CapitalSource Inc. (NYSE:CSE)
Q3 2007 Earnings Call
November 6, 2007 8:30 am ET
Dennis Oakes – IR
John Delaney – Chairman, CEO
Tom Fink – CFO
John Hecht - JMP Securities
Sameer Gokhale - KBW
Carl Drake - SunTrust Robinson Humphrey
Henry Coffey - Ferris Baker Watts
Don Fandetti - Citi
Bob Napoli - Piper Jaffray
Scott Valentin - FBR
Mike Taiano - Sandler O'Neill
Omotayo Okusanya – UBS
Welcome to the third quarter 2007 CapitalSource earningsconference call. (Operator Instructions)I would now like to turn the call over to Dennis Oakes. Please proceed, sir.
Thank you, operator and good morning, everyone. This is theCapitalSource third quarter 2007 earnings conference call. With me today areJohn Delaney, our Chairman and Chief Executive Officer and Tom Fink, our ChiefFinancial Officer.
The call is being webcast live on our website and arecording of the call will be available beginning at approximately 10:30 a.m. Eastern time this morning. Ourpress release and website provide details on accessing the archived call.
I urge you to read the forward-looking statements languagein our earnings release, but essentially it says that statements in thisearnings call, which are not historical facts, may be deemed forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995.
All forward-looking statements, including statementsregarding future financial operating results, involve risks, uncertainties andcontingencies, many of which are beyond CapitalSource's control and which maycause actual results to differ materially from anticipated results. More detailed information about these risk factorscan be found in our press release issued this morning and in our reports filedwith the SEC.
CapitalSource is under no obligation to update or alter ourforward-looking statements, whether as a result of new information, futureevents or otherwise and we expressly disclaim any such obligation.
I would like to turn the call now over to John Delaney.
Thank you, Dennis. Goodmorning, everyone and thanks for joining us. Clearly the markets have seen an amazing level of illiquidity, riskrepricing and deleveraging across the last few months. All events we spoke verydirectly about on our last call and we have talked about in conversations withsome of you we have had since.
As I hope you will appreciate as we go through our call thismorning, CapitalSource was built exactly for this type of challenge and marketopportunity. We were fully prepared for this type of market correction and weare fully prepared for the market opportunity that now lies ahead.
Unquestionably, our entire business model was stress-testedthis past quarter, and we passed this test with high marks, in my mind. In myremarks this morning, I want to touch on four areas:
(1) Ourspecific results for the quarter, which I am very pleased with;
(2) Someperspective on this quarter's results, including some of the lumpy aspects ofour business;
(3) Ouroutlook for the business, which is highly favorable; and,
(4) Our TierOneacquisition.
Let's start with the results. In the third quarter, we had adjustedearnings of $97.6 million or $0.50 per share. These results were lower than oursecond quarter results, in large part due to certain lumpy aspects of thebusiness that were once again, just that.
During the quarter, we grew our commercial loan portfolio byapproximately $700 million. The growth dynamics of the company this quarterplayed out very much in the way we had predicted they would during our lastearnings call in August.
I mentioned certain lumpy aspects of the business. Iconsider a significant portion of the quarter-over-quarter decline in adjustedearnings per share due to this lumpiness. For example, prepayment fee incomewas down substantially from last quarter. Prepayment fee income was $3.2 million this quarter, down over $14million, or $0.07 per share, from last quarter. By comparison, prepayment feeincome was $17.3 million last quarter and was an average of $19.6 million perquarter for the prior four quarters. This substantially lower level of fees wasdriven by lower prepayment volume in the third quarter and lower fee income onthe loans that did prepay.
In terms of yield, prepayment-related fee income contributedjust 13 basis points of yield this quarter compared to 76 basis points lastquarter, and an average of 96 basis points per quarter for the four priorquarters. As it has in the past, I expect prepayment fee income will continueto vary from quarter to quarter. However, I also expect it to rebound from thisquarter's historically low level. Forexample, I can tell you now that so far in the fourth quarter, we have alreadyseen more in prepayment fee income than we did in all of the third quarter.
Another area of lumpiness was in realized gains anddividends on our equity investment portfolio. To review, we regularly makesmall, side-by-side equity investments in borrowers in our corporate financebusiness. This is done alongside of theprivate equity firms who are acquiring these middle market companies. Returnsfrom this equity portfolio, either dividends received or realized gains on salesof those companies, have been a frequent contributor to our bottom lineperformance.
This is clearly part of the core earnings of the company,but the specific amounts realized will fluctuate from quarter to quarter. Overthe prior four quarters, we have seen an average of $9.3 million in equityreturns per quarter. Last quarter wasparticularly strong at $17 million or $0.09 per share, while this quarter, wesaw virtually no equity gains.
An important thing for investors to keep in mind is that inquarters where we see low or no equity gains, it does not mean that this incomeis lost. Rather, since we continue to hold the investments, we consider the returnsdeferred to future periods.
Credit is another lumpy area of the business and charge-offswere up this quarter. Charge-offs were $27.8 million this quarter or $0.14 pershare, bringing our year-to-date total to $51.7 million or 71 basis points. Thecharge-offs this quarter were primarily charge-offs of previously reserved forassets. That is, we previously had specifically reserved for these loans in ourallowance.
