CapitalSource Inc. Q2 2009 Earnings Call Transcript

Aug. 6.09 | About: CapitalSource, Inc. (CSE)

CapitalSource Inc. (NYSE:CSE)

Q2 2009 Earnings Call

August 6, 2009; 8:30 am ET

Executives

John Delaney - Chairman & Chief Executive Officer

Don Cole - Chief Financial Officer

Tad Lowrey - President & Chief Operating Officer of CapitalSource Bank

Dennis Oakes - Investor Relations

Analysts

John Hecht - JMP Securities

Sameer Gokhale - KBW

Mike Taiano - Sandler O’Neill

Tayo Okusanya - UBS

Bob Napoli - Piper Jaffray

Scott Valentin - FBR Capital

Operator

Hello and welcome to the second quarter 2009 earnings conference call and webcast. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today’s presentation. (Operator Instructions) Please note this conference is being recorded.

Now I’d like to turn the conference over to Dennis Oakes. Mr. Oakes, the floor is yours, sir.

Dennis Oakes

Thank you very much. Good morning and thank you, everyone for joining this CapitalSource second quarter results and company update call. Joining me this morning are John Delaney, our Chairman and CEO; Don Cole, our Chief Financial Officer; and Tad Lowrey, who is President and Chief Operating Officer of CapitalSource Bank.

This call is being webcast live on our website and a recording will be available beginning at about noon today. Our earnings press release and website provide details on accessing the archived call. Earlier this morning, we also posted slides on our website to provide additional detail on certain topics, which we will be referring to during our prepared remarks. So listeners might want to make sure that they’re accessing those during the call.

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 and which maybe 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 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 first up this morning. John.

John Delaney

Thanks, Dennis. Good morning, everyone. Over the past four months, we have made substantial progress on key elements of our 2009 strategy. As explained previously, we had planned both a play offense and play defense approach to our business this year. One of the principal defensive goals was to renew and extend our credit facilities with maturities more closely matched to the expected payoffs of the underlying parent company loans. This is now entirely accomplished.

We have also been fully engaged in other key components of our play defense strategy, which is aggressively managing the credit outcomes in our legacy loan portfolio. Though charge-offs and reserves were a bit higher this quarter than we anticipated at the time of our first quarter call, we remain comfortable with our projections of total cumulative charge-offs across the rest of 2009 and 2010.

With the pre-provision earnings we forecast and declining reserves in future quarters, we also continue to believe that there will be little or no capital erosion by the conclusion of next year. We expect however, consistent with our recent comments to maintain a cautious outlook on credit at least through the first half of 2010.

We also made progress in the second quarter on our play offense strategy. Excluding the “A” Participation Interest, 32% of our commercial loans are now owned by CapitalSource Bank. That percentage will increase as legacy loans continue to payoff at the parent company and new loans are made at the bank.

A second component of our play offense strategy is continued redeployment of low yielding assets at the bank into higher yielding loans and selected investment securities. The average all-in yield on the $211 million of loans closed in the second quarter was approximately 900 basis points over LIBOR and virtually all of those loans have LIBOR floors in the 2% to 3% range.

Finally, our play offense strategy contemplates continual improvement in our net interest margin at the bank. In the quarter, we further reduced the period ending average interest rate on deposits by 59 basis points to 2.25%, approximately 21% lower than the average rate at the prior quarter end.

Further quarter-over-quarter, our net interest margin in the bank increased 32 basis points to 3.01%. Reducing rates on deposit has resulted in a short term decline in total deposits, but we remain confident in our ability to rebuild deposits as needed, once we have fully utilized existing excess cash to make new loans.

In order to best manage and understand the company’s credit performance, we are focused on the portfolios performance over the next two years, rather than quarter-to-quarter. In recent investor presentations, we have discussed a stress test performed on our portfolio by one of the 19 large banks that was itself now, stress tested by the treasury.

As of 3/31 that analysis concluded, we could expect to incur about $900 million in cumulative charge-offs through the end of 2010 at the 95% stress case level. Our charge-offs, at $167 million this quarter were marginally above the high-end of the annualized range, but we would have been well within the range, if we had not taken a $29 million charge on the sale of a performing land loan, as I will more fully explain in a moment.

Our credit performance this quarter does not suggest therefore, any deviation from those expected cumulative loss assumptions. In addition to that outside stress-test analysis, we have updated our own estimates of the losses on our legacy loans by classifying our portfolio into loan categories, consistent with the way we currently manage the business.

Designating the remaining loans originated prior to July 2008, including those sold to CapitalSource Bank last year, as the legacy portfolio. We segmented the loans as follows, real estate, with subcategories such as land and second lien, which have greater risk, mortgage rediscount; timeshare receivables and other, cash flow; media; healthcare, and asset-based, and the asset based category includes our security portfolio.

Each category was assessed for loss history, current reserve provisions and expected cumulative losses. The expected losses were derived from an analysis of the specific loans for performance and relative value. We also reviewed the history and severity of past losses to estimate the probability of default and the size of the losses following default. The resulting loss estimates were then tested, relative to the resulting loss of value in the underlying asset needed to achieve our loss expectations.

Based on this analysis, we believe our credit performance over the next six quarters will be consistent with the findings of the earlier third party stress test. We have posted a summary slide on our website this morning that provides a detailed analysis by asset class.

If you would please turn to that slide, it’s on page three of the investor presentation. I’ll walk you through what each of these columns indicates. As you can see from this page, we’ve broken the portfolio out into these subcategories, as I just indicated and there are listed in the first column. Let me walk you through each of these columns, so you understand what this data really means.

The first column after the labeling if you will is what we call the legacy portfolio. This is the portfolio of loans that exist today that also existed as of June 30, 2008. So, in other words, these are the loans that we currently have in our portfolio that were originated prior to the major correction, we’ve experienced in the market.

This number, this sum, which is $8.6 billion, has been grossed up for any of the loans that have been charged-off and I’ll explain in a minute. So, the carrying value of these loans right now on our books is considerably less than this, but for purposes of this first column, we’ve grossed it up by adding back the charge-offs.

What’s not included in the legacy portfolio is any loans that existed as of 6/30/2008 that have since been resolved, either because they have been paid-off or because they have been charged-off. The next set of columns, if you will the next four columns, is the estimated total cumulative losses for each of these asset classes. You can see the first two columns is our low and high percent by asset class and the next two columns is our low and high dollars by asset class.

The next series of columns that begins with charge-offs through 6/30/09, that first column, the charge-off column shows the actual charge-offs that have been taken against these loans. Again, if a legacy loan has been fully resolved, either through being paid-off or being charged-off that will not be included in this data and therefore not included in the charge-off category.

The next column is the existing specific and general reserves with respect to each category of loan. Then the next column after that is the sum of the prior two columns, effectively the total mark we have on this legacy loan portfolio. The next series of columns shows, what we believe to be the future activity around these loans. The first two columns shows the remaining provisions we expect to take, in other words, the low and the high. Then finally, the next two columns are the remaining charge-offs.

So again, look at this first category were we consider to be our most severe category of land loans. I want to walk you through just you to understand the data and I’ll use that as an example. I won’t go through every category, but we’d be happy to answer questions during the Q-and-A.

In the land loan category, we have $585 million of loans on our books today that are considered land loans that also existed as of 6/30/2008. We expect these loans to have cumulative losses ranging from 30% on the low to 40% on the high. Therefore we expect the cumulative losses in land to be $175 million to $234 million.

