement for Directors (2007) (incorporated by reference to exhibit 10.78 to the Form 10-Q filed by CapitalSource on August 8, 2007).

10.7.3	Form of Non-Qualified Option Agreement for Directors (2008) (incorporated by reference to exhibit 10.18.3 to the Form 10-K filed by CapitalSource on February 29, 2008).

10.7.4	Form of Non-Qualified Option Agreement for Directors (2010) (incorporated by reference to exhibit 10.33.4 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.8.1	Form of Restricted Stock Agreement (2005) (incorporated by reference to exhibit 10.3 to the Form 8-K filed by CapitalSource on January 31, 2005).

10.8.2	Form of Restricted Stock Agreement (2007) (incorporated by reference to exhibit 10.79 to the Form 10-Q filed by CapitalSource on August 8, 2007).

10.8.3	Form of Restricted Stock Agreement (2008) (incorporated by reference to exhibit 10.6 to the Form 10-Q filed by CapitalSource on August 11, 2008).

10.8.4	Form of Restricted Stock Agreement (2009) (incorporated by reference to exhibit 10.7 to the Form 10-Q filed by CapitalSource on May 11, 2009).

10.8.5	Form of Restricted Stock Agreement (2010) (incorporated by reference to exhibit 10.34.5 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.8.6	Form of Restricted Stock Agreement (April 2010) (incorporated by reference to exhibit 10.7 to the Form 10-Q filed on May 5, 2010).

10.8.7	Form of Restricted Stock Agreement (July 2010) (incorporated by reference to exhibit 10.6 to the Form 10-Q filed on August 3, 2010).

10.9.1	Form of Restricted Stock Agreement for Directors (2007) (incorporated by reference to exhibit 10.76 to the Form 10-Q filed by CapitalSource on August 8, 2007).

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10.9.2	Form of Restricted Stock Agreement for Directors (2008) (incorporated by reference to exhibit 10.20.2 to the Form 10-K filed by CapitalSource on February 29, 2008).

10.9.3	Form of Restricted Stock Agreement for Directors (2009) (incorporated by reference to exhibit 10.8 to the Form 10-Q filed by CapitalSource on May 11, 2009).

10.9.4	Form of Restricted Stock Agreement for Directors (2010) (incorporated by reference to exhibit 10.36.4 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.9.5	Form of Restricted Stock Agreement for Directors (April 2010) (incorporated by reference to exhibit 10.8 to the Form 10-Q filed by CapitalSource on May 5, 2010).

10.10.1	Form of Restricted Unit Agreement (2007) (incorporated by reference to exhibit 10.70 to the Form 8-K filed by CapitalSource on March 13, 2007).

10.10.2	Form of Restricted Stock Unit Agreement (2007) (incorporated by reference to exhibit 10.80 to the Form 10-Q filed by CapitalSource on August 8, 2007).

10.10.3	Form of Restricted Stock Unit Agreement (2008) (incorporated by reference to exhibit 10.7 to the Form 10-Q filed by CapitalSource on August 11, 2008).

10.10.4	Form of Restricted Stock Unit Agreement (2010) (incorporated by reference to exhibit 10.9 to the Form 10-Q filed by CapitalSource on May 5, 2010).

10.10.5	Form of Restricted Stock Unit Agreement (April 2010) (incorporated by reference to exhibit 10.9 to the Form 10-Q filed by CapitalSource on May 5, 2010).

10.10.6	Form of Restricted Stock Unit Agreement (July 2010) (incorporated by reference to exhibit 10.7 to the Form 10-Q filed by CapitalSource on August 3, 2010).

10.11.1	Form of Restricted Stock Unit Agreement for Directors (2007) (incorporated by reference to exhibit 10.77 to the Form 10-Q filed by CapitalSource on August 8, 2007).

10.11.2	Form of Restricted Stock Unit Agreement for Directors (2008) (incorporated by reference to exhibit 10.22.2 to the Form 10-K filed by CapitalSource on February 29, 2008).

10.11.3	Form of Restricted Stock Unit Agreement for Directors (2010) (incorporated by reference to exhibit 10.37.3 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.11.4	Form of Restricted Stock Unit Agreement for Directors (April 2010) (incorporated by reference to exhibit 10.10 to the Form 10-Q filed by CapitalSource on May 5, 2010).

