Form 10-Q

Please wait

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

Commission File No. 1-31753

CapitalSource Inc.

(Exact name of registrant as specified in its charter)

Delaware

35-2206895

(State of Incorporation)

(I.R.S. Employer

Identification No.)

633 West 5^th Street, 33rd Floor

Los Angeles, CA 90071

(Address of Principal Executive Offices, Including Zip Code)

(213) 443-7700

(Registrant’s Telephone Number, Including Area Code)

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

Yes þ No ¨

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

Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ

Accelerated filer ¨

Non-accelerated filer ¨

(Do not check if a smaller reporting company)

Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No þ

As of August 1, 2012, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 224,984,713.

TABLE OF CONTENTS


		Page

PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011		2
	Consolidated Statements of Operations (unaudited) for the three and six months ended June 30, 2012 and 2011		3
	Consolidated Statements of Comprehensive Income (unaudited) for the three and six months ended June 30, 2012 and 2011		4
	Consolidated Statement of Shareholders’ Equity (unaudited) for the six months ended June 30, 2012		5
	Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2012 and 2011		6
	Notes to the Unaudited Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		54
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		85
Item 4.	Controls and Procedures		85

PART II. OTHER INFORMATION

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		86
Item 5.	Other Information		86
Item 6.	Exhibits		86
Signatures			87
Index to Exhibits			88

CapitalSource Inc.

Consolidated Balance Sheets


	June 30, 2012			December 31, 2011
	(Unaudited)
	($ in thousands, except share amounts)
ASSETS
Cash and cash equivalents	$	416,021		$	458,548
Restricted cash (including $2.7 million and $23.7 million, respectively, of cash that can only be used to settle obligations of consolidated VIEs)		75,523			65,484
Investment securities:
Available-for-sale, at fair value		1,148,042			1,188,002
Held-to-maturity, at amortized cost		108,520			111,706
Total investment securities		1,256,562			1,299,708
Loans:
Loans held for sale		31,519			193,021
Loans held for investment		6,038,091			5,758,990
Less deferred loan fees and discounts		(61,115	)		(68,843	)
Less allowance for loan and lease losses		(133,359	)		(153,631	)
Loans held for investment, net (including $418.8 million and $504.5 million, respectively, of loans that can only be used to settle obligations of consolidated VIEs)		5,843,617			5,536,516
Total loans		5,875,136			5,729,537
Interest receivable		30,296			38,796
Other investments		72,669			81,245
Goodwill		173,135			173,135
Other assets		670,317			453,615
Total assets	$	8,569,659		$	8,300,068
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Deposits	$	5,382,012		$	5,124,995
Term debt (including $214.1 million and $309.4 million, respectively, in obligations of consolidated VIEs for which there is no recourse to the general credit of CapitalSource Inc.)		214,059			309,394
Other borrowings		1,029,606			1,015,099
Other liabilities		162,295			275,434
Total liabilities		6,787,972			6,724,922
Commitments and contingencies (Note 14)
Shareholders’ equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)		—			—
Common stock ($0.01 par value, 1,200,000,000 shares authorized; 224,999,706 and 256,112,205 shares issued and outstanding, respectively)		2,250			2,561
Additional paid-in capital		3,286,833			3,487,911
Accumulated deficit		(1,526,938	)		(1,934,732	)
Accumulated other comprehensive income, net		19,542			19,406
Total shareholders’ equity		1,781,687			1,575,146
Total liabilities and shareholders’ equity	$	8,569,659		$	8,300,068

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Operations


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	(Unaudited)
	($ in thousands, except per share data)
Net interest income:
Interest income:
Loans and leases	$	108,301		$	113,647		$	217,371		$	237,147
Investment securities		9,236			12,688			19,953			31,040
Other		445			1,090			735			1,390
Total interest income		117,982			127,425			238,059			269,577
Interest expense:
Deposits		12,640			13,398			25,931			26,781
Borrowings		7,524			32,409			15,091			65,778
Total interest expense		20,164			45,807			41,022			92,559
Net interest income		97,818			81,618			197,037			177,018
Provision for loan and lease losses		10,536			1,523			21,608			46,332
Net interest income after provision for loan and lease losses		87,282			80,095			175,429			130,686
Non-interest income, net:
Loan fees		3,057			3,410			7,725			8,014
Leased equipment income		3,258			73			6,516			73
(Loss) gain on sales of investments, net		(620	)		8,725			(927	)		32,240
Gain (loss) on derivatives, net		432			(271	)		329			(2,149	)
Other non-interest income, net		2,323			4,340			6,357			4,311
Total non-interest income		8,450			16,277			20,000			42,489
Non-interest expense:
Compensation and benefits		25,408			29,098			51,824			59,477
Professional fees		3,089			6,318			6,689			9,888
Occupancy expenses		6,221			4,019			9,980			7,973
FDIC fees and assessments		1,463			1,341			2,912			3,331
General depreciation and amortization		1,511			1,778			3,206			3,621
Other administrative expenses		13,622			10,367			23,242			20,758
Total operating expenses		51,314			52,921			97,853			105,048
Leased equipment depreciation		2,288			40			4,576			40
Expense of real estate owned and other foreclosed assets, net		3,821			10,956			4,271			21,289
Gain on extinguishment of debt		(8,142	)		—			(8,059	)		—
Other non-interest expense, net		(1,081	)		(1,388	)		(1,391	)		(1,366	)
Total non-interest expense		48,200			62,529			97,250			125,011
Net income before income taxes		47,532			33,843			98,179			48,164
Income tax (benefit) expense		(340,017	)		17,249			(314,308	)		28,411
Net income	$	387,549		$	16,594		$	412,487		$	19,753
Basic income per share	$	1.71		$	0.05		$	1.76		$	0.06
Diluted income per share	$	1.66		$	0.05		$	1.72		$	0.06
Average shares outstanding:
Basic		226,532,286			320,426,484			233,805,456			320,311,588
Diluted		233,097,739			327,087,717			240,348,137			327,025,588
Dividends declared per share	$	0.01		$	0.01		$	0.02		$	0.02

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Comprehensive Income


	Three Months Ended June 30,					Six Months Ended June 30,
	2012			2011		2012			2011
	(Unaudited)
	($ in thousands)
Net income	$	387,549		$	16,594	$	412,487		$	19,753
Other comprehensive (loss) income, net of tax:
Unrealized (loss) gain on available-for-sale securities, net of tax		(960	)		20,454		487			25,297
Unrealized gain (loss) on foreign currency translation, net of tax		—			1,878		(351	)		11,460
Other comprehensive (loss) income		(960	)		22,332		136			36,757
Comprehensive income	$	386,589		$	38,926	$	412,623		$	56,510

See accompanying notes.


4

CapitalSource Inc.

Consolidated Statement of Shareholders’ Equity


	Common Stock			Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income, net		Total Shareholders’ Equity
	(Unaudited)
	($ in thousands)
Total shareholders’ equity as of December 31, 2011	$	2,561		$	3,487,911		$	(1,934,732	)	$	19,406	$	1,575,146
Net income		—			—			412,487			—		412,487
Other comprehensive income		—			—			—			136		136
Dividends paid		—			42			(4,693	)		—		(4,651	)
Stock option expense		—			887			—			—		887
Exercise of options		—			37			—			—		37
Restricted stock activity		(1	)		5,207			—			—		5,206
Repurchase of common stock		(310	)		(207,251	)		—			—		(207,561	)
Total shareholders’ equity as of June 30, 2012	$	2,250		$	3,286,833		$	(1,526,938	)	$	19,542	$	1,781,687

See accompanying notes.


5

CapitalSource Inc.

Consolidated Statements of Cash Flows


	Six Months Ended June 30,
	2012			2011
	(Unaudited) ($ in thousands)
Operating activities
Net income	$	412,487		$	19,753
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option expense		887			3,026
Restricted stock expense		5,844			3,511
Gain on extinguishment of debt		(8,059	)		—
Amortization of deferred loan fees and discounts		(22,434	)		(40,869	)
Paid-in-kind interest on loans		4,056			29,804
Provision for loan and lease losses		21,608			46,332
Amortization of deferred financing fees and discounts		898			15,956
Depreciation and amortization		9,457			74
(Benefit) provision for deferred income taxes		(353,763	)		50,354
Non-cash gain on investments, net		(459	)		(35,708	)
Non-cash loss on foreclosed assets and other property and equipment disposals		871			17,765
Unrealized (gain) loss on derivatives and foreign currencies, net		(1,256	)		2,130
Decrease in interest receivable		8,500			19,276
Decrease in loans held for sale, net		21,673			200,950
Decrease in other assets		139,305			72,029
Decrease in other liabilities		(113,766	)		(76,566	)
Cash provided by operating activities		125,849			327,817
Investing activities:
(Increase) decrease in restricted cash		(10,039	)		27,330
(Increase) decrease in loans, net		(179,879	)		364,546
Reduction of marketable securities, available for sale, net		21,132			94,790
Reduction of marketable securities, held to maturity, net		4,023			54,689
Reduction of other investments, net		6,909			23,683
Acquisition of property and equipment, net		(1,166	)		(7,094	)
Cash (used in) provided by investing activities		(159,020	)		557,944
Financing activities:
Deposits accepted, net of repayments		257,017			164,517
Repayments on credit facilities, net		—			(68,792	)
Repayments and extinguishment of term debt		(95,357	)		(282,985	)
Borrowings under other borrowings		41,159			67,958
Repurchase of common stock		(207,561	)		—
Proceeds from exercise of options		37			804
Payment of dividends		(4,651	)		(6,447	)
Cash used in financing activities		(9,356	)		(124,945	)
(Decrease) increase in cash and cash equivalents		(42,527	)		760,816
Cash and cash equivalents as of beginning of period		458,548			820,450
Cash and cash equivalents as of end of period	$	416,021		$	1,581,266
Supplemental information:
Noncash transactions from investing and financing activities:
Assets acquired through foreclosure	$	11,237		$	10,911

See accompanying notes.