We’ve already experienced $22 million of charge-offs against these loans. We have actually had higher charge-offs against land loans in the last year, but many of them have been fully resolved, so they’re not in the data here. We also have existing specific and general reserves of $82 million against the land loans. So in total, we have $105 million mark against the land loans.

So in terms of remaining provisions, if we were to hit our low end of expectations for example, in other words if we were to have $175 million of cumulative losses against this portfolio. We’ve already taken a $105 million mark. So the remaining P&L hit to our business will be about $70 million. If we were to hit the high estimate of cumulative loss, the remaining P&L hit to the company is about $128 million. So again, we’d be happy to answer questions about these specific categories during the Q-and-A.

That high level of the chart shows estimated total cumulative losses of 11% to 17% and remaining P&L charges of $62 million to $617 million. On a based charge-offs already taken through June 30 of $460 million and current reserves of $413 million. In an environment with considerable uncertainty, we are fairly confident we have a handle on these cumulative losses based on both the internal and external analysis. We believe we have identified a reasonable upper and lower bound for expected losses.

We would expect our results, obviously to be somewhere in the middle of this range. As we have discussed previously and today, the chart highlights commercial real estate, mortgage rediscount and media cash flow as the areas where we expect the most severe losses. These numbers are very consistent with the stress test results we have previously disclosed. This past quarter was directionally consistent with our credit expectations as we have articulated them.

Commercial real estate saw severe weakness in particular segments and general weakness in the overall category. We did see a moderation of problems in cash flow lending and consistent with recent quarters, very few problems in the healthcare and asset based business. In terms of commercial real estate, two large land loans at CapitalSource Bank accounted for approximately 40% or $67 million of total charge-offs.

Land loans pose a particular problem as there’s no current income and support is entirely dependent on the financial sponsor, which has been a mixed experience. Of the losses attributable to the two land loans, one was a $67 million loan that was current and fully performing with one year of fully collectible guaranteed interest payments, guaranteed by the financial sponsor. We elected to sell the loan at 56% of par, resulting in a $29 million loss.

The second was a $60 million maturing loan that became delinquent in early July. We took a $38 million of our charge in the quarter and established an additional $5 million specific reserve against the remaining $22 million balance. While several of the remaining land loans continue to benefit from their financial sponsor support, because of low loan to volume and their desire to protect their equity value, we are very bearish on the cumulative losses in this part of the portfolio.

As a result, we have provided for increased specific in general reserve for the entire land only portion of our portfolio. The remaining balance of our legacy commercial real estate portfolio accounted for only $20 million or 12% of charge-offs in the quarter. The other significant area of charge-offs this quarter was media, were six media cash flow loans accounted for 23% or $38.5 million of the total.

We have a view that our credit losses and those of most financial institutions for that matter are occurring in waves based on a variety of factors, including how fast the values have fallen in a sector, how dependent the loan is to underlying asset value or the availability of financing in overall economic activity.

First hit at CapitalSource was our mortgage rediscount portfolio, which while relatively small has been heavily reserved for and appears to be stabilizing as the underlying asset value stabilized. Next hit were cash flow loans that were tied to discretionary consumer spending, indirectly to the auto or housing sectors or relying on advertising budget.

We believe losses in our media book this quarter may represent of the last wave of big losses in our cash flow book and expect stabilization going forward. We are now in the early to mid innings of the calamity of commercial real estate. Purely collateral dependent loans such as, land loans are hitting us hard right now and we expect them to be our worst hit category.

Though, we expect continued pressure from land and other categories of commercial real estate across the next several quarters, the rest of our loan categories continue to be stable and we believe have largely been through the storm at this point. As we isolate whole categories of problem loans by significantly adding to reserves or charging them off entirely or to liquidation value, we are gaining confidence that we are framing the scope and severity of our likely losses over the next several quarters.

We continue to expect a very challenging operating environment into 2010, which will result in meaningful credit losses. The wave of losses will end however, and we will return to a normalized credit performance. When we do that, I expect CapitalSource will show signs of a reshaped portfolio of loans that reflects lessons learned, from today’s pain and a greater focus on our businesses, like healthcare, that have continued to navigate this environment exceptionally well and in that regard are carrying the company.

Moving from credit to other important components of our play defense strategy, I want to touch on liquidity at the parent. We continue to maintain comfortable and adequate cash levels at the parent, with approximately $200 million at June 30, which was net of a $70 million disbursement on the last day of the quarter, for a scheduled payment on the syndicated bank facility.

Sources of liquidity at the parent include, loan sales and REO, as well as normal operating cash flow and quarterly net lease payments of approximately $27 million. We continue to have substantial excess cash and cash equivalents at CapitalSource Bank with incremental liquidity coming from the monthly collections on the A Participation Interest.

The topic of unfunded commitments is one, we are asked about frequently. As a result, we have done considerable work internally to analyze likely funding both for our own liquidity planning and to be responsive of course, to investor interest. Don Cole will discuss this topic in greater detail, but we remain highly confident that our analysis represents a realistic view of likely funding of unfunded commitments.

Based on past experience and actual funding over the past three quarters; for example, an analysis of approximately 50 loans, we thought had the highest probability of funding up in the second quarter was completed in March. The conservative forecast suggested $122 million in unfunded commitments could fund in the quarter.

Our post quarter analysis found that a net of only $25.4 million of funding actually occurred. The vast majority of unfunded commitments at the parent company are revolving loans, as opposed to term loans. The net draws on all of those revolvers was negative in both the first quarter and second quarters this year. In other words, more revolvers paid down than funded up over the course of each quarter on a net basis.

Before I finish, I want to touch on the valuation adjustment to our deferred tax asset. Again, Don will cover this in more detail, but essentially the accounting rules require us to take a valuation allowance against a portion of this asset, despite the fact that we fully expect to utilize this asset. In a sense, these actions will simply cause us to have lower tax expense in future profitable quarters.

The first six months of the year were highly focused on managing the legacy financing relationships at the parent. With the work we could do on that front behind us for now, we can close that chapter in our turnaround and begin to focus on the next chapters. While the company has lots of heavy lifting ahead over the next few quarters, I’m highly confident we have the right team in place, a viable and strong business model, and a sound balance sheet to carry us through the recession and de-leveraging.

Tad Lowrey will now discuss CapitalSource Bank. Tad.

Tad Lowrey

Thank you, John and good morning to everyone. Although the bank’s results were negatively impacted in this quarter by the two large charge-off of the loans that we purchased from CapitalSource last July. Along with increased provisions for our entire remaining portfolio, CapitalSource Bank remains well capitalized and highly liquid. We have the capacity to continue making loans to middle market companies in this liquidity starved environment.

Though we are clearly not on pace to achieve the annual production levels that we anticipated when the year began, we are reviewing and approving an increasing volume of loans that should ultimately lead to higher loan production. In fact, during the last quarter we approved almost $500 million of new loan commitments, while closing $211 million of those loans and of those closings we funded at closing $123 million.

At quarter end, we had approved commitments pending close of $286 million, and we feel highly confident that over $150 million of those will close. The remainder of the $286 million includes a mix of deals that may or may not close depending on several factors, typical of our business. In our first year of operation, we have experienced a fallout ratio, which we’re defining as the percentage of approved loan commitments that are terminated for some reason prior to closing of about 40%.

In this still uncertain economy, we continue to very carefully and prudently underwrite all new loans, and with all-in expected yields averaging approximately 900 basis points over one month LIBOR. We feel very good about both the quality and the profitability of the loans that we are closing.