Our portfolio credit performance in the third quarter wasquite strong, as indicated by our other credit statistics, notably loans indelinquent or non-accrual status. As aresult of this performance, the charge-offs we took effectively cleaned out ourpipeline of potential charge-off losses and we did not need to replenish thosespecific reserves. As a result, I would expect charge-offs to be substantiallylower in the fourth quarter.
It is important to emphasize that the credit pipelineremains stable, specifically as a percentage of commercial assets. Loans onnon-accrual status, which we consider our principal credit measure, improvedfrom the prior quarter to 1.59% as of September 30. Also, delinquent loansimproved to 0.67%.
These credit stats are at the low end of our historicalranges and while credit stats can and will move around from quarter to quarter,I am encouraged that both of these key metrics are down from last quarter, downfrom year end last year, and down from a year ago; all in a period of greatdisruption in the markets. This provesthe quality of our commercial credit book in our business. CapitalSource ispositioned on a sound and clean foundation.
Now let's move on to my perspective on the quarter. As Isaid, I am very pleased with the quarter and how well CapitalSourceperformed. Liquidity performance inparticular was exceptional and we had no issues -- not one -- in funding anypart of our business. We ended the quarter with lower true leverage than at theend of June. We ended the quarter withsignificant and improved liquidity. Today, we have over $3.2 billion inundrawn, committed funding for our commercial lending business.
As I said, we never had any funding issues during thequarter and this comes as no surprise to us. Since the very beginning of our company,we have carefully planned our funding platform. We have been conservative; we have focused on building the business forthe long run. To us, the right side ofthe balance sheet is as important as the left and this quarter, all thatcareful planning paid off.
As a reminder, this planning took several forms. First, we focus on always maintaining prudentleverage in the business. Whereas it is possible to finance our type of assetswith much higher leverage -- and someothers do -- we think that creates too much risk in the business.
Second, we believe in match funding. We have managed the business to a largelyinterest rate insensitive position.
Third, as a major tenet of our funding strategy, we avoidusing short-term, market-dependent financings to fund less liquid assets. Morethan a few were caught up this quarter as the CP markets seized up. We were not.
Fourth -- and perhaps I should have mentioned this first --prudent credit practices are a significant factor in our funding. Stable assetperformance is the foundation of the liability structure.
Fifth is diversification. We have built a broad and diverse portfolio and maintaining multiple,broad, diverse sources of funding is also critical. We have emphasized diversification on bothsides of the balance sheet.
Sixth is discipline, not being afraid to slow down. It takes discipline to slow down when themarket is not seeing the risks you know are there. We have demonstrated ourdisciplines many times such as our pullback from condo lending almost two yearsago, our pullback from aggressive LBO finance this past spring and our recentpullback in the third quarter. Here wehad the conviction that risk would reprice to our advantage and that disciplineis paying off now.
Last, in maintaining a focus on high risk-adjusted yields.In a sense, we always plan that things could get worse and this planning hasbeen rewarded. Another example of our prudent planning was seen this quarter inour residential mortgage investment portfolio. During a very turbulent periodof the third quarter, our residential mortgage portfolio performed exactly asexpected. That is, we had no issues. We had more than ample liquiditythroughout the third quarter and it continues to be more than ample today.
On a relative basis, we did see some small mark-to-marketchanges in the portfolio value, about 48 basis points in change, but we haveseen similar movements before, both up and down across the life of thisportfolio. They were small in relationto the portfolio size, demonstrating that our hedging and funding and assetselection strategy is performing beautifully. Also, we expect the relative valueto come back.
Onto my outlook. My outlook for the quarters ahead isextremely positive. As predicted, we are seeing the finest environment we haveseen in years. Lending spreads are upapproximately 140 basis points from the first half of the year across ourbusiness units. This is measured off actual third quarter deals. Growth isreturning to the business. Pipeline isgetting very strong and competitors are fading rapidly. I expect 2008 could beone of the best years from an asset quality, yield and growth perspectives andI couldn't be more excited about our business.
We expect credit performance to remain very strong. This is due to two fundamental things. Firstis the conservative posture we have taken with respect to high-risk areas suchas condo lending and aggressive LBO structures. Also and importantly, ourportfolio is anchored with specialty businesses such as healthcare, securityfinance and rediscount. These are areaswe know better than anyone and which we view as very well-positioned should afurther slowdown occur and they combine to represent about 50% of our currentportfolio.
Based on our outlook and view that lumpy areas of thebusiness that under perform this quarter will normalize, we are confident inthe future performance of the business and are planning to pay a quarterlydividend of $0.60 per share in the fourth quarter, which we view as our runrate.
Onto TierOne. Finally, let me touch on the important acquisition of TierOne Bank. Theacquisition is on track in all material respects. A proxy statement was mailedin October and a special meeting of TierOne shareholders has been called forlater this month. The regulatory process has been constructive. I also thinkthe events of the third quarter make clear the value of the acquisition forboth parties. In our case, the recentcapital markets' turmoil underscores the wisdom of our strategy and reinforcesthe need for deposit-based funding. For TierOne shareholders, the opportunity toparticipate in a best-in-class lending platform that delivers stellar creditand high returns is very compelling.
To be clear, we are in a spread business and thisacquisition represents an important way for us to lower our costs and makeourselves a more efficient lender. The acquisition of TierOne presents upsidein '08 and '09 from lower cost of funds and also adds to the breadth anddiversity of our funding.
