09.30.13 10-Q

10-Q 1 a09301310-q.htm 10-Q 09.30.13 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 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)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ No 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 Exchange Act). Yes o No þ

As of October 30, 2013, the number of shares of the registrant's Common Stock, par value $0.01 per share, outstanding was 196,924,255.

TABLE OF CONTENTS



		Page

PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2013 (unaudited) and December 31, 2012	3
	Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2013 and 2012	4
	Consolidated Statements of Comprehensive Income (unaudited) for the three and nine months ended September 30, 2013 and 2012	5
	Consolidated Statement of Shareholders' Equity (unaudited) for the nine months ended September 30, 2013	6
	Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2013 and 2012	7
	Notes to the Unaudited Consolidated Financial Statements	8
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	41
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	82
Item 4.	Controls and Procedures	82

PART II. OTHER INFORMATION

Item 1A.	Risk Factors	83
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	84
Item 5.	Other Information	84
Item 6.	Exhibits	84
Signatures		85
Index to Exhibits		86

CapitalSource Inc.

Consolidated Balance Sheets



	September 30, 2013			December 31, 2012
	(Unaudited)
	($ in thousands, except share amounts)
ASSETS
Cash and due from banks	$	216,377		$	178,880
Interest-bearing deposits in other banks	55,126			110,208
Other short-term investments	159,954			9,998
Restricted cash (including $0 and $36.4 million, respectively, of cash that can only be used to settle obligations of consolidated VIEs)	59,635			104,044
Investment securities:
Available-for-sale, at fair value	911,572			1,079,025
Held-to-maturity, at amortized cost	122,262			108,233
Total investment securities	1,033,834			1,187,258
Loans held for sale	13,977			22,719
Loans held for investment	6,585,585			6,192,858
Less deferred loan fees and discounts	(46,407		)	(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)	6,539,178			6,139,230
Less allowance for loan and lease losses	(115,134		)	(117,273		)
Total loans held for investment, net	6,424,044			6,021,957
Interest receivable	24,813			29,112
Other investments	54,771			60,363
Goodwill	173,135			173,135
Deferred tax assets, net	271,291			362,283
Other assets	267,962			289,048
Total assets	$	8,754,919		$	8,549,005
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits	$	6,051,411		$	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	1,001,599			1,005,738
Other liabilities	108,695			161,637
Total liabilities	7,161,705			6,923,833
Commitments and contingencies (Note 12)
Shareholders' equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)	—			—
Common stock ($0.01 par value, 1,200,000,000 shares authorized; 196,944,961 and 209,551,674 shares issued/outstanding, respectively)	1,969			2,096
Additional paid-in capital	3,030,990			3,157,533
Accumulated deficit	(1,458,647		)	(1,559,107		)
Accumulated other comprehensive income, net	18,902			24,650
Total shareholders' equity	1,593,214			1,625,172
Total liabilities and shareholders' equity	$	8,754,919		$	8,549,005

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Operations



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013		2012
	(Unaudited)
	($ in thousands, except per share data)
Net interest income:
Interest income:
Loans and leases	$	104,211		$	105,066		$	308,046	$	322,437
Investment securities	8,003			9,784			24,936		29,737
Other	504			384			1,236		1,119
Total interest income	112,718			115,234			334,218		353,293
Interest expense:
Deposits	13,407			12,738			38,260		38,669
Borrowings	5,237			6,775			17,021		21,866
Total interest expense	18,644			19,513			55,281		60,535
Net interest income	94,074			95,721			278,937		292,758
Loan and lease loss (recovery) provision	(1,069		)	8,959			16,268		30,567
Net interest income after loan and lease loss (recovery) provision	95,143			86,762			262,669		262,191
Non-interest income:
Loan fees	5,921			4,174			13,299		11,899
Leased equipment income	5,194			3,299			15,039		9,815
Gain on sales or calls of investments, net	2,123			1,856			5,105		929
(Loss) gain on derivatives, net	(1,566		)	(978		)	226		(649		)
Other non-interest income, net	4,036			946			6,805		7,303
Total non-interest income	15,708			9,297			40,474		29,297
Non-interest expense:
Compensation and benefits	26,618			25,523			79,325		77,347
Professional fees	(49		)	2,469			3,176		9,158
Occupancy expenses	3,434			3,422			10,888		13,402
FDIC fees and assessments	1,642			1,507			4,778		4,419
General depreciation and amortization	1,590			1,330			4,687		4,536
Loan servicing expense	925			1,183			5,137		11,228
Other administrative expenses	6,129			6,477			18,995		19,674
Total operating expenses	40,289			41,911			126,986		139,764
Leased equipment depreciation	3,646			2,307			10,573		6,883
(Income from) expense of real estate owned and other foreclosed assets, net	(768		)	2,308			1,142		6,579
Gain on extinguishment of debt	—			—			—		(8,059		)
Other non-interest expense, net	4,447			483			4,263		(908		)
Total non-interest expense	47,614			47,009			142,964		144,259
Net income before income taxes	63,237			49,050			160,179		147,229
Income tax expense (benefit)	14,839			18,003			53,810		(296,305		)
Net income	$	48,398		$	31,047		$	106,369	$	443,534
Basic income per share	$	0.25		$	0.14		$	0.54	$	1.94
Diluted income per share	$	0.24		$	0.14		$	0.53	$	1.88
Average shares outstanding:
Basic	193,099,993			219,664,637			195,606,073		229,091,849
Diluted	198,456,994			226,441,294			200,703,002		235,712,522
Dividends declared per share	$	0.01		$	0.01		$	0.03	$	0.03

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Comprehensive Income



	Three Months Ended September 30,					Nine Months Ended September 30,
	2013			2012		2013			2012
	(Unaudited)
	($ in thousands)
Net income	$	48,398		$	31,047	$	106,369		$	443,534
Other comprehensive (loss) income, net of tax:
Unrealized (loss) gain on available-for-sale securities, net of tax	(4,285		)	2,315		(5,748		)	2,802
Unrealized loss on foreign currency translation, net of tax	—			—		—			(351		)
Other comprehensive (loss) income, net of tax	(4,285		)	2,315		(5,748		)	2,451
Comprehensive income	$	44,113		$	33,362	$	100,621		$	445,985

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Shareholders' Equity



	Common Stock			Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income			Total Shareholders' Equity
	(Unaudited)
	($ in thousands)
Total shareholders' equity as of December 31, 2012	$	2,096		$	3,157,533		$	(1,559,107	)	$	24,650		$	1,625,172
Net income	—			—			106,369			—			106,369
Other comprehensive loss	—			—			—			(5,748		)	(5,748		)
Repurchase of common stock	(150		)	(137,838		)	—			—			(137,988		)
Dividends paid	—			69			(5,909		)	—			(5,840		)
Stock option expense	—			1,318			—			—			1,318
Exercise of options	16			5,538			—			—			5,554
Restricted stock activity	7			4,370			—			—			4,377
Total shareholders' equity as of September 30, 2013	$	1,969		$	3,030,990		$	(1,458,647	)	$	18,902		$	1,593,214

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Cash Flows



	For the Nine Months Ended September 30,
	2013			2012
	(Unaudited)
	($ in thousands)
Operating activities:
Net income	$	106,369		$	443,534
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option expense	1,318			1,229
Restricted stock expense	9,476			8,838
Gain on extinguishment of debt	—			(8,059		)
Amortization of deferred loan fees and discounts	(23,770		)	(31,799		)
Paid-in-kind interest on loans	5,696			6,370
Loan and lease loss provision	16,268			30,567
Amortization of deferred financing fees and discounts	996			1,252
Depreciation and amortization	15,283			14,032
Provision (benefit) for deferred income taxes	98,276			(326,823		)
Gain on investments, net	(4,915		)	(2,133		)
(Gain) loss on foreclosed assets and other property and equipment disposals	(789		)	816
Unrealized loss (gain) on derivatives and foreign currencies, net	1,643			(950		)
Decrease in interest receivable	4,299			6,902
(Increase) decrease in loans held for sale, net	(4,961		)	23,113
Decrease in other assets	24,274			120,194
Decrease in other liabilities	(57,381		)	(102,153		)
Cash provided by operating activities	192,082			184,930
Investing activities:
Decrease (increase) in restricted cash	44,409			(5,928		)
Increase in loans, net	(386,841		)	(160,541		)
Sale and maturity of investment securities, available-for-sale	273,099			250,966
Purchase of investment securities, available-for-sale	(117,580		)	(175,372		)
Sale or call of investment securities, held-to-maturity	35,514			4,893
Purchase of investment securities, held-to-maturity	(47,855		)	—
Reduction of other investments, net	6,115			13,920
Purchase of property and equipment, net	(18,230		)	(5,462		)
Cash used in investing activities	(211,369		)	(77,524		)
Financing activities:
Deposits accepted, net of repayments	472,141			410,487
Repayments and extinguishment of term debt	(177,209		)	(106,118		)
(Repayments) proceeds from other borrowings	(5,000		)	20,931
Repurchase of common stock	(137,988		)	(272,127		)
Proceeds from exercise of options	5,554			3,195
Payment of dividends	(5,840		)	(6,827		)
Cash provided by financing activities	151,658			49,541
Increase in cash and cash equivalents	132,371			156,947
Cash and cash equivalents as of beginning of period	299,086			458,548
Cash and cash equivalents as of end of period	$	431,457		$	615,495
Supplemental information:
Noncash transactions from investing activities:
Assets acquired through foreclosure	$	845		$	12,372

See accompanying notes.

NOTES TO THE UNAUDITED 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 (the "Bank"). References to we, us, the Company or CapitalSource refer to CapitalSource Inc. together with its subsidiaries. References to CapitalSource Bank or the Bank include its subsidiaries, and references to the Parent Company refer to CapitalSource Inc. and its subsidiaries other than the Bank.

For the nine months ended September 30, 2013 and 2012, 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 15, Segment Data.

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. The transaction, currently expected to close in the first quarter of 2014, is subject to customary conditions, including the approval of bank regulatory authorities and the stockholders of both companies.

Note 2. Summary of Significant Accounting Policies

Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements for the year ended December 31, 2012, included in our Form 10-K.

Interim Consolidated Financial Statements Basis of Presentation

Our interim consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, certain disclosures accompanying annual consolidated financial statements are omitted. In the opinion of management, all adjustments and eliminations, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The current period's results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the Securities and Exchange Commission on February 25, 2013 (“Form 10-K”).

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

Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board ("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 is 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 results of operations, financial position or cash flows.

In July 2013, the FASB amended its guidance on income taxes to eliminate diversity in the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The amendments clarify whether unrecognized tax benefits should be presented as a liability on the balance sheet or as a reduction of a deferred tax asset. This guidance is effective for interim and annual periods beginning after December 15, 2013. Early adoption is permitted. We plan to adopt this guidance on January 1, 2014, and do not expect that it will have a material impact on our financial statement presentation.

Note 3. Loans and Credit Quality

As of September 30, 2013 and December 31, 2012, our outstanding loan balance was $6.6 billion and $6.2 billion, respectively. These amounts include loans held for sale and loans held for investment. As of September 30, 2013 and December 31, 2012, interest and fee receivables on these loans totaled $22.2 million and $26.0 million, respectively.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 three and nine months ended September 30, 2013, we transferred loans with a carrying value of $80.0 million and $184.9 million, respectively, which included $21.8 million and $54.7 million of impaired loans, respectively, from held for investment to held for sale. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We did not incur any losses due to lower of cost or fair value adjustments at the time of transfer during the three and nine months ended September 30, 2013. However, we charged off $2.7 million and $14.7 million at the time of transfer due to credit losses inherent in the transferred loans during the three and nine months ended September 30, 2013, respectively. We did not reclassify any loans from held for sale to held for investment during the three and nine months ended September 30, 2013.

During the three and nine months ended September 30, 2012, we transferred loans with a carrying value of $112.1 million and $213.0 million, respectively, which included $23.7 million and $55.0 million of impaired loans, respectively, from held for investment to held for sale. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We incurred $0.4 million of losses due to lower of cost or fair value adjustments at the time of transfer during the three and nine months ended September 30, 2012 which is recorded within Other Non-Interest Income on the Consolidated Statement of Operations. In addition, we charged off $0.2 million and $1.4 million at the time of transfer due to credit losses inherent in the transferred loans during the three and nine months ended September 30, 2012. We did not reclassify any loans from held for sale to held for investment during the three months ended September 30, 2012. We reclassified $5.0 million of loans from held for sale to held for investment during the nine months ended September 30, 2012 based on our intent to retain these loans for investment.

During the three and nine months ended September 30, 2013, we recognized net gains on the sale of loans of $2.1 million and $5.1 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. During the three months ended September 30, 2012, we recognized net losses on the sale of loans of $0.9 million. During the nine months ended September 30, 2012, we recognized net gains on the sale of loans of $2.1 million.

As of September 30, 2013 and December 31, 2012, loans held for sale with an outstanding balance of $3.5 million and $2.5 million, respectively, were classified as non-accrual loans. We did not record any fair value write-downs on non-accrual loans held for sale during the three and nine months ended September 30, 2013 and 2012.

During the three and nine months ended September 30, 2013, we purchased loans held for investment with an outstanding principal balance at the time of purchase of $67.3 million and $274.8 million, respectively. During the three months ended September 30, 2012, we did not purchase any loans held for investment. During the nine months ended September 30, 2012, we purchased loans held for investment with an outstanding principal balance at the time of purchase of $78.3 million.

As of September 30, 2013 and December 31, 2012, the Bank pledged loans held for investment with an unpaid principal balance of $1.0 billion and $724.1 million, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

As of September 30, 2013 and December 31, 2012, the outstanding unpaid principal balance of loans, by type of loan, was as follows:



	September 30, 2013				December 31, 2012
	($ in thousands except percentages)
Commercial and industrial	$	3,688,023	56	%	$	3,594,643	58	%
Real estate	2,785,805		43		2,499,567		41
Real estate - construction	65,350		1		45,020		1
Total⁽¹⁾⁽²⁾	$	6,539,178	100	%	$	6,139,230	100	%

________________________


(1)	Excludes loans held for sale carried at lower of cost or fair value.

(2)

As of September 30, 2013, includes deferred loan fees and discounts of $30.1 million, $15.8 million and $0.5 million for commercial and industrial, real estate and real estate - construction loans, respectively. As of December 31, 2012, includes deferred loan fees and discounts of $38.4 million, $14.9 million and $0.3 million for commercial and industrial, real estate and real estate - construction loans, respectively.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 invest additional capital;


•	require the borrower to provide us with additional collateral;


•	request additional guaranties or letters of credit;


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


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


•	initiate foreclosure proceedings on the collateral; or


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

As of September 30, 2013 and December 31, 2012, the carrying value of loans by class, separated by performing and non-performing categories, was as follows:



	September 30, 2013						December 31, 2012
Class	Performing		Non-Performing		Total		Performing		Non-Performing		Total
	($ in thousands)
Asset-based	$	1,532,540	$	15,017	$	1,547,557	$	1,409,837	$	27,759	$	1,437,596
Cash flow	1,925,576		47,406		1,972,982		1,916,042		51,700		1,967,742
Healthcare asset-based	151,375		—		151,375		179,617		—		179,617
Healthcare real estate	725,944		16,554		742,498		665,058		17,001		682,059
Multifamily	842,034		1,077		843,111		899,963		1,961		901,924
Commercial real estate	977,162		25,205		1,002,367		717,798		12,593		730,391
Small business	273,271		6,017		279,288		233,653		6,248		239,901
Total⁽¹⁾	$	6,427,902	$	111,276	$	6,539,178	$	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 borrower's or counterparty's ability to meet its financial obligations under agreed-upon terms. The degree of credit risk will vary based on many factors including the credit characteristics of the borrower, the contractual terms of the agreement and the availability and quality of collateral. We regularly 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;

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS


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


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

As of September 30, 2013 and December 31, 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 September 30, 2013:
Asset-based	$	1,512,238	$	15,776	$	5,153	$	14,390	$	1,547,557
Cash flow	1,775,058		91,098		106,057		769		1,972,982
Healthcare asset-based	91,099		49,839		10,437		—		151,375
Healthcare real estate	631,828		90,842		3,274		16,554		742,498
Multifamily	832,953		8,502		1,656		—		843,111
Commercial real estate	943,865		552		57,950		—		1,002,367
Small business	272,506		765		6,017		—		279,288
Total⁽¹⁾	$	6,059,547	$	257,374	$	190,544	$	31,713	$	6,539,178
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
Multifamily	857,667		41,709		2,548		—		901,924
Commercial 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.