Dean Graham, who can’t be on today’s call. I have worked to reforecast the bank’s lending projections around those loans that fit best in the bank. This highly productive exercise will allow the parent’s origination team under Dean’s leadership to focus most aggressively on the loans that have demonstrated with strongest yield and the most consistent credit outcomes, such as healthcare for one example, and are therefore the best fit for the bank.

In the quarter, we also opportunistically made purchases of securities, utilizing the same underwriting standards similar to those we use for our commercial loans, capitalizing on the continued dislocation in this segment of the market. Total purchases in the quarter, which are part of our overall strategy to redeploy low yielding assets to achieve higher returns were $129 million, we estimate the yield on those particular purchases of over 7%.

Going forward, though we expect a lower level of purchases of some of these asset classes, such as CMBS, because the margins have narrowed significantly due to the Federal Reserve’s TALF program and the other government-backed liquidity programs. Thinking of liquidity, the liquidity at the bank remains high as we continue to receive monthly payments on the A Participation Interest and we still have a substantial portion of our investment portfolio invested short term.

The A Participation principal payments were $193 million in the quarter. Our outstanding balance is now $888 million or around 23% of the total loan and REO approval that we hold a participation in, which is $3.8 billion at June 30. Although, the pace of repayment has certainly slowed in this portfolio, we continue to forecast the total payoff of this A Participation during 2010, despite the poor condition of the commercial real estate market nationwide.

Turning to funding, as John mentioned, we were successful again in reducing our funding costs. A byproduct of this cost reduction was a modest runoff in deposits of about $179 million. So we ended the second quarter at $4.5 billion. Year-to-date, our efforts have reduced our funding costs by a total of 114 basis points and our new and renewed time deposits in the quarter averaged 1.78%.

We think our net interest margin should continue to grow over the next few quarters as we slightly lower our cost of funds, while at the same time redeploying some of these lower yielding assets, such as the A Participation proceeds and cash equivalents into higher yielding loans, investment securities.

Since the bank was formed one year ago, we’ve been able to reduce our cost of deposits by nearly 34% in what’s been a very turbulent and competitive Southern California market. CapitalSource Bank is attracting customers seeking stability and a community bank they can trust as we offer, because we offer personal service combined with competitive rates.

In the second quarter, our deposit cost of funds averaged 2.58%, which was a 58 basis points less than the average cost during the first quarter, while at the same time retaining over 80% of our maturing time deposits.

We have become a significant player in the California market. The California market has the largest share of deposits of any state in the nation. Based on the most recently available public information, we believe that we ranked 16th in market share of total California banking deposits.

In the quarter, we also increased our borrowing from the Federal Home Loan Bank of San Francisco by $150 million to bring the total at quarter end to $200 million. Our current rate on these borrowings at June 30 is 1.78%, with a weighted average term of 2.4 years. We expect to continue to use Federal Home Loan Bank advances to manage of both our interest rate risk and liquidity risk.

Turning to credit quality, at quarter’s end, the ratio of nonperforming loans to core loans, which for purposes of this measure we’re excluding the A Participation Interest, was 3%. While we had delinquent loans of $5 million are well under 1% of loans. We had $85 million of loans on non-accrual status, and we had charge-offs, as John mentioned, on four loans in the quarter that totaled $70 million.

As a result, we added $90 million to reserves this quarter, which brought our total allowance for loan losses to almost $92 million or 3.3% of our core loans. Also as John mentioned, at the parent company level, at the bank level, we posted a valuation allowance of almost $5 million on our existing net deferred tax asset. So, we took that charge, but we also did not record a tax benefit on the entire pretax loss for the quarter.

This is an accounting charge, and our future net income will benefit from when we reverse this, and we will report a lower effective tax rate until such time as these historical losses are offset by future income. Finally, we also paid $2.5 million to the FDIC, in addition to our normal recurring premium for our deposits. We paid a special assessment, which was our share of the overall charge to recapitalize the Deposit Insurance Fund.

The relationship with our banking regulators remains productive and constructive. Their initial one year regulatory exam began earlier this week. Since, we’ve been through three of these prior visitations by the same agencies, we think we are well prepared for our first initial exam. Then finally, despite the significant level of loss provisions in the quarter, we still have very healthy capital ratios of 12.5% tangible and our risk based stands at 16.8%.

Don, I will turn it over to you now.

Don Cole

Thank you, Tad, and good morning everyone. I want to focus my remarks this morning on further detail on our credit performance in the quarter, the renewal of our credit facilities, and parent company liquidity, including a detailed discussion of unfunded commitments. I’ll also touch briefly on the key drivers of our financial performance in the quarter, before turning back to John for his closing comments.

As with other recent quarters, the key driver of financial performance in the second quarter was credit. During the quarter, we recorded a provision for commercial loan losses of $169 million versus the $141 million we recorded in the first quarter. Commercial charge-offs for the quarter were $167 million versus $119 million for the first quarter, a significant portion of the charge-offs were related to loans that had previously been reserved for.

Our total allowance of $448 million at June 30 represents an increase of $3 million from March 31. We believe that the current allowance level of 4.5% of commercial lending assets, as compared to 4.3% at March 31 is both prudent and adequate and represents the appropriate reserve level for incurred losses in our portfolio.

We also recorded a provision of $35 million related to the Owner Trusts in the second quarter, reducing our net equity in that portfolio to approximately $26 million. The remaining equity is the limit of our economic exposure to that $1.7 billion mortgage portfolio, which is a remnant from our time as a REIT.

Looking at the portfolio as a whole, all of our portion of 58 loans were charged-off in the second quarter from a total pool of over 1,000 loans. Approximately 54% of charge-offs were for commercial real estate, compared to just 23% in the first quarter, 35% were for cash flow loans, compared to 47% in the first quarter, 7% were for rediscount loans, compared to 27% in the first quarter, and similar to the first quarter, 1% were for healthcare loans. Charge-offs was taken on 24 cash flow loans totaling approximately $58 million and 16 commercial real estate loans totaling $90 million.

You will recall we took a significant charge against the residential portion of our rediscount book last quarter, totaling approximately $32 million. Most of our residential mortgage rediscount loans are now classified as impaired, and many are in the process of foreclosure. Our current emphasis for rediscount loans in workout is to mitigate losses by controlling assets and replacing the service there. The balance of our rediscount portfolio slightly over $1 billion continues to perform very well.

As in prior quarters, there were little or no losses in the second quarter in our healthcare credit and healthcare real estate portfolios. Similarly, we experienced no significant losses in general asset based lending, which is principally comprised of our security landing and general rediscount businesses.

As John mentioned, aggressively managing our credit book is a key component of our play defense strategy. We are seeing some signs of stabilization in several areas, with the notable exception of commercial real estate. Though non-accruals, 90 day delinquencies, and impaired loans all increased significantly in the second quarter, an analysis of the dynamics of the credit performance of our portfolio offers some modestly encouraging trends.

For example, as we indicated on our first quarter earnings call, though we continue to see more of certain asset based and real estate loans migrate into our troubled loan categories, the relative number of troubled cash flow loans continues to decline. Most of the charge-offs for cash flow loans in the quarter had already been reserved for in prior quarters. The remaining areas of greatest stress in the cash flow portfolio relate to loans made in the retail and media industries.

We expect the pattern we have seen for the past two quarters that is, continued deterioration in commercial real estate, with a level of relative stability in the rest of our book to persist for at least the next two to three quarters. It is important to remember, as our credit metrics ticked up again meaningfully this quarter, that when we take a specific mark on a troubled loan the entire loan goes into a nonperforming category. For example, a $3 million specific reserve on a $40 million loan means the entire $40 million loan is classified as impaired.