6

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its consolidated subsidiaries. References to CapitalSource Bank include its consolidated subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its consolidated subsidiaries other than CapitalSource Bank.

We are a commercial lender that, primarily through our wholly owned subsidiary, CapitalSource Bank, provides financial products to small and middle market businesses nationwide and provides depository products to customers in southern and central California and, to a lesser extent, our borrowers. The majority of our loans require monthly interest payments at variable rates and, in many cases, our loans provide for interest rate floors that help us maintain our yields when interest rates are low or declining. We price our loans based upon the risk profile of our clients.

For the three and six months ended June 30, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our legacy loan portfolio and investment activities by the Parent Company. For additional information, see Note 17, Segment Data.

Note 2. Summary

of Significant Accounting Policies

Interim Consolidated Financial Statements Basis of Presentation

Our interim consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, certain disclosures accompanying annual consolidated financial statements are omitted. In the opinion of management, all adjustments and eliminations, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The current period’s results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011, as filed with the Securities and Exchange Commission on February 28, 2012 (“Form 10-K”).

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

Reclassifications

Certain amounts in prior period consolidated financial statements have been reclassified to conform to the current period presentation, including the reclassification of the presentation of our consolidated statements of operations to include the captions of non-interest income and non-interest expense as compared to operating expenses and other income (expense). Accordingly, the reclassifications have been appropriately reflected throughout our consolidated financial statements.

Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements for the year ended December 31, 2011, included in our Form 10-K.

New Accounting Pronouncements

In May 2011, the FASB amended its guidance on fair value measurements to achieve common disclosure requirements for GAAP and International Financial Accounting Standards (“IFRS”). The amendments clarify existing GAAP requirements for fair value measurements and eliminate wording differences between current GAAP and IFRS guidelines. This guidance is effective for interim and annual periods beginning after December 15, 2011. We adopted this guidance on January 1, 2012, and it did not have a material impact on our consolidated financial statements.

In June 2011, the FASB amended its guidance on the presentation of comprehensive income. This guidance eliminates the option to report other comprehensive income and its components solely in the consolidated statement of shareholders’ equity. An entity may elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements. Each component of net income and of other comprehensive income needs to be displayed under either alternative. This guidance is effective for interim and annual periods beginning after December 15, 2011. We adopted this guidance on January 1, 2012 and, although it impacted our financial statement presentation, it did not have a material impact on our consolidated results of operations, financial position or cash flows.


7

Note 3. Cash

and Cash Equivalents and Restricted Cash

As of June 30, 2012 and December 31, 2011, our cash and cash equivalents and restricted cash balances were as follows:


	June 30, 2012				December 31, 2011
	Unrestricted		Restricted⁽¹⁾		Unrestricted		Restricted⁽¹⁾
	($ in thousands)
Cash and cash equivalents and restricted cash:
Cash and due from banks	$	186,503	$	32,794	$	231,701	$	41,808
Interest-bearing deposits in other banks⁽²⁾		18,035		—		186,868		16
Other short-term investments⁽³⁾		211,483		42,729		39,979		23,660
Total cash and cash equivalents and restricted cash	$	416,021	$	75,523	$	458,548	$	65,484

⁽¹⁾	Restricted cash includes principal and interest collections received from loans held in securitization trusts, loan-related escrow and reserve accounts, and cash that has been pledged as collateral supporting letters of credit and derivative liabilities.

⁽²⁾	Included in these balances for CapitalSource Bank were $15.1 million and $179.1 million in deposits at the Federal Reserve Bank (“FRB”) as of June 30, 2012 and December 31, 2011, respectively.

⁽³⁾

Unrestricted cash is invested in short term investment grade commercial paper which is rated by at least two of the three major rating agencies (S&P, Moody’s or Fitch) and has a rating of A1 (S&P), P1 (Moody’s) or F1 (Fitch), and restricted cash is invested in a short-term money market fund which has ratings of AAAm (S&P) and Aaa (Moody’s), as well as commercial paper, which is rated by at least two of the three major rating agencies (S&P, Moody’s or Fitch) and has a rating of A1 (S&P), P1 (Moody’s) or F1 (Fitch).

Note 4. Loans

and Credit Quality

As of June 30, 2012 and December 31, 2011, our outstanding loan balance was $6.1 billion and $5.9 billion, respectively. Included in these amounts were loans held for sale and loans held for investment. As of June 30, 2012 and December 31, 2011, interest and fee receivables on these loans totaled $26.8 million and $35.0 million, respectively.

As of June 30, 2012 and December 31, 2011, the outstanding unpaid principal balance of loans including loans held for sale, by type of loan, was as follows:


	June 30, 2012				December 31, 2011
	($ in thousands except percentages)
Commercial	$	3,555,433	59	%	$	3,544,590	60	%
Real estate		2,476,609	40			2,341,136	39
Real estate - construction		37,568	1			66,285	1
Total⁽¹⁾	$	6,069,610	100	%	$	5,952,011	100	%

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

Loans Held for Sale

Loans held for sale are recorded at the lower of cost or fair value. We determine when to sell a loan on a loan-by-loan basis and consider several factors, including the credit quality of the loan, any financing secured by the loan and any requirements related to the release of liens and use of sales proceeds, the potential sale price relative to our loan valuation, our liquidity needs, and the resources necessary to ensure an adequate recovery if we continued to hold the loan. When our analysis indicates that the proper strategy is to sell a loan, we initiate the sale process and designate the loan as held for sale.

During the three and six months ended June 30, 2012, we transferred loans with a carrying value of $90.3 million and $100.9 million, respectively, from held for investment to held for sale which included $21.1 million and $31.3 million of impaired loans, respectively. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We did not incur any losses due to lower of cost or fair value adjustments at the time of transfer during the three and six months ended June 30, 2012. We did not reclassify any loans from held for sale to held for investment during the three months ended June 30, 2012. For the six months ended June 30, 2012, we reclassified $5.0 million of loans from held for sale to held for investment based on our intent to retain these loans for investment.


8

During the three and six months ended June 30, 2011, we transferred loans with a carrying value of $135.4 million and $165.7 million, respectively, all of which were impaired, from held for investment to held for sale. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We incurred $1.4 million of losses due to lower of cost or fair value adjustments at the time of transfer during the three and six months ended June 30, 2011. We also reclassified $28.6 million of loans from held for sale to held for investment during the six months ended June 30, 2011, based on our intent to retain these loans for investment.

During the three and six months ended June 30, 2012, we recognized net pre-tax gains on the sale of loans of $2.0 million and $3.1 million, respectively. During the three and six months ended June 30, 2011, we recognized net pre-tax gains on the sale of loans of $3.1 million and $4.4 million, respectively.

As of December 31, 2011, loans held for sale with an outstanding balance of $2.9 million were classified as non-accrual loans. We did not have any loans held for sale that were on non-accrual status as of June 30, 2012. We did not record any fair value write-downs on non-accrual loans held for sale during the three and six months ended June 30, 2012 and 2011.

Loans Held for Investment

Loans held for investment are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts received or premiums paid on purchased loans. We maintain an allowance for loan and lease losses for loans held for investment, which is calculated based on management’s estimate of incurred loan and lease losses inherent in our loan and lease portfolio as of the balance sheet date. This methodology is used consistently to develop our allowance for loan and lease losses for all loans and leases in our loan portfolio.

Non-performing loans include all loans on non-accrual status and accruing loans which are contractually past due 90 days or more as to principal or interest payments. Our remediation efforts on these loans are based upon the characteristics of each specific situation and include, among other things, one of or a combination of the following:

request that the equity owners of the borrower inject additional capital;

require the borrower to provide us with additional collateral;

request additional guaranties or letters of credit;

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

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

initiate foreclosure proceedings on the collateral; or

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

As of June 30, 2012 and December 31, 2011, the carrying value of loans held for investment by loan class, separated by performing and non-performing categories, was as follows:


	June 30, 2012						December 31, 2011
Class	Performing		Non-Performing		Total		Performing		Non-Performing		Total
	($ in thousands)
Asset-based	$	1,259,354	$	57,687	$	1,317,041	$	1,211,511	$	62,917	$	1,274,428
Cash flow		1,899,956		80,914		1,980,870		1,757,190		186,193		1,943,383
Healthcare asset-based		205,412		—		205,412		265,489		3,937		269,426
Healthcare real estate		555,027		27,965		582,992		561,882		23,600		585,482
Multifamily		881,308		1,654		882,962		852,766		1,703		854,469
Real estate		784,733		18,637		803,370		441,490		158,761		600,251
Small business		195,140		9,189		204,329		152,068		10,640		162,708
Total⁽¹⁾	$	5,780,930	$	196,046	$	5,976,976	$	5,242,396	$	447,751	$	5,690,147

⁽¹⁾	Excludes loans held for sale. Balances are net of deferred loan fees and discounts.