Let me now turn the call over to Tom Fink, our ChiefFinancial Officer, who can provide his perspective on the quarter.
Thank you, John and good morning, everyone. I certainly echoJohn's sentiments about how well CapitalSource performed this quarter with theextreme conditions that existed in the market. I think we weathered the stormycapital markets particularly well and I am excited about the prospects for thebusiness.
In my remarks this morning, I want to take a minute to focuson some things that I think were important about our performance this quarterand provide a little more detail. First, we strengthened our balance sheetsignificantly during the quarter. As aresult, we are well-prepared for the favorable market conditions that webelieve we are now entering.
Second, we maintained our credit discipline and sawimprovements in our key credit statistics; and third, we also saw improvementsin our operating expense ratios, including surpassing our 2% operating expensegoal that we have previously talked about.
Let me spend a minute on each of these and as I close, Iwill touch on the subject of guidance. In the third quarter, we continued tostrengthen our balance sheet. Currently,our undrawn committed credit facility capacity stands at $3.2 billion, up from$2 billion at the end of the second quarter. Since June 30, we have put inplace even more in terms of credit facility capacity. We also completed our convertible noteoffering, which looks more and more like the smart move we thought it might beat the time.
We completed two term financings, one in September and onein October, totaling approximately $1.5 billion. These term financings were more expensivethan our historical term financings, reflecting the current market conditionsand we did suffer some margin compression on those loans funded by them. However, it was our view that the debt capitalmarkets would be in a state of disruption for several months to come and it wasmore important for us to have plenty of dry powder for the future where we seebetter market conditions for the company.
Alternatively, we could've just hoped that the markets wouldimprove and just waited. We certainlywere under no pressure to execute these financings, but we don't manage ourbusiness by hope. We are very cautiouson matters of funding and liquidity and once again chose the prudent pathhere. Also, we did retain an option toprepay this debt so that we can refinance this debt should market conditionsimprove faster or more strongly than we thought.
An important point to keep in mind is that this margincompression I referred to is limited to a finite amount of assets on ourbalance sheet. All future loans are going to be made with these higher fundingcosts in mind and will have, as John mentioned, even higher spreads. We maystill see some short-term volatility in cost of funds due to capital market conditions,but I view this as short term, and the long-term view is positive.
Another aspect of our balance sheet strengthening thisquarter has been our dividend reinvestment and direct investment program. Sincewe reached a 4:1 debt to equity ratio at the end of the second quarter, we didreactivate the DRIP in the third quarter. The DRIP has been an extremely flexible and powerful tool for us tooptimize our capital structure. Weraised approximately $291 million during the quarter in the DRIP, includingover 30% of our shareholders electing to reinvest their dividends.
As John indicated, our credit performance was very good thisquarter. The charge-offs we saw thisquarter primarily were driven by the charge-off of previously reserved-forloans, effectively cleaning out the bulk of our charge-off pipeline. Allforward-looking metrics point to a stable credit outlook and an improvedcharge-off performance next quarter.
As a percentage of commercial assets, loans 60 or more daysdelinquent were down to 0.67% at quarter end, down 30 basis points from lastquarter. Loans on non-accrual were down to 1.59%, down 18 basis points from theprior quarter. Our allowance for loanloss stood at 1.05% at the end of the third quarter with the unallocated portionof the reserve consistent with that of the prior quarter end, also indicatingstability in future credit performance.
To put these credit stats in perspective, the third quarterlevels are the lowest we have seen in many quarters. For delinquencies, this quarter is the lowestlevel we have seen since the first quarter of 2006 and for non-accruals, whichis our primary credit metric, this is the lowest level we have seen since thefirst quarter of 2005.
Our operating expense ratio is another area where we sawimprovement this quarter. In looking at our commercial segment, operatingexpenses were down in the quarter, $63.8 million from $64.6 million lastquarter. Excluding the depreciation andamortization of our direct real estate portfolio, core commercial operatingexpense was $56.2 million, down almost 5% from last quarter's $59 million. As apercentage of commercial assets, core commercial operating expense was 1.95%,breaking through for the first time the 2% level that we had established as a goal.
My last topic is guidance. As John has already indicated, we are guiding to a $0.60 per sharedividend in the fourth quarter. This isbased on our expectation that some of the lumpy aspects of the business we sawthis past quarter will come back to more normal levels in the fourth quarter.We have already seen evidence.
Also as John indicated and as implied by our improvingcredit stats, we do expect charge-offs to be materially lower in the fourthquarter.
I recognize that this is usually the time of year where webegin to set out some objectives for 2008. However, as we have mentionedbefore, we will not be establishing formal guidance for 2008 until after theclose of the TierOne acquisition. The timing and other aspects of ouracquisition of TierOne are the single biggest thing that will affect our futureguidance. This transaction is on track and we do expect to hear more news withrespect to timing in the near future.
We are planning, however, to host an annual investor day in New York City in March.
So to sum up, in many respects, the third quarter certainlypresented many challenges and was a real life stress test by which you and wecould judge the strength of our company. I am pleased that we not only met those challenges, but passed the testwith flying colors in both absolute and relative terms. There are obviouslystill storm clouds hanging over the market, but our important message for todayis that these clouds have a silver lining for CapitalSource.