Non-Accrual and Past Due Loans

We place a loan on non-accrual status when there is substantial doubt about the borrower's ability to service its debt and other obligations or if the loan is 90 or more days past due and is not well-secured and in the process of collection. When a loan is placed on non-accrual status, accrued and unpaid interest is reversed and the recognition of interest and fee income on that loan is discontinued until factors no longer indicate collection is doubtful and the loan has been brought current. Payments received on non-accrual loans are generally first applied to principal. A loan may be returned to accrual status when its interest or principal is current, repayment of the remaining contractual principal and interest is expected or when the loan otherwise becomes well-secured and is in the process of collection. Cash payments received from the 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 $5.4 million and $16.6 million higher for the three and nine months ended September 30, 2013, respectively and $7.7 million and $27.1 million higher for the three and nine months ended September 30, 2012, respectively.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2013 and December 31, 2012, the carrying value of non-accrual loans by class was as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Asset-based	$	15,017	$	27,759
Cash flow	47,406		51,700
Healthcare real estate	16,554		17,001
Multifamily	1,077		1,961
Commercial real estate	25,205		12,593
Small business	6,017		6,248
Total⁽¹⁾	$	111,276	$	117,262

____________________________


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

As of September 30, 2013 and December 31, 2012, the delinquency status of loans by class was as follows:



	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Greater Than 90 Days Past Due and Accruing
	($ in thousands)
As of September 30, 2013:
Asset-based	$	—	$	—	$	—	$	1,547,557	$	1,547,557	$	—
Cash flow	—		2,195		2,195		1,970,787		1,972,982		—
Healthcare asset-based	—		—		—		151,375		151,375		—
Healthcare real estate	—		16,554		16,554		725,944		742,498		—
Multifamily	608		—		608		842,503		843,111		—
Commercial real estate	—		10,247		10,247		992,120		1,002,367		—
Small business	120		1,455		1,575		277,713		279,288		—
Total⁽¹⁾	$	728	$	30,451	$	31,179	$	6,507,999	$	6,539,178	$	—
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		—
Multifamily	656		999		1,655		900,269		901,924		—
Commercial 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;

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS


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


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

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

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

As of September 30, 2013 and December 31, 2012, information pertaining to our impaired loans was as follows:



	September 30, 2013							December 31, 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	$	16,419	$	23,160				$	40,655	$	75,547
Cash flow	19,782		47,713					48,796		118,440
Healthcare asset-based	—		—					—		12,246
Healthcare real estate	16,554		19,784					17,001		18,286
Multifamily	1,077		1,417					1,961		2,108
Commercial real estate	25,205		99,959					12,711		83,363
Small business	6,017		13,813					8,112		15,976
Total	85,054		205,846					129,236		325,966
With allowance recorded:
Asset-based	—		—		$	—		867		859		$	(412	)
Cash flow	32,364		34,802		(1,761		)	71,609		80,322		(6,072		)
Total	32,364		34,802		(1,761		)	72,476		81,181		(6,484		)
Total impaired loans	$	117,418	$	240,648	$	(1,761	)	$	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 September 30, 2013 and December 31, 2012, the carrying value of impaired loans with no related allowance recorded was $85.1 million and $129.2 million, respectively. Of these amounts, $33.6 million and $41.6 million, respectively, related to loans that were charged off to the net fair value less cost of disposal of the underlying collateral. These charge offs were primarily the result of impairment measurements of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $51.5 million and $87.6 million related to loans that had no recorded charge offs or specific reserves as of September 30, 2013 and December 31, 2012, respectively, based on our estimate that we ultimately will collect all principal and interest amounts due.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Average balances and interest income recognized on impaired loans, by loan class, for the three and nine months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2013				2012				2013				2012
	Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾
	($ in thousands)
No allowance recorded:
Asset-based	$	20,476	$	52	$	85,203	$	1,028	$	29,444	$	440	$	70,495	$	2,549
Cash flow	25,246		264		72,361		834		31,214		1,987		71,747		2,871
Healthcare asset-based	—		—		—		78		—		—		1,342		233
Healthcare real estate	16,889		—		23,937		—		16,957		—		26,252		—
Multifamily	1,363		161		1,595		17		1,740		161		1,268		17
Commercial real estate	25,450		—		31,037		478		17,123		5		66,391		3,461
Small business	6,459		—		10,129		—		6,983		242		12,883		—
Total	95,883		477		224,262		2,435		103,461		2,835		250,378		9,131
With allowance recorded:
Asset-based	1,184		—		7,932		—		966		—		8,440		74
Cash flow	33,906		—		86,207		1,030		45,739		1,477		100,313		2,422
Healthcare real estate	—		—		—		—		—		—		785		—
Total	35,090		—		94,139		1,030		46,705		1,477		109,538		2,496
Total impaired loans	$	130,973	$	477	$	318,401	$	3,465	$	150,166	$	4,312	$	359,916	$	11,627

_________________________


(1)	We did not recognize any cash basis interest income on impaired loans during the three and nine months ended September 30, 2013 and 2012.

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 (where applicable).

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

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

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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

Activity in the allowance for loan and lease losses related to our loans held for investment for the three and nine months ended September 30, 2013 and 2012 was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Allowance for loan and lease losses at beginning of period	$	120,493		$	133,359		$	117,273		$	153,631
Charge offs	(2,048		)	(23,090		)	(7,501		)	(69,032		)
Recoveries	436			7,590			3,842			12,911
Net charge offs	(1,612		)	(15,500		)	(3,659		)	(56,121		)
Charge offs upon transfer to held for sale	(2,678		)	(188		)	(14,748		)	(1,447		)
Loan and lease loss (recovery) provision	(1,069		)	8,959			16,268			30,567
Allowance for loan and lease losses at end of period	115,134			126,630			115,134			126,630
Allowance for credit losses on unfunded lending commitments at beginning of period⁽¹⁾	3,240			3,486			3,424			4,877
Allowance for unfunded lending commitments (recovery) provision	(617		)	483			(801		)	(908		)
Allowance for credit losses on unfunded lending commitments at end of period⁽¹⁾	2,623			3,969			2,623			3,969
Total allowance for loan, lease and unfunded lending commitments	$	117,757		$	130,599		$	117,757		$	130,599

_______________________


(1)	Represents additional credit loss reserves for unfunded lending commitments and letters of credit recorded in other liabilities. Unfunded lending commitments totaled $1.0 billion at September 30, 2013 and December 31, 2012.

As of September 30, 2013 and December 31, 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:



	September 30, 2013					December 31, 2012
	Loans		Allowance for Loan and Lease Losses			Loans		Allowance for Loan and Lease Losses
	($ in thousands)
Individually evaluated for impairment⁽¹⁾	$	115,583	$	(1,761	)	$	198,856	$	(6,484	)
Other loan groups with unidentified incurred losses	6,421,759		(113,373		)	5,937,518		(110,789		)
Acquired loans with deteriorated credit quality	1,836		—			2,856		—
Total	$	6,539,178	$	(115,134	)	$	6,139,230	$	(117,273	)

_________________________


(1)	Loans individually evaluated for impairment are net of charge offs of $89.0 million and $162.5 million at September 30, 2013 and December 31, 2012, respectively.

Troubled Debt Restructurings

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

During the three and nine months ended September 30, 2013, the aggregate carrying value of loans involved in TDRs were $19.7 million and $83.4 million, respectively, as of their respective restructuring dates. During the three and nine months ended September 30, 2012, the aggregate carrying value of loans involved in TDRs were $72.8 million and $164.5 million, respectively, as of their respective restructuring dates. Aggregate carrying value includes principal, deferred fees and accrued interest. Loans involved in TDRs are classified as impaired upon closing on the TDR. Generally, a loan that has been involved in a TDR is no longer classified as impaired one year subsequent to the restructuring, assuming the loan performs under the restructured terms

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual	$	75,038	$	62,815
Accruing	6,218		83,367
Total	$	81,256	$	146,182

The specific reserve related to these loans was $1.6 million as of September 30, 2013 and December 31, 2012. As of September 30, 2013 and December 31, 2012, we had unfunded commitments related to these restructured loans of $11.4 million and $21.1 million, respectively.

The following table rolls forward the balance of loans modified in TDRs for the three and nine months ended September 30, 2013 and 2012:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Beginning balance of TDRs	$	103,777		$	246,209		$	146,182		$	309,003
New TDRs	2,038			39,102			4,220			61,363
Draws and pay downs on existing TDRs, net	(2,010		)	(36,606		)	(14,492		)	(74,378		)
Loan sales and payoffs	(19,979		)	(24,317		)	(50,080		)	(50,448		)
Charge offs post modification	(2,570		)	(6,162		)	(4,574		)	(27,314		)
Ending balance of TDRs	$	81,256		$	218,226		$	81,256		$	218,226

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The number and aggregate carrying values of loans involved in TDRs that occurred during the three and nine months ended September 30, 2013 were as follows:



	Three Months Ended September 30, 2013					Nine Months Ended September 30, 2013
	Number of Loans	Carrying Value Prior to TDR		Carrying Value Subsequent to TDR⁽²⁾		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	1	9,796		—		2	10,005		—
Multiple concessions	1	823		823		2	9,398		9,398
	2	10,619		823		5	22,388		12,383
Cash flow:
Maturity extension	—	—		—		2	32,547		32,548
Payment deferral	—	—		—		1	571		571
Discounted payoffs	1	6,504		—		1	6,504		—
Multiple concessions	3	2,275		2,275		7	17,841		17,841
	4	8,779		2,275		11	57,463		50,960
Multifamily:
Discounted payoffs	—	—		—		1	425		—
	—	—		—		1	425		—
Small business:
Discounted payoffs	—	—		—		2	565		—
Foreclosures	1	20		—		3	786		—
Multiple concessions	2	284		284		3	1,782		1,782
	3	304		284		8	3,133		1,782
Total⁽¹⁾	9	$	19,702	$	3,382	25	$	83,409	$	65,125

______________________


(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 September 30, 2013.

During the three and nine months ended September 30, 2013, one small business loan experienced default after its initial restructuring within the previous 12 months. As of September 30, 2013, the carrying value of this loan was $0.1 million.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

A summary of concessions granted by loan type, including the accrual status of the loans as of September 30, 2013 and December 31, 2012 was as follows:



	September 30, 2013						December 31, 2012
	Non-accrual		Accrual		Total		Non-accrual		Accrual		Total
	($ in thousands)
Commercial and industrial:
Maturity extension	$	10,279	$	6,218	$	16,497	$	14,166	$	59,513	$	73,679
Payment deferral	544		—		544		—		—		—
Multiple concessions	51,737		—		51,737		36,786		23,711		60,497
	62,560		6,218		68,778		50,952		83,224		134,176
Real estate:
Maturity extension	55		—		55		59		—		59
Payment deferral	551		—		551		617		—		617
Multiple concessions	1,904		—		1,904		200		143		343
	2,510		—		2,510		876		143		1,019
Real estate - construction:
Maturity extension	9,968		—		9,968		10,758		—		10,758
Multiple concessions	—		—		—		229		—		229
	9,968		—		9,968		10,987		—		10,987
Total	$	75,038	$	6,218	$	81,256	$	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. The majority of such losses has been incurred on our commercial loans and is primarily due to the borrowers' failure to consistently meet their financial forecasts that formed the bases for our restructured loans. Examples of circumstances that resulted in the borrowers not being able to meet their forecasts included acquisitions of other businesses that did not have the expected positive impact on financial results, significant delays in launching products and services, and continued deterioration in the pricing estimates of businesses and product lines that the borrower expected to sell to generate proceeds to repay the loan.

Losses incurred on TDRs since their initial restructuring by concession and loan type for the three and nine months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	($ in thousands)
Commercial and industrial:
Maturity extension	$	263	$	325	$	727	$	4,174
Payment deferral	1		—		1		4
Multiple concessions	697		7,911		3,630		14,633
	961		8,236		4,358		18,811
Real estate:
Maturity extension	—		—		—		950
Multiple concessions	—		—		87		23
	—		—		87		973
Real estate - construction:
Maturity extension	—		—		—		4,709
Multiple concessions	—		613		—		958
	—		613		—		5,667
Total	$	961	$	8,849	$	4,445	$	25,451

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and nine months ended September 30, 2013, all related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status, as of September 30, 2013. We did not recognize any interest income for the three months

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

ended September 30, 2013 on the commercial loans that experienced losses during this period. We recognized approximately $392 thousand of interest income for the nine months ended September 30, 2013 on commercial loans that experienced losses during this period.

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and nine months ended September 30, 2012, 97.7% and 84.3%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status, as of September 30, 2012. We did not recognize any interest income for the three months ended September 30, 2012 on the commercial loans that experienced losses during this period. We recognized approximately $74 thousand of interest income for the nine months ended September 30, 2012 on the commercial loans that experienced losses during this period.

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 three and nine months ended September 30, 2013 and 2012 was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Balance as of beginning of period	$	16,560		$	53,087		$	23,791		$	69,698
Transfers from loans held for investment	118			2,921			845			14,474
Fair value adjustments	(860		)	(2,806		)	(3,079		)	(10,529		)
REO sold	(1,319		)	(6,240		)	(7,058		)	(26,681		)
Balance as of end of period	$	14,499		$	46,962		$	14,499		$	46,962

During the three and nine months ended September 30, 2013, we recognized gains of $2.7 million and $3.5 million, respectively, on the sales of REO as a component of income from real estate owned and other foreclosed assets. During the three months ended September 30, 2012, we recognized gains of $28 thousand, on the sales of REO as a component of income from real estate owned and other foreclosed assets. During the nine months ended September 30, 2012, we recognized losses of $77 thousand, on the sales of REO as a component of expense of real estate owned and other foreclosed assets.

Note 4. Investments

Investment Securities, Available-for-Sale

As of September 30, 2013 and December 31, 2012, our investment securities, available-for-sale were as follows:



	September 30, 2013									December 31, 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	$	832,989	$	12,738	$	(7,545	)	$	838,182	$	960,864	$	23,464	$	(807	)	$	983,521
Asset-backed securities	3,399		201		—			3,600		9,280		312		—			9,592
Collateralized loan obligations	13,722		12,488		—			26,210		13,418		12,832		—			26,250
Equity security	368		5,113		—			5,481		—		—		—			—
Non-agency MBS	21,854		562		(25		)	22,391		40,937		689		(279		)	41,347
SBA asset-backed securities	15,675		33		—			15,708		17,632		683		—			18,315
Total	$	888,007	$	31,135	$	(7,570	)	$	911,572	$	1,042,131	$	37,980	$	(1,086	)	$	1,079,025

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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”).

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 three months ended September 30, 2013, we had repayments on investment securities, available-for-sale of $72.5 million with a net amortized discount of $0.1 million. During the three months ended September 30, 2012, we had repayments on investment securities, available-for-sale of $26.0 million and $80.5 million in purchases, with a net amortized discount of $1.4 million.

During the nine months ended September 30, 2013, we had repayments on investment securities, available-for-sale of $273.1 million and $117.6 million in purchases, with a net amortized discount of $1.5 million. During the nine months ended September 30, 2012, we had repayments on investment securities, available-for-sale of $251.0 million and $175.4 million in purchases, with a net amortized discount of $3.9 million.

During the three months ended September 30, 2013 and 2012, we had $(4.3) million and $2.3 million, respectively, of net unrealized after-tax (losses) gains as a component of accumulated other comprehensive income, net. During the nine months ended September 30, 2013 and 2012, we had $(5.7) million and $2.8 million, respectively, of net unrealized after-tax (losses) gains as a component of accumulated other comprehensive income, net.

During the three months ended September 30, 2013 and 2012, we recorded $61 thousand and $0.1 million other-than-temporary-impairments ("OTTI"), respectively, on our available-for-sale portfolio. During the nine months ended September 30, 2013 and 2012, we recorded $0.2 million and $1.2 million in OTTI, respectively, on our available-for-sale portfolio related to a decline in the fair value of our investments in collateralized loan obligations in 2013 and a municipal bond in 2012. These OTTI were recorded as a component of gain (loss) on sales or calls of investments, net.

The amortized cost and fair value of investment securities, available-for-sale pledged as collateral to the FHLB SF and government agencies as of September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013				December 31, 2012
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB SF	$	—	$	—	$	190,113	$	197,911
Government agencies⁽¹⁾	17,393		17,628		5,390		5,439
	$	17,393	$	17,628	$	195,503	$	203,350

___________________________


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

Investment Securities, Held-to-Maturity

As of September 30, 2013 and December 31, 2012, investment securities, held-to-maturity consisted primarily of investment-grade rated commercial mortgage-backed securities ("CMBS") and CLOs. The amortized cost, gross unrealized gains and losses, and estimated fair value of held-to-maturity securities were as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Amortized Cost	$	122,262		$	108,233
Unrealized Gains	1,368			3,531
Unrealized Losses	(615		)	(376		)
Fair Value	$	123,015		$	111,388

During the three months ended September 30, 2013 and 2012, we recorded $0.6 million and $1.1 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 nine months ended September 30, 2013 and 2012, we recorded $3.5 million and $3.3 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 three months ended September 30, 2013, we had repayments of investment securities, held-to-maturity of $0.3 million with a net amortized discount of $21 thousand. 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 nine months ended September 30, 2013. The Company decided to sell the security because its rating was downgraded to B. During the nine months ended September 30, 2013, we had repayments and purchases

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

on investment securities, held-to-maturity of $35.5 million and $47.9 million, respectively, with a net amortized discount of $1.5 million.

During the three and nine months ended September 30, 2012, we had no purchases of investment securities, held-to-maturity. During the three months ended September 30, 2012, we had $0.9 million of principal repayments on investment securities, held-to-maturity with a net amortized discount $0.4 million. During the nine months ended September 30, 2012, we had $4.9 million of principal repayments on investment securities, held-to-maturity with a net amortized discount of $1.3 million.

The amortized costs and estimated fair values of the investment securities, held-to-maturity pledged as collateral as of September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013				December 31, 2012
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB SF	$	3,772	$	4,003	$	4,060	$	4,497
Federal Reserve Bank ("FRB")	70,198		70,447		87,038		88,381
	$	73,970	$	74,450	$	91,098	$	92,878

Unrealized Losses on Investment Securities

As of September 30, 2013 and December 31, 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 September 30, 2013
Investment securities, available-for-sale:
Agency securities	$	(6,976	)	$	326,782	$	(569	)	$	14,379	$	(7,545	)	$	341,161
Non-agency MBS	(16		)	1,525		(9		)	707		(25		)	2,232
Total investment securities, available-for-sale	$	(6,992	)	$	328,307	$	(578	)	$	15,086	$	(7,570	)	$	343,393
Total investment securities, held-to-maturity	$	(615	)	$	47,244	$	—		$	—	$	(615	)	$	47,244

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 September 30, 2013 and December 31, 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 September 30, 2013, each of the agency, Non-agency MBS, and CLOs with unrealized losses had investment grade ratings and 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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Contractual Maturities

As of September 30, 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	8,658		8,899		—		—
Due after five years through ten years⁽¹⁾	23,936		25,094		85,198		85,297
Due after ten years⁽²⁾⁽³⁾	855,413		877,579		37,064		37,718
Total	$	888,007	$	911,572	$	122,262	$	123,015

____________________


(1)	Includes Agency MBS, Non-agency MBS, Non-agency ABS, Non-agency CMBS, and CLOs with fair values of $17.6 million, $3.9 million, $3.6 million, $60.5 million and $24.8 million, respectively, and weighted average expected maturities of approximately 2.28, 1.82, 1.68, 0.62 and 6.54 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2013.