In the second quarter for example, just four relatively large loans ranging in size from $55 million to $75 million accounted for over 70% of the increase in impaired loans. Our specific reserves for these three loans currently total $12 million. Similarly, a few large loans can have a significant impact on delinquency and non-accrual statistics as happened in the second quarter.

Two loans totaling $92 million accounted for 81% of the quarter-over-quarter increase in delinquencies and three different loans totaling $176 million accounted for two thirds of the increase in non-accruals. None of the large loans discussed here were cash flow loans. Rather, each had had some form of underlying asset that should allow for enhanced recoveries. With regard to commercial real estate in particular, refinance options are scarce. So nearly every loan that matures requires restructuring or extension and is likely to become classified as a troubled loan.

Near term maturities are therefore likely to cause a continued increase in the percentage of loans added to our troubled loan categories. There are nearly 50 commercial real estate loans totaling approximately $900 million scheduled to mature over the next 12 months. Approximately one third of those loans have extension options, typically six months to two years, which are generally the borrower’s option if a loan is not in default.

Total troubled assets in the second quarter, excluding any double counting of assets in multiple categories were 12.9% of our commercial lending assets. We have posted a slide on our website this morning, as part of the investor presentation showing a breakdown of troubled loans, including the delinquencies, non-accruals, and impaired loans that make up this number.

Turning to parent company liquidity, as John mentioned, the recent renewal and extension of our credit facilities resulting in a better match of the debt with the duration of the assets in those borrowings was a very substantial accomplishment. Each of the facilities with the loan exception of a euro-denominated facility has been extended until 2012.

These extensions had eliminated short term liquidity needs relating to the funding of those assets. The euro facility matures in May of next year; but because of its low advance rate and strong credit performance, we expect we’ll be able to renew or refinance the facility prior to that date.

We now have four remaining credit facilities. The collateral package for each of the three non-recourse facilities is limited to their specific loan pool. The syndicated facility collateral package, as most listeners know, includes loans specifically pledged to that facility, the stock in CapitalSource Bank and our healthcare REIT, the equity in our securitizations, and certain other assets.

At June 30, the four facilities had a collective outstanding principal balance of $1.25 billion. Utilizing the proceeds from our secured notes and equity offerings, we made a $300 million payment on the syndicated facility at the end of July, which reduced the overall principal outstanding of the four facilities to approximately $900 million. Additional details about each of the facilities, including the collateral distribution, number of loans, number of states, seniority of the loans, and weighted average remaining term, are included on a slide posted on our website.

We have also posted a slide showing the current balances on our securitizations, which experienced pay downs of roughly $235 million in the second quarter to reduce the issued debt balance from $3.4 billion to $3.2 billion.

Our current equity in those securitizations is therefore approximately $1 billion. In sum, approximately 53% of the entire $9 billion CapitalSource loan portfolio is either in non-recourse securitizations or non-recourse credit facilities 32% is in CapitalSource Bank, and 15% is pledged to our syndicated facility.

John spoke a bit about our liquidity and capital positions, as well as the potential impact of unfunded commitments. I want to elaborate a little on each of those areas. Over the past few quarters, we have been maintaining a consistent cash level at the parent in a range of $175 million to $275 million.

With fairly predictable cash uses until 2010 and some incremental sources this year, such as the HUD mortgage proceeds, I would expect our unrestricted cash to continue in that range over the next few quarters, which we feel is an adequate and comfortable level. I do want to point out however, that 75% of the HUD mortgage proceeds are committed to the lenders in the syndicated bank facility.

Assuming net proceeds of $119 million, we would pay approximately $90 million to the syndicated facility banks, 85% of which would go to the extending lenders. As we’re able to credit these payments against our future step downs, this would effectively move our first required step down to the extending lenders from April of 2000, until at least July of 2000.

Tad touched on liquidity and capital positions at CapitalSource Bank, which are both very strong. The capital position at the parent company, which stood at over $1.7 billion of tangible common equity at June 30, is also strong. On a consolidated basis, our CapitalSource tangible common equity ratio was 16.2% at quarter end.

Turning now to the topic of unfunded commitments, the total at June 30 was approximately $3 billion, with about $780 million as obligations of CapitalSource Bank. Of the commitments embedded in the legacy loan portfolio held at the parent company, the portfolio can be broken into four general categories. Those categories, the unfunded commitments, and our expected funding levels are shown on a slide posted today on our website and are as follows.

Real estate development is about $250 million of the total and we expect roughly 50% to 60% of those commitments will fund. These are primarily development loans for which we are committed to providing advances at various stages of completion. As projects proceed therefore, we will fund those commitments.

Our expectation that 40% to 50% of these commitments will not fund over the next four quarters is based on a project-by-project analysis of the status of construction and the incremental funding necessary to maximize underlying collateral value. Additionally, some of the projects are multiphase developments and we know that later phases are currently on hold.

Importantly, approximately 75% of our expected advances on these commitments are related to real estate loans in the 2006-A securitization, which had a remaining capacity to fund unfunded commitments of $83 million at June 30 for borrowers with loans already financed in that facility.

The three other broad areas of unfunded commitments are the rediscount warehouse lines, which totaled approximately $500 million. Our healthcare and security asset based loans, which account for about $650 million and all other loans, which include cash flow loans and other asset based revolvers, totaling approximately $800 million of unfunded commitments.

We expect the healthcare security and rediscount asset based loans could fund in the 5% to 10% range of outstanding commitment amounts and assume the corporate finance and other loans would be a bit higher at 10% to 15%. All of these estimates are based on a loan-by-loan, bottoms up analysis, which is refreshed on a regular basis.

It is important to note that $1.9 billion of the $2.2 billion of the parent company unfunded commitments relate to revolving credit lines. Increased asset based revolver draws generally require the posting of collateral, and new collateral sources generally require CapitalSource approval, which have been key factors in the stability of funding levels for these commitments overtime.

Additionally, our unfunded commitments have come down significantly from the end of 2008, in part because we have canceled revolvers for loans in default. Similarly, acquisition lines that are at the discretion of CapitalSource and rediscount advances are impacted by discretionary underwriting of newly proposed collateral. Finally, unfunded commitments on loans financed in the CS Funding VII facility totaled $330 million. Of that amount, we expect to fund approximately $30 million, which can be partially drawn from our remaining capacity in that facility.

Our ongoing evaluation of likely funding of the total of unfunded commitments is based on detailed work by our relationship managers, who have substantial knowledge of the funding patterns of each of our borrowers. That input, together with our experience in the contractual terms of the loans with unfunded commitments informs our expectations about potential funding draws over the next 12 months.

In short, our experience throughout the history of the company and consistent with the last few quarters of the current economic crisis, suggest that the level of funding of unfunded commitments is manageable in the context of our current liquidity sources and based on reasonable expectations about future financial performance at the parent company level.

Turning back to second quarter earnings, with the exception of the credit charges that we have discussed and the effect of the deferred tax asset reserve that I will address in a moment, our second quarter performance was inline with our expectations. Before turning the call back to John, however, I want to touch briefly on a few key financial drivers in the quarter.

Net investment income at $139 million was $11 million lower than the first quarter, but almost all of that difference was driven by reduced interest received on the residential mortgage investment portfolio, caused by the sale of our agency assets during the first quarter. Our pre-provision income after cash operating expenses was lower by roughly the same amount, at $74 million compared to $81 million in the first quarter. Our net interest margin at the bank continued to improve, reaching 3.01% in the quarter, primarily due to the improvements in the cost of deposits as described by Tad earlier.

