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Executives

Dennis Oakes - VP, IR

John Delaney - Chairman and CEO

Dean Graham - President and COO

Don Cole - CFO

Tad Lowrey - President and CEO of Capital Source Bank.

Analysts

John Hecht - JMP Securities

Andrew Wessel - JPMorgan

Don Fandetti - Citi

Sameer Gokhale - Keefe, Bruyette & Woods

Michael Taiano - Sandler O’Neill

Scott Valentin - FBR Capital Markets

Bob Napoli - Piper Jaffray

CapitalSource Inc. (CSE) Q1 2009 Earnings Call Transcript May 7, 2009 8:00 AM ET

Operator

Welcome to the CapitalSource First Quarter 2009 Earnings Conference Call. All participants will be in a listen-only mode. (Operator instructions) Please note this conference is being recorded.

Now I would like to turn the conference over to Dennis Oakes, Vice President of Investor Relations. Mr. Oakes you may begin.

Dennis Oakes

Thank you. Good morning, everyone and thanks for joining the CapitalSource first quarter results and company update call.

Joining me this morning are John Delaney, our Chairman and CEO; Dean Graham, our President, and Chief Operating Officer; and Don Cole, our Chief Financial Officer; and Tad Lowrey, President and CEO of Capital Source Bank.

The call is being broadcast live on our website and a recording will be available beginning at approximately 12:00 noon today. Our earnings press release and website provide details on accessing the archived call. We have also posted some slides on our website to provide additional detail on certain topics, which will be referred to during our prepared remarks and those slides are up on the site now.

Investors are urged to read the forward-looking statements language in our earnings release, but essentially, it says that statements made on this call, which are not historical facts may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

All forward-looking statements, including statements regarding future financial operating results and outlook, involve risks, uncertainties and contingencies, many of which are beyond the control of CapitalSource and which may cause actual results to differ materially from anticipated results.

CapitalSource is under no obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise, and we expressly disclaim any obligation to do so. More detailed information about risk factors can be found in our reports filed with the SEC.

John Delaney is up first this morning. John?

John Delaney

Thanks, Dennis and good morning everyone. As I described in our fourth quarter earnings call in February, we have a two-pronged strategy with play offense and some play defense components to manage our business through these challenging economic times.

Our results this quarter are largely as we expected and represent progress on both fronts. Since the first of the year, we have met our liquidity needs including redemption of $180 million in convertible debt, while maintaining adequate cash levels and taking steps to supplement normally, quarterly cash generation.

Reduced the levels of charge-offs by roughly one-third compared to the fourth quarter, while keeping our reserves in a prudent level, equal to roughly 4.3% of total commercial lending assets and 5.9% of parent company loans.

We wrote our corporate reach status and sold the agency RMBS portion of our related compliance portfolio; initiated the process of renewing our credit facilities and extending their durations to better match the scheduled maturities of the underlying loans.

Funded 200 million of new loans at CapitalSource Bank, prior to March 31 with an average spread of 780 basis points over month LIBOR, including coupon interest and fees. Produced first quarter net investment income of $150 million, despite a significant decline in one-month LIBOR, which is the benchmark for most of our borrowing and lending outside of deposits. That decline had a reduced impact on interest income as nearly 50% of our loans had in the money interest rate floors, though we had a breakeven quarter CapitalSource Bank despite a $25 million increase in loan loss provisions.

I will spend time this morning providing a detailed look at credit performance, an update on renewals of our bank lines and a review of sources and uses of cash in the quarter. Next Dean Graham will share the results of our own portfolio stress testing using the Treasury Department guidance and he will review the commentary we provided in February.

Our new CFO, Don Cole will review the numbers and key earnings drivers in the quarter, provide new disclosure about the characteristics of loans in our securitizations and credit facilities, so investors can better value those assets and he will explain the new reporting segments established to best reflect our current operating structure. Tad Lowrey will then speak about results of CapitalSource Bank and I will conclude with an updated view of the four components of our business, as we continue to believe the market is not fully appreciated true value of the CapitalSource enterprise.

Aggressively managing our credit book is the top priority of our play defense strategy, with a necessary caveat that one quarter does not constitute to trend, we did see some modest re-encouraging signs in the first quarter, including a substantial decline in charge-offs from a $184 million in the fourth quarter to $124 million in the first quarter, and a dramatic decline in incremental provisions for loan losses from $445 million in fourth quarter to $155 million this quarter.

We are maintaining a conservative view of future performance however, and have written a number of loans down to liquidation value over the past three quarters. We saw significant increases this quarter, non-accrual delinquencies and impaired loans, which is why among other reasons we continue to maintain a cautious outlook on credit.

Not concerned if the increases were not surprising. Importantly, because we are now seeing more asset-based loans and real estate loans migrating to these categories, recovery should be much higher than recoveries for cash flow loans not secured by hard assets. Additionally, we saw significant decline in 30 to 89 day delinquencies from 2.75% of commercial lending assets at December 31, to 1.21% at March 31.

At a 20,000 foot level, we observed the following trends. Stabilization in the number of non-performing loans associated with our cash flow financing, which accounted for 47% of charge-offs in the quarter, compared to 53% in the prior quarter.

A clear bifurcation has emerged between the portion of our rediscount or lender financed business associated with residential mortgage finance, with eight of our loans in that portion of the portfolio, now in the impaired category, while the balance of the rediscount business continues to perform very well.

The residential mortgage category accounts for about $250 million of loans, against which we have already taken credit charges including specific and general reserves of $30.9 million. The remainder of the rediscount book is 1.75 billion and at quarter end, they were less than 1% delinquencies there.

Many observers have wondered how long commercial real estate could hold up, as residential real estate was deteriorating. In the first quarter, softness in the commercial real estate market became more pronounced, due to the current recessionary pressures and the dearth of available financing in the industry.

We recognize $29 million of charge-offs from commercial real estate in the quarter and also had REO losses of $16.1 million.

Our policy reserve level for the non-healthcare commercial real estate loans and our legacy book is 5.8%. So we have already set aside that level of reserves for the entire non-bank to CRE portfolio. We also expect our commercial real estate losses to be mitigated by the fact that we underwrote them based on loan to cost, not loan to value, which provides for greater alignment with our clients and less cap rate dependency, which we believe will lead to relatively greater recoveries.

Our commercial mortgage loans were designed to be intermediate bridge loans typically two to three years until the underlying properties were rehabilitated or otherwise stabilized, sold and/or refinanced but take-out options are obviously limited in today’s market. Until such time as permanent financing once again becomes reasonably available, we expect to extend performing real estate loans by an average of 18 to 24 months with sponsors contributing cash, additional collateral, and other structural enhancements on top of higher pricings.

To be clear, we view the lack of financing available in the commercial real estate industry and the corresponding declining asset values with real concern, and the situation should not be sugarcoated. We like others who are estimating the levels and timing of stabilization for this asset class, and our comments should be viewed with that caveat in mind.