(2)

Includes Agency MBS, SBA ABS, Non-agency MBS, Non-agency CMBS, an equity security, and CLOs with fair values of $817.0 million, $15.7 million, $13.1 million, $15.3 million, $5.5 million, and $48.7 million, respectively, and weighted average expected maturities of approximately 4.71, 6.95, 1.91, 2.88, 10.00 and 5.41 years, respectively, based on interest rates and expected prepayment speeds as of September 30, 2013.


(3)	Includes securities with no stated maturity.

Other Investments

As of September 30, 2013 and December 31, 2012, our other investments were as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Investments carried at cost	$	18,792	$	23,963
Investments accounted for under the equity method	35,979		36,400
Total	$	54,771	$	60,363

Proceeds and net pre-tax gains from sales of other investments for the three and nine months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	($ in thousands)
Proceeds from sales	$	2,376	$	1,860	$	3,392	$	6,200
Gain from sales	2,354		924		3,370		3,943

During the three months ended September 30, 2013 and 2012, we recorded $0.1 million and $1.2 million, respectively, of dividends which were recorded as a component of gain (loss) on sales or calls of investments, net. During the nine months ended September 30, 2013 and 2012, we recorded $2.7 million and $2.3 million, respectively, of dividends.

During three months ended September 30, 2013 and 2012, we recorded $0.3 million and $0.5 million of OTTI, respectively, relating to our investments carried at cost which was recorded as a component of gain (loss) on sales or calls of investments, net. During the nine months ended September 30, 2013 and 2012, we recorded $1.4 million and $5.2 million of OTTI, respectively.

Note 5. Deposits

As of September 30, 2013 and December 31, 2012, the Bank had $6.1 billion and $5.6 billion, respectively, in deposits insured up to the maximum limit by the Federal Deposit Insurance Corporation ("FDIC"). As of September 30, 2013 and December 31, 2012, the Bank had $757.7 million and $597.8 million, respectively, of certificates of deposit in the amount of $250,000 or more and $3.0 billion and $2.6 billion, respectively, of certificates of deposit in the amount of $100,000 or more.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

As of September 30, 2013 and December 31, 2012, interest-bearing deposits at the Bank were as follows:



	September 30, 2013				December 31, 2012
	Balance		Weighted Average Rate		Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	259,434	0.45	%	$	257,961	0.49	%
Savings	659,924		0.47	%	704,890		0.52	%
Certificates of deposit	5,132,053		0.97	%	4,616,419		0.94	%
Total interest-bearing deposits	$	6,051,411	0.89	%	$	5,579,270	0.87	%

As of September 30, 2013, certificates of deposit detailed by maturity were as follows ($ in thousands):



Maturing by:
September 30, 2014	$	4,616,492
September 30, 2015	378,622
September 30, 2016	81,627
September 30, 2017	18,196
September 30, 2018	37,116
Total	$	5,132,053

For the three and nine months ended September 30, 2013 and 2012, interest expense on deposits was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Savings and money market	$	1,165		$	1,374		$	3,522		$	4,801
Certificates of deposit	12,301			11,409			34,921			34,020
Fees for early withdrawal	(59		)	(45		)	(183		)	(152		)
Total interest expense on deposits	$	13,407		$	12,738		$	38,260		$	38,669

Note 6. 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 $61.6 million and $115.4 million as of September 30, 2013 and December 31, 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 maximum exposure to loss as a result of our involvement with these entities was $91.1 million and $151.9 million as of September 30, 2013 and December 31, 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 the underlying assets of the Issuers, primarily comprising contributed loans. We serviced the underlying loans contributed to the Issuers and earned periodic servicing fees paid from the cash flows of the underlying loans. During the nine months ended September 30, 2013, we called the remaining securitizations

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 September 30, 2013, we had no remaining securitizations. As of December 31, 2012, the total outstanding balance of the securitizations was $398.9 million. This amount includes $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 September 30, 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 to assets that can only be used to settle obligations of the Issuers.

During 2010, we delegated certain of our collateral management and special servicing rights in the 2006-A term debt securitization trust (the "2006-A Trust") and sold our equity interest and certain notes issued by the 2006-A Trust. As a result of this transaction, we determined that we no longer had the power to direct the activities that most significantly impact the economic performance of the 2006-A Trust. Therefore, we concluded that we were no longer the primary beneficiary and deconsolidated the 2006-A Trust. For additional information, see Note 12, Commitments and Contingencies.

As of September 30, 2013 and 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 as of September 30, 2013 and December 31, 2012 was $26.2 million and $26.3 million, respectively, and was classified as investment securities, available-for-sale. We have 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 have not provided any additional financial support to the 2006-A Trust since the deconsolidation. This swap exposure had a fair value to the counterparty of $10.1 million and $13.5 million as of September 30, 2013 and December 31, 2012, respectively. During the three and nine months ended September 30, 2013, we recorded gross unrealized losses of $1.1 million and $0.3 million, respectively, which was included as a component of other comprehensive income, on the securities that we still hold in the 2006-A Trust as of September 30, 2013.

Note 7. Borrowings

As of September 30, 2013 and December 31, 2012, the composition of our outstanding borrowings was as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Term debt - obligations of consolidated VIEs for which there is no recourse to the general credit of CapitalSource Inc. ⁽¹⁾	$	—	$	177,188
Other borrowings:
Subordinated debt	411,599		410,738
FHLB SF borrowings	590,000		595,000
Total other borrowings	1,001,599		1,005,738
Total borrowings	$	1,001,599	$	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 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 nine months ended September 30, 2013, we called the 2006-1, 2006-2

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 September 30, 2013, we had no outstanding term debt securitizations.

Our outstanding term debt transactions held by third parties as of September 30, 2013 and December 31, 2012, were as follows:



	Amounts Issued		Outstanding Third Party Held Debt Balance as of				Interest Rate Spread⁽¹⁾	Original Expected Maturity Date
	Amounts Issued		September 30, 2013		December 31, 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)	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 three and nine months ended September 30, 2013 and 2012, the interest expense recognized on our convertible debentures and the effective interest rates on the liability components were as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Interest expense recognized on:
Contractual interest coupon	$	—		$	72		$	—		$	1,006
Amortization of deferred financing fees	—			1			—			7
Amortization of debt discount	—			5			—			66
Total interest expense recognized	$	—		$	78		$	—		$	1,079
Effective interest rate on the liability component:
7.25% senior subordinated convertible debentures due 2037 ⁽¹⁾	—		%	—		%	—		%	—		%

____________________

(1) Repurchased in full during 2012.

Subordinated Debt

We have issued subordinated debt to statutory trusts (“TP Trusts”) that are formed for the purpose of issuing preferred securities to outside investors, which we refer to as Trust Preferred Securities (“TPS”). We generally retained 100% of the common

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

securities issued by the TP Trusts, representing 3% of their total capitalization. The terms of the subordinated debt issued to the TP Trusts and the TPS issued by the TP Trusts are substantially identical.

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

In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and canceled during the three months ended June 30, 2012, and we recognized a related pre-tax gain of $8.1 million on the extinguishment of debt.

FHLB SF Borrowings and FRB Credit Program

The Bank is a member of the FHLB SF. As of September 30, 2013 and December 31, 2012, the Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Borrowing capacity	$	892,659		$	841,309
Less: outstanding principal	(590,000		)	(595,000		)
Less: outstanding letters of credit	(150		)	(300		)
Unused borrowing capacity	$	302,509		$	246,009

The Bank is an approved depository institution under the primary credit program of the FRB of San Francisco's discount window and is eligible to borrow from the FRB for short periods, generally overnight. As of September 30, 2013 and December 31, 2012, collateral with amortized costs of $70.2 million and $87.0 million, respectively, and fair values of $70.4 million and $88.4 million, respectively, had been pledged under this program. As of September 30, 2013 and December 31, 2012, there were no borrowings outstanding.

Note 8. Shareholders' Equity

Common Stock Shares Outstanding

Common stock share activity for the nine months ended September 30, 2013 was as follows:



Outstanding as of December 31, 2012	209,551,674
Repurchase of common stock	(15,002,800	)
Exercise of options	1,707,824
Restricted stock activity	688,263
Outstanding as of September 30, 2013	196,944,961

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Accumulated other comprehensive income, net

Accumulated other comprehensive income, net, as of September 30, 2013 and December 31, 2012 was as follows:



	September 30, 2013
	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, 2013	$	24,650		$	—	$	24,650
Other comprehensive loss before reclassifications, net of tax benefit of $7.3 million ⁽¹⁾	(6,046		)	—		(6,046		)
Amounts reclassified from accumulated other comprehensive income, net ⁽²⁾	298			—		298
Other comprehensive loss, net of tax benefit of $7.3 million	(5,748		)	—		(5,748		)
Ending balance as of September 30, 2013	$	18,902		$	—	$	18,902


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


(2)	Gross amount included in Other non-interest expense, net, with no related tax impact.



	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 9. 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.

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. During 2012, we reversed a significant portion of the valuation allowance, and such reversal was recorded as a benefit in our income tax expenses. The deferred tax asset was evaluated based on our evaluation of the available positive and negative evidence, including the associated character and jurisdiction of the deferred tax asset along with our ability to realize the deferred tax asset. A valuation allowance remains in effect 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. As of September 30, 2013 and December 31, 2012, the valuation allowance was $123.1 million and $128.6 million, respectively.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

income tax expense (benefit) for the nine months ended September 30, 2013 and 2012 was $53.8 million and $(296.3) million, respectively. Consolidated income tax expense for the nine months ended September 30, 2013 was primarily due to the tax expense on the pre-tax book income offset by the tax benefit resulting from the resolution of an IRS examination for the 2006-2008 tax years. The tax benefit recorded for the nine months ended September 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets.

The effective income tax rate on our consolidated net income was 23.5% and 36.7% for the three months ended September 30, 2013 and 2012, respectively, and the effective income tax rate on our consolidated net income was 33.6% and (201.3)% for the nine months ended September 30, 2013 and 2012, respectively.

We file income tax returns with the United States and various state, local and foreign jurisdictions and generally remain subject to examinations by these tax jurisdictions for tax years 2006 through 2012. We are currently under examination by certain state jurisdictions for the tax years 2006 to 2011.

Note 10. Net Income Per Share

The computations of basic and diluted net income per share for the three and nine months ended September 30, 2013 and 2012, respectively, were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	($ in thousands, except per share data)
Net income	$	48,398	$	31,047	$	106,369	$	443,534
Average shares - basic	193,099,993		219,664,637		195,606,073		229,091,849
Effect of dilutive securities:
Option shares	2,502,473		2,383,884		2,476,263		2,333,940
Stock units and unvested restricted stock	2,854,529		4,392,773		2,620,665		4,286,733
Average shares - diluted	198,456,994		226,441,294		200,703,002		235,712,522
Basic net income per share	$	0.25	$	0.14	$	0.54	$	1.94
Diluted net income per share	$	0.24	$	0.14	$	0.53	$	1.88

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



	Three Months Ended September 30,		Nine Months Ended September 30,
	2013	2012	2013	2012
Stock units	—	5,881	—	7,433
Stock options	454,994	793,571	496,908	1,099,851
Unvested restricted stock	—	2,645	—	197,131

Note 11. 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.

NOTES TO THE UNAUDITED 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 September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013								December 31, 2012
	Actual				Minimum Required				Actual				Minimum Required
	Amount		Ratio		Amount		Ratio		Amount		Ratio		Amount		Ratio
	($ in thousands)
Tier 1 Leverage	$	1,044,933	13.55	%	$	385,564	5.00	%	$	933,837	13.06	%	$	357,443	5.00	%
Tier 1 Risk-Based Capital	1,044,933		15.02		417,366		6.00		933,837		15.24		367,651		6.00
Total Risk-Based Capital	1,132,146		16.28		1,043,415		15.00		1,010,746		16.50		919,128		15.00

Note 12. Commitments and Contingencies

As of September 30, 2013 and December 31, 2012, we had committed lending arrangements to our borrowers of approximately $7.8 billion and $7.4 billion, respectively, of which approximately $1.0 billion were unfunded. As of September 30, 2013 and December 31, 2012, the Bank had total unfunded commitments of $980.3 million and $922.4 million, respectively. As of September 30, 2013 and December 31, 2012, the Parent Company had total unfunded commitments of $47.9 million and $88.5 million, respectively. Our failure to satisfy our full contractual funding commitment to one or more of our borrowers could create a breach of contract, expose us to lender liability claims 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 twelve years and contain provisions for certain annual rental escalations, if any. 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 September 30, 2013 and December 31, 2012, we had issued $43.2 million and $54.2 million, respectively, in 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 under these arrangements.

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

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

Note 13. Derivative Instruments

We are exposed to certain risks related to our ongoing business operations. The primary risks managed through the use of derivative instruments are interest rate risk and foreign exchange risk. We do not enter into derivative instruments for speculative purposes. As of September 30, 2013 and December 31, 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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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 September 30, 2013, the gross positive fair value of derivative financial instruments was $0.6 million. As a result of our master netting arrangements, we had no exposure to this positive fair value as we are in a net liability position as of September 30, 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 September 30, 2013 and December 31, 2012. For derivatives that were in a liability position, we had posted no collateral as of September 30, 2013 and $1.5 million collateral as of December 31, 2012. As of September 30, 2013, we also posted collateral of $10.0 million related to counterparty requirements for foreign exchange contracts at the Bank.

During the three months ended September 30, 2013, we had no termination activity on our swap contracts. During the nine months ended September 30, 2013, we had $4.7 million of interest rate swaps that were terminated in conjunction with calling the two remaining securitizations.

As of September 30, 2013 and December 31, 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:



	September 30, 2013						December 31, 2012
	Notional Amount		Fair Value				Notional Amount		Fair Value
	Notional Amount		Other Assets		Other Liabilities		Notional Amount		Other Assets		Other Liabilities
	($ in thousands)
Interest rate contracts	$	—	$	—	$	—	$	6,712	$	—	$	11
Foreign exchange contracts	54,758		587		826		34,553		—		471
Total	$	54,758	$	587	$	826	$	41,265	$	—	$	482

The gains and losses on our derivative instruments recognized during the three and nine months ended September 30, 2013 and 2012, 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 During the Three Months Ended September 30,						Gain (Loss) Recognized in Income During the Nine Months Ended September 30,
	Location	2013			2012			2013			2012
		($ in thousands)
Interest rate contracts	(Loss) gain on derivatives, net	$	1,567		$	(2	)	$	(233	)	$	339
Foreign exchange contracts	Gain (loss) on derivatives, net	(1		)	(976		)	7			(988		)
Total		$	1,566		$	(978	)	$	(226	)	$	(649	)

Note 14. 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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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

Assets and Liabilities

Cash

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

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consist of Agency MBS, Non-agency MBS, agency asset-backed securities, non-agency asset-backed securities, an equity security 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 available for sale securities were transferred from or into Level 3 during the nine months ended September 30, 2013.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists of CMBS and CLOs. 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.

NOTES TO THE UNAUDITED 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 September 30, 2013 and December 31, 2012, we charged off an additional $30.7 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 September 30, 2013, $36.2 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.

NOTES TO THE UNAUDITED 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 September 30, 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.

NOTES TO THE UNAUDITED 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 September 30, 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	$	838,182	$	—	$	838,182	$	—
Asset-backed securities	3,600		—		3,600		—
Collateralized loan obligations	26,210		—		—		26,210
Equity securities	5,481		5,481		—		—
Non-agency MBS	22,391		—		22,391		—
SBA asset-backed securities	15,708		—		15,708		—
Total investment securities, available-for-sale	911,572		5,481		879,881		26,210
Other assets held at fair value
Derivative assets	587		—		587		—
Total Assets	$	912,159	$	5,481	$	880,468	$	26,210
Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	826	$	—	$	826	$	—

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	$	—

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the changes in the fair values of assets and liabilities carried at fair value for the nine months ended September 30, 2013 that have been classified in Level 3 of the fair value hierarchy was as follows:



	Investment Securities, Available-for-Sale
	Collateralized Loan Obligation
	($ in thousands)
Balance as of January 1, 2013	$	26,250
Realized and unrealized gains:
Included in income	2,299
Included in other comprehensive income, net	(344		)
Total realized and unrealized gains	1,955
Transfers to/from Level 3
Transfers into Level 3	—
Transfers out of Level 3	—
Total Level 3 transfers	—
Sales, issuances, and settlements:
Sales	—
Issuances	—
Settlements	(1,995		)
Total sales, issuances, and settlements	(1,995		)
Balance as of September 30, 2013	$	26,210

Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the three and nine months ended September 30, 2013 and 2012, reported in interest income and loss on investments, net were as follows:



	Three Months Ended September 30,										Nine Months Ended September 30,
	Interest Income				Loss on Investments, Net						Interest Income				Loss on Investments, Net
	2013		2012		2013			2012			2013		2012		2013			2012
	($ in thousands)
Total gains (losses) included in earnings for the period	$	841	$	1,390	$	(61	)	$	(140	)	$	2,504	$	3,018	$	(204	)	$	(1,241	)
Unrealized gains (losses) relating to assets still held at reporting date	841		695		(61		)	—			2,504		2,312		(204		)	—

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, including related transaction costs, for which nonrecurring fair value adjustments were recorded as of September 30, 2013 and December 31, 2012, classified by their position in the fair value hierarchy.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS



	September 30, 2013								December 31, 2012
	Fair Value Measurement as of September 30, 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)
Assets
Loans held for sale	$	3,474	$	—	$	3,474	$	—	$	1,000	$	—	$	1,000	$	—
Loans held for investment	4,834		—		—		4,834		9,287		—		—		9,287
Investments carried at cost	785		—		777		8		597		—		571		26
Real estate owned	3,148		—		426		2,722		6,178		—		1,844		4,334
Total assets	$	12,241	$	—	$	4,677	$	7,564	$	17,062	$	—	$	3,415	$	13,647

The net losses (gains) of the assets resulting from nonrecurring fair value adjustments for the three and nine months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	($ in thousands)
Assets
Loans held for sale	$	697	$	397	$	1,781	$	397
Loans held for investment	1,617		2,343		4,010		23,317
Investments carried at cost	320		492		767		5,192
Investments accounted for under the equity method	—		1		—		1
Real estate owned	168		1,433		2,063		3,419
Total net loss from nonrecurring measurements	$	2,802	$	4,666	$	8,621	$	32,326

NOTES TO THE UNAUDITED 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 September 30, 2013 a summary of the significant unobservable inputs and valuation techniques is as follows:



	Fair Value Measurement as of September 30, 2013		Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
	($ in thousands)
Assets
Collateralized loan obligation	$	26,210	Third-Party Pricing	Marketability Discount	N/A⁽¹⁾
				Illiquidity Discount	N/A⁽¹⁾

Loans held for investment
Services	2,724		Market and Income Approach	EBITDA Multiple	3.0 x
				Capitalization Rate	40.0%

Commercial Real Estate	2,110		Market and Income Approach	Price Per Square Foot	$22 - $1,638 ($338)
				Room Revenue Multiple	2.25x
				Illiquidity Discount	36.0%
				Marketability Discount	10.0% - 60.0% (34.4%)
				Capitalization Rate	9.0% - 11.0% (10.5%)
Total loans held for investment	4,834

Investments carried at cost	8		Market Approach	EBITDA Multiple	8.0 x
				Illiquidity Discount	25.0%

Real estate owned	2,722		Market and Income Approach	Marketability Discount	9.2% - 79.8% (56.0%)
				Price Per Square Foot	$47.50 - $727.05 ($712.63)
				Room Revenue Multiple	2.2x - 2.4x (2.2x)
				Capitalization Rate	11.0%
	$	33,774

______________________


(1)	Information is unavailable as valuation was obtained from third-party pricing services.