The other significant negative earnings driver this quarter was the deferred tax asset allowance we recorded. This allowance was created through a non-cash charge on the income taxes line of our income statement. The allowance was created based on accounting literature that indicates that companies with a recent history of cumulative GAAP losses are unable to rely on forecasted future earnings to offset recorded future tax deductions.

However, it is important to note that this reserve in no way reflects management’s belief about its future profitability, as we strongly expect to return to profitability at the end of this credit cycle, nor does it have any impact on our legal right to utilize these tax deductions in the future under existing tax law.

The allowance we booked this quarter was $137 million and reflects the full net deferred tax asset for several of our taxable groups. The groups without a three year cumulative loss history have not recorded an allowance and these entities have remaining net deferred tax assets of $142 million.

For those entities where an allowance has been recorded, we will be able to reverse the allowance once we reestablish a history of positive earnings and meet the test that accounting standards require. Until such time as the allowance is reversed, as Tad mentioned related to CapitalSource Bank, GAAP earnings in those subsidiary companies that have an allowance will not be offset by income taxes on our income statement.

One final comment on liquidity relates to our healthcare net lease segment. As previously indicated, we’ve received commitments from mortgage debt of about $130 million on certain of our healthcare net lease assets guaranteed by the U.S. Department of Housing and Urban Development. Those loans will begin closing this month, and we expect all of the closings will be completed over the next 60 to 90 days with net proceeds of approximately $119 million.

With this additional debt, we will still have approximately $400 million in equity in the net lease portfolio. A variety of options to further monetize the balance of these net leased assets remain under active consideration. Completing the process of extracting our equity from the portfolio remained a high priority, which we expect to execute over the next six to 24 months.

I will now turn the call back over to John for his concluding remarks. John.

John Delaney

Thanks, Don. Before opening the call for questions, I would like to restate the investment thesis for the company as we seeing. CapitalSource has several important strengths, a well established, and highly successful national lending platform, ample liquidity at CapitalSource Bank to fuel our planned growth, and very strong capital at the parent company and at the bank.

These assets provide a solid foundation and cushion to absorb current and projected credit losses, which we anticipate will subside by the end of next year. Disciplined underwriting, a well reserved credit book, strong pre-provision earnings, few market competitors, and expanding margins help chart a course for profitable growth.

Additionally, CapitalSource Bank has a proven deposit platform in the deposit rich California marketplace, a loyal depositor base, an efficient and scalable infrastructure, and we have been making high yield loans since the middle of 2008, which will produce a larger and larger portion of our earnings as the lower yielding asset and higher cost debt for rolls off our books across the next several years. In short, we see the CapitalSource business model as very viable, fully capable of weathering the current economic storm and then driving in the aftermath.

Operator, we’re now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Hecht - JMP Securities.

John Hecht - JMP Securities

You guys provided great detail in terms of your stress test, that the legacy assets and the legacy organization. If I remember it, you also conducted a similar stress test at the bank level. I’m wondering if that’s accurate. Can you maybe discuss that in a little bit more detail some of the assumptions you made there and some of the results as well?

John Delaney

No, John. We’ve done a variety of internal work, but we haven’t done a specific stress test for the banks that we’ve disclosed publicly, unless Don or Tad, I’m missing something. I don’t believe we have. I want to make sure I don’t misspeak.

We have run the same kind of stress tests, you have in front of you or you may have in front of you, which is what we’ve laid out in our presentation today. We have done similar work like that for the bank, and it indicates the bank has adequate capital. We haven’t done any test that we’ve disclosed. Again, Don, unless I’m missing something.

Don Cole

John, I don’t recall anything.

John Delaney

I don’t think we’ve put anything out on the bank.

Tad Lowrey

Now, everything you said is accurate.

John Delaney

I just wanted to make sure that there was something that I might have forgotten that we spoke about.

John Hecht - JMP Securities

I’m wondering if maybe you can discuss the expected credit trends at the bank level. At least, it looks like you’re keeping reserves to nonperforming assets, around 100%, so good coverage there. Do you expect to keep that reserve coverage ratio? Do you expect to see continued deterioration in credit at the bank like you would at the holding company? Given that these are newer and higher quality assets we’d expect to see a different kind of linearity there?

John Delaney

Well, the bank’s portfolio, there’s a couple of ways to think about the bank’s portfolio. The entire asset base of the bank, if you will is about a third legacy loans, right and that’s where we will experience stress. About a third of the bank’s loans are non-legacy loans, in other words, loans that have been made since the middle of ‘08.

The bank in general is under lent. So, what’s positive for the bank obviously, is its percentage of legacy loans relative to its balance sheet is small, but the legacy loans, we do expect come under pressure and they have. There was a positive selection process that was associated with moving the loans into the bank.

Obviously, that positive selection process was still on a relative basis, right. Our legacy portfolio like others is coming under a lot of stress and just because we positively selected certain loans in the bank that doesn’t mean they were immune from stress. In other words, they were strong on a relative basis, but compared to new loans, they are not necessarily strong on an absolute basis.

What I can give you, which might be helpful John is if you look at the breakdown of the legacy portfolio by asset class. That we’ve indicated on page three, I can tell you kind of generally what percentage of those loans are in the bank, which might be helpful. If you have that in front of you, at this point I’ll just go through these very quickly and give you percentages.

Of the land legacy portfolio, about 30% of that’s in the bank. Of the second lien, zero percent of that is in the bank at this point. Of the resort club about 60%, of the CRE other about 30%. Timeshare receivable portfolio is about half in the bank. The mortgage rediscount, none of that’s in the bank. The cash flow portfolio, about 20% of that’s in the bank. The media portfolio about 8% of that is in the bank. Healthcare portfolio, it’s about 25% is in the bank, and asset based is about 20% in the bank.

So, just looking at that some of the, what we consider some of the tougher classes, like second lien, real estate and medias and mortgage rediscount is underrepresented in the bank, which would indicate a more positive overall credit outcome.

John Hecht - JMP Securities

Then I guess the positive selection should be some incremental amount of positive credit outcome as well.

John Delaney

Yes, for example the mortgage rediscount stuff, we started seeing pressure on that pretty early which is, why none of that went in the bank. For example, in media same thing; we did see some pressure on that early, which is why none of that went in the bank.

Don Cole

But to your point, even within some of the other asset classes, that positive selection will improve credit performance.

John Delaney

Yes.

John Hecht - JMP Securities

That’s great detail to conduct a stress test for the bank. Final question is ex-FDIC one time assessments. Your operating cost looks pretty stable during the quarter. Is that a good run rate to assume going forward?

Don Cole

Yes, and before we let you off the call John, I just want to give Tad an opportunity to see if there is, since, he should really be speaking to the bank more than I should at some level. I want to make sure if he just want to add anything to what I said a few seconds ago.

Tad Lowrey

No, I don’t. I was taking notes, and you covered all the points I would have made.

Don Cole

John, I’ll just make one comment about OpEx. I think we’re running in some ways, an elevated level of OpEx around workout expenses. So as we move through the credit cycle and the incidence of troubled loans decreases, some of those professional fees we’re spending for workout expenses will comedown.

John Delaney

That’s a material number, actually. We don’t expect it unfortunately to comedown in the near term, but it’s a material number.

John Hecht - JMP Securities

Can you give a sense for the materiality, like percentage of total OpEx that’s related to workouts?

John Delaney

10% to 20% of that.

Operator

Your next question comes from Sameer Gokhale - KBW.

Sameer Gokhale - KBW

Just a couple of quick ones, the first one is, in the bank. Maybe, Tad can answer this question, but it looks like there was some sort of equity infusion of about $20 million. I think the parent into the bank. Could you give us some color as to exactly, what that is and reasoning behind that?