Diving a bit deeper on the commercial real estate portfolio is instructive. Our total current book of 86 loans totals approximately $1.8 billion in commercial real estate with $287 million on non-accrual. We currently have specific reserves on the commercial real estate book of $29 million on top of the 5.8% policy reserves on the entire portfolio, I mentioned a moment ago.

About 50% of the portfolio is either in non recourse securitizations or non-recourse credit facilities; 34% is in CapitalSource Bank or 16% pledge to our syndicated credit facilities. We have only one significant geographic concentration Manhattan, which represent about 25% of our commercial real estate loans by dollar amount, 91% of those are performing.

Finally, as has been the case since CapitalSource was founded, our healthcare real estate and healthcare credit businesses had virtually no losses in the quarter. Only one loan accounted for $1.6 million of charge-offs. There are no loans in our security business on non-accrual and no charge-offs associated with that business, which is approximately $485 million.

As I mentioned on the fourth quarter 2008 earning call, our actions in recent quarters to boost reserves both specific and policy reserves were designed to identify and ring fence our problem assets, which are principally in our legacy loan portfolio. The significant decline in charge-offs and reserves this quarter are early indicators that we are making progress to that goal.

In the quarter, we added a net $8 million to specific reserves and $13 million to our policy reserves. The $124 million charged-off in the quarter was a decline of about one-third from the fourth quarter level. But it is too early to be certain this is indicative of a downward trend in charge-offs.

Forty one loans were charged-off in the quarter from a total pool of 1055 and the five largest charge-offs accounted for 34% of the total. Approximately 47% of charged-offs were for cash flow loans, 23% for commercial real estate, 27% for rediscount and 1% for healthcare.

The cash flow loans written-off in the quarter included 21 loans totaling approximately $58.5 million. The two largest charge-offs totaled $17.5 million, the two largest commercial real estate charge-offs totaled $12 million. The rediscount losses were $32.4 million and were related to mortgage lenders impact by the ongoing deterioration of residential real estate.

About 40% of charge-offs in the quarter were loans made between 2003 and 2005 and about 60% were made between 2006 and 2007. We expect the pattern we saw this quarter to extend for at least the next couple of quarters that is a continued deterioration of commercial real estate with a level of relative stability in the rest of our book.

We continue to believe that our senior position in 98% of our commercial real estate loans and still relatively manageable LTVs across our entire portfolio will result in a performance that will be somewhat better than the broader commercial real estate market.

Turning now to a second principle of our three different strategy; we are very focused on making substantial progress towards our goal of match funding as closely as possible, substantially all of the assets in our commercial loan portfolio. At quarter end, approximately 45% of our $9.3 billion of commercial loans were funded in sixth non-recourse securitizations.

31% were in CapitalSource Bank and funded with deposits, which effectively provide permanent financing and the remaining 24% were pledged to bank credit facilities. About two weeks ago, we announced that the first of our six credit facilities had been renewed with three year term and the capacity to draw an additional $50 million to fund unfunded commitments.

We are working with our lenders to extend the duration of our other facilities, including CS funding frame, which had an outstanding principle balance of $81 million at March 31. QRS Funding I, which had an outstanding balance of $15 million and CS Europe, which had an outstanding balance of $159 million.

We hope to have those discussions concluded within the next several weeks. By extending the terms of these facilities to more closely match the duration of their assets, we intend to eliminate short-term liquidity needs relating to these facilities.

Briefly overviewing our sources and uses of cash, particularly in the second quarter. Our available cash today is $175 million outside the substantial cash and CapitalSource Bank, after paying down $25 [billion] earlier this week on the syndicated bank facility. During the second quarter, we expect to have fairly limited cash uses outside of the bank.

We have reduced the commitment amount on our syndicated facility from $1.07 billion to $970 million and we will make an additional $70 million step down in commitment by June 30th. We also plan to fund any unfunded commitments drawn by our borrowers.

Our expected sources in the second quarter include initial proceeds from HUD financing of certain of our net lease properties. We have applied for appropriately $93 million of HUD financing and are in the process of applying for an additional $25 million.

We will receive proceeds as mortgages close on each individual property, the initial phase, which we expect to begin in June. We also continue to look at other methods for further monetizing the net lease assets, including sales. Also, any REO or loan sales and loan payoffs will provide further liquidity in the quarter.

In addition to reviewing our performance in the quarter, we thought it would be useful today to address two key questions, we believe in increasing number of investors, US critical considerations, when making a decision about owning a bank or financial institution.

The first question is, does the institution have enough capital to withstand a stress scenario? Answering that question requires an examination of starting capital levels and pre-provision profits that buffer additional provisions.

The second question is, how strong will be institutions’ pre-provision profits be, when the current recession is behind us? Put in another way when all the losses inherent in the system today are ultimately realized, which they will be. Does the entity have a valuable and strong earning stream?

Most telling indicator to answer that question is the net interest margin at present and the potential for the institution to grow its margins over the next several years in today's very attractive lending market.

As Dean will explain to you in more detail now, we believe we have both sufficient capital to weather this storm and meaningful pre-provision profit today to cushion for the loan-losses. In addition, we expect to be able to grow capital over the next three years as well as expand profitability as we deploy the excess liquidity at CapitalSource Bank into high margin loans and investment opportunities, while at the same time reducing our funding cost.

So with that I'll turn it over to Dean.

Dean Graham

Thanks John. As we indicated on our February call, we performed a shock analysis on the entire portfolio at year end 2008. In order to inform our reserving and to realistically access how bad things might get, we examined past recessionary periods and applied that experience to current economic conditions.

More recently, we asked an independent third party to conduct an additional analysis during the stress test performed by the Federal Reserve on major US banks. The institution we retained was actually one of the 19 banks examined, so they had access to the details of the government tests.

Adopting the approach, the federal government used regarding credit performance, including application of the treasury downside scenario, which is harsher than the current economic consensus, they stressed our entire portfolio. The assumptions were applied to all loans originated before CapitalSource Bank opened in the third quarter of 2008, based on balances and net charge-offs at March 31, 2009.

Applying these assumptions CapitalSource would pass the test of maintaining capital levels at the end of 2010 that are roughly equal to current tangible common equity levels of $2.6 billion. In fact, our internal projections suggest book equity could be meaningfully higher in three years at the end of 2011, even under an elevated stress of scenario.

Our pre-provision income in the first quarter was $150 million. As our CapitalSource Bank President Tad Lowrey will describe, we continue to see excellent opportunities to deploy the liquidity we have at the bank at very attractive spreads.

The low yielding, “A” participation interest and excess cash on the bank balance sheet are currently constraining our profitability. Similarly, the higher cost of funding our legacy loans and credit facilities over the next three years is affecting our margins on a consolidated basis.

As more and more of our assets are in the bank and more of the bank capital is deployed at higher yields, our already respectable margin should increase significantly over the next three to five years, particularly as credit issues fade along with the recession.

Next, I want to review some of the key financial metrics, I spoke about on our fourth quarter call in February. We felt it was appropriate today to update those numbers, as we now have the first quarter behind us.