I will now turn the call back to Dennis Oakes and we will beready for your questions.
Thank you, Tom. Operator, we are ready for the firstquestion please.
Your first question comes from John Hecht -JMP Securities.
John Hecht -JMPSecurities
Could you give a little bit more detail on your near-termmargin outlook? You are talking about incremental margins on new loans of 100basis points upside and I am wondering if you can maybe discuss the pipelineand the balance sheet add with respect to fourth quarter and how much yieldimprovement will come from that? And when you see the prepayment and feeactivity start to increase and add to margins as well?
Sure, John. What Imentioned in my comments was that loans that we have prescreened in the thirdquarter had a spread over LIBOR of 140 basis points higher than loans in thefirst half of the year. We thought that would be a good data point; not a datapoint that you can actually carry forward for years, but a good data point asto what the market is presenting right now. It's certainly obvious to us thatour ability to price our loans is much greater than it has been in the past andwe expect this to result in wider margins in the future.
The pipeline is building nicely. Clearly, we took a conservative orientationin the third quarter and we talked extensively about that on our last call. I would describe the pipeline right now asbuilding up very nicely and I would expect 2008 to be a terrific year in terms oforiginations.
In terms of prepays and equity gains, I don't think there ismuch to read into that other than it is lumpy. It just happened to be lumpy ina quarter where we had this very significant capital market disruption, but aswe unpack that and look at the specific situations, there is nothing that wecan necessarily correlate to the capital markets. In fact, in the fourth quarter as it relatesto prepayments we are already, as I said, ahead of where we were for all of thethird quarter.
So I would put the prepay and the equity performance reallyunder the category of lumpy and we obviously expect those to normalize. I would describe the pipeline as building upvery nicely and '08 originations I view as being very strong or likely to bevery strong.
In terms of our ability to drive higher yields and quitefrankly more conservative structures on the lending side, I think it is verygood. We are seeing the competitors fading. Either they are pulling back or they are actually exiting the market,which is an incredibly positive trend for the business and should allow us toprice our loans along the lines of the way we did when we started thebusiness. We think it is a greatopportunity.
Unlike when we started the business, when the platform was-- to use a word, immature -- we had strength in some areas and not strengthsin other areas, I would describe the platform right now as fully built out andhitting on all cylinders. So this timeas the market is coming our way we can really pounce on it.
John Hecht -JMPSecurities
Can you maybe characterize the pipeline, where are youseeing the initial signs of activity?
I would say we are seeing it across the board. I think ourrediscount business in particular has seen an uptick in the pipeline. Ourhealthcare business is seeing a lot of activity. Obviously, there is lots ofactivity in the more market-based businesses like commercial real estate andcorporate LBO lending, where you see the most significant swings in marketcompetitors. I would have to describe the pipeline as building across allbusinesses.
John Hecht -JMPSecurities
So it sounds like the originations side, you are seeing someincreased visibility, increased origination activity across all facets of thebusiness. Turning to the funding side, last quarter, John, you were talkingabout looking for market equilibrium in the CLO market where you may see an exitingof the business at synthetic buyers, but are you going to see some consistencywith the cash buyers. Are you seeing anyequilibrium there where you think that market may normalize along with theoriginations?
I would say we are not seeing equilibrium yet. We completedtwo securitizations and we expect to complete our third one very shortly andthese are somewhat unique structures where they are single buyersecuritizations and we reserve the right to take the assets back. Either to resecuritize them when the marketdoes obtain equilibrium or to fund it with deposits once we have our depositorycapability.
I would describe our ability to access the secured marketsis very good, but different. Meaning, as I said, we will probably have ourthird CLO complete in a few weeks since the beginning of the market when themarket started these very significant disruptions and I don't know how manyother lenders have been able to do any, for that matter.
So I would say our ability to access the market isgood. We can't access it in exactly thesame we did before, which is broadly syndicated securitizations. So I wouldhave to say that there is no equilibrium in that market yet, but there arecertainly signs, particularly around the AAA class, where we are seeing it firmup.
Tom could add more texture to that.
I agree with everything John said, but also I think it isimportant to note the significant undrawn, committed credit facility capacitywe have, which is the whole reason we undertook those term financings wecompleted in September and October, was to reestablish that dry powder, as Isaid, to allow us to pursue these great market opportunities that we see comingour way.
Also importantly, this is not the only means with which weuse to fund the business and here, the breadth and diversity of our fundingplatform will also help the company.
Your next question comes from Sameer Gokhale - KBW.
Sameer Gokhale - KBW
Thank you and good morning. I just had a question about the integration efforts for TierOne Bank. Irealize it is in its own kind of unique geographic footprint, but can you giveus a sense for how far those efforts are along and if one were to take anegative view and say the deals weren't going to go through, would that causeany amount of significant disruption to your existing businesses? Some color onthat would be helpful. Thank you.
I would describe the integration efforts thus far as verysuccessful. We are getting along very well with the team. I think we share acommon view as to how these businesses will work together and I would describeour integration efforts; an integration of an acquisition like this is a fairlymassive undertaking, particularly if you want to do it well. I would describeour efforts as essentially right on track.
We are very confident the TierOne transaction willclose. I couldn't imagine anydisruptions if it were not to close for any reason, which is part of yourquestion, but it is hard for me to imagine that because I believe it is goingto close.