9

During the three and six months ended June 30, 2012, we purchased loans held for investment with an outstanding principal balance at the time of purchase of $34.9 million and $78.3 million, respectively.

As of June 30, 2012 and December 31, 2011, CapitalSource Bank pledged loans held for investment with an outstanding principal balance of $661.8 million and $459.5 million, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

Credit Quality

Credit risk within our loan portfolio is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. The degree of credit risk will vary based on many factors, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral. We continuously monitor a client’s ability to perform under its obligations. Additionally, we manage the size and risk profile of our loan portfolio by syndicating loan exposure to other lenders and selling loans.

changes in the client’s financial condition, cash flow or financial position. We use risk rating aggregations to measure credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by client industries and real estate property types (where applicable).

We believe that the likelihood of not being paid according to the contractual terms of a loan is, in large part, dependent upon the assessed level of risk associated with the loan, and we believe that our internal risk rating process provides a view as to the relative risk of each loan. This risk rating scale is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:

Pass — Loans with standard, acceptable levels of credit risk;

Special mention — Loans that have potential weaknesses that deserve close attention, and which, if left uncorrected, may result in a loss or deterioration of our credit position;

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

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


10

As of June 30, 2012 and December 31, 2011, the carrying value of each class of loans held for investment, by internal risk rating, was as follows:


	Internal Risk Rating
Class	Pass		Special Mention		Substandard		Doubtful		Total
	($ in thousands)
As of June 30, 2012:
Asset-based	$	1,217,609	$	15,311	$	50,578	$	33,543	$	1,317,041
Cash flow		1,589,549		124,324		214,115		52,882		1,980,870
Healthcare asset-based		114,143		76,461		14,808		—		205,412
Healthcare real estate		512,587		42,440		27,965		—		582,992
Multifamily		864,846		15,172		2,944		—		882,962
Real estate		714,467		33,675		55,228		—		803,370
Small business		189,002		5,488		9,645		194		204,329
Total⁽¹⁾	$	5,202,203	$	312,871	$	375,283	$	86,619	$	5,976,976
As of December 31, 2011:
Asset-based	$	953,406	$	180,588	$	132,848	$	7,586	$	1,274,428
Cash flow		1,602,838		27,018		228,502		85,025		1,943,383
Healthcare asset-based		177,996		75,980		15,397		53		269,426
Healthcare real estate		489,099		72,783		23,600		—		585,482
Multifamily		849,251		3,516		1,702		—		854,469
Real estate		428,750		42,634		128,867		—		600,251
Small business		143,709		8,869		1,470		8,660		162,708
Total⁽¹⁾	$	4,645,049	$	411,388	$	532,386	$	101,324	$	5,690,147

⁽¹⁾	Excludes loans held for sale. Balances are net of deferred loan fees and discounts.

Non-Accrual and Past Due Loans

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

As of June 30, 2012 and December 31, 2011, the carrying value of each class of non-accrual loans was as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Asset-based	$	57,687	$	33,236
Cash flow		80,914		110,280
Healthcare asset-based		—		822
Healthcare real estate		27,965		23,600
Multifamily		1,654		1,703
Real estate		18,637		87,663
Small business		5,997		5,995
Total⁽¹⁾	$	192,854	$	263,299

⁽¹⁾	Excludes loans held for sale and purchased credit impaired loans. Balances are net of deferred loan fees and discounts.


11

As of June 30, 2012 and December 31, 2011, the delinquency status of loans in our loan portfolio was as follows:


	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Greater than 90 Days Past Due and Accruing
	($ in thousands)
As of June 30, 2012:
Asset-based	$	456	$	2,763	$	3,219	$	1,313,822	$	1,317,041	$	—
Cash flow		—		3,237		3,237		1,976,060		1,979,297		—
Healthcare asset-based		—		—		—		205,412		205,412		—
Healthcare real estate		—		27,965		27,965		555,027		582,992		—
Multifamily		—		1,032		1,032		881,930		882,962		—
Real estate		—		17,779		17,779		785,591		803,370		—
Small business		269		4,250		4,519		196,618		201,137		—
Total⁽¹⁾	$	725	$	57,026	$	57,751	$	5,914,460	$	5,972,211	$	—
As of December 31, 2011:
Asset-based	$	2,611	$	8,677	$	11,288	$	1,260,754	$	1,272,042	$	—
Cash flow		218		9,701		9,919		1,933,464		1,943,383		—
Healthcare asset-based		—		—		—		269,426		269,426		—
Healthcare real estate		—		17,951		17,951		567,531		585,482		—
Multifamily		1,565		188		1,753		852,716		854,469		—
Real estate		5,762		44,049		49,811		550,440		600,251		5,603
Small business		2,213		4,675		6,888		151,313		158,201		—
Total⁽¹⁾	$	12,369	$	85,241	$	97,610	$	5,585,644	$	5,683,254	$	5,603

⁽¹⁾	Excludes loans held for sale and purchased credit impaired loans. Balances are net of deferred loan fees and discounts.

If our non-accrual loans had performed in accordance with their original terms, interest income would have been $24.0 million and $50.2 million higher for the three and six months ended June 30, 2012, respectively, and $28.7 million and $61.7 million higher for the three and six months ended June 30, 2011, respectively.

Impaired Loans

We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the original loan agreement. In this regard, impaired loans include loans for which we expect to encounter a significant delay in the collection of and/or a shortfall in the amount of contractual payments due to us.

Assessing the likelihood that a loan will not be paid according to its contractual terms involves the consideration of all relevant facts and circumstances and requires a significant amount of judgment. For such purposes, factors that are considered include:

the current performance of the borrower;

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

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

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

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

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


12

As of June 30, 2012 and December 31, 2011, information pertaining to our impaired loans was as follows:


	June 30, 2012							December 31, 2011
	Carrying Value⁽¹⁾		Legal Principal Balance⁽²⁾		Related Allowance			Carrying Value⁽¹⁾		Legal Principal Balance⁽²⁾		Related Allowance
	($ in thousands)
With no related allowance recorded:
Asset-based	$	98,454	$	139,259	$	—		$	55,445	$	89,519	$	—
Cash flow		75,975		144,368		—			80,453		143,131		—
Healthcare asset-based		—		12,443		—			3,937		15,133		—
Healthcare real estate		27,965		34,976		—			23,600		28,961		—
Multifamily		1,654		1,757		—			1,703		2,988		—
Real estate		48,924		134,813		—			123,766		226,359		—
Small business		10,367		17,468		—			14,679		20,938		—
Total		263,339		485,084		—			303,583		527,029		—

With allowance recorded:
Asset-based		6,995		7,125		(2,071	)		7,472		9,847		(2,030	)
Cash flow		87,148		93,743		(18,728	)		105,740		117,766		(24,418	)
Healthcare asset-based		—		—		—			—		—		—
Healthcare real estate		—		—		—			—		—		—
Multifamily		—		—		—			—		—		—
Real estate		—		—		—			—		—		—
Small business		—		—		—			—		—		—
Total		94,143		100,868		(20,799	)		113,212		127,613		(26,448	)
Total impaired loans	$	357,482	$	585,952	$	(20,799	)	$	416,795	$	654,642	$	(26,448	)

⁽¹⁾	Carrying value of impaired loans before applying specific reserves. Excludes loans held for sale. Balances are net of deferred loan fees and discounts.

⁽²⁾	Represents the contractual amounts owed to us by borrowers. The difference between the carrying value and the contractual amounts owed relates to the previous recognition of charge offs and are net of deferred loan fees and discounts.


13

Average balances and interest income recognized on impaired loans held for investment, by loan class, for the three and six months ended June 30, 2012 and 2011 were as follows:


	Three Months Ended June 30,								Six Months Ended June 30,
	2012				2011				2012				2011
	Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾		Average Balance		Interest Income Recognized⁽¹⁾
	($ in thousands)
No allowance recorded:
Asset-based	$	76,710	$	1,091	$	69,557	$	622	$	66,085	$	1,521	$	75,611	$	1,392
Cash flow		66,941		989		115,414		2,501		72,001		2,037		122,127		3,721
Healthcare asset-based		399		—		1,421		101		1,916		155		1,002		101
Healthcare real estate		31,047		—		21,852		165		27,820		—		20,579		165
Multifamily		934		—		7,198		—		1,137		—		8,813		—
Real estate		59,496		1,815		188,509		1,245		84,098		2,982		246,797		2,921
Small business		13,662		—		10,129		—		14,098		—		10,014		—
Total		249,189		3,895		414,080		4,634		267,155		6,695		484,943		8,300

With allowance recorded:
Asset-based		10,408		—		41,694		—		8,524		74		61,933		—
Cash flow		107,685		689		126,335		831		106,493		1,391		137,642		1,663
Healthcare asset-based		—		—		811		—		—		—		1,429		—
Healthcare real estate		1,962		—		8,802		—		1,121		—		9,296		—
Multifamily		—		—		1,242		—		—		—		710		—
Real estate		—		—		31,509		—		—		—		45,901		—
Small business		—		—		511		—		—		—		425		—
Total		120,055		689		210,904		831		116,138		1,465		257,336		1,663
Total impaired loans	$	369,244	$	4,584	$	624,984	$	5,465	$	383,293	$	8,160	$	742,279	$	9,963

⁽¹⁾	We recognized $0.1 million of cash basis interest income on impaired loans during the six months ended June 30, 2011. We did not recognize any cash basis interest income on impaired loans during the three and six months ended June 30, 2012 or the three months ended June 30, 2011.