We expect total commercial assets, which include loans, loans held for sale, “A” participation interest, our sale of lease back assets and related accrued interest to average $11.4 billion during the year. They were $11.4 billion in the first quarter and we expect a modest increase during the year, as loans in the band grow somewhat faster than the expected reduction in “A” participation interest.

Excluding the A participation interest, we previously indicated commercial assets would average $10.6 billion for the year. They stood at $10.3 billion at the end of the first quarter. Those are $200 million of loans funded in the first quarter our CapitalSource Bank, a shy of the run rate needed to achieve our expected full year loan growth target of $1.4 billion. We are still comfortable with that level of new loans by year-end, which would result in the expected level of average commercial assets.

Our pipeline is strong and approximately $262 million of loan commitments were approved at the bank, but not funded in the quarter. Our previous full year estimate of $925 million to $975 million of interest fee and operating lease income, excluded the RMIP portfolio because we knew the agency RMBS in our compliant portfolio would be sold in January.

First quarter interest fee and operating lease income of $281 million, includes approximately $31 million of interest earned from our residential mortgage assets. Including the Owners Trust, which is now part of the other commercial finance segment, we now estimate full year consolidated interest fee and operating lease income will be in the range of $1 billion to $1.1 billion.

Likewise, our interest expense in the quarter of $131 million included $23 million of interest expense for the agency RMBS prior to their sale and the Owners Trusts. We now estimate that full year consolidate interest expense will be $475 million to $500 million. Net investment income this quarter of $150 million was at the top of our previous estimate of $525 million to $600 million for the year.

Run rate operating expenses of $63 million excluding depreciation and amortization and a one-time charge are consistent with our expectations of quarterly operating expenses of approximately $60 million. About 40% of those expenses are for the operation of CapitalSource Bank.

As John mentioned, charge-offs of $124 million in the first quarter were consistent with our full year projection of total charge-offs in the range of $300 million to $400 million. Since we expected the first quarter to be the highest level for charge-offs with a modest decline throughout the year.

Loan loss provisions of $155 million were higher than we anticipated. We continue to be conservative and I believe realistic in our reserve assumptions. However, so we have rebuilt the reserves this quarter to a level somewhat higher than charge-offs.

As expected, excluding the book loss on the convertible debt conversion, we saw less volatility in the other income lines for the quarter. Of course, the greatest volatility over the last three years has been in connection with the agency portion of our residential mortgage investment portfolio, which has been sold. Any foreign exchange gains or losses and investment gains and losses will however, continue to flow through other income in future quarters.

Don Cole will now provide his insights on the quarter.

Don Cole

Thanks Dean. Let me begin by explaining some of the changes you will see in the format of our financial reporting this quarter. Specifically, we have modified our segment disclosure to reflect the way we are viewing the business going forward.

We still have three distinct segments, but the composition of those segments has changed. One segment that remains the same is our Healthcare Net Lease segment. This segment contains the same basic business, as reported in 2008.

Among the changes, first as the key component our playoff and strategy CapitalSource Bank is now shown on a standalone basis in its own segment. Second; we are now presenting a segment called Other Commercial Finance, which contains all the legacy assets and liabilities of the company not associated with the bank or the Healthcare Net Lease business.

Finally, as previously announced we have eliminated our residential mortgage investment segment. You will also now see a column titled intercompany eliminations, which removes the impact of certain transactions between the segments to arrive at the consolidated number.

I mentioned the elimination of our residential mortgage investment segment. This change reflects the continued simplification of our business and occurs in conjunction with the sale of our remaining agency RMBS Securities and relative derivatives. These transactions resulted in a net gain during the quarter of $15.3 million.

The only remaining asset associated with the formal residential mortgage investment segment, are the two Owners Trust, which are now included in our new other commercial finance segment. The assets of these trusts appear on our balance sheet as mortgage related receivables and the debt is included in the term deadline. This debt does not recourse to the company so our total exposure is limited to the net equity we retain, which had an approximate book value of $69 million at March 31st.

The key drivers of earnings in the quarter included net investment income, which was $150 million, very much in line with the prior quarter. Interest and fee income declined about $47 million in the quarter due to declining interest rates and a slightly smaller base of loans, but falling interest rates also resulted in a decline in interest expense of approximately $45 million.

Net finance margin for the CapitalSource Bank and other commercial finance segments increased 68 basis points to 3.89% on a combined basis as compared to the fourth quarter of 2008. A primary driver of the increase was the existence of interest rate flows on many of our loans, the vast majority of which are currently in the money, due to the very low level of short-term interest rate.

Because of the aggregate balance of loans within the money flows, however, if LIBOR interest rates rise in accordance with the current forward curve, we will experience a negative impact on loan spreads of approximately 25 to 40 basis points by year end.

Well, these flows had a positive impact on spreads in the quarter; a factor that negatively impacted spread was the relatively higher level of loans are non-accrual.

Turning to balance sheet, loan repayments in our legacy portfolio not surprisingly, continue at a moderate pace in the first quarter totaling $100 million. In light of anticipated loan extensions, we expect this slower than normal pace of repayments to continue throughout 2009 and into 2010. The decrease in loans in the legacy portfolio was offset by the new loans of CapitalSource Bank as Dean has already discussed.

As for the "A" participation interest held with CapitalSource Bank, payment received in the first quarter totaled $330 million. At March 31st, the outstanding balance was 1.1 billion, which represent a 27% of the outstanding loan pool of $4.1 billion that secures the participation interest. An additional payment of $92 million has been received since the quarter closed and we continue to expect to be paid in full during 2010.

Moving to the liability side of the balance sheet, we thought it would be helpful to provide some incremental detail about the loans in each of our six securitizations. All are non-recourse, but each have a somewhat different mix of loans. For example, the securitization loan is 2006-1 contains loans with the balance of $194 million. The outstanding debt balance is a $163 million, which results an equity balance held by CapitalSource of $31 million. This represents an affective advance rate of 84%.

The loan pool yield was 8.5% as compared to our debt coupon of one month LIBOR plus 44 basis points. This result in an healthy net interest margin of appropriately 750 basis points. The mix of loans, include 65% asset base loans and 35% cash flow loans.

We have posted a slide on our website this morning that has the same details for the other five securitizations, which we refer to as 2006-2, 2006-A, 2007-1, 2007-2 and 2007-A.

In addition to our term securitizations, we currently have six credit facilities, five are non-recourse to CapitalSource and the sixth is the syndicated facility, which is recourse debt.

The collateral package for each of the non-recourse facilities is limited to their specific loan pool. The syndicated facility collateral package includes loans specifically pledge to that facility, as well as the CapitalSource Bank stock to Healthcare REIT stock, the equity in our securitizations and certain other assets.

At March 31st, the six facilities collectively had principal outstanding of $1.4 billion, including $934 million in the syndicated facility and $466 million in the five other secured facilities.

Loan collateral securing the non-recourse facilities totaled $885 million giving them an effective advanced rate of approximately 53%. Some details regarding each of these credit facilities, similar to the information provided for our securitizations are also shown on the slide posted today on our website.

As John indicated, we renewed one of the non-recourse facilities in April known as CS Funding VII and we are currently in discussions with our lenders about three other facilities, which mature in 2009. CS Funding III, QRS Funding I and CS Europe.