Sameer Gokhale - KBW
The other thing I was curious about is it seemed like in thesubordinated loan category there was pretty healthy growth during the quarteron a percentage basis, certainly compared to some of your other businesses. Isthis just a function of you guys seeing better pricing opportunities in thatpart of the market?
If you look out to 2008, assuming there is more disruptionin the market and the pricing environment continues to improve, would youperhaps tend to back end load the second half of the year loan growth in thesubordinated loan business? Can you provide any color there?
Most, if not all of that growth in the subordinate loancategory came from our healthcare real estate business where we had what weconsider some unique opportunities based on our ability to play up and down thecapital structure. Meaning in that business, we engage in sale leasebacktransactions, we engage in senior first mortgages and from time to time, weengage in subordinate secured financings based on financing a transaction wherewe feel like we understand the assets and in fact, would love to own the assetsat that price. So we had a few uniqueopportunities.
That, I think, did come our way because of what happened inthe larger markets and that is where most of that activity was concentrated inthe healthcare real estate business. Our orientation is as a senior lender, asyou know, but in the healthcare real estate business because of the quality ofthe team and the way we execute against that strategy, which is to provide bothsenior debt and also to provide sale leasebacks, we are effectively buying theassets. We feel comfortable playing in a subordinate position because weunderstand the assets and in fact, if we view assets where we would love to ownthem at the price, we are fairly comfortable providing subordinatefinancing.
I tend to think our subordinate activities would generallybe focused on areas where we feel we have greater expertise like healthcare.
I would just add it is clearly not a change in the strategyof the business. It's just a very good example of us being nimble andresponding to really the best opportunities that we are seeing.
Sameer Gokhale - KBW
In terms of the loans that charged off in the quarter, whatkind of loans were those? You seem to be pretty bullish on the outlook forcredit going forward. Obviously, your forward credit markers are showing prettypositive trends, but as you look at your portfolio, when you look at competitivetrends, as you look at what charged off in the quarter, are there any themesemerging that you can identify going forward?
No. We would agree with your assessment that the creditpipeline looks very good. We significantly reduced the amount of loans that hadbeen specifically reserved for, which is generally a precursor to charge-offs. Themetrics have improved, which means not many new situations entered the problemloans bucket, so that is all positive.
I would echo the comments I made last quarter, which is tosay that about half of our business is in healthcare, rediscount and securityfinance which is financing security alarm dealers and we continue to have asituation on our hands where we have no credit issues in those businesses. Sothat would imply that the charge-offs would continue to come from the moregeneralist businesses; corporate finance, commercial real estate, stuff likethat.
There are no trends that we see. We effectively just cleanedout a lot of loans that had been specifically reserved for is the way it playedout this quarter.
Your next question comes from Carl Drake - SunTrust RobinsonHumphrey.
Carl Drake - SunTrustRobinson Humphrey
John, I was wondering if you could talk a little bit aboutthe changes in the competitive landscape. I imagine the hedge funds have leftthe business in certain areas, but we have also heard some of your peers talkabout regional banks getting more competitive. Maybe you could talk about the underwriting quality; also what you areseeing on new transactions in terms of covenants and leverage?
New transactions are better in all respects. I would view the structures as moreconservative, the covenants as tighter and the spreads as wider. As I said in my comments, we think that thelending environment right now is terrific.
In terms of competitors, we are seeing a pullback from hedgefunds, and I think that is due to a couple of reasons. One, some of the true, large,well-established branded hedge funds that were in this business seeopportunities to allocate capital in other parts of this market that areexperiencing tremendous upheaval. Theseare smart people with lots of capital, and they tend to migrate to where theopportunities are.
Unfortunately, there are a lot of secondary opportunitiesright now going on, and we are not a secondary market player and I think thehedge funds will tend to allocate their capital there.
And then I think there are some smaller hedge funds that weare getting into our business that have less established platforms and areprobably hunkering down more than anything else and not allocating capital toless liquid investments like middle-market lending. So I think the hedge funds, depending uponhow you kind of characterize them, the super-brandedhedge funds with plenty of liquidity and probably growing liquidity in light ofthis environment, tend to be allocating their capital less from directoriginations of less liquid investments more to secondary market opportunities.Where some of the smaller guys who were kind of nibbling at our ankles in ourbusiness the past few years, I think are more hunkering down and are focused ontheir own liquidity.
In terms of the investment banks, obviously we had manyinvestment bank competitors who had platforms or who dabbled in our business. We are seeing very dramatic pullback there.One large investment bank that had a healthcare real estate business that wecompeted head-to-head with has exited the business, which we view as a terrificsign, for example. So we are seeing a lotof pullback from specialty platforms, asset management platforms that wereoverly reliant on the CLO market.
As Tom indicated in his comments, we have many ways offunding our business. We are notconcerned about funding the growth we have, in part because we have built thisfunding platform that can pull on a lot of different levers to get liquidity;whereas we were competing from time to time with competitors that were I woulddescribe overly reliant upon the CLO market. Now that the CLO market is closed,they can't access capital and they are pulling back.
So in terms of a lot of our core competitors, investmentbanks, specialty lending platforms and hedge funds, we are seeing, as I said,either they are exiting the business or there is a significant pullback.