As of June 30, 2012 and December 31, 2011, the carrying value of impaired loans with no related allowance recorded was $263.3 million and $303.6 million, respectively. Of these amounts, $73.2 million and $136.3 million, respectively, related to loans that were charged off to their carrying values. These charge offs were primarily the result of impairment measurements of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $190.1 million and $167.3 million related to loans that had no recorded charge offs or specific reserves as of June 30, 2012 and December 31, 2011, respectively, based on our estimate that we ultimately will collect all principal and interest amounts due.

Allowance for Loan and Lease Losses

Our allowance for loan and lease losses represents management’s estimate of incurred loan and lease losses inherent in our loan and lease portfolio as of the balance sheet date. The estimation of the allowance for loan and lease losses is based on a variety of factors, including past loan and lease loss experience, the current credit profile and financial position of our borrowers, adverse situations that have occurred that may affect the borrowers’ ability to repay, the estimated value of underlying collateral and general economic conditions. Provisions for loan and lease losses are recognized when available information indicates that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated.

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


14

Under our credit risk management process, the credit quality of our portfolio is assessed on an ongoing basis. Each loan is assigned an internal risk rating that is based on defined credit review standards. While rating criteria vary by product, each loan rating focuses on: the borrower’s financial performance and financial standing, the borrower’s ability to repay the loan, and the adequacy of the collateral securing the loan. Subsequent to loan origination, risk ratings are monitored and reassessed on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the borrower’s financial condition, cash flow or financial position. We use risk rating aggregations to measure credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by borrower industries and real estate property types (where applicable).

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

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

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

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

Activity in the allowance for loan and lease losses related to our loans held for investment for the three and six months ended June 30, 2012 and 2011 was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	151,902		$	283,274		$	153,631		$	329,122
Charge offs		(33,494	)		(83,468	)		(45,942	)		(179,930	)
Recoveries		4,415			2,563			5,321			15,976
Net charge offs		(29,079	)		(80,905	)		(40,621	)		(163,954	)
Charge offs upon transfer to held for sale		—			(4,754	)		(1,259	)		(12,362	)
Provision for loan and lease losses		10,536			1,523			21,608			46,332
Balance as of end of period	$	133,359		$	199,138		$	133,359		$	199,138

As of June 30, 2012 and December 31, 2011, the balances of the allowance for loan and lease losses and the carrying value of loans held for investment disaggregated by impairment methodology were as follows:


	June 30, 2012					December 31, 2011
	Loans		Allowance for Loan and Lease Losses			Loans		Allowance for Loan and Lease Losses
	($ in thousands)
Individually evaluated for impairment	$	362,976	$	(20,799	)	$	418,429	$	(26,448	)
Collectively evaluated for impairment		5,670,341		(112,560	)		5,333,668		(127,183	)
Acquired loans with deteriorated credit quality		4,774		—			6,893		—
Total	$	6,038,091	$	(133,359	)	$	5,758,990	$	(153,631	)


15

Troubled Debt Restructurings

During the three and six months ended June 30, 2012, the aggregate carrying value of loans involved in troubled debt restructurings (“TDRs”) were $20.7 million and $91.7 million, respectively, as of their respective restructuring dates. During the three and six months ended June 30, 2011, the aggregate carrying values of loans involved in a TDR were $68.7 million and $223.5 million, respectively, as of their respective restructuring dates. Aggregate carrying value includes principal, deferred fees and accrued interest. Loans involved in TDRs are classified as impaired upon closing on the TDR. Generally, a loan that has been involved in a TDR is no longer classified as impaired one year subsequent to the restructuring, assuming the loan performs under the restructured terms and the restructured terms are commensurate with current market terms. In most cases, the restructured terms of loans involved in TDRs are not commensurate with current market terms. As of June 30, 2012, one loan with an aggregate carrying value of $22.8 million, that had been restructured in a TDR, was no longer classified as impaired because it had performed in accordance with the restructured terms for one year subsequent to the restructuring.

As loans involved in TDRs are deemed to be impaired, such impaired loans, including those that subsequently experienced defaults, are individually evaluated in accordance with our allowance for loan and lease losses methodology under the same guidelines as non-TDR loans that are classified as impaired. Our evaluation of whether collection of interest and principal is reasonably assured is based on the facts and circumstances of each individual borrower and our assessment of the borrower’s ability and intent to repay in accordance with the revised loan terms. We generally consider such factors as historical operating performance and payment history of the borrower, indications of support by sponsors and other interest holders, the terms of the TDR, the value of any collateral securing the loan and projections of future performance of the borrower as part of this evaluation.

The accrual status for loans involved in a TDR is assessed as part of the evaluation mentioned above. For a loan that accrues interest immediately after that loan is restructured in a TDR, we generally do not charge off a portion of the loan as part of the restructuring. If a portion of a loan has been charged off, we will not accrue interest on the remaining portion of the loan if the charged off portion is still contractually due from the borrower. However, if the charged off portion of the loan is legally forgiven through concessions to the borrower, then the restructured loan may be placed on accrual status if the remaining contractual amounts due on the loan are reasonably assured of collection. In addition, for certain TDRs, especially those involving a commercial real estate loan, we may split the loan into an A note and a B note, placing the performing A note on accrual status and charging off the B note. For loans involved in a TDR that have been classified as non-accrual, the borrower is required to demonstrate sustained payment performance for a minimum of six months to return to accrual status.

The aggregate carrying values of loans that had been restructured in TDRs as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual	$	62,105	$	130,389
Accruing		184,104		178,614
Total	$	246,209	$	309,003

The specific reserves related to these loans were $2.1 million and $7.3 million as of June 30, 2012 and December 31, 2011, respectively. As of June 30, 2012 and December 31, 2011, we had unfunded commitments related to these restructured loans of $104.5 million and $103.1 million, respectively.


16

The following table rolls forward the balance of loans modified in TDRs for the three and six months ended June 30, 2012 and 2011:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Beginning balance of TDRs	$	256,995		$	528,466		$	309,003		$	555,113
New TDRs		14,852			15,747			22,630			96,222
Draws and pay downs on existing TDRs, net		(10,101	)		(15,073	)		(39,275	)		(12,762	)
Loan sales and payoffs		(189	)		(13,056	)		(23,795	)		(54,506	)
Charge offs post modification		(15,348	)		(61,733	)		(22,354	)		(129,716	)
Ending balance of TDRs	$	246,209		$	454,351		$	246,209		$	454,351

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


17

The number and aggregate carrying values of loans involved in TDRs that occurred during the three and six months ended June 30, 2012 were as follows:


	Three Months Ended June 30, 2012						Six Months Ended June 30, 2012
	Number of Loans		Carrying Value Prior to TDR		Carrying Value Subsequent to TDR		Number of Loans		Carrying Value Prior to TDR		Carrying Value Subsequent to TDR
	($ in thousands)
Asset-based:
Maturity extension		—	$	—	$	—		1	$	350	$	350
Discounted payoffs		—		—		—		1		188		—
Multiple concessions		—		—		—		2		3,374		2,702
		—		—		—		4		3,912		3,052

Cash flow:
Maturity extension		—		—		—		2		3,886		3,886
Multiple concessions		3		15,426		15,426		8		27,099		27,099
		3		15,426		15,426		10		30,985		30,985

Multifamily:
Foreclosures		1		189		—		2		1,040		—
		1		189		—		2		1,040		—

Real estate:
Maturity extension		1		860		860		2		48,709		48,709
Discounted payoffs		1		4,246		—		1		4,246		—
		2		5,106		860		3		52,955		48,709

Small business:
Discounted payoffs		—		—		—		1		597		—
		—		—		—		1		597		—
Total⁽¹⁾		6	$	20,721	$	16,286		20	$	89,489	$	82,746

⁽¹⁾	Excludes loans held for sale and purchased credit impaired loans.


18

A summary of concessions granted by loan type, including the accrual status of the loans as of June 30, 2012 and December 31, 2011 was as follows:


	June 30, 2012						December 31, 2011
	Non-accrual		Accrual		Total		Non-accrual		Accrual		Total
	($ in thousands)
Commercial
Maturity extension	$	23,437	$	61,802	$	85,239	$	24,208	$	72,174	$	96,382
Payment deferral		248		—		248		252		8,335		8,587
Multiple concessions		26,289		69,098		95,387		37,766		26,718		64,484
		49,974		130,900		180,874		62,226		107,227		169,453
Real estate
Interest rate and fee reduction		—		—		—		188		—		188
Maturity extension		63		22,775		22,838		1,023		41,213		42,236
Payment deferral		—		—		—		47,849		—		47,849
Multiple concessions		—		30,429		30,429		861		146		1,007
		63		53,204		53,267		49,921		41,359		91,280
Real estate — construction
Maturity extension		11,210		—		11,210		18,242		—		18,242
Multiple concessions		858		—		858		—		30,028		30,028
		12,068		—		12,068		18,242		30,028		48,270
Total	$	62,105	$	184,104	$	246,209	$	130,389	$	178,614	$	309,003

We have experienced losses incurred on some TDRs subsequent to their initial restructuring. These losses include both additional specific reserves and charge offs on the restructured loans. The majority of such losses has been incurred on our commercial loans and is primarily due to the borrowers’ failure to consistently meet their financial forecasts that formed the bases for our restructured loans. Examples of circumstances that resulted in the borrowers not being able to meet their forecasts included acquisitions of other businesses that did not have the expected positive impact on financial results, significant delays in launching products and services, and continued deterioration in the pricing estimates of businesses and product lines that the borrower expected to sell to generate proceeds to repay the loan.