CS Funding III had a maturity date of April 29th, but it has been extended for 30 days, during which time we expect to close our revised facility. As we indicated at the time we announced the renewal of CS Funding VII, that facility now has a three-year term and $50 million of incremental borrowing capacity for unfunded commitments.

We intend to pursue similar durations for the other credit facilities, so that we can more closely match fund the loans in those facilities, similar to what we have accomplished with the loan funded in CapitalSource Bank and in our securitizations. We remain confident of our ability to accomplish that goal.

As we work to make these changes on our credit facilities, we believe that our liquidity position about, which John spoke in some detail, remain sufficient for expected need with the parent and of course particularly strong at CapitalSource Bank.

One area we continue to carefully monitor relates to our unfunded commitments, was declined during the quarter by about $550 million to $3.0 billion. Of the remaining amount, $695 million are obligations of CapitalSource Bank.

Many of the non-bank commitments are either at the full discretion of CapitalSource or require the borrower to pledge additional collateral to obtain additional advances. Because of these factors, we are seeing no measurable difference in the draws on unfunded commitments in recent quarters and do not anticipate any change in the coming quarters.

As John and I both mentioned, the renewal of CS Funding VII added a $50 million line for certain non-funding commitments. We also continue to have availability of $83 million in the revolving crunch of our 2006-A securitization to fund additional advances on assets owned by that facility.

Turning to our capital position, GAAP equity remains very strong at the bank at $916 million. Likewise, the Parent Company had over $1.9 billion of tangible common equity at quarter end. Total risk-based capital to bank was 17.2% and the bank’s ratio of tangible common equity to tangible assets was 13.1%. The tangible common equity ratio at CapitalSource Inc. was a combined 17.1%.

I will now turn the call over to Tad Lowrey, who will provide a brief update on activities at CapitalSource Bank.

Tad Lowrey

Okay, thanks Don. As Dean mentioned earlier, we continue to see excellent opportunities to make high yielding loans with tight structures to high quality borrowers in the bank. We are also capitalizing on the current dislocation in the CMBS, Commercial Mortgage-Backed Securities market applying our underwriting discipline to the purchase of season securities.

During the last quarter, we purchased $77 million of AAA rated CMBS with an expected yield to maturity at 15%. Bank’s liquidity position remains strong and we have the ability to fund more than $1.1 billion, in new loans and unfunded commitments, while also deploying up to $300 million of lower yielding short-term investments in CMBS and other securities.

We also foresee significant pay downs on the “A” participation interest for the remainder of 2009, which should create more liquidity, meaning we expect to meet our origination targets and still close 2009 with ample on balance sheet liquidity. We remain cautious in this environment however, and will not deviate from our conservative underwriting guidelines for the sake of achieving this lending volume.

The volume of new loans funded in the first quarter amounted to 200 million of which about 15 million came from CapitalSource legacy loan maturities. And our pipeline is strong and we continue to see new opportunities each week to lend money to small mid sized businesses who are finding few sources of capital to fund their operations.

As has been previously stated our capital levels remain very strong. At quarter end we had total risk based capital ratio of 17.2% about the same as year end. A tangible common equity to tangible assets ratio of over 13% is among the highest in the industry, combining with excess capital with our liquidity position and we have ample room to continue to grow our national lending franchise.

Recognizing that excess cash is a drag on earnings and with the confidence that we can manage our deposit levels by adjusting the CD rates we offer, we lowered our CD rates and incurred a nominal level of deposited amounts ending the quarter with $4.7 billion in deposits, while reducing our funding cost by over 33 basis points. That’s the caused of the continued defaults since quarter end.

The monthly payments which average about a $100 million from the “A” participation interest added to our liquidity flexibility. I am highly confident we can grow our interest margin meaningfully over the next few years as we both grow assets and see the full benefits of redeploying our lower yielding assets into higher yielding loans and investments.

I want to touch briefly on our credit quality. At quarter end the bank's non-performing loan ratio, which we express as a percentage of core loans, which excludes the “A” participation interest were 79 basis points and we had no delinquent loans. All of the non-performing loans re currently paying but are on non-accrual status due to our doubts about the full principal collections.

In the first quarter we had a single charge-off of $10 million on a cash flow loan to a business; it was direct victim of current economic conditions and is no longer viable. We added another $15 million net to reserve this quarter to bring our total allowance to loan losses to $71 million. Despite the low level of non-performing assets and no REOs we have prudently built our allowance up to 240 basis points of core loans due to the economic conditions.

In closing, as a de novo bank we received lots of attention from our regulators. Our interactions to date have been very constructive and productive including three separate regulatory visitations since we opened in July. No surprises emerge from these visits and we continue to believe that we have a strong relationship with and support from our regulators.

John will now rap up before we take questions. John?

John Delaney

Thanks Tad. So as we focus on the execution of this play offense and some play defend strategies that I've outlined, I remain convinced of the substantial value in our overall business, though the market continues to discount our assets.

Given the current economic climate and concerns about credit performances and liquidity CapitalSource is far from the only financial services firms selling at a discount.

We have made substantial progress on the number of important fronts in the first four months of the year and will continue to work hard for the balance of 2009 and beyond to accomplish the objectives, we have laid out.

Before closing I want to briefly review our four business components, which include first CapitalSource Bank, which Tad just described. It’s a clean well-capitalized bank paired with historically strong CapitalSource asset generation platform. At March 31, CapitalSource Bank had no delinquencies of very manageable level non-accruals, $4.7 billion of deposits, approximately 60,000 retail deposit customers, book equity of $916 million and a clear ability to raise additional deposits as it needs to fund its growth.

The second component of our business is our Healthcare Net Lease business, which is comprised of 184 skilled nursing facilities, which we own and lease back to operators. Similar assets along with our other healthcare business have held their value quite well in the current economy and are generally viewed as defensive investments.

We believe these assets are worth their current book value of $500 million or more based on any objective market analysis. The final two components make up the bulk of our core other commercial finance segment. We have $4.4 billion of our commercial loans that are currently permanently financed in match funded term securitization with $3.4 billion of debt, which is the third component of our business.

Each of the securitization is non-recourse to capital source, or we essentially own the residual interest totaling approximately a $1 billion dollars. The fourth component of our business is what I previously have referred to is everything else. Included here are the $2.2 billion of loans that are funded by our credit facilities, unwritten $144 million of equity investments, a net REO portfolio, estimated at approximately $94 million and a residual interest of appropriately $69 million in the Owner Trusts portfolio. There is clearly substantial value among the four components of our business, well an access of our current market capitalization.

In conclusion, I believe in the short-term we will continue to make steady progress on the simplification of our business, the affective management of credit liquidity at the Parent Company and the prudent growth of CapitalSource Bank.

Taking a longer term view, investor should focus on our current balance sheet strength and pre-provision earnings power, which will sustain us even under a severe stress scenario that we laid out.