We are not necessarily seeing an uptick on banks. We don't overlap with regional banks thatmuch. We do in certain parts of ourbusiness. It tends to be a little morebased on a relationship than based on them having a thematic business aroundwhere we compete. For example, from time to time, our healthcare business willlose a deal to a regional bank, not because they have a healthcare platform andthat we compete with day in and day out, but because they may have arelationship with a company and they may like the company and may like thepeople running the company and they may decide to make a loan to thathealthcare company based on those very important determinants of credit by theway, which is the people and their relationship with the company.
So the competitive environment with banks, which tends to bemore random, I would not describe as us seeing any change there.
Carl Drake - SunTrustRobinson Humphrey
So you would characterize the opportunities, the growthopportunities for '08 are more competition leaving the market than the level ofactivity in the market picking up?
Carl Drake - SunTrustRobinson Humphrey
A second question in terms of less liquidity in the marketas you just described, does that put some pressure on recovery rates in thebusiness in terms of charge-offs going forward?
Yes, and we have always said that, by the way. We havealways said that we don't expect our credit statistics to change all thatdramatically if the country were to go say into a recession, but we expectrecoveries to go down. I have said that before and I'm going to stickwith that. I think it is somewhat of alogical conclusion.
Again, we are not seeing anything there. Unfortunately, the credit pipeline is in manyways improving. So even in an environment with potentially lower recoveries, ifyou have less loans entering those buckets, it shouldn't have a material affecton your outcomes.
Carl Drake - SunTrustRobinson Humphrey
On prepayments in a less liquidity market, would you expecta permanently lower prepayment fee contribution or yield contribution? I thinkwe had always modeled 50 basis points or so. Do you think that is reasonable?
We spend a lot of time thinking about that because here wehave a situation where the markets go through this fairly massive disruptionand our prepays are down. Initially you say to yourself, well, maybe there is acorrelation there and maybe we could see an environment where prepays will belumpy for a while because again, these things are not lost, they aredeferred. We have the prepayment fees inthe deals, they will ultimately prepay and we have this equity portfolio, whichwill ultimately be harvested.
I think it is way too early for us to come to any kind ofconclusion around that and I think first evidence of that is the fact that thefourth quarter is already shaping up to be stronger and the fourth quarter iscertainly not a better quarter as it relates to market liquidity than the thirdquarter necessarily. So I think it isway too early to draw any conclusion there. We certainly expect these things toreturn to normal levels and if anything, they are not lost, they are deferred.
So in other words, the prepayments we didn't realize thisquarter and the equity gains we didn't realize this quarter, we will realizethose at some point because they are not lost. We are not giving up ourprepayment fees and in fact in the new lending opportunities, those kind ofstructures getting tight prepayment fees and getting equity co-investopportunities, we have much more ability to obtain those things in the loansnow than we really have in the last several years even though we have been ableto get them. So I would actually thinkinto the future, we would see those things increase.
Your next question comes from Henry Coffey - Ferris BakerWatts.
Henry Coffey - FerrisBaker Watts
I am appreciating some of your comments here, John. I amgoing to ask the most unfair question, which I know you get asked a lot, but asyou start juggling through '08, is TierOne additive or somewhat dilutive toearnings? Is there enough evidence out there to talk about a base level ofquarterly adjusted FFO or adjusted earnings? If so, where do you think thatlower number would fall in?
I will start and then I will let Tom chime in, Henry, ifthat's okay with you. TierOne provides many benefits to the company, principallylower cost of funds. That lower cost of funds, which was pretty significantwhen we announced the transaction, is now becoming, in a word, dramatic interms of its ability to increase our profitability. '08 and '09 for that matter will be in partdependent; as I said, the businesswithout TierOne is performing at a very good level and as I indicated, we arepaying a $0.60 dividend for the fourth quarter. We view that as a run rate.
I think our ability to use TierOne and potentially our ILCwith that, which we have been approved for, could drive significantprofitability for the business. It is a little early for us to talk about howthat could change the business which is the reason we are not providingguidance, because we don't know exactly our ability to utilize the franchiseyet because we have an application pending with the OTS and as we said in priorcalls, we want to be very respectful and deferential of that relationship.
We think we have got a terrific business and we think wewill perform beautifully for the regulators and we think we should be able togrow the business to support the growth of our company, but that is also up tothem. We understand that.
So it is hard for us to comment specifically on '08 until weknow how much we can utilize this very important acquisition to us. I am probablybeing a little evasive to your question, but I am trying to frame the driversof how I would answer the question should I have the answers to thoseindividual variables.
The only thing I would add, Henry, is that when we announcedthe transaction, we said that we did not think it would be accretive in '08.Certainly some things have changed since then. The proceeds or the price whichwe have agreed upon, there's a cash component, there is a share component. Withrespect to what our assumptions were, certainly I would point to our cost offunds assumption. Today, our alternative cost of funds would be higher, again pointing to theadvantage of the deposit-based funding.
I don't want to go too far in terms of starting to give anyguidance, which with respect to '08 we will do once the acquisition has closed,but those would be my comments.
Your next question comes from Don Fandetti - Citi.
Don Fandetti - Citi
John, assuming the traditional CLO market doesn't come backanytime soon, could you talk about the depth of the single buyer CLO market?Does that give you enough confidence to really push the new investmentactivities going into '08?