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.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The table below provides fair value estimates for our financial instruments as of September 30, 2013 and December 31, 2012, excluding financial assets and liabilities which are recorded at fair value on a recurring basis.



	September 30, 2013										December 31, 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	$	431,457	$	431,457	$	—	$	—	$	431,457	$	299,086	$	299,086	$	—	$	—	$	299,086
Restricted cash	59,635		59,635		—		—		59,635		104,044		104,044		—		—		104,044
Loans held for sale	13,977		—		14,370		—		14,370		22,719		—		22,723		—		22,723
Loans held for investment, net	6,424,044		—		—		6,338,158		6,338,158		6,021,957		—		—		5,953,226		5,953,226
Investments carried at cost	18,792		—		2,353		44,897		47,250		23,963		—		—		61,742		61,742
Investments accounted for under the equity method	35,979		1,449		12,397		23,000		36,846		36,400		1,087		12,372		24,055		37,514
Investment securities, held-to-maturity	122,262		—		123,015		—		123,015		108,233		—		111,388		—		111,388
Liabilities:
Deposits	6,051,411		919,359		5,138,414		—		6,057,773		5,579,270		962,851		4,626,715		—		5,589,566
FHLB SF Borrowings	590,000		—		600,397		—		600,397		595,000		—		614,062		—		614,062
Term debt	—		—		—		—		—		177,188		—		—		146,548		146,548
Subordinated debt	411,599		—		308,699		—		308,699		410,738		—		273,141		—		273,141
Loan commitments and letters of credit	—		—		21,854		—		21,854		—		—		—		21,559		21,559

Note 15. Segment Data

The financial results of our operating segments as of and for the three months ended September 30, 2013 were as follows:



	Three Months Ended September 30, 2013
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	107,810	$	4,598		$	310		$	112,718
Interest expense	16,106		2,538			—			18,644
Loan and lease loss provision (recovery)	2,230		(3,299		)	—			(1,069		)
Non-interest income	16,039		3,401			(3,732		)	15,708
Non-interest expense	42,101		9,510			(3,997		)	47,614
Net income (loss) before income taxes	63,412		(750		)	575			63,237
Income tax expense (benefit)	25,015		(10,176		)	—			14,839
Net income (loss)	$	38,397	$	9,426		$	575		$	48,398
Total assets as of September 30, 2013	$	7,913,564	$	850,363		$	(9,008	)	$	8,754,919
Total assets as of December 31, 2012	$	7,371,643	$	1,190,044		$	(12,682	)	$	8,549,005

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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



	Three Months Ended September 30, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	99,807	$	16,899		$	(1,472	)	$	115,234
Interest expense	15,521		3,992			—			19,513
Loan and lease loss provision	273		8,686			—			8,959
Non-interest income	13,585		1,439			(5,727		)	9,297
Non-interest expense	39,964		13,037			(5,992		)	47,009
Net income (loss) before income taxes	57,634		(7,377		)	(1,207		)	49,050
Income tax expense (benefit)	23,782		(5,779		)	—			18,003
Net income (loss)	$	33,852	$	(1,598	)	$	(1,207	)	$	31,047

The financial results of our operating segments for the nine months ended September 30, 2013 were as follows:



	Nine Months Ended September 30, 2013
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	311,403	$	20,474		$	2,341		$	334,218
Interest expense	46,327		8,954			—			55,281
Loan and lease loss provision	12,438		3,830			—			16,268
Non-interest income	44,688		9,271			(13,485		)	40,474
Non-interest expense	124,412		31,394			(12,842		)	142,964
Net income (loss) before income taxes	172,914		(14,433		)	1,698			160,179
Income tax expense (benefit)	69,804		(15,994		)	—			53,810
Net income (loss)	$	103,110	$	1,561		$	1,698		$	106,369

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



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

The accounting policies of each of the individual operating segments are the same as those described in Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2012, included in our Form 10-K.

NOTES TO THE UNAUDITED 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 the Bank and by the Bank to the Parent Company, loan sales between the Parent Company and the Bank, and daily loan collections received at the Bank for Parent Company loans and daily loan disbursements paid at the Parent Company for the Bank loans.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q, including the footnotes to our unaudited consolidated financial statements included herein, contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including certain plans, strategies, goals, and projections and including statements about our pending merger between the Company and PacWest, interest spread and asset yield, CapitalSource Bank net interest margin, CapitalSource Bank and Parent Company liquidity, expectation about the deferred tax asset valuation allowance reversal, expectation about additional deferred tax asset valuation allowance reversal, and interest rate risk management. All statements contained in this Form 10-Q that are not clearly historical in nature are forward-looking, including statements about the pending merger between the Company and PacWest, and the words “anticipate,” “assume,” “intend,” “believe,” “forecast,” “expect,” “estimate,” “plan,” “continue,” “will,” “should,” “look forward” and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: the ability to complete the pending merger between the Company and PacWest, including obtaining regulatory approvals and approval by the stockholders of PacWest and the Company, or any future transaction, successfully integrate the companies following completion of the merger or achieve 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 timeframes 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 of the companies’ customers, employees and counterparties; competitive and other market pressures on product pricing and services; unfavorable changes in asset mix; changes in loan repayment levels due to negative impact of rate changes to discounts and premiums; change in interest rates and lending spreads; compression of spreads on newly originated loans; higher than anticipated payoff levels; changes in our loan product could further compress NIM; continued or worsening credit losses, charge-offs, reserves and delinquencies; changes in economic or market conditions; reduced demand for our services; 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; tax planning or disallowance of tax benefits by tax authorities; risks related to the timing of the recoverability of the deferred tax asset, which is subject to considerable judgment; expiration of carry forwards before utilization; 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 risk factors described in our audited consolidated financial statements, and other risk factors described in this Form 10-Q and documents filed by us with the SEC. All forward-looking statements included in this Form 10-Q are based on information available at the time the statement is made.

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

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

Overview

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.

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 September 30, 2013, we had total assets of $8.8 billion, total loans of $6.6 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.

Current Developments

On July 23, 2013, the Parent Company announced that it had entered into the Merger with 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. The transaction, currently expected to close in the first quarter of 2014, is subject to customary conditions, including the approval of bank regulatory authorities and the stockholders of both companies.

Our business focus includes operating the Bank. As of September 30, 2013 and 2012, the Bank had $7.9 billion and $7.3 billion of assets, respectively. In the third quarter of 2013, the Bank's loan portfolio grew by approximately $174.1 million or 2.7%, while the loan portfolio of the Parent Company decreased by $116.6 million or 45.3%; resulting in net loan growth of $57.5 million. Non-performing assets as of September 30, 2013 were $44.4 million, or 0.6% of total assets, a decrease of $3.9 million from December 31, 2012. The allowance for loan losses as of September 30, 2013 was $105.5 million or 1.6% of loans compared to $98.9 million or 1.8% of loans as of December 31, 2012.

The Bank net interest margin for the three months ended September 30, 2013 increased to 4.86% as the loan portfolio grew, however, the margin was partially offset by lower portfolio yields. We anticipate that the net interest margin will remain relatively flat as compared to the third quarter. Net interest margin was 4.79%, 5.08%, 4.84% and 4.97% for the three months ended June 30, 2013, March 31, 2013, December 31, 2012, and September 30, 2012, respectively.

Consolidated Results of Operations

We compared our consolidated operating results for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,							Nine Months Ended September 30,
	2013			2012		% Change		2013		2012			% Change
	($ in thousands)
Interest income	$	112,718		$	115,234	(2.2	)%	$	334,218	$	353,293		(5.4	)%
Interest expense	18,644			19,513		(4.5	)	55,281		60,535			(8.7	)
Loan and lease loss (recovery) provision	(1,069		)	8,959		(111.9	)	16,268		30,567			(46.8	)
Non-interest income	15,708			9,297		69.0		40,474		29,297			38.2
Non-interest expense	47,614			47,009		1.3		142,964		144,259			(0.9	)
Income tax expense (benefit)	14,839			18,003		(17.6	)	53,810		(296,305		)	118.2
Net income	48,398			31,047		55.9	%	106,369		443,534			(76.0	)%

Three Months Ended September 30, 2013 and 2012

The significant factors influencing our consolidated results of operations for the three months ended September 30, 2013, compared to the three months ended September 30, 2012 include a decrease in interest income and interest expense, a decrease in the loan and lease loss provision, an increase in non-interest income, and a decrease in provision for income taxes. Interest income decreased from $115.2 million during three months ended September 30, 2012 to $112.7 million during the three months ended September 30, 2013 due to lower yields on our loan portfolio and investment securities available-for-sale portfolio. The loan and lease loss provision decreased from $9.0 million for the three months ended September 30, 2012 to $(1.1) million for the three months ended September 30, 2013 due to an improvement in our overall portfolio credit profile with reserve releases and reversals related to loans at the Parent. Non-interest income increased primarily due to gains on sale of assets, leased equipment income

and loan fees. The provision for income tax decreased $3.2 million primarily due to the tax expense on the pre-tax book income offset by the tax benefit resulting from the resolution of an IRS examination for the 2006-2008 tax years.

Nine Months Ended September 30, 2013 and 2012

The significant factors influencing our consolidated results of operations for the nine months ended September 30, 2013, compared to the nine months ended September 30, 2012 include an increase in net income tax expense, a decrease in interest income and a decrease in loan and lease loss provision. Consolidated income tax expense for the nine months ended September 30, 2013 and 2012 was $53.8 million and $(296.3) million, respectively. The $350.1 million increase in income tax expense was primarily the result of the release of the deferred tax valuation allowance during the nine months ended September 30, 2012, that was not repeated in 2013. Interest income decreased from $353.3 million during nine months ended September 30, 2012 to $334.2 million during the nine months ended September 30, 2013 due to lower yields on our loan portfolio and investment securities available-for-sale portfolio. The loan and lease loss provision decreased from $30.6 million for the nine months ended September 30, 2012 to $16.3 million for the nine months ended September 30, 2013 due to an improvement in our overall portfolio credit profile with reserve releases and reversals related to loans at the Parent Company.

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the three months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,
	2013						2012
	Average Balance		Interest Income / (Expense)		Yield / Rate		Average Balance		Interest Income / (Expense)		Yield / Rate
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	193,192	$	131	0.27	%	$	379,550	$	351	0.37	%
Investment securities	1,076,245		8,003		2.95	%	1,228,007		9,784		3.17	%
Loans ⁽¹⁾	6,531,395		104,211		6.33	%	5,995,021		105,066		6.97	%
Other assets	31,417		373		4.71	%	28,110		33		0.47	%
Total interest-earning assets	$	7,832,249	$	112,718	5.71	%	$	7,630,688	$	115,234	6.01	%
Interest-bearing liabilities:
Deposits	$	5,963,151	$	13,407	0.89	%	$	5,469,501	$	12,738	0.93	%
Other borrowings	1,043,295		5,237		1.99	%	1,219,045		6,775		2.21	%
Total interest-bearing liabilities	$	7,006,446	$	18,644	1.06	%	$	6,688,546	$	19,513	1.16	%
Net interest income/spread ⁽²⁾			$	94,074	4.65	%			$	95,721	4.85	%
Net interest margin					4.77	%					4.99	%

________________________


(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. Net yield on interest-earning assets is defined as net interest-earnings divided by average total interest-earning assets.

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the nine months ended September 30, 2013 and 2012 were as follows:



	Nine Months Ended September 30,
	2013						2012
	Average Balance		Interest Income / (Expense)		Yield / Rate		Average Balance		Interest Income / (Expense)		Yield / Rate
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	247,984	$	464	0.25	%	$	370,954	$	1,015	0.37	%
Investment securities	1,090,766		24,936		3.06	%	1,257,518		29,737		3.16	%
Loans ⁽¹⁾	6,291,134		308,046		6.55	%	5,930,657		322,437		7.26	%
Other assets	29,325		772		3.52	%	27,913		104		0.50	%
Total interest-earning assets	$	7,659,209	$	334,218	5.83	%	$	7,587,042	$	353,293	6.22	%
Interest-bearing liabilities:
Deposits	$	5,796,560	$	38,260	0.88	%	$	5,347,534	$	38,669	0.97	%
Other borrowings	1,068,301		17,021		2.13	%	1,271,751		21,866		2.30	%
Total interest-bearing liabilities	$	6,864,861	$	55,281	1.08	%	$	6,619,285	$	60,535	1.22	%
Net interest income/spread ⁽²⁾			$	278,937	4.75	%			$	292,758	5.00	%
Net interest margin					4.87	%					5.15	%

________________________


(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. Net yield on interest-earning assets is defined as net interest-earnings divided by average total interest-earning assets.

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. During 2012, we reversed a significant portion of the valuation allowance, and such reversal was recorded as a benefit in our income tax expenses. The deferred tax asset 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 the associated character and jurisdiction of the deferred tax asset. A valuation allowance remains in effect 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. As of September 30, 2013 and December 31, 2012, the valuation allowance was $123.1 million and $128.6 million, respectively.

Consolidated income tax expense for the three months ended September 30, 2013 and 2012 was $14.8 million and $18.0 million, respectively. The tax expense for the three months ended September 30, 2013 was primarily due to tax expense on the pre-tax income offset by the tax benefit resulting from the resolution of an IRS examination for the 2006-2008 tax years. The tax expense for the three months ended September 30, 2012 was primarily the result of tax expense on the pre-tax income. Consolidated income tax expense (benefit) for the nine months ended September 30, 2013 and 2012 was $53.8 million and $(296.3) million, respectively. Consolidated income tax expense for the nine months ended September 30, 2013 was primarily due to the tax expense on the pre-tax book income offset by the tax benefit resulting from the resolution of an IRS examination for the 2006-2008 tax years. The tax benefit recorded for the nine months ended September 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets.

CapitalSource Bank Segment

We compared our Bank segment operating results for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013		2012		% Change		2013		2012		% Change
	($ in thousands)
Interest income	$	107,810	$	99,807	8.0	%	$	311,403	$	294,539	5.7	%
Interest expense	16,106		15,521		3.8		46,327		46,974		(1.4	)%
Loan and lease loss provision	2,230		273		716.8		12,438		14,745		(15.6	)%
Non-interest income	16,039		13,585		18.1		44,688		42,252		5.8	%
Non-interest expense	42,101		39,964		5.3		124,412		124,307		0.1	%
Income tax expense	25,015		23,782		5.2		69,804		62,047		12.5	%
Net income	38,397		33,852		13.4	%	103,110		88,718		16.2	%

Interest Income

Three Months Ended September 30, 2013 and 2012

Total interest income increased to $107.8 million for the three months ended September 30, 2013 from $99.8 million for the three months ended September 30, 2012, with an average yield on interest-earning assets of 5.72% for the three months ended September 30, 2013 compared to 5.88% for the three months ended September 30, 2012. During the three months ended September 30, 2013 and 2012, interest income on loans was $100.5 million and $91.4 million, respectively, yielding 6.30% and 6.95% on average loan balances of $6.3 billion and $5.2 billion, respectively. The decrease in loan yield is primarily made-up of a 37 basis point decrease from lower loan and lease yields, a 25 basis point decrease due to lower discount accretion, a 6 basis point decrease due to lower deferred loan fee amortization, offset by a 3 basis point increase due to non-accrual interest on loans and other yield factors.

Included in the lower loan yield analysis above, interest income of $1.1 million and $1.9 million during the three months ended September 30, 2013 and 2012, respectively, was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.07% and 0.16%, respectively. During the three months ended September 30, 2013 and 2012, $0.2 million and $0.1 million of interest was collected on loans previously on non-accrual status and recognized in interest income, respectively.

During the three months ended September 30, 2013 and 2012, interest income from our investments, including available-for-sale and held-to-maturity securities, was $6.9 million and $8.1 million, yielding 2.63% and 2.68% 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 decrease is primarily due to a 41 basis point decrease resulting from relatively higher yielding securities paying down and purchasing new securities at lower yields, offset by an 36 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 $1.2 million which was due to a $0.7 million decrease in interest income from available-for-sale securities, plus a $0.5 million decrease in interest income from held-to-maturity securities.