Over the next two to three years, we expect to be able to meaningfully grow our net interest margin or these pre-provision earnings if you will. As we redeploy low yielding assets in CapitalSource Bank, pay down our credit facilities and experience a return to a more normalized credit in capital markets.

We are now ready for questions, operator.

Question-and-Answer Session

Operator

(Operator Instruction) Our first question comes from John Hecht of JMP Securities.

John Hecht - JMP Securities

The first is, just a couple of further questions about your credit experience during the quarter. I thought, I heard you right, you're expecting charge-offs kind of level off have come down despite higher increased non-performing assets. Is that going to be the result of I guess better feeling of non-performing assets or is that going to be the result of better recoveries? What are you seeing out there, when you do liquidate a loan in the markets?

John Delaney

Well, John, it varies a lot by the type of loan obviously., to the extent, the non-performing loans are more asset base we have higher recoveries. Historically, prior to the recent kind of market conditions, we were experiencing recoveries for kind of assets secured loans of certainly in excess of 80% and for a long period of time, we had recoveries on kind of asset secured loans in excess of 90%. And then our recoveries on things that were more enterprise value based tended to be more than 70%. That's the way it use to be. The way it is now is things with hard assets, we are generally seeing recoveries kind of in the 50% to 75% range and business or problems that are more enterprise value sub 50%.

So this clearly have been a meaningful affect on recoveries. What’s happened on problem asset is the -- one of the things with the problem assets is, if we have a loan, if we have a $40 million loan that we feel like we need to take a $3 million specific reserve on, and if we feel like that's really the liquidation value, the assets, so you mark a loan from 40 to 37, the whole 40 becomes a non-performing loan.

So one of the things that happens with a non-performing assets is, if you take any specific marks on them, it move the whole asset to the non-performing category. So to the extent, you end up taking relatively modest mix on asset secured loans, you end up potentially ballooning your non-performing loan category, which is why our non-accruals exceed our delinquencies many of these loans are still [carried].

John Hecht - JMP Securities

Okay.

John Delaney

I know that helps.

John Hecht - JMP Securities

I see it’s a classification and kind of credit pipeline situation along with higher recoveries, it sounds like that you are experiencing in the asset based loans relative to many be a couple months ago?

John Delaney

Because even if you take a very small provision on an asset loans that is carried, you can't really have it in as accrual asset any longer.

John Hecht - JMP Securities

I got it, that's great color. Thanks very much. Second a couple of questions on the bank. There that you saw a good amortization in the 80s and good loan production and is it fair to think that the strategy will be good as the 80s, continue to amortize fund loans with that and with the excess of the amortization above what you can fund losses, would you do things like buy high yielding AAA CMBS? Is that a fair way to think about that, kind of asset base at the bank level?

John Delaney

Yes and what I’m going to do is actually have Tad add a little to that but the one comment I would make is when we’re looking at some of these high yielding say, CMBS assets, we are obviously very careful as to what we are looking at, because there is a big difference between buying a 2001 vintage CMBS bond that is 50% cash to fees, which is the kind of stuff we are trying to do versus buying a more later vintage bond. So I want to make sure people understand what we’re really focused on but Tad, why don’t I have you add some more color to the question?

Tad Lowrey

Okay, John, there is a -- what you said is basically correct but a couple of things to add to that, even with the “A” participation fees, amortization slows down, we have plenty of on balance sheet liquidity to fund loans for the remainder of the year and redeploy some of these short-term securities into CMBS and other things. But we do expect the “A” participation interest to continue to pay down.

So we think we’re going to meet our target and still end up with quite bit of liquidity going forward. The key to this so is this, its allowing us to be pretty aggressive on our deposit rates and buy aggressive, I mean lowering these deposit rates and we are picking up quite a bit of spread just by continuing to lower those and if they fall on another 30, 40 basis points on the entire base, just since quarter end.

John Hecht - JMP Securities

And final question on the new loans you’re writing at the bank and you wrote a couple of hundred million this quarter. A two parts question. What did you say, 15% of those were written from some of the, I guess you call legacy CapitalSource pool? Second is what kind of spread that you’re getting those loans and I’ll step aside and thanks for answering the questions.

Tad Lowrey

It was $15 million. So, it’s quite a bit less than 15% were the legacy loans and I think, John recorded the spread at 780 over LIBOR, John?

John Delaney

Yes, 780 over LIBOR and effectively the banks in a position upon a maturity of loan at CapitalSource to effectively provide a new loan to the borrower and that's what that $15 million loss.

Operator

Our next question comes from Andrew Wessel of JPMorgan.

Andrew Wessel - JPMorgan

Just starting on a couple housekeeping things, the QRS facility in the CapitalSource you have. What are the actual dated maturity dates today for those?

John Delaney

Which facility did you?

Andrew Wessel - JPMorgan

The QRSI in the CapSource Europe, I think believe that you said there is still --

John Delaney

CapSource Europe is in September, the CapitalSource Europe facility maturity is September of 2009.

Andrew Wessel - JPMorgan

Okay.

Don Cole

The QRS one is April of 2010 and that is currently its amortization, one-year amortization period.

Andrew Wessel - JPMorgan

Great and so, when you mentioned those kind of that in conjunction with CS III are those, - because is in its amortization period, you're trying to give that QRS facility pushed outside, it maybe mood maturity date out, and also move the amortization period out?

Don Cole

Yes. I mean, our basic strategy is to try those, essentially role the three together to have the same term and same period.

Andrew Wessel - JPMorgan

Okay, great. Thanks.

John Delaney

We role the two domestic ones together and keep the European ones separate, which there is an argument is to why that maybe better just because of the nature of the collateral and where its located?

Andrew Wessel - JPMorgan

Right, and that make sense, thank you and then on the unfunded commitments, the holding company?

John Delaney

Yes.

Andrew Wessel - JPMorgan

Based on that slide, it says 133 million of capacity and $2.3 billion remaining unfunded. I know in the fourth quarter, you said basically note for the most part have the ability to be funded due to covenants or other restrictions. Is that still the case, do you still see the vast majority of that $2.3 billion unable to be funded today?

John Delaney

Yes and its unable and it not just covenants, a lot of those things are collateral dependent and a lot of the collateral requires our pre-approval and things like that. So, its not just it is certain number of companies obviously they don't have covenant issues in that borrowings are available, but there is a large number of companies are performing just fine, but they don't have the collateral and normally don’t require additional collateral we would have to approve in.

This is such that there are nursing home with $5 million receivables and a $20 million line and the only way they can get more financing or they to use $20 million line is to buy another nursing home, which we effectively have to approve. So, there is some great performing companies in there that they don’t have any real way of accessing their commitment based on the way it structured.

Dean Graham

Just to add to what John said, we haven't seen any change in the draws or performance I know it is unfunded commitments largely for the reasons he cited and also we take a close look at this regularly to see, where we think these things are going over time and we haven't seen any change that I have been forecast, so.

Andrew Wessel - JPMorgan

Great. That 130 millionish that you have available to fund the Parent Company right now that feels you feel very comfortable with that amount based on your outlook on estimate is?

Dean Graham

So, you are adding together that 2006-A number and new credit facility number, which is just the 130.