I will repeat Don's question because he was a little faintjust so the others hear the question. The question was, what is the depth ofthe single buyer CLO market and do we feel there is enough depth there tosupport what we consider to be fairly aggressive origination, the reasonablyaggressive origination views we have into '08 based on the market opportunitythat is presenting itself. I think I paraphrased your question there, Don.
Tom, do you want to start on that?
Well first of all, Don, I would say categorically we dobelieve the CLO market is going to come back. It may not come back as completely or as freely flowing or as with astight spreads as we were seeing certainly in the first half of 2007, but wethink it is a viable market and I would say that I think that most of ourcertainly historical investor base is sitting on the sidelines watching/waitingor still active in the market. So wecertainly see it coming back, so I don't have concerns about that.
Also, I would say that CapitalSource is widely recognized inour marketplace as a premier issuer, so I would go even further to say that ifit doesn't come back for all players, I think there is certainly a place forCapitalSource in that market where we do have the respect and the admiration,if you will, of folks as being a very good originator, underwriter and servicerof middle-market assets.
Just to add a little more texture to what Tom said, we haveactually been encouraged by some of the financial institutions we work with togo out and do some broadly marketed CLOs with a view that we are a premierissuer and we're the right one to go out and start reestablishing the marketand with a further view that we can get them done.
We have elected to do the single buyer CLOs in part because,at this point in time with all the things we have going on, including trying toget TierOne done, they are easier and it gives us the flexibility should we getthe TierOne acquisition done in the way we would like to potentially refinancesome of those single buyer CLOs with bank deposits.
So I think Tom is being a little modest there because he hasbeen pushed a lot by people to go out and do the kind of multi-week road showsyou need to do to reestablish that as a funding vehicle for us and there's areasonable degree of confidence that we can get those deals done. But I thinkwhen we look at the totality of the facts right now, it is our view that doingthese single buyer CLOs makes a little more sense right now for us when youconsider everything.
Your next question comes from Bob Napoli - Piper Jaffray.
Bob Napoli - PiperJaffray
Your credit metrics this quarter, your delinquencies and non-performingassets, the best levels in several years. There's obviously a lot of gloom anddoom out there about the USeconomy and the expectations for the trends in the economy and especially withregard to how financial stocks broadly are being treated. How do you reconcilethe performance of your credit metrics? Is the economy better than what peoplethink or is this unique to you guys? If you could also just comment on yourexposure to sub-prime mortgage?
Well, I would say the reason we consistently deliver goodcredit performance is that we do good credit work. CapitalSource is not a buyerof paper. We are a direct originator of paper. We do our credit work. We arevery disciplined. Our business is largely built around specialty platforms,which have historically demonstrated exceptional credit performance and I havemade the comment in the past that half our business is in these highlyspecialized platforms and they have had impeccable credit performance; and infact, even in our corporate finance business where we have a generalistpractice and some specialty platforms, the specialty platforms have performedfrom a credit perspective much better.
So I think we do very good credit work. I think we have organized the businessesaround these specialty platforms where we have an opportunity to consistentlydeliver very good credit performance because they are niches and we don't haveas much competition and we really know what we are doing. I think that is whywe have and will continue to deliver very good credit results and I think thosestatistics have improved and I expect them to essentially stay at these levels. So wefeel good about the credit performance.
I am of the view that we do have as an economy some roughtimes ahead and I think the business is well-prepared for that and we have beenfactoring that into our asset investment decisions across the last severalyears. It is one of the reasons we pulled back from condo lending say two yearsago. I am sure we left some money on the table in doing that, but we have acommercial real estate portfolio right now that doesn't have as much exposureto that and we feel terrific about that.
We have backed away from some of the aggressive LBOtransactions that were occurring in the spring. In fact, when the marketdisruptions occurred across the summer and people had lots and lots of hungcredits that they couldn't syndicate, I think we had $7 million of loans thatneeded to be syndicated because we had I think acted prudently.
So I think the reason our credit is performing the way it is,is because we do good credit work, we are focused on businesses where we havethe opportunity because of specialization to deliver exceptionally good creditperformance and I think we are disciplined as a franchise in terms of where weallocate our capital.
As far as sub-prime exposure, we have talked about that inthe past. We have specifically gone fourcredits in our rediscount business where we rediscount what I'd consider to behard money residential lenders, which are in some ways one step below sub-prime,but in many ways much better shape because the loan to values are so low and welend against those loans at a discount. I think our number was $120 million when we last talked about it. I think that number hasn't changedmaterially. It is probably plus or minusa couple million dollars and all those loans continue to perform very well. SoI think you don't have to worry about that as it relates to this franchise.
Bob Napoli - PiperJaffray
With regards to growth by sector, do you expect tospecialize in the pipeline building? I would imagine that there is a lot of demandfor LBO lending in the areas where there has been a lot of market disruption,but in this environment and your concerns about the economy, are we going tosee the growth in your specialty businesses more so than say the LBO lendingbusiness?
I would say the growth will continue to be across theboard. The specialty businesses tend tobe more consistent growers and the LBO business, for example, we tend to growthat business more when the market is more in our favor. To the extent thatmarket is more in our favor, we could see some good growth in that business.