19

Losses incurred on TDRs since their initial restructuring by concession and loan type for the three and six months ended June 30, 2012 and 2011 were as follows:


	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
	($ in thousands)
Commercial
Interest rate and fee reduction	$	—	$	—	$	—	$	18,728
Maturity extension		2,888		4,309		4,929		8,810
Payment deferral		—		100		4		7,543
Multiple concessions		3,333		11,158		5,960		36,041
		6,221		15,567		10,893		71,122
Real estate
Interest rate and fee reduction		—		11		—		11
Maturity extension		—		425		950		425
Payment deferral		—		11,162		—		11,162
Multiple concessions		23		—		23		—
		23		11,598		973		11,598
Real estate — construction
Maturity extension		4,390		3,035		4,709		14,831
		4,390		3,035		4,709		14,831
Total	$	10,634	$	30,200	$	16,575	$	97,551

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and six months ended June 30, 2012, 58.4% and 76.2%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status. We did not recognize any interest income for the three months ended June 30, 2012, on commercial loans that experienced losses during these periods. We recognized approximately $74 thousand of interest income for the six months ended June 30, 2012 on the commercial loans that experienced losses during these periods.

Of the additional losses recognized on commercial loan TDRs since their initial restructuring for the three and six months ended June 30, 2011, 27.8% and 38.2%, respectively, related to loans for which the initial TDR on the borrower occurred prior to 2008, 86.5% and 81.6%, respectively, related to loans that had additional modifications subsequent to their initial TDRs, and all related to loans that were on non-accrual status as of June 30, 2011. We recognized approximately $0.2 million of interest income for the six months ended June 30, 2011 on the commercial loans that experienced losses during this period.

Foreclosed Assets

Real Estate Owned (“REO”)

When we foreclose on a real estate asset that collateralizes a loan or other assets, we record the asset at its estimated fair value less costs to sell at the time of foreclosure if the related REO is classified as held for sale. Upon foreclosure, we evaluate the asset’s fair value as compared to the asset’s carrying amount and record a charge off when the carrying amount of the asset exceeds fair value less costs to sell. For REO determined to be held for sale, subsequent valuation adjustments are recorded as a valuation allowance, which is recorded as a component of net expense of real estate owned and other foreclosed assets. REO that does not meet the criteria of held for sale is classified as held for use and initially recorded at its fair value. Except for land acquired, the real estate asset is subsequently depreciated over its estimated useful life. Fair value adjustments on REO held for use are recorded only if the carrying amount of an asset is not recoverable and exceeds its estimated fair value less cost to sell.


20

As of June 30, 2012 and December 31, 2011, we had $17.5 million and $23.6 million, respectively, of REO classified as held for sale, which was recorded as a component of other assets. Activity related to REO held for sale for the three and six months ended June 30, 2012 and 2011 was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	32,553		$	70,050		$	23,649		$	92,265
Transfers from loans held for investment and other assets		176			8,840			11,617			13,589
Fair value adjustments		(2,225	)		(11,080	)		(2,429	)		(13,124	)
Real estate sold		(12,976	)		(20,798	)		(15,309	)		(45,718	)
Balance as of end of period	$	17,528		$	47,012		$	17,528		$	47,012

During the three and six months ended June 30, 2012, we recognized losses of $1.2 million and $0.4 million, respectively, on the sales of REO held for sale as a component of expense of real estate owned and other foreclosed assets, net. During the three and six months ended June 30, 2011, we recognized gains of $1.1 million and $1.4 million, respectively, on the sales of REO held for sale as a component of expense of real estate owned and other foreclosed assets, net.

As of June 30, 2012 and December 31, 2011, we had $1.4 million of REO classified as held for use, which was recorded in other assets. During the three and six months ended June 30, 2012 and 2011, we did not recognize any impairment losses on REO held for use as a component of expense of real estate owned and other foreclosed assets, net.

Other Foreclosed Assets

When we foreclose on a borrower whose underlying collateral consists of loans or other assets, we record the acquired assets at the estimated fair value less costs to sell at the time of foreclosure. At the time of foreclosure, we record charge offs when the carrying amount of the original loan exceeds the estimated fair value of the acquired assets. We may also write down or record allowances on the acquired loans or assets subsequent to foreclosure if such loans or assets experience additional deterioration. As of June 30, 2012 and December 31, 2011, we had $11.1 million and $14.7 million, respectively, of loans acquired through foreclosure, net of valuation allowances of $0.1 million and $0.9 million, respectively, which were recorded in other assets. The reserve release and provision for losses and gains on sales of other foreclosed assets, which were recorded as a component of expense of real estate owned and other foreclosed assets, net for the three and six months ended June 30, 2012 and 2011 were as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
(Reserve release) provision for losses on other foreclosed assets	$	(328	)	$	(398	)	$	(1,025	)	$	7,405
(Losses) gains on sales of other foreclosed assets		—			(32	)		—			1,647


21

Note 5. Investments

Investment Securities, Available-for-Sale

As of June 30, 2012 and December 31, 2011, our investment securities, available-for-sale were as follows:


	June 30, 2012									December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	($ in thousands)
Agency securities	$	1,019,686	$	24,233	$	(273	)	$	1,043,646	$	1,031,275	$	25,656	$	(103	)	$	1,056,828
Asset-backed securities		11,941		512		—			12,453		15,023		604		(20	)		15,607
Collateralized loan obligation		13,000		7,451		(587	)		19,864		11,915		5,848		—			17,763
Corporate debt		—		—		—			—		742		—		(42	)		700
Equity security		—		—		—			—		202		191		—			393
Municipal bond		2,129		—		—			2,129		3,235		—		—			3,235
Non-agency MBS		50,164		966		(345	)		50,785		67,662		831		(1,563	)		66,930
U.S. Treasury and agency securities		18,258		907		—			19,165		25,902		644		—			26,546
Total	$	1,115,178	$	34,069	$	(1,205	)	$	1,148,042	$	1,155,956	$	33,774	$	(1,728	)	$	1,188,002

Included in investment securities, available-for-sale, were agency securities which included callable notes issued by Fannie Mae, Freddie Mac, the Federal Home Loan Bank (“FHLB”) and Federal Farm Credit Bank, bonds issued by the FHLB, discount notes issued by Fannie Mae, Freddie Mac and the FHLB, and commercial and residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae; asset-backed securities; investments in a collateralized loan obligation; corporate debt; an equity security; a municipal bond; commercial and residential mortgage-backed securities issued by non-government agencies (“Non-agency MBS”) and U.S. Treasury and agency asset-backed securities issued by the Small Business Administration.

The amortized cost and fair value of investment securities, available-for-sale pledged as collateral as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012				December 31, 2011
Source	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	360,568	$	372,404	$	475,694	$	490,437
Non-government Correspondent Bank⁽¹⁾		—		—		39,990		39,990
Government Agency⁽²⁾		11,576		11,711		44,462		45,816
	$	372,144	$	384,115	$	560,146	$	576,243

⁽¹⁾	Represents the amounts pledged as collateral for letters of credit and foreign exchange contracts.

⁽²⁾	Represents the amounts pledged as collateral to secure funds deposited by a local or state government agency.

Realized gains or losses resulting from the sale of investments are calculated using the specific identification method and are included in (loss) gain on sales of investments, net. We sold $1.3 million of available-for-sale investment securities and recognized $0.4 million of related net pre-tax gains during the three and six months ended June 30, 2012. We sold $70.2 million of available-for-sale securities and recognized $14.5 million related pre-tax gains during the six months ended June 30, 2011. We did not sell any available-for-sale securities during the three months ended June 30, 2011.

During the three and six months ended June 30, 2012, we recorded $1.1 million of other-than-temporary impairments (“OTTI”) in our available-for-sale portfolio relating to a decline in the fair value of our municipal bond which was recorded as a component of (loss) gain on


22

sales of investments, net. We recorded no OTTI during the three months ended June 30, 2011. We recorded $1.5 million of OTTI during the six months ended June 30, 2011, relating to a decline in the fair value of our municipal bond which was recorded as a component of (loss) gain on sales of investments, net.