Andrew Wessel - JPMorgan

Right.

Dean Graham

Obviously we have cash on the balance sheet or that available cash as John mentioned of a $175 million and other cash from operation, so yes between all those sources.

Andrew Wessel - JPMorgan

Okay.

Dean Graham

We feel comfortable our ability to fund the unfunded commitments with the Parent.

Andrew Wessel - JPMorgan

Okay, great, thanks a lot, I appreciate it.

Operator

Thank you, our next question comes from Don Fandetti of Citi.

Don Fandetti - Citi

Hi Good morning, John, it seems like the bank funding position is obviously very strong, the parent company, may be a little bit tighter but you have some options like the HUD financing. How quickly could you sell and monetize the real estate portfolios you had, do you feel comfortable that there is that demand?

John Delaney

Yes, we actually do, we got a couple of the property -- we sold some already. We got a couple of properties under letter of intent, including kind of a substantial portfolio. And then we have a kind of core group of assets that we think there might be some interesting kind of steps towards monetization paths that we are pursuing.

So you know Don, because you understand these companies well, these healthcare and our lease businesses. It’s a stable asset. The sectors performed well. Recently there has been transactions -- in the capital raising transaction in the space and we think that its one of the assets where there is actually more liquidity.

One of the things that helps is HUD is actively lending in the sector. So that helps, because you do have – that’s historically been a good source of liquidity for the sector and the sectors relied upon it historically and that the HUD financing program has not been interrupted based on what’s happened in the rest of the world.

So there’s liquidity kind of at the small operator level, where people can actually get financing from the government to buy these assets. Now, that’s not an easy process. We’re in the middle of it now and its time consuming, cumbersome process but your tolerance for those kinds of things are much greater these days right, when its one of the best sources of financing.

So there’s HUD financing available to us, there’s HUD financing available to smaller operators who we think are interested in buying the assets. As we said, we sold some assets are ready, we’ve got some letter of intents signed or at least a one good sized letter of intent for our portfolio of assets. And then the residual assets, we think there is some interesting things we can do with them and the larger more strategic side, particularly with the space feeling are little better, as you know from your work in the space. So that would be my view.

Don Fandetti - Citi

Okay. And then just quickly. Can you just remind us what sort of the trigger risk are on some of your CLOs kind of bare case scenario?

John Delaney

When you say trigger risk…

Don Fandetti - Citi

Is there anything that would force a liquidity event on any of your CLOs or CDOs if that were to deteriorate?

John Delaney

No, we don't -- they are non-recourse in every respect. So there is no ability for the bond holders to demand capital from CapitalSource.

Don Fandetti - Citi

Okay. Thank you.

Operator

Thank you. Our next question comes from Sameer Gokhale of Keefe, Bruyette & Woods.

Sameer Gokhale - Keefe, Bruyette & Woods

Hi. Thank you and good morning.

John Delaney

Good morning, Sameer.

Sameer Gokhale - Keefe, Bruyette & Woods

Just sort of few questions. The first one was -- I think, Dean went over a kind of the outlook update and I may have missed it. But in terms of the loan loss provision, was there a specific point number or range you would given as an updated range for 2009?

John Delaney

No.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay. I mean, based on the Q1 results, is there a kind of sense you could give us for relative to the $175 million to $250 million where you think we could end up?

Dean Graham

175 plus million, for which period…

John Delaney

No, I don't think, we have any update at this point.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay.

John Delaney

He commented both kind of where we were relative to what we talked about last quarter and then he also covered the results of the distressed test we ran on the business.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay. And then in terms of the -- I mean, I am just looking or eyeballing the numbers, it looks like you are loans paid down, your portfolio of paid down and perhaps at faster rate this quarter than last quarter. Could you just confirm, whether you think that's right and if so what color could you give us on that? What is driving the increase in loan pay down sequentially?

John Delaney

I'm going to let Don to answer this specific question. What I will say is that in the last week or two we've actually have seen a little bit of uptick in liquidity in the underlying portfolio. I think the world is feeling slightly better. You're starting to see a little more activity, which we think will lead to greater prepayment rates, which we think will be good. In terms of the specific question, I'm going to refer to Don.

Don Cole

Yes, I think they were a few paydowns more in this quarter at the Parent side was in the past. I think those were specific situations. I wouldn't say we view that necessarily as a strong trend for more aggressive pay down. Obviously other component of the loan decrease was related to the charge-offs in the quarter, but I wouldn't sort to say that we've seen a significant uptick in pay down speed.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay. Yes, I was referring to the pay down excluding the charge-offs, but it seems like in Q4 last year maybe the market is just kind of frozen and now maybe we are seeing a little bit of flowing and that's what I want to get color on?

Don Cole

I think you are right. Your math is probably correct. So, but I think where we could start seeing those trends is in the next few quarters because as I said anecdotally there is definitely a little more action in the portfolio. I would say that's kind of [wearing] a trend in two different ways.

First of all on our REO assets, we’ve definitely seen a dramatic uptick in activity for these assets. We've got about a 100 million our portfolio of REO, which by the way is marked pretty hard, when it goes into REO based on a pretty involved valuation process.

I would say in the fourth quarter, the activity was slow on some of these assets and we’ve definitely seen an uptake in terms of people, multiple bids on assets, people coming in and putting in bids for pools of assets and that’s an encouraging sign that people, while they’re still looking to invest in things like this at very high rates of return. There is at least a rate of return that they seem willing to invest in and I think that’s good.

Then also we did see kind of anecdotal evidence that some prepayment might increase in the underlying loan portfolio. Again, it’s early, but to your points are mere things are feeling a little better. We may see a little more strategic M&A activity, which could create more liquidity in the corporate finance portfolio and so I think again it’s early, but directionally it seems to be moving in the right way.

Sameer Gokhale - Keefe, Bruyette & Woods

That’s really helpful color and then just my last question and maybe it just kind of early days here, as you’re kind of ramping up the bank, but perhaps Tad has some perspective on any progress in terms of capturing incremental revenue streams. I think one of the idea is, when you bought the bank was, you have all these customers. If you offer them a checking accounts and lockbox services and things like that, you may have some cross selling opportunities. Has there been any progress along those lines or so far, maybe just been busy with other things at this point?

Tad Lowrey

Yes, I said there is two things. One we are busy with other things, even though that is really part of our business plan. Secondly, we have to resolve the Parent company’s bank holding company status, which when we independent at the end of the year is been on a slower trajectory and I think its our view that we want to get our debt financings in place before obtaining holding company status really makes sense.

So, I think the priority of the bank is to grow the bank through lending. The priority of the parent in addition to managing credit is to extend our credit facilities. And I think once that's done then holding company status makes more sense and then we can change some of the services that are available in the bank.

Sameer Gokhale - Keefe, Bruyette & Woods

Okay. That's a very helpful color. Thank you all.

Operator

Our next question comes from Michael Taiano of Sandler O’Neill.