During the three months ended September 30, 2013, we purchased no available-for-sale securities and no held-to-maturity securities while $72.4 million and $0.3 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively. During the three months ended September 30, 2012, we purchased $26.0 million of available-for-sale securities and no held-to-maturity securities while $80.5 million and $0.9 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the three months ended September 30, 2013 and 2012, interest income on cash and cash equivalents was $64 thousand and $0.3 million, respectively, yielding 0.33% and 0.39% on average balances of $78.1 million and $286.3 million, respectively.

Nine Months Ended September 30, 2013 and 2012

Total interest income increased to $311.4 million for the nine months ended September 30, 2013 from $294.5 million for the nine months ended September 30, 2012, with an average yield on interest-earning assets of 5.77% for the nine months ended September 30, 2013 compared to 5.96% for the nine months ended September 30, 2012. During the three months ended September 30, 2013 and 2012, interest income on loans was $288.5 million and $267.9 million, respectively, yielding 6.47% and 7.09% on average loan balances of $6.0 billion and $5.0 billion, respectively. The decrease in loan yield is primarily made up of

a 43 basis point decrease from lower loan and lease yields, a 22 basis point decrease due to lower discount accretion, offset by 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 $3.2 million and $6.6 million during the nine months ended September 30, 2013 and 2012, respectively, was not recognized for loans on non-accrual status which negatively impacted the yield on loans by 0.04% and 0.19%, respectively. During the nine months ended September 30, 2013 and 2012, nine months ended September 30, 2013, $0.4 million and $0.9 million of interest was collected on loans previously on non-accrual status and recognized in interest income, respectively.

During the nine months ended September 30, 2013 and 2012, interest income from our investments, including available-for-sale and held-to-maturity securities, was $21.7 million and $25.6 million, yielding 2.74% and 2.78% on average balances of $1.1 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 37 basis point decrease resulting from relatively higher yielding securities paying down and purchasing new securities at lower yields, offset by an 11 basis point increase resulting from accelerated discount amortization of a held-to-maturity commercial mortgage-backed security ("CMBS") from its prepayment and a 22 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 $3.9 million attributed to an $4.1 million decrease in interest income from available-for-sale securities, offset by a $0.2 million increase in interest income from held-to-maturity securities.

During the nine months ended September 30, 2013, we purchased $117.6 million available-for-sale securities and $47.9 million of held-to-maturity securities while $270.9 million and $29.1 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively. During the nine months ended September 30, 2012, we purchased $175.4 million of available-for-sale securities and no held-to-maturity securities while $260.3 million and $4.9 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the nine months ended September 30, 2013 and 2012, interest income on cash and cash equivalents was $0.4 million and $0.9 million, respectively, yielding 0.29% and 0.41% on average balances of $166.1 million and $293.5 million, respectively.

Interest Expense

Three Months Ended September 30, 2013 and 2012

Total interest expense increased slightly by $0.6 million to $16.1 million for the three months ended September 30, 2013 from $15.5 million for the three months ended September 30, 2012. The increase was primarily due to an increase in average balances of interest-bearing liabilities of $6.6 billion and $6.1 billion as of September 30, 2013 and 2012, respectively, which consisted of deposits and borrowings. This increase was mostly offset by a decrease in the average cost of interest-bearing liabilities of 0.97% and 1.02% for the three months ended September 30, 2013 and 2012, 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.

Our interest expense on deposits for the three months ended September 30, 2013 and 2012 was $13.4 million and $12.7 million with an average cost of deposits of 0.89% and 0.93% on average balances of $6.0 billion and $5.5 billion, respectively. Despite the net decrease in average cost of deposits from the three months ended September 30, 2012 to 2013, the cost of deposits has increased slightly from the prior quarter as the average balances rose over the period. During the three months ended September 30, 2013, $1.5 billion of our time deposits matured with a weighted average interest rate of 0.87% and $1.6 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.93%. During the three months ended September 30, 2012, $1.1 billion of our time deposits matured with a weighted average interest rate of 0.96%, and $1.3 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.86%.

During the three months ended September 30, 2013, our interest expense on borrowings, consisting of FHLB SF borrowings, was $2.7 million with an average cost of 1.69% on an average balance of $632.6 million. The primary reason for using FHLB SF borrowings as a funding source is to manage interest rate risk and the secondary reason is to provide a source of liquidity. For the three months ended September 30, 2013, there were no new term advances taken, a $5.0 million term advance matured with a rate of 1.20% and we maintained average overnight advances of $41.8 million with a weighted average rate of 0.12%. Our maximum overnight borrowing during the quarter was $100.0 million. At September 30, 2013, we had no overnight borrowings outstanding and the weighted average rates for FHLB SF term borrowings maturing within one year, one to five years, and greater than five years were 1.55%, 1.82% and 1.78%, respectively. Overall, the FHLB SF borrowing balance had a weighted-average life of 2.6 years. For the three months ended September 30, 2012, our interest expense on FHLB SF borrowings was $2.8 million with an average cost of 1.85% on an average balance of $597.7 million. For the three months ended September 30, 2012, there were $13.0 million in term advances taken with a weighted-average rate of 0.89%, $10.0 million of maturities with a weighted-average rate of 2.25% and no overnight advances.

Nine Months Ended September 30, 2013 and 2012

Total interest expense decreased $0.7 million to $46.3 million for the nine months ended September 30, 2013 from $47.0 million for the nine months ended September 30, 2012. The decrease was primarily due to a decrease in the average cost of interest-bearing liabilities of 0.97% and 1.06% for the nine months ended September 30, 2013 and 2012, 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 $6.4 billion and $5.9 billion as of September 30, 2013 and 2012, respectively, which consisted of deposits and borrowings.

Our interest expense on deposits for the nine months ended September 30, 2013 and 2012 was $38.3 million and $38.7 million with an average cost of deposits of 0.88% and 0.97% on average balances of $5.8 billion and $5.3 billion, respectively. During the nine months ended September 30, 2013, $2.9 billion of our time deposits matured with a weighted average interest rate of 0.82% and $3.5 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.90%. During the nine months ended September 30, 2012, $4.2 billion of our time deposits matured with a weighted average interest rate of 1.01%, and $3.8 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.87%.

During the nine months ended September 30, 2013, our interest expense on borrowings, consisting of FHLB SF borrowings, was $8.1 million with an average cost of 1.76% on an average balance of $611.4 million. The primary reason for using FHLB SF borrowings as a funding source is to manage interest rate risk and the secondary reason is to provide a source of liquidity. For the nine months ended September 30, 2013, there were $23.0 million in term advances taken with a weighted-average rate of 0.87%, $28.0 million of term advances maturing with a weighted-average rate of 1.50%, and we maintained average overnight advances of $15.0 million with a weighted average rate of 0.12%. Our maximum overnight borrowing during the nine months ended September 30, 2013 was $100.0 million. For the nine months ended September 30, 2012, our interest expense on FHLB SF borrowings was $8.3 million with an average cost of 1.90% on an average balance of $583.8 million. For the nine months ended September 30, 2012, there were $98.0 million in advances taken with a weighted-average-rate of 1.02%, $48.0 million of maturities with a weighted-average-rate of 2.00% and no overnight advances.

Net Interest Margin

The yields on income earning assets and the costs of interest-bearing liabilities for this segment for the three months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,
	2013						2012
	Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost		Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	78,097	$	64	0.33	%	$	286,328	$	284	0.39	%
Investment securities	1,044,070		6,922		2.63	%	1,206,868		8,123		2.68	%
Loans⁽¹⁾	6,326,704		100,461		6.30	%	5,231,242		91,367		6.95	%
Other assets	31,418		363		4.58	%	28,111		33		0.47	%
Total interest-earning assets	$	7,480,289	$	107,810	5.72	%	$	6,752,549	$	99,807	5.88	%
Interest-bearing liabilities:
Deposits	$	5,963,151	$	13,407	0.89	%	$	5,469,501	$	12,738	0.93	%
Other borrowings	632,608		2,699		1.69	%	597,674		2,783		1.85	%
Total interest-bearing liabilities	$	6,595,759	$	16,106	0.97	%	$	6,067,175	$	15,521	1.02	%
Net interest income/spread			$	91,704	4.75	%			$	84,286	4.86	%
Net interest margin					4.86	%					4.97	%

_______________________________________


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

The yields on income earning assets and the costs of interest-bearing liabilities for this segment for the nine months ended September 30, 2013 and 2012 were as follows:



	Nine Months Ended September 30,
	2013						2012
	Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost		Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	166,131	$	361	0.29	%	$	293,483	$	906	0.41	%
Investment securities	1,062,215		21,742		2.74	%	1,229,735		25,626		2.78	%
Loans⁽¹⁾	5,963,288		288,540		6.47	%	5,046,915		267,905		7.09	%
Other assets	29,325		760		3.47	%	27,912		102		0.49	%
Total interest-earning assets	$	7,220,959	$	311,403	5.77	%	$	6,598,045	$	294,539	5.96	%
Interest-bearing liabilities:
Deposits	$	5,796,560	$	38,260	0.88	%	$	5,347,534	$	38,669	0.97	%
Other borrowings	611,374		8,067		1.76	%	583,785		8,305		1.90	%
Total interest-bearing liabilities	$	6,407,934	$	46,327	0.97	%	$	5,931,319	$	46,974	1.06	%
Net interest income/spread			$	265,076	4.80	%			$	247,565	4.90	%
Net interest margin					4.91	%					5.01	%

_______________________________________


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

Loan and Lease Loss Provision

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

Non-Interest Income

The 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 (unpaid principal balance) by the Bank for the benefit of others were $951.0 million and $1.4 billion as of September 30, 2013 and December 31, 2012, respectively, of which $145.6 million and $549.0 million, respectively, were owned by the Parent Company. The Bank also provides administrative, tax, credit, treasury and other similar services to the Parent Company for which it receives fees.

We compared the various components of non-interest income for this segment for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,											Nine Months Ended September 30,
	2013			2012			$ Change			% Change		2013		2012			$ Change			% Change
	($ in thousands)
Loan fees	$	5,643		$	3,469		$	2,174		62.7	%	$	12,658	$	9,566		$	3,092		32.3	%
Leased equipment income	5,194			3,299			1,895			57.4		15,039		9,814			5,225			53.2
Gain on investments, net	—			(1		)	1			100.0		208		(1		)	209			20,900.0
(Loss) gain on derivatives	(1,567		)	(976		)	(591		)	(60.6	)	233		(989		)	1,222			123.6
Bank fees	151			150			1			0.7		176		180			(4		)	(2.2	)
Gain (loss) on sale of assets	42			(554		)	596			107.6		1,046		(520		)	1,566			301.2
Loan servicing revenue	1,159			2,305			(1,146		)	(49.7	)	4,271		8,273			(4,002		)	(48.4	)
Intercompany shared service revenue	2,576			3,434			(858		)	(25.0	)	7,795		11,298			(3,503		)	(31.0	)
Other	2,841			2,459			382			15.5		3,262		4,631			(1,369		)	(29.6	)
Total	$	16,039		$	13,585		$	2,454		18.1	%	$	44,688	$	42,252		$	2,436		5.8	%

Three Months Ended September 30, 2013 and 2012


•	Loan fee income increased $2.2 million, or 62.7%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to loan termination fees arising from the pay down of loans within the loan portfolio.

•

Leased equipment income increased $1.9 million, or 57.4%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to a $41.1 million, or 51.9%, increase in equipment on operating leases. In addition, average balances of our leased equipment increased $42.7 million, or 42.3% from the three months ended September 30, 2012 to the three months ended September 30, 2013.


•	Loan servicing revenue decreased $1.1 million, or 49.7%, from the three months ended September 30, 2012 to the three months ended September 30, 2013, as the number of Parent Company loans serviced by the Bank declined with the run-off of its loan portfolio.

Nine Months Ended September 30, 2013 and 2012


•	Loan fee income increased $3.1 million, or 32.3%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to loan termination fees arising from the pay down of loans within the loan portfolio.

•

Leased equipment income increased $5.2 million, or 53.2%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to a $41.1 million, or 51.9%, increase in equipment on operating leases. In addition, average balances on our leased equipment increased $36.7 million, or 35.7%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013.


•	Loan servicing revenue decreased $4.0 million, or 48.4%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013, as the number of Parent Company loans serviced by the Bank declined with the run-off of its loan portfolio.


•	Intercompany shared service revenue decreased $3.5 million, or 31.0%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013, as general services provided to the Parent Company decreased with the reduction in Parent Company operations and activities.

Non-Interest Expense

We compared the various components of non-interest expense for this segment for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,										Nine Months Ended September 30,
	2013			2012		$ Change			% Change		2013			2012		$ Change			% Change
	($ in thousands)
Compensation and benefits	$	27,421		$	25,254	$	2,167		8.6	%	$	78,973		$	74,818	$	4,155		5.6	%
Professional fees	984			1,404		(420		)	(29.9	)	3,195			4,615		(1,420		)	(30.8	)
Occupancy expenses	2,436			2,520		(84		)	(3.3	)	7,246			7,660		(414		)	(5.4	)
FDIC fees and assessments	1,642			1,507		135			9.0		4,777			4,419		358			8.1
General depreciation and amortization	1,252			953		299			31.4		3,588			2,920		668			22.9
Loan servicing expense	(78		)	171		(249		)	(145.6	)	1,201			4,885		(3,684		)	(75.4	)
Other administrative expenses	5,125			5,293		(168		)	(3.2	)	15,542			16,744		(1,202		)	(7.2	)
Total operating expenses	38,782			37,102		1,680			4.5		114,522			116,061		(1,539		)	(1.3	)
Leased equipment depreciation	3,646			2,307		1,339			58.0		10,573			6,883		3,690			53.6
Expense of real estate owned and other foreclosed assets, net	6			16		(10		)	(62.5	)	(9		)	1,334		(1,343		)	(100.7	)
Other non-operating (gains) expenses	(333		)	539		(872		)	(161.8	)	(674		)	29		(703		)	(2,424.1	)
Total	$	42,101		$	39,964	$	2,137		5.3	%	$	124,412		$	124,307	$	105		0.1	%

Three Months Ended September 30, 2013 and 2012


•	Compensation and benefits increased $2.2 million, or 8.6%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 due to increases in incentive bonuses.


•	Leased equipment depreciation increased $1.3 million, or 58.0%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to a $41.1 million, or 51.9% increase in equipment on operating leases.

Nine Months Ended September 30, 2013 and 2012


•	Compensation and benefits increased $4.2 million, or 5.6%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to increases in base compensation, bonuses and stock compensation.


•	Loan servicing expense decreased $3.7 million, or 75.4%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to lower third party legal costs. Loan servicing expense can be volatile period-to-period due to the timing of the billing of third party loan services.


•	Leased equipment depreciation increased $3.7 million, or 53.6%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to a $41.1 million, or 51.9%, increase in equipment on operating leases.

Other Commercial Finance Segment

We compared our Other Commercial Finance segment operating results for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2013			2012			% Change		2013			2012			% Change
	($ in thousands)
Interest income	$	4,598		$	16,899		(72.8	)%	$	20,474		$	62,579		(67.3	)%
Interest expense	2,538			3,992			(36.4	)%	8,954			13,561			(34.0	)%
Loan and lease loss (recovery) provision	(3,299		)	8,686			(138.0	)%	3,830			15,822			(75.8	)%
Non-interest income	3,401			1,439			136.3	%	9,271			6,524			42.1	%
Non-interest expense	9,510			13,037			(27.1	)%	31,394			40,226			(22.0	)%
Income tax (benefit)	(10,176		)	(5,779		)	76.1	%	(15,994		)	(358,352		)	(95.5	)%
Net loss	9,426			(1,598		)	689.9	%	1,561			357,846			(99.6	)%

Interest Income

Three Months Ended September 30, 2013 and 2012

Interest income decreased to $4.6 million for the three months ended September 30, 2013 from $16.9 million for the three months ended September 30, 2012, with an average yield on interest-earning assets of 5.19% for the three months ended September 30, 2013 compared to 7.66% for the three months ended September 30, 2012. During the three months ended September 30, 2013, our average balance of interest-earning assets decreased by $526.2 million, or 59.9%, compared to the three months ended September 30, 2012, primarily due to the run-off of the Parent Company loan portfolio.

Nine Months Ended September 30, 2013 and 2012

Interest income decreased to $20.5 million for the nine months ended September 30, 2013 from $62.6 million for the nine months ended September 30, 2012, with an average yield on interest-earning assets of 6.25% for the nine months ended September 30, 2013 compared to 8.47% for the nine months ended September 30, 2012. During the nine months ended September 30, 2013, our average balance of interest-earning assets decreased by $549.0 million, or 55.6%, compared to the nine months ended September 30, 2012, primarily due to the run-off of the Parent Company loan portfolio.

Interest Expense

Three Months Ended September 30, 2013 and 2012

Interest expense decreased $1.5 million, or 36.4%, to $2.5 million for the three months ended September 30, 2013 from $4.0 million for the three months ended September 30, 2012, primarily due to a decrease of $210.7 million, or 33.9%, in average interest-bearing liabilities from $621.4 million as of September 30, 2012 to $410.7 million as of September 30, 2013. The decrease in interest-bearing liabilities was primarily driven by the extinguishment and repayment of the 2006-1, 2006-2 and 2007-1 term debt securitizations. The Parent Company's cost of borrowings decreased to 2.45% for three months ended September 30, 2013 from 2.56% for the three months ended September 30, 2012.

Nine Months Ended September 30, 2013 and 2012

Interest expense decreased $4.6 million, or 34.0%, to $9.0 million for the nine months ended September 30, 2013 from $13.6 million for the nine months ended September 30, 2012, primarily due to a decrease of $231.1 million, or 33.6%, in average interest-bearing liabilities from $688.0 million as of September 30, 2012 to $456.9 million as of September 30, 2013. The decrease in interest-bearing liabilities was primarily driven by the extinguishment and repayment of the 2006-1, 2006-2 and 2007-1 term debt securitizations. Our cost of borrowings remained fairly consistent at 2.62% for nine months ended September 30, 2013 compared to 2.63% for the nine months ended September 30, 2012.