Investment Securities, Held-to-Maturity

As of June 30, 2012 and December 31, 2011, the balances of our investment securities, held-to-maturity were $108.5 million and $111.7 million, respectively, and consisted of commercial mortgage-backed securities rated A+ or higher. The amortized costs and estimated fair values of the investment securities, held-to-maturity pledged as collateral as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012				December 31, 2011
Source:	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	($ in thousands)
FHLB	$	4,341	$	4,780	$	7,177	$	7,681
FRB		86,316		87,972		93,899		94,305
	$	90,657	$	92,752	$	101,076	$	101,986

Unrealized Losses on Investment Securities

As of June 30, 2012 and December 31, 2011, the gross unrealized losses and fair values of investment securities that were in unrealized loss positions were as follows:


	Less Than 12 Months					12 Months or More					Total
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value
	($ in thousands)
As of June 30, 2012
Investment securities, available-for-sale:
Agency securities	$	(273	)	$	72,223	$	—		$	—	$	(273	)	$	72,223
Collateralized loan obligation		(587	)		4,642		—			—		(587	)		4,642
Non-agency MBS		—			—		(345	)		12,080		(345	)		12,080
Total investment securities, available-for-sale	$	(860	)	$	76,865	$	(345	)	$	12,080	$	(1,205	)	$	88,945
Total investment securities, held-to-maturity	$	(469	)	$	23,678	$	(1,220	)	$	41,165	$	(1,689	)	$	64,843
As of December 31, 2011
Investment securities, available-for-sale:
Agency securities	$	(103	)	$	35,704	$	—		$	—	$	(103	)	$	35,704
Asset-backed securities		(20	)		4,826		—			—		(20	)		4,826
Corporate debt		(42	)		700		—			—		(42	)		700
Non-agency MBS		(169	)		14,921		(1,394	)		13,406		(1,563	)		28,327
Total investment securities, available-for-sale	$	(334	)	$	56,151	$	(1,394	)	$	13,406	$	(1,728	)	$	69,557
Total investment securities, held-to-maturity	$	(3,018	)	$	64,012	$	—		$	—	$	(3,018	)	$	64,012


23

Held-to-maturity investment securities in unrealized loss positions are analyzed individually as part of our ongoing assessment of OTTI. As of June 30, 2012 and December 31, 2011, we do not believe that any unrealized losses in our held-to-maturity portfolio represent an OTTI. The unrealized losses are primarily related to one Agency MBS, one Non-agency MBS and two commercial MBS which are attributable to fluctuations in the market prices of the securities due to market conditions and interest rate levels. The one Agency MBS has the highest debt rating and are backed by government-sponsored entities. As of June 30, 2012, each of the non-agency MBS with unrealized losses was investment grade. As of June 30, 2012, each of the commercial MBS with unrealized losses was investment grade and had a credit support level that exceeds 20% which, in accordance with the CapitalSource Bank investment policy, is the minimum required for purchases of this security type. As such, we expect to recover the entire amortized cost basis of the impaired securities.

Contractual Maturities

As of June 30, 2012, the contractual maturities of our available-for-sale and held-to-maturity investment securities were as follows:


	Investment Securities, Available-for-Sale				Investment Securities, Held-to-Maturity
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	($ in thousands)
Due in one year or less	$	23,670	$	23,810	$	—	$	—
Due after one year through five years		7,129		7,182		27,019		30,093
Due after five years through ten years⁽¹⁾		51,500		54,013		59,297		57,879
Due after ten years⁽²⁾⁽³⁾		1,032,879		1,063,037		22,204		23,262
Total	$	1,115,178	$	1,148,042	$	108,520	$	111,234

⁽¹⁾	Includes Agency, Non-agency MBS and CMBS, with fair values of $22.6 million, $18.9 million and $57.9 million, respectively, and weighted-average expected maturities of 2.34 years, 1.50 years and 1.96 years, respectively, based on interest rates and expected prepayment speeds as of June 30, 2012.

⁽²⁾	Includes Agency, Non-agency MBS and CMBS, with fair values of $992.1 million, $31.9 million and $23.3 million, respectively, and weighted-average expected maturities of 3.01 years, 2.77 years and 4.56 years, respectively, based on interest rates and expected prepayment speeds as of June 30, 2012.

⁽³⁾	Includes securities with no stated maturity.

Other Investments

As of June 30, 2012 and December 31, 2011, our other investments were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Investments carried at cost	$	31,361	$	36,252
Investments carried at fair value		—		192
Investments accounted for under the equity method		41,308		44,801
Total	$	72,669	$	81,245

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


	Three months ended June 30,				Six months ended June 30,
	2012		2011		2012		2011
	($ in thousands)
Proceeds from sales	$	2,220	$	9,923	$	4,340	$	20,020
Net pre-tax gain from sales		1,593		7,416		3,019		17,251


24

During the three and six months ended June 30, 2012, we recorded $2.1 million and $4.7 million, respectively, of OTTI in our other investments portfolio relating to a decline in the fair value of investment carried at cost which was recorded as a component of (loss) gain on sale of investments, net. During the three and six months ended June 30, 2011, we recorded $0.2 million and $0.4 million, respectively, of OTTI relating to a decline in the fair value of other investments carried at cost.

Note 6. Guarantor

Information

The following represents the supplemental consolidating condensed financial information as of June 30, 2012 and December 31, 2011 and for the three and six months ended June 30, 2012 and 2011 of (i) CapitalSource Inc., which as discussed in Note 9, Borrowings, is the issuer of our Senior

Subordinated Debentures, (ii) CapitalSource Finance LLC (“CapitalSource Finance”), which is a guarantor of our Senior Subordinated Debentures, and (iii) our subsidiaries that are not guarantors of the Senior Subordinated Debentures. CapitalSource Finance, a wholly owned indirect subsidiary of CapitalSource Inc., has guaranteed the Senior Subordinated Debentures, fully and unconditionally, on a senior subordinate basis. Separate consolidated financial statements of the guarantor are not presented, as we have determined that they would not be material to investors.

In July 2012, we repurchased the remaining outstanding Senior Subordinated Debentures totaling $23.2 million which extinguished the associated debt issued by CapitalSource Inc. and the senior subordinate guarantee issued by CapitalSource Finance.


25

Consolidating Balance Sheet

June 30, 2012

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Assets
Cash and cash equivalents	$	1,385		$	225,373		$	188,171		$	1,092		$	—		$	416,021
Restricted cash		—			72,255			3,126			142			—			75,523
Investment securities:
Available-for-sale, at fair value		—			1,126,049			—			21,993			—			1,148,042
Held-to-maturity, at amortized cost		—			108,520			—			—			—			108,520
Total investment securities		—			1,234,569			—			21,993			—			1,256,562
Loans:
Loans held for sale		—			31,519			—			—			—			31,519
Loans held for investment		—			5,701,516			184,297			152,278			—			6,038,091
Less deferred loan fees and discounts		—			(56,657	)		(3,046	)		(2,064	)		652			(61,115	)
Less allowance for loan and lease losses		—			(121,172	)		(5,869	)		(6,318	)		—			(133,359	)
Loans held for investment, net		—			5,523,687			175,382			143,896			652			5,843,617
Total loans		—			5,555,206			175,382			143,896			652			5,875,136
Interest receivable		—			26,492			10,395			(6,591	)		—			30,296
Investment in subsidiaries		1,595,650			2,048			1,360,260			1,364,221			(4,322,179	)		—
Intercompany receivable		—			—			29,168			—			(29,168	)		—
Other investments		—			54,219			13,148			5,302			—			72,669
Goodwill		—			173,135			—			—			—			173,135
Other assets		215,881			235,442			32,618			194,226			(7,850	)		670,317
Total assets	$	1,812,916		$	7,578,739		$	1,812,268		$	1,724,281		$	(4,358,545	)	$	8,569,659
Liabilities and shareholders’ equity
Liabilities:
Deposits	$	—		$	5,382,012		$	—		$	—		$	—		$	5,382,012
Term debt		—			214,059			—			—			—			214,059
Other borrowings		23,223			597,000			409,383			—			—			1,029,606
Other liabilities		8,006			52,454			43,134			69,715			(11,014	)		162,295
Intercompany payable		—			—			—			29,168			(29,168	)		—
Total liabilities		31,229			6,245,525			452,517			98,883			(40,182	)		6,787,972
Shareholders’ equity:
Common stock		2,250			921,000			—			—			(921,000	)		2,250
Additional paid-in capital		3,286,833			(259,682	)		237,790			1,479,913			(1,458,021	)		3,286,833
(Accumulated deficit) retained earnings		(1,526,938	)		656,396			1,106,603			131,796			(1,894,795	)		(1,526,938	)
Accumulated other comprehensive income, net		19,542			15,500			15,358			13,689			(44,547	)		19,542
Total shareholders’ equity		1,781,687			1,333,214			1,359,751			1,625,398			(4,318,363	)		1,781,687
Total liabilities and shareholders’ equity	$	1,812,916		$	7,578,739		$	1,812,268		$	1,724,281		$	(4,358,545	)	$	8,569,659