Michael Taiano - Sandler O’Neill

Hi. Good morning. I just had a few questions. I guess, just going back to the recoveries question earlier. When you said the recovery rates on loans that are backed by assets is somewhere in the $0.50 to $0.75 on a dollar range. Now, does that also include commercial real-estate or is that just the…?

Don Cole

That was actually really -- that was really the commercial real-estate number.

Michael Taiano - Sandler O’Neill

Okay.

Don Cole

We haven't had many recent pure asset based liquidations --. So that's really commercial real-estate. I should have said that more specifically then, because that's where we have a little more data.

Michael Taiano - Sandler O’Neill

And that would compare to 80% to 90% and like previous years?

Don Cole

Yes.

Michael Taiano - Sandler O’Neill

Okay. And then just on the healthcare, I mean, is that, I guess two questions. One, are you seeing -- is there an issue now that that you are no longer or read in terms of competitiveness where, one of the reasons, I think you converted with a REIT which had to be more competitive in that business.

And then secondly, I know its still early, but it looks like the equity markets are starting to stabilize some. And so could you maybe give us a sense of timeline over which you would consider going forward on the spinout?

John Delaney

Yes. CapitalSource’s healthcare REIT which is the portfolio of 180 nursing homes, is a great business and its performing really well. We are not giving it capital at this point to grow itself, so its effectively got a great management team and kind of a static portfolio.

It is organizers are REIT, still but it is not owned by a REIT any longer, so it effectively pays us dividends but we pay cash on those dividends. We're not paying tax now on those dividends, because of the loss that the company had but theoretically when we return to paying tax we'll be paying tax on those dividends.

So it makes sense for CapitalSource Healthcare REIT to end up in the hands of people who want to own a healthcare REIT and the path that we pursued in the past was to take the company public. We picked the bad week to do that, we picked the week that Lehman Brothers stalled. They tried to take it public which wasn't great timing and we weren't able to get it done. We still view that those assets should end up being owned by people who want to own a very steady stream of tax sufficient dividends, back by healthcare assets which we view as defensive.

So we are clearly going to continue to try to move in that direction. In the meantime, we are paying some of our capital to run the business through HUD financings and some pruning in sales here, but what we will effectively end up with is kind of a core, modestly levered, equity position in that business is that we want to do something with. Because its not – the CapitalSource as the owner of that business is ultimately not the best thing for that enterprise because we don't plan on giving it additional capital to grow and it should grow because its got a great team and its really a good business.

So ultimately it should end up being somewhat separate from us. It’s a long winded answer to your question. The short answer to your question is, we are definitely focused on moving in the direction you are indicating. Trying to figure out the best way to do that is complicated and we're early in kind of the core equity market for recoveries if you will. So we are just evaluating all those things.

Michael Taiano - Sandler O’Neill

Okay, great. And then just final question; any update on whether you would be able utilize TALF on your commercial real estate loans?

John Delaney

Well, the problem is announced. Its focused on new originations. So our portfolio is a legacy portfolio and what they’ve rolled out thus far is not focused on loans that have originated prior to certain dates. So as the -- and I’m not an expert on the TALF CMBS program but it appears the initial version is focused on new origination and will do a very nice job starting in the origination market it seems to me, with a couple of caveats.

One caveat is ensuing as tightness spreads of existing bonds, its going to be hard to sell new bonds. So I think what will happen is some combination of them potentially pushing back the date for legacy loans or quite frankly, people just rewriting their old loans with new loans and then potentially making them TALF eligible.

So I think we can’t answer that question specifically but the observations we have are similar to observations other people have, which is it’s a great step getting the CMBS market restarted is critically important. This is clearly a step in the right direction. I think a lot of people would want some tweaks and one of the tweak being using it for pre-existing bonds or some legacy loans that would be helpful to us.

And then I think the other thing people are trying to figure out is can you just rewrite old loans to new loans assuming they can form and have them be TALF eligible and I don’t think there’s a clear answer to that yet.

Michael Taiano - Sandler O’Neill

In other words, if you have extensions on some of these commercial real estate loans that you mentioned earlier would those would be eligible for TALF, in a broader sense?

John Delaney

We – I don’t think, that was in the details on some of these things and I don’t think a lot of those details are flushed out, I think people are saying, well, what if I have a loan that I originated last year and its performing well. Can I call the borrower or just give them a new loan to refinance my old loans. Would that be eligible certainly, right. So I think, people are trying to get their hands around those questions.

Michael Taiano - Sandler O’Neill

Right.

John Delaney

Because those things were not addressed. Theoretically it is a new loan and the TALF underwriting criteria for CMBS is restricted. But theoretically if you write the new loan and you meet those underwriting guidelines, the fact that you refinanced that with an old loan, because that making it ineligible, I don't think that questions been answered.

Michael Taiano - Sandler O’Neill

Got you. Okay.

John Delaney

Maybe as, people proper out what will happen is, they will just push back the eligibility, so we they will to deal with that question. So I think, there is more to come.

Michael Taiano - Sandler O’Neill

Okay, great. Thanks a lot.

Operator

Our next question comes from Scott Valentin of FBR Capital Markets.

Scott Valentin - FBR Capital Markets

Good morning. Thanks for taking my question. Just in terms of negotiation with some of the vendors, having you noticed any change in kind of receptiveness over the past couple of months or they seem to be more open to negotiation?

John Delaney

I would say the answer is, yes. I mean, I think, at very high level here, the fourth quarter and first quarter were very stressful for everyone. They were stressful for the large banks, obviously, and it was very stressful for borrowers from large banks. And some of the renegotiations we did, we are in the middle of that very stressful period.

And I am very pleased to say that we are able to accomplish those renegotiations and still maintain a terrific relationship with our lending partners. I think there is a sense -- things are coming down a little bit, we are clearly seeing we are not getting into specific data, but we are clearly seeing additional liquidity in lots of the little corners of the credit market.

I think the stressed test process seems to have been very constructive and productive. And so I think, everyone is a little more calm these days. We have maintained even through the period of significant stress, very good relationships, I believe with our vendors and most of these vendors have been terrific partners to us over the last over the last seven, eight years not only as institutions but as individuals within the institutions, so we value those relationships tremendously.

I think they generally have a view that we've done the right things from not only a strategic standpoint but from a capital standpoint and liquidity standpoint and I think they clearly see in us a lot of the things we talked about here, which is, there is a very vital and valuable business at the other end of the cycle. And so I think there is a lot of – there is a very good environment for us to work through what we need to work through with them because its not only in our interest but its in their interest.

So there is no – this is not adversarial, this is not attorneys talking attorneys, restructuring people talking to workout people. These are business people talking to business people, working our deals that I think will be good for CapitalSource and therefore good for them. So that's how I describe the relationship right now.

Scott Valentin - FBR Capital Markets

Okay. That was helpful and then just in terms of credit migration as you look at, it sounds like maybe the scenario of the cash flow loans, for the first loans you see stressed, and now across maybe in the commercial real estate, is that the general trend you've seen?

John Delaney

Yes.

Scott Valentin - FBR Capital Markets

Okay. And then commercial real estate appreciates the geographic concentration, is there any make and break up by type maybe office versus lodging versus retail?