Net Interest Margin

The yields on income earning assets and the costs of interest-bearing liabilities for this segment for the three months ended September 30, 2013 and 2012 were as follows:



	Three Months Ended September 30,
	2013						2012
	Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost		Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	115,095	$	77	0.27	%	$	93,221	$	67	0.29	%
Investment securities	32,175		1,081		13.33	%	21,140		1,661		31.26	%
Loans ⁽¹⁾	204,258		3,440		6.68	%	763,361		15,171		7.91	%
Total interest-earning assets	$	351,528	$	4,598	5.19	%	$	877,722	$	16,899	7.66	%
Interest-bearing liabilities:
Other borrowings⁽²⁾	$	410,686	$	2,538	2.45	%	$	621,371	$	3,992	2.56	%
Total interest-bearing liabilities	$	410,686	$	2,538	2.45	%	$	621,371	$	3,992	2.56	%
Net interest income/spread			$	2,060	2.74	%			$	12,907	5.10	%
Net interest margin					2.32	%					5.85	%

_______________________________________

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

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

The yields on income earning assets and the costs of interest-bearing liabilities for this segment for the nine months ended September 30, 2013 and 2012 were as follows:



	Nine Months Ended September 30,
	2013						2012
	Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost		Weighted Average Balance		Net Interest Income/ (Expense)		Average Yield/Cost
	($ in thousands)
Interest-earning assets:
Cash and cash equivalents	$	81,853	$	115	0.19	%	$	77,472	$	111	0.19	%
Investment securities	28,551		3,194		14.96	%	27,783		4,111		19.77	%
Loans ⁽¹⁾	327,871		17,165		7.00	%	882,013		58,357		8.84	%
Total interest-earning assets	$	438,275	$	20,474	6.25	%	$	987,268	$	62,579	8.47	%
Interest-bearing liabilities:
Other borrowings⁽²⁾	$	456,928	$	8,954	2.62	%	$	687,966	$	13,561	2.63	%
Total interest-bearing liabilities	$	456,928	$	8,954	2.62	%	$	687,966	$	13,561	2.63	%
Net interest income/spread			$	11,520	3.63	%			$	49,018	5.84	%
Net interest margin					3.51	%					6.63	%

_______________________________________

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

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

Loan and Lease Loss Provision (Recovery)

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

Non-Interest Income

We compared the various components of non-interest income for this segment for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,											Nine Months Ended September 30,
	2013			2012			$ Change			% Change		2013			2012		$ Change			% Change
	($ in thousands)
Loan Fees	$	278		$	705		$	(427	)	(60.6	)%	$	641		$	2,334	$	(1,693	)	(72.5	)%
Gain on investments, net	2,123			1,856			267			14.4		4,897			930		3,967			426.6
Gain (loss) on derivatives	1			(2		)	3			150.0		(7		)	339		(346		)	(102.1	)
Gain (loss) on sale of assets	2,028			(386		)	2,414			625.4		5,458			1,676		3,782			225.7
Loan servicing (loss) revenue	(3		)	6			(9		)	(150.0	)	30			92		(62		)	(67.4	)
Other	(1,026		)	(740		)	(286		)	(38.6	)	(1,748		)	1,153		(2,901		)	(251.6	)
Total	$	3,401		$	1,439		$	1,962		136.3	%	$	9,271		$	6,524	$	2,747		42.1	%

Three Months Ended September 30, 2013 and 2012


•	Gain on sale of assets increased $2.4 million, or 625.4%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to a gain recognized from the sale of a loan as the Company continues to exercise its strategy of liquidating the Parent Company portfolio.

Nine Months Ended September 30, 2013 and 2012


•	Loan fees decreased $1.7 million, or 72.5%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to decreased unused line fees and termination fees with the run-off of the Parent Company loan portfolio.


•	Gain on investments, net increased $4.0 million, or 426.6%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to decreased valuation adjustments on investments combined with increased dividends received on investments carried at cost during the nine months ended September 30, 2012.


•	Gain (loss) on sale of assets increased $3.8 million, or 225.7%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to lower fixed asset write-offs coupled with intercompany gain on sales of loans to the Bank.


•	Other non-interest income decreased $2.9 million, or 251.6%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to decreases in the Parent Company portfolio and related activity.

Non-Interest Expense

We compared the various components of non-interest expense for this segment for the three and nine months ended September 30, 2013 and 2012 as follows:



	Three Months Ended September 30,											Nine Months Ended September 30,
	2013			2012			$ Change			% Change		2013			2012			$ Change			% Change
	($ in thousands)
Compensation and benefits	$	(803	)	$	269		$	(1,072	)	(398.5	)%	$	352		$	2,529		$	(2,177	)	(86.1	)%
Professional fees	(1,033		)	1,065			(2,098		)	(197.0	)	(19		)	4,543			(4,562		)	(100.4	)
Occupancy expenses	1,141			1,046			95			9.1		4,070			6,172			(2,102		)	(34.1	)
General depreciation and amortization	460			500			(40		)	(8.0	)	1,466			1,984			(518		)	(26.1	)
Loan servicing expense	2,159			3,305			(1,146		)	(34.7	)	8,187			14,524			(6,337		)	(43.6	)
Other administrative expenses	3,580			4,617			(1,037		)	(22.5	)	11,250			14,225			(2,975		)	(20.9	)
Total operating expenses	5,504			10,802			(5,298		)	(49.0	)	25,306			43,977			(18,671		)	(42.5	)
Expense of real estate owned and other foreclosed assets, net	(774		)	2,292			(3,066		)	(133.8	)	1,151			5,245			(4,094		)	(78.1	)
Loss on extinguishment of debt	—			—			—			—		—			(8,059		)	8,059			100.0
Other operating expenses	4,780			(57		)	4,837			8,486.0		4,937			(937		)	5,874			626.9
Total	$	9,510		$	13,037		$	(3,527	)	(27.1	)%	$	31,394		$	40,226		$	(8,832	)	(22.0	)%

Three Months Ended September 30, 2013 and 2012


•	Compensation and benefits decreased $1.1 million, or 398.5%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 due to stock compensation expense adjustments.


•	Professional fees decreased $2.1 million, or 197.0%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 due to lower tax and consulting service fees as a result of the simplification and run-off of the Parent Company loan portfolio, and the settlement of a litigation matter which was lower than previously accrued.


•	Loan servicing expense decreased $1.1 million, or 34.7%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 due to the run-off of the Parent Company loan portfolio.


•	Other administrative expenses decreased $1.0 million, or 22.5%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to decreases in shared services reimbursed to the Bank as a result of the simplification and run-off of the Parent Company loan portfolio.


•	Expense of real estate owned and other foreclosed assets, net decreased $3.1 million, or 133.8%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to gains from the sale of foreclosed assets.


•	Other operating expenses increased $4.8 million or 8,486.0%, from the three months ended September 30, 2012 to the three months ended September 30, 2013 primarily due to merger-related costs.

Nine Months Ended September 30, 2013 and 2012


•	Compensation and benefits decreased $2.2 million, or 86.1%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to stock compensation expense adjustments.


•	Professional fees decreased $4.6 million, or 100.4%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to lower tax and consulting service fees as a result of the simplification and run-off of the Parent Company loan portfolio, and the settlement of a litigation matter which was lower than previously accrued.


•	Occupancy expenses decreased $2.1 million, or 34.1%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to the loss incurred during the nine months ended September 30, 2012 from the lease abandonment for part of the Chevy Chase, Maryland facility which was not repeated in the nine months ended September 30, 2013.


•	Loan servicing expense decreased $6.3 million, or 43.6%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to the run-off of the Parent Company loan portfolio.


•	Other administrative expenses decreased $3.0 million, or 20.9%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 due to decreases in shared services reimbursed to the Bank as a result of the simplification and run-off of the Parent Company loan portfolio.

•

Expense of real estate owned and other foreclosed assets, net decreased $4.1 million, or 78.1%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to gains from the sale of foreclosed assets. In addition, certain REO assets experienced realized losses during the nine months ended September 30, 2012 which were not repeated during the nine months ended September 30, 2013.


•	There was no loss on extinguishment of debt incurred during the nine months ended September 30, 2013. The loss of $8.1 million during the nine months ended September 30, 2012 related to the repurchase of our 7.25% convertible debentures.


•	Other operating expenses increased $5.9 million, or 626.9%, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013 primarily due to merger-related costs.

Financial Condition

Consolidated

As of September 30, 2013 and December 31, 2012, our consolidated balance sheet included:



	September 30, 2013			December 31, 2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	491,092		$	403,130
Investment securities, available-for-sale	911,572			1,079,025
Investment securities, held-to-maturity	122,262			108,233
Loans held for sale	13,977			22,719
Loans held for investment, net⁽²⁾	6,539,178			6,139,230
Allowance for loan and lease losses	(115,134		)	(117,273		)
Interest receivable	24,813			29,112
Other investments⁽³⁾	54,771			60,363
Goodwill	173,135			173,135
Deferred tax assets, net	271,291			362,283
Other assets	267,962			289,048
Total	$	8,754,919		$	8,549,005
Liabilities:
Deposits	$	6,051,411		$	5,579,270
Borrowings	1,001,599			1,182,926
Other liabilities	108,695			161,637
Total	$	7,161,705		$	6,923,833

_______________________________________


(1)	As of September 30, 2013 and December 31, 2012, the amounts include restricted cash of $59.6 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"); an equity security; 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”). The Bank pledges a portion of its investment securities, available-for-sale, to the State of California as collateral for deposits the state has with the Bank. For additional information on our investment securities, available-for-sale, see Note 4, Investments, in our accompanying consolidated financial statements for the three months ended September 30, 2013.

Investment securities, held-to-maturity consists of investment-grade rated commercial mortgage-backed securities and collateralized loan obligations. During the nine months ended September 30, 2013, we sold one CMBS with a net carrying value of $6.2 million and realized a net gain of $0.2 million. The Company decided to sell the security because its rating was downgraded to B. We did not sell any held-to-maturity investments during the three months ended September 30, 2013. The 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. For additional information on our investment securities, held-to-maturity, see Note 4, Investments, in our accompanying consolidated financial statements for the three months ended September 30, 2013.



	September 30, 2013		December 31, 2012
	($ in thousands)
Investment securities, available-for-sale:
Agency debt securities	$	838,182	$	983,521
Asset-backed securities	3,600		9,592
Collateralized loan obligations	26,210		26,250
Equity security	5,481		—
Non-agency MBS	22,391		41,347
SBA asset-backed securities	15,708		18,315
Total investment securities, available-for-sale	$	911,572	$	1,079,025
Investment securities, held-to-maturity:
Commercial loan obligations	$	47,860	$	—
Commercial mortgage-backed securities	$	74,402	$	108,233
Total investment securities, held-to-maturity	$	122,262	$	108,233

Loan Portfolio Composition

The outstanding unpaid principal balance of loans in our loan portfolio by category as of September 30, 2013 and December 31, 2012 was as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Commercial and industrial	$	3,688,023	$	3,594,643
Real estate	2,785,805		2,499,567
Real estate - construction	65,350		45,020
Total loans⁽¹⁾	$	6,539,178	$	6,139,230

_______________________________________


(1)	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 California Department of Business Oversight ("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 September 30, 2013, real estate construction loans were $65.9 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 (like the project's progress compared to underwriting and the market in which the project is located) may lead to an impairment determination. Impairment is then measured based on a fair market or discounted cash flow value to assess the current value of the loan relative to the principal balance. If the valuation analysis indicates that repayment in full is doubtful, the loan will be placed on non-accrual status and designated as non-performing.

Obtaining updated third-party valuations is considered when significant negative variances to expected performance exist. Generally, our policy on updating appraisals is to obtain current appraisals subsequent to the impairment date if there are significant changes to the 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:



	September 30, 2013⁽¹⁾			December 31, 2012
	($ in thousands except percentages)
Total real estate - construction loans⁽²⁾⁽³⁾	$	65,915		$	45,315
Non-performing	10,297			11,317
Non-performing as a % of total real estate - construction	15.6		%	25.0		%
Cumulative capitalized interest	$	10,826		$	10,890

_______________________________________


(1)	As of September 30, 2013, 1 of the 24 loans that comprise our real estate construction portfolio has been extended, renewed or restructured since origination. These modifications have occurred for various reasons including, but not limited to, changes in business plans and/or work-out efforts that were best achieved via a restructuring.


(2)	We recognized interest income on the real estate construction loan portfolio of $0.8 million and $2.1 million for the three and nine months ended September 30, 2013, respectively.


(3)	Excludes deferred loan fees and discounts of $0.6 million and $0.3 million as of September 30, 2013 and December 31, 2012, respectively.

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in our consolidated loan portfolio as of September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
Commercial and industrial	$	62,368	$	79,400
Real estate	38,940		26,875
Real estate - construction	9,968		10,987
Total loans on non-accrual	$	111,276	$	117,262
Accruing loans contractually past-due 90 days or more
Commercial and industrial	$	—	$	—
Real estate	—		—
Real estate - construction	—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	—
Total non-performing loans
Commercial and industrial	$	62,368	$	79,400
Real estate	38,940		26,875
Real estate - construction	9,968		10,987
Total non-performing loans⁽¹⁾	$	111,276	$	117,262

_______________________________________


(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 September 30, 2013 is primarily due to payoffs and sales of non-performing loans, offset by loans that were placed on non-accrual status during the nine months ended September 30, 2013.

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 September 30, 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 was 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:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	728	$	20,313
90+ days delinquent	30,451		39,094
Total delinquent non-accrual loans⁽¹⁾	$	31,179	$	59,407
Accruing loans
30-89 days delinquent	$	—	$	4,153
90+ days delinquent	—		—
Total delinquent accruing loans⁽¹⁾	$	—	$	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 three and nine months ended September 30, 2013 and 2012 was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Balance as of beginning of period	$	120,493		$	133,359		$	117,273		$	153,631
Charge offs:
Commercial and industrial	(1,065		)	(20,043		)	(5,156		)	(48,984		)
Real estate	(983		)	(2,548		)	(2,116		)	(10,264		)
Real estate - construction	—			(499		)	(229		)	(9,784		)
Total charge offs	(2,048		)	(23,090		)	(7,501		)	(69,032		)
Recoveries:
Commercial and industrial	363			2,818			3,482			7,865
Real estate	73			4,772			360			5,046
Real estate - construction	—			—			—			—
Total recoveries	436			7,590			3,842			12,911
Net charge offs	(1,612		)	(15,500		)	(3,659		)	(56,121		)
Charge offs upon transfer to held for sale	(2,678		)	(188		)	(14,748		)	(1,447		)
Loan and lease loss provision (recovery):
General	831			(5,742		)	2,584			(20,366		)
Specific	(1,900		)	14,701			13,684			50,933
Total loan and lease loss (recovery) provision	(1,069		)	8,959			16,268			30,567
Balance as of end of period	$	115,134		$	126,630		$	115,134		$	126,630
Allowance for loan and lease losses ratio	1.8		%	2.2		%	1.8		%	2.2		%
Loan and lease loss (recovery) provision as a percentage of average loans outstanding (annualized)	(0.1		)%	0.6		%	0.3		%	0.7		%
Net charge offs as a percentage of average loans outstanding (annualized)	0.3		%	1.0		%	0.4		%	1.3		%

Our allowance for loan and lease losses decreased by $2.2 million to $115.1 million as of September 30, 2013 from $117.3 million as of December 31, 2012. This decrease was comprised of a $2.6 million increase in general reserves and a $4.8 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 is due to previously recorded specific provisions being charged off or reversed and a lower amount of new specific provisions. 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 trends.

Impaired loans

We employ a formal quarterly process to both identify impaired loans and record appropriate specific reserves based on available collateral and other borrower-specific information. We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due according to the contractual terms of the original loan agreement. In this regard, impaired loans include those loans where we expect to encounter a significant delay in the collection of, and/or shortfall in the amount of contractual payments due to us as well as loans that we have assessed as impaired, but for which we ultimately expect to collect all payments. Each quarter, we determine each impaired loan's fair value. The fair value is either i) the present value of payments expected to be received discounted at the loan's effective interest rate, ii) the fair value of the collateral for collateral dependent loans, or iii), the impaired loan's observable market price. Each impaired loan's fair value is compared to the recorded investment in the impaired loan. If a shortfall exists, a specific reserve is established. The specific reserves in place at each period end are directly related to the population of impaired loans in place at each period end.

As of September 30, 2013 and December 31, 2012, our non-impaired and impaired loan balances were as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	6,466,186		$	5,986,768
General reserves allocated	113,373			110,790
Effective reserve %	1.8		%	1.9		%
Impaired loans
Unpaid principal balance	$	119,399		$	206,090
Specific reserves allocated⁽¹⁾	1,761			6,483
Original legal balance previously charge off⁽²⁾	88,958			162,462
Total cumulative charge offs and specific reserves	90,719			168,945
Legal balance	240,648			407,147
Expected total loss of the legal balance (%)	37.7		%	41.5		%

_______________________________________

(1)

The decrease in specific reserves from December 31, 2012 to September 30, 2013 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $4.0 million, ii) reversals of specific reserves for loans impaired as of December 31, 2012 net of related reversals or charge offs of $1.4 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the nine months ended September 30, 2013 of $0.6 million. The specific reserves in place at September 30, 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 measure 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 September 30, 2013 and December 31, 2012, the ratio was 21.8% and 32.2%, respectively.