Tad Lowrey

Sameer, we had four charge-offs in the quarter. Two of those related to some raw land deals that we have. It was basically the entire component of the land portfolio that we had at the bank. One of those the loss content was fairly high. So the parent to made a decision to make a capital contribution, it was a cash $20 million infusion that occurred in June. That was viewed, as what I would call a regulatory offset to taking that loss.

The regulators have already acknowledged that and have been favorably impressed by that. It didn’t move our capital ratio that much. The capital ratio we measure ourselves by is risk based capital, because we have this 15% hurdle and as you saw we’re at 16.77%. So it probably moved it a few basis points, but it was cosmetically. It was a strong sign of support from the parent to the extent that we had significant loss provisions.

Sameer Gokhale - KBW

I mean the capital ratios of the bank do seem pretty strong. I was just wondering, the recent capital raise that the company did. Can we expect additional infusions of capital from the parent into the bank along these lines for this reason?

John Delaney

No. As the capital ratios indicate, the bank doesn’t need capital. So the parent would really be only putting capital in the bank at this point if it needs it. I think what Tad summarized, I agree with 100%.

Obviously, it was a voluntary capital contribution that we did. Perhaps under the category of we felt unfortunate that some of these land loans that we transferred in went bad and we thought it was the right thing to do. It was done without consulting with the regulators. It was done on a voluntary basis and they obviously knew about it fairly after the fact. So it wasn’t something that was done based on any request.

Tad Lowrey

Sameer, if I could add to that. Based on our current operating model and our current projection of all of our numbers, we don’t show a need for a capital contribution as far out as we can see. We think we can manage within the 15% boundary.

John Delaney

Sometimes there is a little bit Sameer, doing what you should do. I think this fell more into the category of doing what we should do.

Sameer Gokhale - KBW

Then just another question about the deferred tax asset write-down, I think maybe it was Don that was talking about this. You’d mentioned you have to demonstrate a history of positive earnings before maybe you can realize some of the write-downs back as a tax benefit at some point in time in the future. Is there a definitive or are there definitive guidelines as far as how many quarters of earnings you have to demonstrate before that happens? Is this an ‘11 event or is it a late ‘10 event? How should we think about that?

Don Cole

Sameer, I would say the easy and not too flip answer, their definitive guidance is no, because in a lot of the accounting it’s not that definitive. What I will say, kind of the way we look at it is you have to demonstrate that there’s a history of performance, which we think is probably at least in the sort of three to five quarter range.

So looking at that I think it’s fair to say it’s probably looking at sort of a 2011, but it’s difficult to forecast because the standards are not that clear and you have to weigh all the evidence at each balance sheet date. I think it’s fair to say it looks out quite a few quarters.

John Delaney

Right; but it’s important to note that for those entities, when we have taxable incomes in those periods, we’ll have no tax expenses. Tad and I both mentioned, so it impacts…

Tad Lowrey

So you may have end up using it before you can even reverse it, just through the normal kind of organic use of the provision.

Operator

Your next question comes from Mike Taiano - Sandler O’Neill.

Mike Taiano - Sandler O’Neill

I’m just curious as to, the rational behind the purchases of CMBS. I know the yields were been attractive, but just when you sort of weigh the use of capital in buying those securities versus loans, which you said is 9% plus over LIBOR in the quarter. What your thought process is there?

John Delaney

Well, I’ll start and then I’ll let Tad chime-in in more detail. First of all, CMBS is broadly defined. It includes not only traditional CMBS, but it includes CMBS bonds in healthcare related securitizations, which is obviously an area we care a lot about. It also includes occasionally business loans that get characterized as CMBS, like tower financings where people have securitized pools of communications towers.

Those things are considered CMBS bonds, even though we look at them as business loans. So, I think that the first point I’d make is, CMBS is a little more broad than just traditional commercial real estate. So, that’s the first observation. Secondly, it is fairly capital efficient.

We view investing our liquidity portfolio, which is being reserved for loans, as something that we should be focused only, try to reduce the negative carry on it as much as we can. So, there’s been a fairly a disciplined process set up as to what type of CMBS to invest in, so that we really are going after the lowest-risk tranches of those structures. I’ll let Tad chime-in, in more detail.

Tad Lowrey

Yes, just to clarify, Michael. The risk weighting on, as I said earlier, we’re really managing the bank on the risk weighted capital and the risk weighting on these securities is 20%. So, what that means is its one-fifth of the level of a commercial loan. The original yields we were getting on these were in the 12 to 15 range. As you saw in this quarter, it was closer to 7%. Risk based capital adjusted these are the highest yielding assets that we can find.

We are really sourcing them through the same process as we’re commercial loans. So, we’re really viewing these as a proxy for commercial loans that are much more tax efficient. So, we view them quite favorably. We haven’t used them to crowd out any room for commercial loans. We still have ample liquidity.

The negative is that would be, we’re not seeing nearly as many of these opportunities anymore. The efficiency in the market others have discovered and the TALF program have all combined to force deals down. So, I think you’ll see a slowdown in that area.

Mike Taiano - Sandler O’Neill

So, it sounds like more over to the capital efficiency reasons within the bank is the primary reason.

Tad Lowrey

Yes.

Mike Taiano - Sandler O’Neill

Then could you maybe help me reconcile just, I guess on page five of your slides on the bank. The loan loss provision there is $90 million, but I believe in the call report that you filed earlier in the week. It looks like it was $115 million. Why would there be that? What makes up that difference? I think the same thing at the consolidated level. I think in the text of the press release it says $169 million with the actual financials have over a $200 million provisions.

Don Cole

So the reason, the difference on the reserve line of the financial statement is the reserve line of the financial statements includes both the commercial loans and the Owner Trust, because the Owner Trust are effectively accounted for like loans and the Owner Trust provision, as I indicated in my remarks was $35 million this quarter. So, that’s the difference between the $169 million and what’s showing up on the income statement.

Tad Lowrey

I don’t have an immediate answer on the call report. I can tell you that the $90 million is the correct number for us that we added to our provision. Most of that was to offset the $70 million in charge-offs. So, it may have something to do with the way those had to be reported on the call report. We’ll have to get back to you on that.

Don Cole

Well, Tad, one other thing could be add. I believe and Tad, correct me if I’m wrong, but the call report is a six months report. It’s a year-to-date report, rather than just a quarterly report.

Tad Lowrey

I think there might be both. Usually there are both quarterly and that could be a year-to-date number. That’s correct.

Mike Taiano - Sandler O’Neill

That would seem to make up the difference, because I think the first quarter was $25 million.

Tad Lowrey

It was. So, it’s got to be a year-to-date number. Thank you, Don.

Mike Taiano - Sandler O’Neill

Then just to clarify. On all of your, I guess recently renewals of credit facilities and I guess the issuance of bonds, are there any covenants at this point related to credit performance at this stage?

Don Cole

I would say there’s covenants related to credit performance and there are in one of the recourse facilities there is still charge-off covenants, but they were loosened materially, but in our recourse facility, the syndicated bank facility, we eliminated the charge off covenant that we had in the system.

Obviously, credit impacts others, net worth covenants, etc, but two important points I think on the recourse facility. We eliminated the charge off covenant, and our coverage covenant is now done pre-provision. So I would say to your answer, yes, there are some; but ultimately they’re not nearly as significant as they were before the renewals, and we think they are all sort of set at levels that we can manage even within these existing stress cases.

Mike Taiano - Sandler O’Neill

Then just final question, any residual impact from what happened with CIT post the end of the quarter in terms of either business opportunities or draw downs on unfunded commitments?