John Delaney

Yes. We can. It might be better for us to -- I know we provided that detail in the past. I don't think we have that specific detail right here but we have no issue giving that to you. So…

Scott Valentin - FBR Capital Markets

Okay. I could follow up. All right.

John Delaney

If we decide its something that we need to disclose to everyone we'll just put it on our website and tell you.

Scott Valentin - FBR Capital Markets

Okay. Thanks.

Dennis Oakes

Nicky, we have time for one more question.

Operator

Thank you. Our last question comes from Bob Napoli of Piper Jaffray.

Bob Napoli - Piper Jaffray

Thank you, good morning.

Dennis Oakes

Hey, Bob. You're little late for the call.

Bob Napoli - Piper Jaffray

I have been on but I was held by another call at the same time. I'm going back and forth here but I think a couple of questions I don't think were asked yet. I mean you guys locate your portfolio on a monthly basis, I mean, you report the performance of the company is pretty closely on a monthly basis, is that correct?

John Delaney

To the best of our ability, we do that.

Bob Napoli - Piper Jaffray

As you look at those companies, are you seeing, I mean, how --are you seeing any incremental signs of stability in generally or not, I mean -- ?

John Delaney

Bob, if you look at it -- clearly what’s happened is the rate of decline has slowed or flattened, right? And so I think people look at that and say well, that’s what happens before things start going the other way. And I would say that’s generally what we are experiencing.

Bob Napoli - Piper Jaffray

And how do you – what is CapitalSource’s outlook for the economy? How do you feel, how do you guys feel, what is the years going to play out economically for in the US?

John Delaney

The way you’re not looking at -- I think there is a couple of variables to that, they are very hard to pin point, what the saving rate of the country will ultimately be. What will happen to the markets? Does that affect people’s view on their wealth and ability to spend? So the key variables are spending -- the key variable is really spending.

The government’s done good job providing tremendous kind of demand into the system through the stimulus bill right, because consumers weren’t spending so the government stepped in and is doing it. I think the consumer spending rate is way up which is good long-term. We don’t want it go too high, because if it goes too high, then there will be no spending in the near term.

As the markets feel a little better, will the saving rates kind of settle in at 4%? If so, I think you could see the economy recovering this year. So I think our general view is that, we’ll see some recovery in the economy this year, which doesn’t mean you won’t have lagging asset issues way into '10, right. Because the economy recovering and asset values returning are two different things. I think our view is probably that economy recoveries end of this year, asset value don't really stabilized into solidly next year.

Bob Napoli - Piper Jaffray

Now that's looking at -- the bank is under leveraged. Are there any restrictions, regulatory restrictions on the growth of new assets and the timing of growth of new assets that are tied to the bank?

John Delaney

The answer is obviously yes and no. Yes, in that we have capital levels we have to maintain, so it came go too fast, right, outside your capital as we've got plenty of cushions there as you know.

Secondly, we have a business plan approved with the regulators, which shows us growing this business a certain amount over three years. And that business plan -- you look at and say, that's terrific growth. So that's not a limiting factor for us, but we couldn't triple the size of the bank without having the regulators approve a new business plan. But can we grow the banks loans from 2.9 billion to 7 billion, yeah, we can do that.

So, there are some larger restrictions, but there is not restriction that relates to the kind of things we are talking about doing. I'll defer to Tad to provide any more color on that.

Tad Lowery

I think that covers pretty much all of it. The key restriction is, Bob, its 15% risk based capital, but that expires in a couple of years and that we think it would go back down to, maybe the 10 level. But as John said, even at that 15% risk base capital level, we have so much excess capital now, we can hit those numbers.

Bob Napoli - Piper Jaffray

Then my question, I mean, in trying to tie together the economy and the bank, I think the competitive environment is probably better then you've ever seen it. Is that a fair…?

John Delaney

If you just tell me, give me one word to – if I had to give you one word to describe the competition, I would use word, non-existed.

Bob Napoli - Piper Jaffray

Right. Now, and there is a big secondary market for loans, I think you can quite buy it pretty -- I mean at what point do you get comfortable enough with the economy that you would take the move to put on a larger amount of incredibly priced and structured loans into the bank and that’s I mean it is 200 million in the quarter but I mean there’s got to be so much opportunity out there…?

John Delaney

Yeah. There is. I mean I think the bigger factor is that we've always had a very vigorous underwriting process here at CapitalSource. I would say that underwriting process is extended now even further because the banks, the existence of the bank has created kind of an additional overlay and things we have to do on our underwriting process.

So I think that process is just going to take time for us underwrite loans, so this is somewhat a limiting factor of how much volume we can do based on that. And we certainly don't want to make any mistakes early on with the bank. The most important thing that we are focused on is the institution is not doing anything to screw up the bank.

So we've been very careful about the underwriting and loan approval process and so that’s somewhat of a limiting factor.

Secondly, there are things you can underwrite in this market and there are things that are very hard to underwrite this market. I mean you can't – its very hard to underwrite a retailer in this market. So you can do some kind of an asset based deal but even if the asset is secured it becomes a [criticized] asset in the bank and that is a [no-good].

So we are trying to find things that we think not only are safe in the traditional way we've look it at safe but are also safe in the judgment of the regulators in terms of not having kind of optical hair on it, even if we think its money good. You see what I mean. And so the bottom line is we are focusing really hard on healthcare. We want this business in the future to be 50% of healthcare because we've learned that the stable, a very stable and incredibly profitably part of our business, so really, really focused on healthcare.

Our technology business has done great, our security financed business has done. We are really pushing those things. Interestingly enough there is incredibly good opportunities in commercial real estate but its mostly financing people who are buying debt we think, meaning there is lots of situations out there where people have put up $50 million to buy something, they borrowed a 100 million, they are underwater at their $150 million basis. They can buy their senior loan back for $60 million and they want to put in $30 million and borrow 30 million to buy the senior loan.

So suddenly you’re making a $30 million senior loan on something that someone made a $100 million senior loan on a few years ago. There is a lot of that kind of stuff out there in commercial real estate that we are very focused on.

So we’re really trying to do stuff that’s very safe and get very, very strong returns. I don’t think it’s a right strategy for the bank to just be hitting the ball – trying to hit the ball out of the park every time. We want to hit solid doubles and triples with the thing and because what we think will happen and that’s why we spent some time with the stress test and asked someone to help us go through it, which is clearly there is a lot of losses in the system. We have them and everyone has them. You got to work through.

So the question is what did the business make at the other side? What’s going to happen to us is, we are going to redeploy all this liquidity we have and really drive our pre-provision earnings and guess what, there will be a quarter where there is no more provisions and then you just have a very higher earnings stream in the business.

Bob Napoli - Piper Jaffray

Did you give out – what are the incremental yields that you are putting on today John…?

John Delaney

Well that stuff we did in the first quarter was of 800 over.

Bob Napoli - Piper Jaffray

Great, thank you very much.

Dennis Oakes

Thank you, Operator. Thanks everyone for listening.

Operator

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Source: CapitalSource Inc. Q1 2009 Earnings Call Transcript
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