	September 30, 2013			December 31, 2012
	($ in thousands)
Substandard loans and associated unfunded commitments	$	245,094		$	355,883
REO and foreclosed assets	14,499			25,772
Substandard investment securities	31,876			26,250
Total classified items	$	291,469		$	407,905

Tier 1 capital	$	1,222,484		$	1,150,770
Allowance for loan and lease losses	115,134			117,273
Total Tier 1 capital plus allowance for loan and lease losses	$	1,337,618		$	1,268,043

Adversely classified items coverage ratio	21.8		%	32.2		%

CapitalSource Bank Segment

As of September 30, 2013 and December 31, 2012, the Bank segment included:



	September 30, 2013			December 31, 2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	180,261		$	230,305
Investment securities, available-for-sale	879,696			1,052,775
Investment securities, held-to-maturity	122,262			108,233
Loans held for sale	10,503			—
Loans held for investment, net⁽²⁾	6,397,882			5,618,810
Allowance for loan and lease losses	(105,549		)	(98,905		)
Interest receivable	24,069			24,598
Other investments⁽³⁾	22,134			22,795
Goodwill	173,135			173,135
Deferred tax assets, net	(19,677		)	3,492
FHLB SF stock	32,430			28,200
Other assets	195,165			206,463
Total	$	7,912,311		$	7,369,901
Liabilities:
Deposits	$	6,051,411		$	5,579,270
FHLB SF borrowings	590,000			595,000
Other borrowings	86,903			85,179
Total	$	6,728,314		$	6,259,449

__________________________


(1)	As of September 30, 2013 and December 31, 2012, the amounts include restricted cash of $43.6 million and $48.2 million, respectively.


(2)	Includes deferred loan fees and discounts.


(3)	Includes 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. Treasury and agency securities. The Bank pledges a portion of its investment securities, available-for-sale, to the State of California as collateral for deposits the state has with the Bank as of September 30, 2013. For additional information, see Note 4, Investments, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2013.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists primarily of investment-grade rated commercial mortgage-backed securities and collateralized loan obligations. During the nine months ended September 30, 2013, we sold one CMBS with a net carrying value of $6.2 million and realized a net gain of $0.2 million. The Company decided to sell the security because its rating was downgraded to B. We did not sell any held-to-maturity investments during the three months ended September 30, 2013. The Bank pledges a portion of its investment securities, held-to-maturity, to the FHLB SF and the FRB as a source of borrowing capacity. For additional information on our investment securities, held-to-maturity, see Note 4, Investments, in our accompanying consolidated financial statements for the three and nine months ended September 30, 2013.

Loan Portfolio Composition

As of September 30, 2013 and December 31, 2012, the composition of the Bank loan portfolio by loan type was as follows:



	September 30, 2013				December 31, 2012
	($ in thousands, except percentages)
Commercial and industrial	$	3,574,367	56	%	$	3,137,863	56	%
Real estate	2,768,133		43	%	2,446,914		43	%
Real estate - construction	55,382		1	%	34,033		1	%
Total⁽¹⁾	$	6,397,882	100	%	$	5,618,810	100	%

_________________________


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

As of September 30, 2013, the scheduled maturities of the 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 and industrial	$	168,708	$	2,535,718	$	869,941	$	3,574,367
Real estate	160,594		1,539,193		1,068,346		2,768,133
Real estate - construction	—		34,790		20,592		55,382
Total loans⁽¹⁾	$	329,302	$	4,109,701	$	1,958,879	$	6,397,882

_______________________


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

As of September 30, 2013 and December 31, 2012, approximately 80% and 81%, respectively, of the Bank accruing adjustable rate portfolio was subject to an interest rate floor. Due to low market interest rates as of September 30, 2013 and December 31, 2012, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on accruing loans was 0.91% and 1.00% as of September 30, 2013 and December 31, 2012, respectively. To the extent the underlying indices subsequently increase, the Bank's interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.

As of September 30, 2013, the composition of the Bank loan balances by adjustable rate index and by loan type was as follows:



	Loan Type						Total		Percentage
	Commercial and industrial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	1,397,223	$	1,313,071	$	34,790	$	2,745,084	43	%
2-Month LIBOR	36,259		—		—		36,259		1
3-Month LIBOR	1,064,524		157,780		—		1,222,304		19
6-Month LIBOR	53,291		80,037		—		133,328		2
6-Month EURIBOR	—		4,030		—		4,030		—
Prime	288,747		217,026		20,592		526,365		8
Other	44,826		45,085		—		89,911		1
Treasuries	—		23,567		—		23,567		—
Total adjustable rate loans	2,884,870		1,840,596		55,382		4,780,848		74
Fixed rate loans⁽¹⁾	671,553		905,206		—		1,576,759		25
Loans on non-accrual status	17,944		22,331		—		40,275		1
Total loans⁽²⁾	$	3,574,367	$	2,768,133	$	55,382	$	6,397,882	100	%

_____________________


(1)	Includes $725.2 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 September 30, 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 September 30, 2013.

Deposits

As of September 30, 2013 and December 31, 2012, a summary of the Bank's deposits by product type and the maturities of the certificates of deposit were as follows:



	September 30, 2013			December 31, 2012
	Balance		Weighted Average Rate	Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	259,434	0.45%	$	257,961	0.49%
Savings	659,924		0.47%	704,890		0.52%
Certificates of deposit	5,132,053		0.97%	4,616,419		0.94%
Total interest-bearing deposits	$	6,051,411	0.89%	$	5,579,270	0.87%



	September 30, 2013
	Balance		Weighted Average Rate
	($ in thousands)
Remaining maturity of certificates of deposit:
0 to 3 months	$	1,850,546	0.90%
4 to 6 months	933,981		0.88%
7 to 9 months	765,976		0.96%
10 to 12 months	1,065,989		1.01%
Greater than 12 months	515,561		1.29%
Total certificates of deposit	$	5,132,053	0.97%

FHLB SF Borrowings

FHLB SF borrowings decreased to $590.0 million as of September 30, 2013 from $595.0 million as of December 31, 2012. The primary reason for using FHLB SF borrowings as a funding source is to manage interest rate risk and the secondary reason is to provide a source of liquidity. The weighted-average remaining maturities of the borrowings were approximately 2.6 and 3.2 years as of September 30, 2013 and December 31, 2012, respectively.

As of September 30, 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	$	80,000	1.55%
After 1 year through 2 years	92,500		1.89%
After 2 years through 3 years	204,000		2.04%
After 3 years through 4 years	128,000		1.31%
After 4 years through 5 years	48,000		2.07%
After 5 years	37,500		1.78%
Total	$	590,000	1.78%

Credit Quality and Allowance for Loan and Lease Losses

Non-performing loans

The outstanding unpaid principal balances of non-performing loans in the Bank loan portfolio as of September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
Commercial and industrial	$	17,944	$	32,187
Real estate	22,331		9,814
Real estate - construction	—		—
Total loans on non-accrual	$	40,275	$	42,001
Accruing loans contractually past-due 90 days or more
Commercial and industrial	$	—	$	—
Real estate	—		—
Real estate - construction	—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	—
Total non-performing loans
Commercial and industrial	$	17,944	$	32,187
Real estate	22,331		9,814
Real estate - construction	—		—
Total non-performing loans⁽¹⁾	$	40,275	$	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 September 30, 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 was 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:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	727	$	20,253
90+ days delinquent	1,959		6,907
Total delinquent non-accrual loans	$	2,686	$	27,160
Accruing loans
30-89 days delinquent	$	—	$	4,153
90+ days delinquent	—		—
Total delinquent accruing loans	$	—	$	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 three and nine months ended September 30, 2013 and 2012 was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Balance as of beginning of period	$	104,979		$	101,784		$	98,905		$	94,650
Charge offs:
Commercial and industrial	6			(7,687		)	(1,763		)	(9,786		)
Real estate	(869		)	(874		)	(2,102		)	(7,091		)
Total charge offs	(863		)	(8,561		)	(3,865		)	(16,877		)
Recoveries:
Commercial and industrial	27			188			320			955
Real estate	73			4,751			359			4,962
Total recoveries	100			4,939			679			5,917
Net charge offs	(763		)	(3,622		)	(3,186		)	(10,960		)
Charge offs upon transfer to held for sale	(897		)	—			(2,608		)	—
Loan and lease loss provision (recovery):
General	745			2,242			7,669			5,567
Specific	1,485			(1,969		)	4,769			9,178
Total loan and lease loss provision (recovery)	2,230			273			12,438			14,745
Balance as of end of period	$	105,549		$	98,435		$	105,549		$	98,435
Allowance for loan and lease losses ratio	1.6		%	1.9		%	1.6		%	1.9		%
Loan and lease loss provision as a percentage of average loans outstanding (annualized)	0.1		%	—		%	0.3		%	0.4		%
Net charge offs as a percentage of average loans outstanding (annualized)	0.1		%	0.3		%	0.1		%	0.3		%

Our allowance for loan and lease losses increased by $6.6 million to $105.5 million as of September 30, 2013 from $98.9 million as of December 31, 2012. This increase was comprised of a $7.7 million increase in general reserves and a $1.1 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 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 September 30, 2013 and December 31, 2012, our non-impaired and impaired loan balances were as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	6,402,311		$	5,607,591
General reserves allocated	104,743			97,074
Effective reserve %	1.6		%	1.7		%
Impaired loans
Unpaid principal balance	$	41,184		$	58,947
Specific reserves allocated⁽¹⁾	806			1,831
Original legal balance previously charge off⁽²⁾	34,739			39,941
Total cumulative charge offs and specific reserves	35,545			41,772
Legal balance	80,149			103,936
Expected total loss of the legal balance (%)	44.3		%	40.2		%

__________________________________

(1)

The decrease in specific reserves from December 31, 2012 to September 30, 2013 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $0.3 million, ii) reversals of specific reserves for loans impaired as of December 31, 2012 net of related additions or charge offs of $1.4 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the nine months ended September 30, 2013 of $0.6 million. The specific reserves in place at September 30, 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 the Bank's July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. For the year ended December 31, 2012, there were no charge offs related to these loans. However, for the years ended December 31, 2011 and 2010, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception comprised, 71.0% and 93.0%, respectively, of those years' charge offs. Due to the severity of charge offs in this category in 2011 and 2010, we did record net recoveries of $9.3 million for the year ended December 31, 2012. As of September 30, 2013 and December 31, 2012, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception totaled $48.4 million and $53.7 million, respectively, or 0.8% and 1.0% of total loans, respectively.

Troubled Debt Restructurings

During the three and nine months ended September 30, 2013, loans with an aggregate carrying value of $2.1 million and $6.9 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and nine months ended September 30, 2012, loans with an aggregate carrying value of $70.4 million and $135.3 million, respectively, as of their respective restructuring dates, were involved in TDRs. 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 was $0.7 million of specific reserves allocated to loans that were involved in TDRs as of September 30, 2013 and December 31, 2012.

Certain TDRs are the product of a workout strategy involving an "A note/ B note" structure, in which the B note component is fully charged off. This workout strategy results in an A note equaling a balance the borrower can service and is underwritten to a loan to value ratio based on the current collateral valuation. The A note may be assigned an internal risk rating of pass based on the revised terms and management's assessment of the borrower's ability and intent to repay. The A note is structured at a market interest rate, and the A note debt service is typically covered by the in-place property operations allowing it to be placed on accrual status. The reduced loan amount induces the borrower to continue to support the loan and maintain the collateral despite the

observed reduction in the collateral value. The B note usually bears no interest or an interest rate significantly below the market rate. The A note contains amortization provisions, and the B note requires amortization only after the full repayment of the A note.

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

All loans that have undergone this A note / B note restructuring are considered TDRs. The A notes are deemed impaired and remain so classified for at least one year from the date of the restructuring. After one year, the A notes are evaluated quarterly to determine if the loan performance has complied with the terms of the TDR such that the impairment classification may be removed. As of September 30, 2013 and December 31, 2012, there were no loans outstanding that have undergone this A note / B note restructuring.

Adversely Classified Items Coverage Ratio



	September 30, 2013			December 31, 2012
	($ in thousands)
Substandard loans and associated unfunded commitments	$	153,780		$	113,682
REO and foreclosed assets	4,098			6,255
Total classified items	$	157,878		$	119,937

Tier 1 capital	$	1,044,933		$	933,837
Allowance for loan and lease losses	105,549			98,905
Total Tier 1 capital plus allowance for loan and lease losses	$	1,150,482		$	1,032,742

Adversely classified items coverage ratio	13.7		%	11.6		%

Other Commercial Finance Segment

As of September 30, 2013 and December 31, 2012, the Other Commercial Finance segment included:



	September 30, 2013			December 31, 2012
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	310,831		$	172,825
Investment securities, available-for-sale	31,876			26,250
Loans held for sale	3,474			22,719
Loans held for investment, net⁽²⁾	141,296			520,420
Allowance for loan and lease losses	(9,585		)	(18,368		)
Interest receivable	744			4,514
Other investments⁽³⁾	32,637			37,568
Deferred tax assets, net	292,041			359,864
Other assets	40,645			52,719
Total	$	843,959		$	1,178,511
Liabilities and Shareholders' Equity:
Borrowings	$	411,599		$	587,926
Other liabilities	46,423			78,672
Shareholders' equity	391,088			521,704
Total	$	849,110		$	1,188,302

_________________________


(1)	As of September 30, 2013 and December 31, 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.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale consists of our interests in the 2006-A Trust of $26.2 million, equity securities of $5.5 million and non-agency MBS of $184 thousand as of September 30, 2013.

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 to whom the Parent Company lent.

Loan Portfolio Composition

As of September 30, 2013 and December 31, 2012, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:



	September 30, 2013				December 31, 2012
	($ in thousands except percentages)
Commercial and industrial	$	113,656	80	%	$	456,780	88	%
Real estate	17,672		13		52,653		10
Real estate - construction	9,968		7		10,987		2
Total⁽¹⁾	$	141,296	100	%	$	520,420	100	%

_________________________


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

As of September 30, 2013, the scheduled 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 and industrial	$	103,558	$	10,039	$	59	$	113,656
Real estate	16,585		847		240		17,672
Real estate - construction	9,968		—		—		9,968
Total⁽¹⁾	$	130,111	$	10,886	$	299	$	141,296

____________________________


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

As of September 30, 2013 and December 31, 2012, substantially all 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 September 30, 2013 and December 31, 2012, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on accruing loans was 2.62% and 1.70% as of September 30, 2013 and December 31, 2012, respectively. To the extent the underlying indices subsequently increase, the interest yield on these adjustable rate loans will not rise as quickly due to the effect of the interest rate floors.

As of September 30, 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 and industrial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	40,864	$	20	$	—	$	40,884	29	%
2-Month LIBOR	10		—		—		10		—
3-Month LIBOR	3,745		1,007		—		4,752		3
6-Month LIBOR	—		20		—		20		—
Prime	24,579		9		—		24,588		17
Other	16		—		—		16		—
Total adjustable rate loans	69,214		1,056		—		70,270		49
Fixed rate loans	18		7		—		25		—
Loans on non-accrual status	44,424		16,609		9,968		71,001		51
Total loans⁽¹⁾	$	113,656	$	17,672	$	9,968	$	141,296	100	%

_____________________________


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

Shareholders' Equity

Shareholders' equity decreased by $130.6 million from December 31, 2012 to September 30, 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 nine months ended September 30, 2013. As a result of entering into the Merger Agreement, the Stock Repurchase Program has been suspended.

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 September 30, 2013 and December 31, 2012 were as follows:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
Commercial and industrial	$	44,424	$	47,213
Real estate	16,609		17,061
Real estate - construction	9,968		10,987
Total loans on non-accrual	$	71,001	$	75,261
Accruing loans contractually past-due 90 days or more
Commercial and industrial	$	—	$	—
Real estate	—		—
Real estate - construction	—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	—
Total non-performing loans
Commercial and industrial	$	44,424	$	47,213
Real estate	16,609		17,061
Real estate - construction	9,968		10,987
Total non-performing loans⁽¹⁾	$	71,001	$	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:



	September 30, 2013		December 31, 2012
	($ in thousands)
Non-accrual loans
30-89 days delinquent	$	1	$	60
90+ days delinquent	28,492		32,187
Total delinquent non-accrual loans	$	28,493	$	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 three and nine months ended September 30, 2013 and 2012 was as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	($ in thousands)
Balance as of beginning of period	$	15,514		$	31,575		$	18,368		$	58,981
Charge offs:
Commercial and industrial	(1,071		)	(12,356		)	(3,393		)	(39,198		)
Real estate	(114		)	(1,674		)	(14		)	(3,173		)
Real estate - construction	—			(499		)	(229		)	(9,784		)
Total charge offs	(1,185		)	(14,529		)	(3,636		)	(52,155		)
Recoveries:
Commercial and industrial	336			2,630			3,162			6,911
Real estate	—			21			1			83
Total recoveries	336			2,651			3,163			6,994
Net charge offs	(849		)	(11,878		)	(473		)	(45,161		)
Charge offs upon transfer to held for sale	(1,781		)	(188		)	(12,140		)	(1,447		)
Loan and lease loss provision (recovery):
General	86			(7,984		)	(5,085		)	(25,934		)
Specific	(3,385		)	16,670			8,915			41,756
Total loan and lease loss (recovery) provision	(3,299		)	8,686			3,830			15,822
Balance as of end of period	$	9,585		$	28,195		$	9,585		$	28,195
Allowance for loan and lease losses ratio	6.8		%	4.2		%	6.8		%	4.2		%
Loan and lease loss (recovery) provision as a percentage of average loans outstanding (annualized)	(6.4		)%	4.5		%	1.6		%	2.4		%
Net charge offs as a percentage of average loans outstanding (annualized)	5.1		%	6.3		%	5.1		%	7.0		%

Our allowance for loan and lease losses decreased by $8.8 million to $9.6 million as of September 30, 2013 from $18.4 million as of December 31, 2012. This decrease was comprised of a $5.1 million decrease in general reserves and a $3.7 million decrease in specific reserves on impaired loans. The decrease in the general reserve resulted from having a lower amount of unimpaired loans at September 30, 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

As of September 30, 2013 and December 31, 2012, our non-impaired and impaired loan balances were as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Non-impaired loans
Unpaid principal balance	$	63,875		$	379,177
General reserves allocated	8,630			13,716
Effective reserve %	13.5		%	3.6		%
Impaired loans
Unpaid principal balance	$	78,215		$	147,143
Specific reserves allocated⁽¹⁾	955			4,652
Original legal balance previously charged off⁽²⁾	54,219			122,521
Total cumulative charge offs and specific reserves	55,174			127,173
Legal balance	160,499			303,211
Expected total loss of the legal balance (%)	34.4		%	41.9		%

__________________________________


(1)	The decrease in specific reserves from December 31, 2012 to September 30, 2013 stems from loan resolutions of impaired loans with existing specific reserves of $3.7 million. The specific reserves in place at September 30, 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.