John Delaney

I’ll focus more just on the unfunded commitment part, because the CIT situation appears to be stabilizing, which is what, we’re pleased with that on a whole variety of levels. So in terms unfunded commitments, we did monitor very closely the borrowers that we shared with CIT as that was happening.

Were kind of having daily calls among senior people, monitoring borrowing activity among some of the borrowers that we share with them, whether they are the agent and we were a participant or whether we’re the agent and they were the participant.

We did see some activity associated with that, but it was not kind of the thing where there was activity across the board. There was clearly an uptick in activity among that very discrete portfolio of loans that we share, but that has certainly subsided at this point.

Operator

Your next question comes from Tayo Okusanya - UBS.

Tayo Okusanya - UBS

Just a couple of quick questions, John, thanks for the detail in regards to the portion of your loans that are at the Bank with the breakout on page three of the presentation. I just wanted to confirm two numbers. Is that 30% of the land loans are at CapitalSource Bank?

John Delaney

That’s right.

Tayo Okusanya - UBS

How much of the second lien?

John Delaney

Zero.

Tayo Okusanya - UBS

Okay, so zero of the second lien. It is the land loans, though, that caused the increase in charge offs that primarily caused the increase in charge offs this quarter. Correct?

John Delaney

Again, I lost you there.

Tayo Okusanya - UBS

It’s the land loans that caused, that were the primary drivers of the charge offs at the Bank this quarter?

John Delaney

Yes.

Tayo Okusanya - UBS

Okay, so there’s zero of, I guess just kind of given the…

John Delaney

Just to add some further detail, one of those was a loan, as I said, that wasn’t due for a year and we had a full sponsor guarantee on interest for a year. So one of them was a loan that would have stayed current for the next year, but we elected to sell it at a discount. So the charge off was really on loan. So it’s the same thing. A loss is a loss no matter how you get there, but I just think it’s a relevant point because I think we are trying to clear this stuff out.

Tayo Okusanya - UBS

Okay, so I guess with the land loans and the CRE loans that are kind of risky, portion of your entire portfolio right now, any thoughts in regards to maybe at the very beginning we shouldn’t have had up to 30% of this stuff at CapitalSource Bank at the beginning, and most of those assets should have been more like the healthcare stuff?

John Delaney

Well, yes. Clearly in hindsight, which we all know is can be very clear, we would have not transferred those land loans into the Bank. Now the land loans that we had across the whole CapitalSource portfolio, the land loans peaked at kind of 6% of the whole business. So it wasn’t like it was a dominant activity for us and these land loans were made typically to borrowers that were large real estate financial sponsors that were typically putting up at least 50% of the capital from a loan-to-cost perspective.

So most of these were made at kind of 50% loan-to-cost with very supportive sponsors, as evidenced by the one loan that we had that, in addition to being a 50% loan-to-cost loan, the interest on that loan was not funded with an interest reserve, but was actually funded out of pocket from the sponsor with the guarantee. So we had a view and time has proven us wrong, but we had a view that those loans had adequate loan-to-value because, again, they were made at 50% loan-to-cost.

Typically, there had been value add associated with the property since we made the loan. So absent a market disruption, the loan-to-value was lower than 50% and they were not owned by kind of fly-by-night developers they were owned by deep-pocketed real estate private equity firms, who typically had additional equity commitments to the project.

So we had a view, again in hindsight it was dumb, because it’s turned out to not be accurate. We had a view at a minimum worst case scenario would be very high loan to value, that we could get out most of our money or more likely that the sponsor would support them. We’ve seen such dramatic, just to put it in perspective. The loan that we sold, again it was made at 50% loan to cost.

Kind of loan to value estimates of the loan based on progress that the sponsor made with the project, in terms of changing of zoning and putting money into the project, etc., at one point indicated that the loan to value was closer to 30%. Then we ended up selling a little more than 50% of our cost in the loan. We actually thought that that was probably 30% more than the current value. So in that situation, we saw a diminution in value of 85%. So that’s some of the…

Tayo Okusanya - UBS

The backdrop.

John Delaney

So obviously, if we thought values could go down 85%, we would have never made these loans. To answer your question directly, in hindsight it would have been better not to some of these loans into the bank. At the time, they were well performing and all of the metrics around the loans were appropriate.

Tad Lowrey

I would add to that, there was a put option for six months that we thought adequately protected the bank. For the first six months not only these loans, but most loans looked fine, and the put back was limited to basically three or four deals.

Tayo Okusanya - UBS

Then just a couple of other questions, when you just kind of look at loans at CapitalSource Bank right now, is there anything that’s kind of on any type of watchlist that you’re actively watching for potential nonperformance at this point?

John Delaney

Yes, there’s obviously stuff that’s in that category.

Tayo Okusanya - UBS

Could you give us a sense of just how large that watchlist is?

John Delaney

That we’re not trying to disclose, but rather than, I don’t know. Tad, if you feel comfortable, because I’m not sure watchlist that float around, depending upon severity, so.

Tad Lowrey

Usually, watchlist is confidential between a bank and its regulator, which allows us to be fairly aggressive there. What I will say is that our watchlist has grown successively each quarter and that’s what’s driving the large increase you see. Well, that and the charge-offs. So what’s driving the provisions, not delinquencies and nonperforming and non-accrual loans like you would typically see drive these providing.

So we’re providing or adding loss reserves for a substantial portion of these loans on the watchlist, even though they are current and paying and the companies look find. The companies are weaker than they were last time we measured them. Other than commercial real estate in general, that’s the category that I would say we have the greatest concern on.

Tayo Okusanya - UBS

Just one more question and I’ll get back in the queue. Page 12 of the presentation, the credit summary, I mean you continue to present this as total loans on non-accrual $885 million. Within it, still these loans that are current, which I’ve never kind of understood that. If all the loans are non-accrual, you still have all these loans that are current, but they are also on non-accrual?

Don Cole

That’s correct. As John mentioned, for example some of the loans that may or may not have an interest reserve. I mean the way we go through our quarter end credit process is we rate every one of our assets every quarter and go through an in-depth rating process that rates them in several categories, one of which is sort of what we think of maybe as our watchlist.

For all those loans that get a watchlist, regardless of payment status, delinquency status, we do sort of a full review to decide if we think there is some impairment of the ultimate ability for the borrower to pay. If essentially, as our non-accrual slide shows, if we feel a loan will not be able to fully meet its obligations. We’ll proactively put it on non-accrual. So that’s one of the main drivers, why these large number of loans that are current end up in our non-accrual bucket.

John Delaney

I mean here is an example. Just to make a stark kind of point is that any commercial real estate loan by and large originated in ‘06 and ‘07 probably had some loss content associated with it, but probably the vast majority of those loans across all financial institutions are current, a lot of current interest reserves. So the delinquency is kind of a technical thing.

I mean if you have an interest reserve and it’s paying, it’s a current loan, but that doesn’t mean that the loan may not have some loss embedded in it and the maturity like the loan that we sold at a discount, which would have stayed current the whole year without question, we would have put that loan on non-accrual if we didn’t sell would be, because it was due within a year, and once something is due within a year you kind of have to test it for this stuff. We would put that loan on non-accrual even though we would have been paid. We would have just viewed those interest payments as a reduction of principal.

Don Cole

That’s right and to that point, I mean…

John Delaney

So that loan, let’s say we didn’t sell it; that would have been in non-accrual this quarter and it would have added to the non-accrual total and it would have added to the loans that are current total. Right?

Operator

Your next question comes from Bob Napoli - Piper Jaffray.