I think in commercial real estate, we continue to be verydisciplined because there could be further shakeout in that area, so I wouldsay that commercial real estate is not likely to be a big grower in the nearterm. I think we have got a terrific portfolio and it has been invested andcreated very wisely. It doesn't have very significant exposures to areas thatpeople should be concerned about and I think we are very happy about that. Ithink the team is being fairly prudent in terms of what they do in the currentmarket as we see cap rates adjusting and other things.
The LBO market could come our way a little sooner, so youcould see an uptick of growth there. ButI think the specialty businesses will continue to dominate this franchise.
Bob Napoli - PiperJaffray
I know Merrill Lynch has been a big competitor and with thechallenges that they have had there, has that affected the way they have actedin the market in your business?
Could you repeat the question?
Bob Napoli - PiperJaffray
I know Merrill Lynch has been a very big competitor in yourhealthcare market and probably the most in that market, I think in some of theother markets in the commercial real estate lending business. I just wondered if with the challenges thatthey have had there, if you've seen less competition out of Merrill Lynchbecause I just know they have been a very big competitor?
Out of respect for our various competitors, we never reallytalk about people individually on these open public forms and we would hopepeople wouldn't do that about us. Ithink I would go back to my general comments, which we are seeing ourcompetitors either exit or pull back.
Your next question comes from Scott Valentin - FBR.
Scott Valentin - FBR
One quick blunt question, but on the dividend for '07, onAugust 1 you put out a press release saying you expected to pay $2.40 in'07. Adding up the dividend so far, Iget $2.38. I was just curious, $0.02 doesn't seem likethat much of a big deal to pay to avoid my question of why would the dividendbe less than what you guided to on August 1? Or maybe you just feel comfortablewith a $0.60 run rate going forward and that was what drove the decision. Can you give some color on that?
Yes, I think it was more the latter. We thought the $0.60 run rate is the rightlevel to be at, recognizable we are providing lots of detailed guidance afterour TierOne transaction. So we did the same math, but felt like $0.60 run ratewas the right answer.
Scott Valentin - FBR
On the TierOne acquisition, S4, a memo was filed and clearlyCapitalSource's stock is trading below the $21.98 on the S&P financial indexgiving TierOne the opportunity or entitlement to ask for morecompensation.
Putting that aside, how much of an impact if the TierOneacquisition does not go through, you still have the industrial loan charter,how much of an impact do you think? Would it be significant if the TierOnetransaction did not go through and it had to rely upon the industrial loancharter to raise deposits?
I would reiterate my comments before that I fully expect theTierOne transaction to close. We clearlyhave the approval. We've specifically waited to accept that until after TierOnehas closed for some very technical reasons. CapitalSource will have deposit-based funding next year to my mind.
Scott Valentin - FBR
One final question. ROEthis quarter, about 15%. You mentionedlumpiness in the business. That is understood. So would a normalized ROE going forward, given the higher funding costs,given the little wider spreads, do you think it is in that high teens range ona go-forward basis?
Your next question comes from Mike Taiano - Sandler O'Neill.
Mike Taiano - SandlerO'Neill
Just a question on the securitization you did in September.I think you had about $400 million of additional capacity on that deal. I was just wondering if you had tapped thatas of yet? Also on the upcoming securitization you are expecting, can you giveus some color on what you think pricing may be relative to the deal in Octoberand September?
I would say that for your first part of your question, wehave used some of, but may not use all of, that growth capacity in thatsecuritization. Bear in mind, we are also maintaining a certain amount of loans that wehope and anticipate transferring into TierOne upon the completion of thatacquisition.
With respect to pricing, I would expect, generally speaking,to see something similar to the transaction that we saw in October, perhaps alittle better.
Mike Taiano - SandlerO'Neill
On the asset side, are you guys seeing anything different orabnormal on your clients drawing down on unfunded commitments?
No, we are not.
Mike Taiano - SandlerO'Neill
On TierOne, obviously, they put out some news a couple weeksago on non-performers. I don't know if you can comment on it, but can you justtell us what they have said publicly is consistent with what you discovered orthought would happen when you did your due diligence?
Yes, I would say that it is consistent with the diligencethat we have done.
Your final question comes from Omotayo Okusanya – UBS.
Omotayo Okusanya –UBS
I just wanted to ask a quick question in regard to youroutlook for Medicare and Medicaid reimbursement policies in 2008 and how itcould potentially impact your healthcare real estate platform?
Our healthcare real estate platform tends to focus onlong-term care, obviously, and at this point, we have a view that '08 willcontinue to be attractive. We have a large team of people that continues to lookat not only Medicare changes, but obviously Medicaid changes, which tends to bemuch more significant in the long-term care sector. We remain very bullish onthat business.
One of the things we indicated that we are going to betreating our sale leaseback business as a separate segment starting in thefourth quarter. We have said in the past that we think that business is a veryvaluable asset. It's got a run rate of well over $100 million of lease income.We think it is undervalued in our franchise and we think that it would makesense at some point to realize the value of that business as a separatecompany, which is one of the reasons we broke it out as a separate segment.
Which is a way of saying what we continue to feel verybullish about that business through '08 and that is factoring in the Medicareand Medicaid changes that are occurring. Medicaid tends to be a moresignificant factor for us due to the profile of our portfolio.
There are no additional questions at this time. I would now like to turn the call back overto management for closing remarks.
Thank you very much. That concludes our call. A reminder that a transcript will be postedon the CapitalSource website later today and we thank everyone for joining us.
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