In the Other Commercial Finance portfolio, the areas with more credit risk than others are those that have comprised a greater degree of our historical charge offs. For the years ended December 31, 2012, 2011 and 2010, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception comprised 18%, 22% and 48%, respectively, of those years' charge offs. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. As of September 30, 2013 and December 31, 2012, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank's July 2008 inception, totaled $10.4 million and $49.4 million, respectively, or 7.2% and 9.0% of total loans, respectively. Additionally, cash flow based commercial loans originated prior to the Bank's July 2008 inception are considered to be higher risk based on historical charge offs. For the years ended December 31, 2012, 2011 and 2010, cash flow based commercial loans originated prior to the Bank's July 2008 inception comprised 51%, 55% and 40%, respectively, of those years' charge offs. As of September 30, 2013 and December 31, 2012, cash flow based commercial loans originated prior to the Bank's July 2008 inception totaled $56.8 million and $336.6 million, respectively, or 39.0% and 61.2% of total loans, respectively.

Troubled Debt Restructurings

During the three and nine months ended September 30, 2013, loans with an aggregate carrying value of $17.6 million and $76.5 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and nine months ended September 30, 2012, loans with an aggregate carrying value of $2.4 million and $29.2 million, respectively, as of their respective restructuring dates, were involved in TDRs. 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 September 30, 2013 and December 31, 2012.

Liquidity and Capital Resources

We separately manage the liquidity of the 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 the Bank.

As of September 30, 2013, we had $1.0 billion of unfunded commitments to extend credit to our borrowers, of which $980.3 million were commitments of the Bank and $47.9 million were commitments of the Parent Company. Due to their nature, we cannot know with certainty the aggregate amounts we will be required to fund under these unfunded commitments. In many cases, our obligation to fund unfunded commitments is subject to our borrowers' ability to provide collateral to secure the requested additional fundings, 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 fundings 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.

The information contained in this section should be read in conjunction with, and is subject to and qualified by the information set forth in our Risk Factors and the Cautionary Note Regarding Forward Looking Statements in our Form 10-K and in this Form 10-Q.

CapitalSource Bank Liquidity

The Bank's liquidity sources and uses are as follows:

Liquidity Sources


•	Deposits;


•	Payments of principal and interest on loans and securities;


•	Cash and 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 and related interest;


•	Operating expenses;


•	Tax payments and 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 the Bank to meet depositor demands and fund loan commitments and operations as well as to maintain liquidity ratios required by our regulators. The 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 the 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.

Pursuant to agreements with our regulators, to the extent the Bank independently is unable to do so, the Parent Company must maintain the Bank's total risk-based capital ratio at not less than 15% and must maintain the capital levels of the Bank at all times to meet the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. As such, per the Capital Maintenance and Liquidity Agreement ("CMLA"), the Parent Company has provided a $150.0 million unsecured revolving credit facility to the Bank that the Bank may draw on at any time it or the FDIC deems necessary. As of September 30, 2013, there were no amounts drawn or outstanding under this facility. As of September 30, 2013, in connection with the Bank's liquidity risk analysis, we have determined that a draw on this facility would not be required under an adverse stress scenario.

In addition, we have a policy to maintain 7.5% of the 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 the Bank would be able to maintain sufficient liquidity and ratios in excess of its required minimum ratios in these events and scenarios and would not need to borrow from the Parent to cover a shortfall per the CMLA. The Bank has a contingency funding plan which contains the steps the Company would take to mitigate a liquidity crisis.

The Bank's primary source of liquidity is deposits, most of which are in the form of certificates of deposit. As of September 30, 2013, deposits at the 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 5, Deposits, in our accompanying unaudited consolidated financial statements for the three months ended September 30, 2013.

The Bank supplements its liquidity with borrowings from the FHLB SF. As of September 30, 2013, the Bank had financing availability with the FHLB SF equal to 35.0% of the Bank's total assets, or $2.7 billion as of September 30, 2013 and $2.6 billion as of December 31, 2012. The financing is subject to various terms and conditions including pledging acceptable collateral, satisfaction of the FHLB SF stock ownership requirement and certain limits regarding the maximum term of debt. As of September 30, 2013, securities collateral with an estimated fair value of $4.0 million and loans with an unpaid principal balance of $1.0 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 September 30, 2013 and December 31, 2012, the Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:



	September 30, 2013			December 31, 2012
	($ in thousands)
Borrowing capacity	$	892,659		$	841,309
Less: outstanding principal	(590,000		)	(595,000		)
Less: outstanding letters of credit	(150		)	(300		)
Unused borrowing capacity	$	302,509		$	246,009

The Bank participates in the primary credit program of the FRB of San Francisco's discount window under which approved depository institutions are eligible to borrow from the FRB for periods of up to 90 days. As of September 30, 2013, collateral with an estimated fair value of $70.4 million had been pledged under this program, and there were no borrowings outstanding under this program.

The Bank also maintains a portfolio of investment securities. As of September 30, 2013, the Bank had $136.6 million of unrestricted cash and cash equivalents and $879.7 million in 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 the Bank⁽¹⁾;


•	Payments of principal and interest on loans and securities;


•	Asset sales;


•	Dividends from the Bank⁽²⁾;


•	Borrowings from other banks⁽³⁾; and


•	Issuance of debt and equity securities.

Liquidity Uses


•	Interest and principal payments on existing debt;


•	Tax payments;


•	Operating expenses;


•	Debt repurchases and repayments;


•	Dividends;


•	Funding unfunded commitments; and


•	Provide funding to the Bank under the CMLA.

______________________________

(1) Pursuant to our intercompany tax allocation arrangement.

(2) As permitted by banking regulations and guidelines.

(3) Represents secondary sources of funding.

We intend to maintain sufficient liquidity at the Parent Company to pay current quarterly dividends to common stockholders, fund revolving loan balances, make interest payments on trust preferred securities, pay operating expenses and pay certain liabilities. Additionally, 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. Management regularly monitors the liquidity needs of the Parent Company and will implement appropriate strategies, as necessary, to remain adequately capitalized and to meet its cash needs. We regularly assess the amount and likelihood of projected funding requirements through a review of factors such as current and projected market and economic conditions, individual borrower funding needs, and existing and planned business activities. Our Management Asset/Liability Committee (“ALCO”) provides oversight to the liquidity management process and recommends policy guidelines for the approval of our Board of Directors, and courses of action to address our actual and projected liquidity needs.

As discussed, to the extent the Bank independently is unable to do so, the Parent Company must maintain the Bank's total risk-based capital ratio at not less than 15% and must maintain the capital levels of the Bank at all times to meet the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. As such, per the CMLA, the Parent Company has provided a $150.0 million unsecured revolving credit facility to the Bank that the Bank may draw on at any time it or the FDIC deems necessary. As of September 30, 2013, there were no amounts drawn or outstanding under this facility. As of September 30, 2013, in connection with the Bank's liquidity risk analysis, we have determined that a draw on this facility would not be required under a severely adverse stress scenario. Under these scenarios, the Parent Company also has included the ability to offer and sell securities under its shelf registration and the ability to sell assets with pricing for such sales executed under an adverse stress scenario.

Special Purpose Entities

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

We evaluate all SPEs with which we are affiliated to determine whether such entities must be consolidated for financial statement purposes. If we determine that such entities represent VIEs, we consolidate these entities if we also determine that we are the primary beneficiary of the entity. For special purpose entities for which we determine we are not the primary beneficiary, we account for our economic interests in these entities in accordance with the nature of our investments. The assets and related liabilities of all SPEs that we use to issue our term debt are recognized in our accompanying audited consolidated balance sheets as of December 31, 2012. During the nine months ended September 30, 2013, we called the securitizations and repaid the outstanding third-party debt of $177.2 million, resulting in no outstanding securitizations as of September 30, 2013. Upon this extinguishment of debt, we had no assets and no liabilities related to our SPEs on our consolidated balance sheet as of September 30, 2013.

Commitments, Guarantees & Contingencies

As of September 30, 2013 and December 31, 2012, we had committed lending arrangements to our borrowers of approximately $7.8 billion and $7.4 billion of which approximately $1.0 billion were unfunded. As of September 30, 2013 and December 31, 2012, the Bank had total unfunded commitments of $980.3 million and $922.4 million, respectively. As of September 30, 2013 and December 31, 2012, the Parent Company had total unfunded commitments of $47.9 million and $88.5 million, respectively. Our failure to satisfy our full contractual funding commitment to one or more of our borrowers could create a breach of contract, expose us to lender liability claims 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 twelve 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 September 30, 2013 and December 31, 2012, we had issued $43.2 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.

Additional information on these contingencies is included in Note 16, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2012, included in our Form 10-K, and Liquidity and Capital Resources herein.

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 borrowers' financial condition and performance.

Substantially all new loans have been originated at the 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 DBO. 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 Credit Policy Committee of the Bank Board.

We regularly 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 a regular 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 September 30, 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 22.3% and 21.6% of the outstanding loan portfolio, respectively. As of September 30, 2013, general real estate loans were our largest loan concentration by sector and represented approximately 14% of our loan portfolio.

Apart from the borrower industry concentrations, loans secured by real estate represented approximately 44% of our outstanding loan portfolio as of September 30, 2013. Within this area, the largest property type concentration was the multifamily category, comprising approximately 11% of total loans and 26% of loans secured by real estate. The largest geographical concentration was in California, comprising approximately 10% of total loans and 23% of loans secured by real estate.

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 September 30, 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)
$	78,764	1.2	%	Commercial and Industrial and Real Estate	Health Care and Social Assistance	$	79,756	Yes	—	Senior care facilities	n/a	(2)
$	78,764	1.2	%			$	79,756

______________________


(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 $78.8 million as of September 30, 2013 primarily consists of real estate loans to senior care facility owners and operators and senior care facilities that had a total value of $136.8 million as of September 30, 2013. Total senior debt, including our loan balance, secured by the collateral was $101.0 million as of September 30, 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 102 credit relationships in the non-performing portfolio as of September 30, 2013, and our largest non-performing credit relationship totaled $29.8 million and comprised 26.8% of our total non-performing loans.

Derivative Counterparty Credit Risk

2013, the gross positive fair value of derivative financial instruments was $0.6 million. As a result of our master netting arrangements, we had no exposure to this positive fair value as we are in a net liability position as of September 30, 2013.

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 NII for a twelve-month period based on changes in the interest rates applied to the combined portfolios of our segments as of September 30, 2013, were as follows ($ in thousands):



Change in Market Interest Rates (basis points)	Estimated Change in NII
Change in Market Interest Rates (basis points)	Amount			%
+200	$	33,609		9.4	%
+100	10,229			2.9
-100	1,526			0.4
-200	(498		)	(0.1	)

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 September 30, 2013, were as follows ($ in thousands):



Change in Market Interest Rates (basis points)	Estimated Change in EVE
Change in Market Interest Rates (basis points)	Amount			%
+200	$	(65,279	)	(4.0	)%
+100	(39,599		)	(2.4	)
-100	52,176			3.2
-200	74,347			4.6

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 September 30, 2013, approximately 60% 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 September 30, 2013 were as follows:



	Amount Outstanding		Percentage of Total Portfolio
	($ in thousands)
Loans with contractual interest rates:
Below the interest rate floor	$	3,655,516	55.9	%
Exceeding the interest rate floor	11,196		0.2
At the interest rate floor	249,986		3.8
Loans with no interest rate floors	934,420		14.3
Total adjustable rate loans	4,851,118		74.2
Loans on non-accrual	111,276		1.7
Fixed rate loans⁽¹⁾	1,576,784		24.1
Total	$	6,539,178	100.0	%

_______________________________________


(1)	Includes $725.2 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 September 30, 2013.

Critical Accounting Estimates

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. This preparation requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. These policies relate to the allowance for loan and lease losses, fair value measurements, and income taxes. We have established detailed policies and procedures to ensure that the assumptions and judgments surrounding these areas are adequately controlled, independently reviewed and consistently applied from period to period. Management has discussed the development, selection and disclosure of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed our disclosures related to these estimates.

There have been no significant changes during the nine months ended September 30, 2013 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Estimates within Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Form 10-K for the year ended December 31, 2012.

Supervision and Regulation

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.

The following is an update to certain sections from our discussion of Supervision and Regulation in our Form 10-K. For further information and discussion, see Item I. Business - Supervision and Regulation, in our Form 10-K for the year ended December 31, 2012.

In March 2013, the Federal Reserve Board, the FDIC, and the Office of the Comptroller of the Currency ("OCC") issued Final Joint Guidance on Leveraged Lending which outlines for agency-supervised institutions high-level principles related to safe-and-sound leveraged lending activities, including leveraged lending definitions, underwriting considerations, assessing and documenting enterprise value, risk management expectations for credits awaiting distribution, stress-testing expectations, pipeline portfolio management, and risk management expectations for exposures held by the institution. The implementation of this guidance was completed in the third quarter of 2013.

In July 2013, the Federal Reserve Board, FDIC and OCC approved the Basel III Capital Interim Final Rule and Notice of Proposed Rulemaking proposed by the international Basel Committee on Banking Supervision on December 16, 2010. The Interim Final Rule revises regulatory capital definitions and minimum ratios, redefines Tier I capital as two components, creates a new capital ratio, implements a capital conservation buffer, revises prompt corrective action thresholds, and changes risk weights for certain assets and off-balance sheet exposures, among other things. The implementation of these standards is to be phased-in beginning January 2015.

Additionally, in January 2013, the Basel Committee issued two new measures of liquidity risk in addition to capital requirements: the Liquidity Coverage Ratio (the "LCR") and the Net Stable Funding Ratio (the "NSFR"), which are intended to measure, over different time spans, the amount of liquid assets held by the Bank. The objective of the LCR is to promote short-term resilience of the Bank's liquidity risk profile by ensuring that it has sufficient High Quality Liquid Assets ("HQLA") to survive a significant stress scenario lasting for one month. The objective of the NSFR is to promote resilience over a longer time horizon by creating additional incentives for the Bank to fund its activities with more stable sources of funding on an ongoing basis. The implementation of both of these standards is to commence in January 2015 and January 2018, respectively.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain financial market risks, which are discussed in detail in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Market Risk Management section of this Form 10-Q and our Form 10-K. In addition, for additional information on our derivatives, see Note 13, Derivative Instruments, in our consolidated financial statements for the three and nine months ended September 30, 2013, and Note 19, Credit Risk, in our audited consolidated financial statements for the year ended December 31, 2012 included in our Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2013. There have been no changes in our internal control over financial reporting during the three and nine months ended September 30, 2013, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1A. RISK FACTORS

On July 23, 2013, the Parent Company announced that it had entered into a Merger Agreement with PacWest. In connection with the execution of the Merger Agreement, the Parent Company has supplemented the risk factors previously disclosed in the Parent Company's Annual Report on Form 10-K as follows:

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 connection with the Merger Agreement, the Company has also granted a stock option to PacWest which permits PacWest, under certain circumstances relating to third party acquisition transactions involving the Company, to purchase up to 39,191,656 shares of the Company's common stock, or to surrender the option for $91 million, subject to adjustment as provided in the stock option agreement. These provisions 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.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

A summary of our repurchases of shares of our common stock for the three months ended September 30, 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⁾
July 1 - July 31, 2013	106,951	$	11.92	—
August 1 - August 31, 2013	153,700	11.86		—
September 1 - September 30, 2013	163,131	11.75		—
Total	423,782	$	11.83	—	$	86,490,728

__________________________


(1)	Includes the number of shares acquired as payment by employees of applicable statutory minimum withholding taxes owed upon vesting of restricted stock granted under our Third Amended and Restated Equity Incentive Plan.

(2)

In December 2010, our Board of Directors authorized the repurchase of $150.0 million of our common stock over a period of up to two 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 has been suspended.

ITEM 5. OTHER INFORMATION

On October 30, 2013, the Bank filed its Consolidated Reports of Condition and Income for A Bank With Domestic Offices Only - FFIEC 041, for the quarter ended September 30, 2013 (the “Call Report”) with the Federal Deposit Insurance Corporation.

ITEM 6. EXHIBITS


(a)	Exhibits

The Index to Exhibits attached hereto is incorporated herein by reference.

Signatures

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



	CAPITALSOURCE INC.

Date: November 1, 2013	/s/ JAMES J. PIECZYNSKI
	James J. Pieczynski
	Director and Chief Executive Officer (Principal Executive Officer)

Date: November 1, 2013	/s/ JOHN A. BOGLER
	John A. Bogler
	Chief Financial Officer (Principal Financial Officer)

Date: November 1, 2013	/s/ MICHAEL A. SMITH
	Michael A. Smith
	Senior Vice President and Chief Accounting Officer (Principal Accounting Officer)

INDEX TO EXHIBITS



Exhibit No	Description
3.1	Second Amended and Restated Certificate of Incorporation (composite version; reflects all amendments through May 1, 2008) (incorporated by reference to exhibit 3.1 to the Form 10-Q filed by CapitalSource on May 12, 2008).
3.2	Amended and Restated Bylaws (composite version; reflects all amendments through February 16, 2011) (incorporated by reference to exhibit 3.1 to the Form 8-K filed by CapitalSource on February 18, 2011).
12.1	Ratio of Earnings to Fixed Charges.†
31.1	Rule 13a - 14(a) Certification of Chief Executive Officer.†
31.2	Rule 13a - 14(a) Certification of Chief Financial Officer.†
32	Section 1350 certifications.†
101.INS	XBRL Instance Document†
101.SCH	XBRL Taxonomy Extension Schema Document†
101.CAL	XBRL Taxonomy Calculation Linkbase Document†
101.LAB	XBRL Taxonomy Label Linkbase Document†
101.PRE	XBRL Taxonomy Presentation Linkbase Document†
101.DEF	XBRL Taxonomy Definition Document†


†	Filed herewith.


*	Management contract or compensatory plan or arrangement.