Bob Napoli - Piper Jaffray

Thanks for the additional disclosures. It would be helpful to see the same charts next quarter to compare.

John Delaney

I think that’s the plan. Part of the plan, Bob, is to shift from the more macro credit stress test that we’ve disclosed in the past, which we think was very informative; and actually comes to essentially the same conclusion this does, but what we’re trying to do now is make it a little more granular related to our business. So this, I think will be the future disclosure as opposed to the government sponsored, quote stress test. Which again we still think is relevant; but it’s just a little macro.

Bob Napoli - Piper Jaffray

Yes. Okay, question on the loans that are being done out of the bank. I know you said they are LIBOR 900 on average yields, but what types of loans are they? What sectors are they in? I’d like a little more color on what you’re seeing, on what you have closed, what is in the pipeline, where you’re seeing opportunities.

John Delaney

I’ll let Tad start there, if that’s okay with you, Tad.

Tad Lowrey

Yes. Let me start, Bob, with the yield first. When we quote yields, the major portion of that of course comes from our spreads. We are seeing spreads today on healthcare deals of say LIBOR 3%, 3.50%, 4% over, but most of these would have a 4% floor. So, that gets you most of the way there, but on most of the healthcare deals they have a substantial unfunded portion and we charge fees on that.

We also charge a front-end fee and a fee on the way out. When you aggregate that it gets the yield closer to between 9% and 11%. On our cash flow deals, we’re probably seeing margins at a much higher level. The floor is the same but the LIBOR over is 6%, in the 6% range, instead of the 3.5% range.

As far as a breakdown, not speaking of the pipeline but just talking about the deals, the $211 million that we disclosed for the quarter, I would say that’s a combination of healthcare, healthcare real estate and ABL and cash flow. If I were to break those down, about a third of those are straight cash flow deals, with the remaining two-thirds being a combination of healthcare real estate, healthcare ABL, and general ABL.

So, about two- thirds are the asset classes that I mentioned that we would like to focus on. You notice there is no real estate in there other than healthcare real estate, which we view as quite a bit different as commercial real estate. I will say we’re seeing a number of commercial estate deals, but obviously they pencil differently and they look a lot different than what’s in our portfolio today.

At least in this particular quarter we didn’t close any of those deals. On the pipeline or what we call approved pending close, those have a similar composition to what I just described, except probably a greater percentage of those would be healthcare ABL type deals.

Bob Napoli - Piper Jaffray

Are these deals that somebody is looking to refinance? Are they M&A related or…?

Tad Lowrey

The M&A activity have dropped dramatically so we’re seeing a timing piece of that, but more of a typical deal is where somebody owns an existing facility. One of the ones that we pulled up is a social rehab services within California actually. That’s owned by a wealthy family and they’re expanding and so they needed money to expand and that’s why there is a large unfunded piece of that. They also at the same time were refinancing their existing line. So that was growth related there actually is growth occurring in some sectors out there. We’re looking at M&A deals, but a very small percentage.

Bob Napoli - Piper Jaffray

Okay and then just my last question is, in a more broad on John, what you’re seeing on pay down. If you look at the non-bank, where you’re not really originating anything and you’re just, the loans would only increase through draw downs of unfunded commitments primarily, it just looks like and with only $1 million of prepayment penalties, if you back out the charge-off that there was very little repayment activity of any kind in the quarter.

Just wondering how you monitor that? I think in healthier environment certainly you’d see more pay downs. I just don’t know if the slowdown in pay downs is means that credit problems could be budding beyond expectations.

Don Cole

We clearly monitor the pay down pace. I think it was about $100 million of pay downs on loans at the parent company in the second quarter, which is consistent with our first quarter. Obviously, that is a lot lower than what we’ve historically sort of seen and that I should say, is actually pay-offs.

There are a fair amount of loans that have regular amortization and cash flow sweeps etc., so, the balance comes down even further, but as we said and especially in the commercial real estate space, obviously we’re seeing a lot of loan extensions. Those loan extensions then again get sucked up in our credit process, in our troubled loan categories, etc.

What I will say is, the way typically loans are written our real estate loans definitely have the shorter maturities. So, that’s the largest percentage of the loans that are coming due over the next year. I think 75% or so of the real estate loans come due in the next year versus 20% to 25% of the rest of the book.

John Delaney

We haven’t had a lot of corporate loans come up for maturity this year.

Bob Napoli - Piper Jaffray

What is the maturity? The corporate loans, aren’t they generally two to three year loans?

John Delaney

They were typically five year.

Bob Napoli - Piper Jaffray

So, the maturity of those loans increases significantly in 2010 and ’11.

John Delaney

There is a very large percentage of the corporate loans are due.

Operator

Your final question comes from Scott Valentin - FBR Capital.

Scott Valentin - FBR Capital

Just on the deposit cost, you noted deposit costs were coming down and you had some runoff. Just curious what’s happening with duration on the CDs? If you are managing to extend those while rates come down?

Tad Lowrey

Unless you consider moving from six months to 10 months effective duration, our primary product right now is a 10-month CD and that’s varied between 6, 9, and 11. We change that at different times for different reasons. We actually have put some offers on the table for longer term CDs, but we’ve been unsuccessful generating a lot of dollars there.

We think the amount of premium that we would have to pay up for those long term is nowhere near worth it. If we did need to extend our duration of our liabilities, we are building substantial collateral at the Federal Home Loan Bank, so we could utilize that, because we can basically pick any term that we like.

We were recently approved the action we filed our call report for a larger percentage of assets to increase our borrowing capacity at the Home Loan Bank. Basically, the only fixed rate assets that we have or assets of any duration are some of these securities that we bought recently. So, our mismatch actually goes the other direction. So, we really don’t have a strong need to extend the liabilities much further.

Scott Valentin - FBR Capital

Just kind of looking at last quarter’s presentation versus this quarter; one of the slides last quarter Outlook Update, I guess it was five or six different categories. You did lack of a [Inaudible] yourselves kind of what the thought was on ’09? Then where you were in the first quarter? What the outlook was?

I think John you may have mentioned earlier that charge- offs may be running a little bit higher than what you thought they would be in the first quarter. Wondering, how you are scoring in terms of loan growth? I think your operating expense is running a little bit lower and just where you stand maybe relative to your outlook.

Dennis Oakes

I don’t have our outlook in front of us, but I think you hit on the key ones, right. I think charge-offs are ahead of where we would have put them out in February, both through two quarters. Now, I think we realized that February forecast would be light. Loan originations are down.

I think last quarter we said we thought we would still look for a pickup and still sort of target the same level we had laid out. I think again, from a loan only perspective, I think now, I think we’re behind that schedule. However, as John and Tad both talked about, the CMBS originations, which are originated much like the loans have certainly filled some of that gap.

OpEx, I think we’re sort of on target and I’m trying to remember what the other points were. I would say probably cost of funds were, where we would have expected to be and yields were where we would have expected to be.

Scott Valentin - FBR Capital

Then one final quick question; prepayment income are slowing, that the prepayment income will remain depressed?

Don Cole

I think that’s right. I think it might have been in our presentation last time or in the slides. The last income, last quarter was one loan. We have a prepayment fee on, but generally speaking, I think we expect prepayment income to remain significantly reduced from where it was a couple years ago as prepayment rate certainly stay loan.

John Delaney

Thank you, everyone for joining us. Just a reminder again, this call will be archived on our website later today and a transcript should be out later as well. Thanks very much.

Operator

Thank you, gentlemen; the conference is now concluded. We thank you for attending today’s presentation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!