10.12*	CapitalSource Inc. Amended and Restated Deferred Compensation Plan effective October 26, 2011 (incorporated by reference to exhibit 10.16 to the Form 10-K filed by CapitalSource on February 28, 2012).

10.13*	Summary of Non-employee Director Compensation (incorporated by reference to exhibit 10.1 to the Form 10-Q filed by CapitalSource on May 3, 2013).

10.14*	CapitalSource Bank Compensation for Non-Employee Directors (incorporated by reference to exhibit 10.40 to the Form 10-K filed by CapitalSource on March 1, 2010).

10.15*	Form of Indemnification Agreement between CapitalSource Inc. and each of its non-employee directors (incorporated by reference to exhibit 10.4 to the Form 10-Q filed by CapitalSource on November 7, 2003).

10.16*	Form of Indemnification Agreement between CapitalSource Inc. and each of its employee directors (incorporated by reference to exhibit 10.5 to the Form 10-Q filed by CapitalSource on November 7, 2003).

10.17*	Amended and Restated Employment Agreement dated September 28, 2012 between CapitalSource Inc., CapitalSource Bank and James J. Pieczynski (incorporated by reference to exhibit 10.1 to the Form 8-K filed by CapitalSource on October 2, 2012).

10.17.1*	Amended and Restated Employment Agreement dated January 1, 2013 between CapitalSource Inc., CapitalSource Bank and James J. Pieczynski (incorporated by reference to exhibit 10.22.1 to the Form 10-K filed by CapitalSource on February 25, 2013).

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10.18*	Amended and Restated Employment Agreement dated September 28, 2012 between CapitalSource Bank and Douglas Hayes Lowrey (incorporated by reference to exhibit 10.2 to the Form 8-K filed by CapitalSource on October 2, 2012).

10.19*	Employment Agreement dated October 26, 2011 by and between CapitalSource Inc., CapitalSource Bank and John A. Bogler (incorporated by reference to exhibit 10.1 to the Form 10-Q filed by CapitalSource on November 1, 2011).

10.20*	Employment Agreement dated October 26, 2011 by and between CapitalSource Inc., CapitalSource Bank and Laird M. Boulden (incorporated by reference to exhibit 10.2 to the Form 10-Q filed by CapitalSource on November 1, 2011).

10.21*	Amended and Restated Employment Agreement dated as of October 26, 2011 between CapitalSource Bank and Bryan M. Corsini (incorporated by reference to exhibit 10.3 to the Form 10-Q filed by CapitalSource on November 1, 2011).

10.22*	2013 Executive Compensation Program.†

10.23*	2013 Chief Accounting Officer Compensation Program.†

12.1	Ratio of Earnings to Fixed Charges.†

21.1	List of Subsidiaries.†

23.1	Consent of Ernst & Young LLP.†

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.†

99.1	Federal Deposit Insurance Corporation in Re: CapitalSource Bank (In Organization) Pasadena, California, Applications for Federal Deposit Insurance and Consent to Purchase Certain Assets and Assume Certain Liabilities and Establish 22 Branches - Order Granting Deposit Insurance, Approving a Merger, and Consenting to the Establishment of Branches dated June 17, 2008 (incorporated by reference to exhibit 99.1 to the Form 8-K filed by CapitalSource on June 18, 2008)

99.2	Form of Voting Agreement, dated July 22, 2013, between CapitalSource Inc. and certain stockholders of PacWest Bancorp (incorporated by reference to Exhibit 99.3 to the Form 8-K filed by CapitalSource on July 23, 2013).

99.3	Form of Voting Agreement, dated July 22, 2013, between PacWest Bancorp and certain stockholders of CapitalSource Inc. (incorporated by reference to Exhibit 99.4 to the Form 8-K filed by CapitalSource on July 23, 2013).

101.INS	XBRL Instance Document†

101.SCH	XBRL Taxonomy Extension Schema Document†

101.CAL	XBRL Taxonomy Calculation Linkbase Document†

101.LAB	XBRL Taxonomy Label Linkbase Document†

101.PRE	XBRL Taxonomy Presentation Linkbase Document†

101.DEF	XBRL Taxonomy Definition Document†


†	Filed herewith.


*	Management contract or compensatory plan or agreement.

The registrant agrees to furnish to the Commission, upon request, a copy of each agreement with respect to long-term debt not filed herewith in reliance upon the exemption from filing applicable to any series of debt that does not exceed 10% of the total consolidated assets of the registrant.

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