26

Consolidating Balance Sheet

December 31, 2011


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Assets
Cash and cash equivalents	$	12,618		$	324,848		$	118,648		$	2,434		$	—		$	458,548
Restricted cash		—			29,605			35,737			142			—			65,484
Investment securities:
Available-for-sale, at fair value		—			1,159,819			6,793			21,390			—			1,188,002
Held-to-maturity, at amortized cost		—			111,706			—			—			—			111,706
Total investment securities		—			1,271,525			6,793			21,390			—			1,299,708
Loans:
Loans held for sale		—			138,723			38			54,260			—			193,021
Loans held for investment		—			5,377,778			146,395			234,817			—			5,758,990
Less deferred loan fees and discounts		—			(59,015	)		(4,462	)		(8,502	)		3,136			(68,843	)
Less allowance for loan and lease losses		—			(137,052	)		(7,394	)		(9,185	)		—			(153,631	)
Loans held for investment, net		—			5,181,711			134,539			217,130			3,136			5,536,516
Total loans		—			5,320,434			134,577			271,390			3,136			5,729,537
Interest receivable		—			28,839			16,873			(6,916	)		—			38,796
Investment in subsidiaries		1,592,510			2,591			1,432,579			1,339,759			(4,367,439	)		—
Intercompany receivable		—			—			26,691			—			(26,691	)		—
Other investments		—			56,641			13,955			10,649			—			81,245
Goodwill		—			173,135			—			—			—			173,135
Other assets		11,521			236,575			80,432			156,682			(31,595	)		453,615
Total assets	$	1,616,649		$	7,444,193		$	1,866,285		$	1,795,530		$	(4,422,589	)	$	8,300,068
Liabilities and shareholders’ equity
Liabilities:
Deposits	$	—		$	5,124,995		$	—		$	—		$	—		$	5,124,995
Term debt		—			309,394			—			—			—			309,394
Other borrowings		28,903			550,000			436,196			—			—			1,015,099
Other liabilities		12,600			71,908			96,696			128,484			(34,254	)		275,434
Intercompany payable		—			—			—			26,691			(26,691	)		—
Total liabilities		41,503			6,056,297			532,892			155,175			(60,945	)		6,724,922
Shareholders’ equity:
Common stock		2,561			921,000			—			—			(921,000	)		2,561
Additional paid-in capital		3,487,911			(203,537	)		288,752			1,669,098			(1,754,313	)		3,487,911
(Accumulated deficit) retained earnings		(1,934,732	)		654,578			1,028,928			(42,296	)		(1,641,210	)		(1,934,732	)
Accumulated other comprehensive income, net		19,406			15,855			15,713			13,553			(45,121	)		19,406
Total shareholders’ equity		1,575,146			1,387,896			1,333,393			1,640,355			(4,361,644	)		1,575,146
Total liabilities and shareholders’ equity	$	1,616,649		$	7,444,193		$	1,866,285		$	1,795,530		$	(4,422,589	)	$	8,300,068


27

Consolidating Statement of Operations

Three Months Ended June 30, 2012

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans and leases	$	—		$	96,950		$	8,871		$	4,925		$	(2,445	)	$	108,301
Investment securities		—			8,032			162			1,042			—			9,236
Other		—			403			42			—			—			445
Total interest income		—			105,385			9,075			5,967			(2,445	)		117,982
Interest expense:
Deposits		—			12,640			—			—			—			12,640
Borrowings		512			4,213			2,799			1,337			(1,337	)		7,524
Total interest expense		512			16,853			2,799			1,337			(1,337	)		20,164
Net interest (loss) income		(512	)		88,532			6,276			4,630			(1,108	)		97,818
Provision for loan and lease losses		—			5,967			(6,819	)		11,388			—			10,536
Net interest (loss) income after provision for loan and lease losses		(512	)		82,565			13,095			(6,758	)		(1,108	)		87,282
Non-interest income:
Loan fees		—			2,834			248			(25	)		—			3,057
Leased equipment income		—			3,258			—			—			—			3,258
Gain (loss) on investments, net		—			983			4			(1,607	)		—			(620	)
Gain on derivatives, net		—			432			—			—			—			432
Other non-interest income, net		—			7,995			(301	)		971			(6,342	)		2,323
Earnings (loss) in subsidiaries		139,536			(46	)		38,487			44,211			(222,188	)		—
Total non-interest income		139,536			15,456			38,438			43,550			(228,530	)		8,450
Non-interest expense:
Compensation and benefits		287			24,981			140			—			—			25,408
Professional fees		896			1,850			99			244			—			3,089
Occupancy expenses		—			2,781			3,584			—			(144	)		6,221
FDIC fees and assessments		—			1,463			—			—			—			1,463
General depreciation and amortization		—			1,044			590			—			(123	)		1,511
Other administrative expenses		1,315			7,842			10,790			17			(6,342	)		13,622
Total operating expenses		2,498			39,961			15,203			261			(6,609	)		51,314
Leased equipment depreciation		—			2,288			—			—			—			2,288
Expense of real estate owned and other foreclosed assets, net		—			3,158			(55	)		718			—			3,821
Loss (gain) on extinguishment of debt		18			—			(8,160	)		—			—			(8,142	)
Other non-interest expense		—			(574	)		(507	)		—			—			(1,081	)
Total non-interest expense		2,516			44,833			6,481			979			(6,609	)		48,200
Net income before income taxes		136,508			53,188			45,052			35,813			(223,029	)		47,532
Income tax (benefit) expense		(251,041	)		15,106			—			(104,082	)		—			(340,017	)
Net income		387,549			38,082			45,052			139,895			(223,029	)		387,549
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on available-for- sale securities, net of tax		(594	)		(594	)		—			228			—			(960	)
Other comprehensive (loss) income		(594	)		(594	)		—			228			—			(960	)
Comprehensive Income	$	386,955		$	37,488		$	45,052		$	140,123		$	(223,029	)	$	386,589


28

Consolidating Statement of Operations

Three Months Ended June 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans and leases	$	10,183		$	98,409		$	11,837		$	10,048		$	(16,830	)	$	113,647
Investment securities		—			11,599			—			1,089			—			12,688
Other		—			404			686			—			—			1,090
Total interest income		10,183			110,412			12,523			11,137			(16,830	)		127,425
Interest expense:
Deposits		—			13,398			—			—			—			13,398
Borrowings		23,851			5,054			4,031			12,537			(13,064	)		32,409
Total interest expense		23,851			18,452			4,031			12,537			(13,064	)		45,807
Net interest (loss) income		(13,668	)		91,960			8,492			(1,400	)		(3,766	)		81,618
Provision for loan and lease losses		—			6,340			(3,258	)		(1,559	)		—			1,523
Net interest (loss) income after provision for loan and lease losses		(13,668	)		85,620			11,750			159			(3,766	)		80,095
Non-interest income:
Loan fees		(17	)		1,733			1,572			122			—			3,410
Leased equipment income		—			73			—			—			—			73
Gain on investments, net		—			8,413			8			304			—			8,725
(Loss) gain on derivatives, net		—			(356	)		5,557			(5,472	)		—			(271	)
Other non-interest income, net		—			3,717			20,379			1,979			(21,735	)		4,340
Earnings (loss) in subsidiaries		32,703			(78	)		37,015			42,041			(111,681	)		—
Total non-interest income		32,686			13,502			64,531			38,974			(133,416	)		16,277
Non-interest expense:
Compensation and benefits		667			13,116			15,902			—			(587	)		29,098
Professional fees		4,437			522			1,581			(222	)		—			6,318
Occupancy expenses		—			2,141			2,021			—			(143	)		4,019
FDIC fees and assessments		—			1,341			—			—			—			1,341
General depreciation and amortization		—			1,203			698			—			(123	)		1,778
Other administrative expenses		1,185			16,637			9,967			3,203			(20,625	)		10,367
Total operating expenses		6,289			34,960			30,169			2,981			(21,478	)		52,921
Leased equipment depreciation		—			40			—			—			—			40
Expense of real estate owned and other foreclosed assets, net		—			10,589			47			320			—			10,956
Other non-interest expense		—			(1,388	)		—			—			—			(1,388	)
Total non-interest expense		6,289			44,201			30,216			3,301			(21,478	)		62,529
Net income before income taxes		12,729			54,921			46,065			35,832			(115,704	)		33,843
Income tax (benefit) expense		(3,865	)		17,764			—			3,350			—			17,249
Net income		16,594			37,157			46,065			32,482			(115,704	)		16,594
Other comprehensive income, net of tax
Unrealized gain on available-for- sale securities, net of tax		5,955			9,267			—			5,232			—			20,454
Unrealized gain on foreign currency translation, net of tax		—			1,878			—			—			—			1,878
Other comprehensive income		5,955			11,145			—			5,232			—			22,332
Comprehensive Income	$	22,549		$	48,302		$	46,065		$	37,714		$	(115,704	)	$	38,926


29

Consolidating Statement of Operations

Six Months Ended June 30, 2012

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans and leases	$	—		$	196,696		$	15,873		$	9,786		$	(4,984	)	$	217,371
Investment securities		—			17,517			162			2,274			—			19,953
Other		—			691			44			—			—			735
Total interest income		—			214,904			16,079			12,060			(4,984	)		238,059
Interest expense:
Deposits		—			25,931			—			—			—			25,931
Borrowings		1,091			8,309			5,691			2,631			(2,631	)		15,091
Total interest expense		1,091			34,240			5,691			2,631			(2,631	)		41,022
Net interest (loss) income		(1,091	)		180,664			10,388			9,429			(2,353	)		197,037
Provision for loan and lease losses		—			6,862			25			14,721			—			21,608
Net interest (loss) income after provision for loan and lease losses		(1,091	)		173,802			10,363			(5,292	)		(2,353	)		175,429
Non-interest income:
Loan fees		—			6,235			1,429			61			—			7,725
Leased equipment income		—			6,516			—			—			—			6,516
Gain (loss) on investments, net		—			2,304			35			(3,266	)		—			(927	)
(Loss) gain on derivatives, net		—			(55	)		593			(209	)		—			329
Other non-interest income, net		—			18,526			224			1,359			(13,752	)		6,357
Earnings (loss) in subsidiaries		169,266			(292	)		83,358			75,768			(328,100	)		—
Total non-interest income		169,266			33,234			85,639			73,713			(341,852	)		20,000
Non-interest expense:
Compensation and benefits		476			49,565			1,783			—			—			51,824
Professional fees		1,839			3,245			1,251			354			—			6,689
Occupancy expenses		—			5,161			5,105			—			(286	)		9,980
FDIC fees and assessments		—			2,912			—			—			—			2,912
General depreciation and amortization		—			2,170			1,282			—			(246	)		3,206
Other administrative expenses		2,231			16,643			17,895			225			(13,752	)		23,242
Total operating expenses		4,546			79,696			27,316			579			(14,284	)		97,853
Leased equipment depreciation		—			4,576			—			—			—			4,576
Expense of real estate owned and other foreclosed assets, net		—			3,196			57			1,018			—			4,271
Loss (gain) on extinguishment of debt		101			—			(8,160	)		—			—			(8,059	)
Other non-interest expense		—			(510	)		(881	)		—			—			(1,391	)
Total non-interest expense		4,647			86,958			18,332			1,597			(14,284	)		97,250
Net income before income taxes		163,528			120,078			77,670			66,824			(329,921	)		98,179
Income tax (benefit) expense		(248,959	)		38,265			—			(103,614	)		—			(314,308	)
Net income		412,487			81,813			77,670			170,438			(329,921	)		412,487
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on available-for- sale securities, net of tax		—			(3	)		—			490			—			487
Unrealized loss on foreign currency translation, net of tax		—			(351	)		—			—			—			(351	)
Other comprehensive (loss) income		—			(354	)		—			490			—			136
Comprehensive Income	$	412,487		$	81,459		$	77,670		$	170,928		$	(329,921	)	$	412,623


30

Consolidating Statement of Operations

Six Months Ended June 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource Inc.
	($ in thousands)
Net interest income:
Interest income:
Loans and leases	$	20,377		$	203,463		$	9,946		$	30,586		$	(27,225	)	$	237,147
Investment securities		—			26,322			7			4,711			—			31,040
Other		—			642			741			7			—			1,390
Total interest income		20,377			230,427			10,694			35,304			(27,225	)		269,577
Interest expense:
Deposits		—			26,781			—			—			—			26,781
Borrowings		48,276			10,764			8,948			23,790			(26,000	)		65,778
Total interest expense		48,276			37,545			8,948			23,790			(26,000	)		92,559
Net interest (loss) income		(27,899	)		192,882			1,746			11,514			(1,225	)		177,018
Provision for loan and lease losses		—			5,543			36,945			3,844			—			46,332
Net interest (loss) income after provision for loan and lease losses		(27,899	)		187,339			(35,199	)		7,670			(1,225	)		130,686
Non-interest income:
Loan fees		(334	)		4,017			3,090			1,241			—			8,014
Leased equipment income		—			73			—			—			—			73
Gain on investments, net		—			20,062			30			12,148			—			32,240
(Loss) gain on derivatives, net		—			(1,133	)		4,435			(5,451	)		—			(2,149	)
Other non-interest income, net		—			6,285			37,438			2,207			(41,619	)		4,311
Earnings (loss) in subsidiaries		59,948			(1,176	)		109,300			55,191			(223,263	)		—
Total non-interest income		59,614			28,128			154,293			65,336			(264,882	)		42,489
Non-interest expense:
Compensation and benefits		902			25,144			34,849			—			(1,418	)		59,477
Professional fees		5,387			881			2,911			709			—			9,888
Occupancy expenses		—			3,781			4,479			—			(287	)		7,973
FDIC fees and assessments		—			3,331			—			—			—			3,331
General depreciation and amortization		—			2,469			1,397			—			(245	)		3,621
Other administrative expenses		2,355			33,533			21,182			5,746			(42,058	)		20,758
Total operating expenses		8,644			69,139			64,818			6,455			(44,008	)		105,048
Leased equipment depreciation		—			40			—			—			—			40
Expense of real estate owned and other foreclosed assets, net		—			12,932			236			8,121			—			21,289
Other non-interest expense		—			(1,388	)		22			—			—			(1,366	)
Total non-interest expense		8,644			80,723			65,076			14,576			(44,008	)		125,011
Net income before income taxes		23,071			134,744			54,018			58,430			(222,099	)		48,164
Income tax expense (benefit)		3,318			24,544			(10	)		559			—			28,411
Net income		19,753			110,200			54,028			57,871			(222,099	)		19,753
Other comprehensive income, net of tax
Unrealized gain on available-for- sale securities, net of tax		5,955			8,710			223			10,409			—			25,297
Unrealized gain on foreign currency translation, net of tax		—			11,460			—			—			—			11,460
Other comprehensive income		5,955			20,170			223			10,409			—			36,757
Comprehensive Income	$	25,708		$	130,370		$	54,251		$	68,280		$	(222,099	)	$	56,510


31

Consolidating Statement of Cash Flows

Six Months Ended June 30, 2012

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource, Inc.
	($ in thousands)
Operating activities:
Net income	$	412,487		$	81,813		$	77,670		$	170,438		$	(329,921	)	$	412,487
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Stock option expense		148			1,015			(276	)		—			—			887
Restricted stock expense		328			5,064			452			—			—			5,844
Loss (gain) on extinguishment of debt		101			—			(8,160	)		—			—			(8,059	)
Amortization of deferred loan fees and discounts		—			(15,090	)		(5,095	)		(2,249	)		—			(22,434	)
Paid-in-kind interest on loans		—			(115	)		3,733			438			—			4,056
Provision for loan and lease losses		—			6,862			25			14,721			—			21,608
Amortization of deferred financing fees and discounts		67			646			185			—			—			898
Depreciation and amortization		—			8,175			1,282			—			—			9,457
(Benefit) provision for deferred income taxes		(232,166	)		6,489			10,420			(138,506	)		—			(353,763	)
Non-cash (gain) loss on investments, net		—			(2,043	)		—			1,584			—			(459	)
Non-cash (gain) loss on foreclosed assets, other property and equipment disposals		—			(264	)		2,216			(1,081	)		—			871
Unrealized (gain) loss on derivatives and foreign currencies, net		—			(64	)		(1,401	)		209			—			(1,256	)
Decrease (increase) in interest receivable		—			2,347			6,478			(325	)		—			8,500
Decrease (increase) in loans held for sale, net		—			24,796			(1,769	)		(1,354	)		—			21,673
Increase in intercompany receivable		—			—			(2,477	)		—			2,477			—
Decrease in other assets		17,378			181			43,990			101,501			(23,745	)		139,305
Decrease in other liabilities		(5,231	)		(19,390	)		(53,616	)		(58,769	)		23,240			(113,766	)
Net transfers with subsidiaries		13,671			(131,560	)		(438	)		(209,615	)		327,942			—
Cash provided by (used in) operating activities		206,783			(31,138	)		73,219			(123,008	)		(7	)		125,849
Investing activities:
(Increase) decrease in restricted cash		—			(42,650	)		32,611			—			—			(10,039	)
(Increase) decrease in loans, net		—			(260,746	)		(37,554	)		115,937			2,484			(179,879	)
Reduction of marketable securities, available for sale, net		—			21,132			—			—			—			21,132
Reduction of marketable securities, held to maturity, net		—			4,023			—			—			—			4,023
Reduction of other investments, net		—			2,873			784			3,252			—			6,909
(Acquisition) reduction of property and equipment, net		—			(1,629	)		463			—			—			(1,166	)
Cash (used in) provided by investing activities		—			(276,997	)		(3,696	)		119,189			2,484			(159,020	)
Financing activities:
Deposits accepted, net of repayments		—			257,017			—			—			—			257,017
Increase in intercompany payable		—			—			—			2,477			(2,477	)		—
Repayments and extinguishment of term debt		—			(95,357	)		—			—			—			(95,357	)
(Repayments) borrowings of other borrowings		(5,841	)		47,000			—			—			—			41,159
Proceeds from exercise of options		37			—			—			—			—			37
Repurchase of common stock		(207,561	)		—			—			—			—			(207,561	)
Payment of dividends		(4,651	)		—			—			—			—			(4,651	)
Cash (used in) provided by financing activities		(218,016	)		208,660			—			2,477			(2,477	)		(9,356	)
(Decrease) increase in cash and cash equivalents		(11,233	)		(99,475	)		69,523			(1,342	)		—			(42,527	)
Cash and cash equivalents as of beginning of period		12,618			324,848			118,648			2,434			—			458,548
Cash and cash equivalents as of end of period	$	1,385		$	225,373		$	188,171		$	1,092		$	—		$	416,021


32

Consolidating Statement of Cash Flows

Six Months Ended June 30, 2011

(Unaudited)


				CapitalSource Finance LLC
	CapitalSource Inc.			Combined Non- Guarantor Subsidiaries			Combined Guarantor Subsidiaries			Other Non- Guarantor Subsidiaries			Eliminations			Consolidated CapitalSource, Inc.
	($ in thousands)
Operating activities:
Net income	$	19,753		$	110,200		$	54,028		$	57,871		$	(222,099	)	$	19,753
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Stock option expense		—			964			2,062			—			—			3,026
Restricted stock expense		—			1,584			1,927			—			—			3,511
Amortization of deferred loan fees and discounts		—			(29,609	)		(5,324	)		(5,936	)		—			(40,869	)
Paid-in-kind interest on loans		—			29,827			372			(395	)		—			29,804
Provision for loan and lease losses		—			5,543			36,945			3,844			—			46,332
Amortization of deferred financing fees and discounts		14,150			2,783			179			(1,156	)		—			15,956
Depreciation and amortization		—			(1,323	)		1,397			—			—			74
Provision for deferred income taxes		21,513			1,488			—			27,353			—			50,354
Non-cash (gain) loss on investments, net		—			(30,178	)		112			(5,642	)		—			(35,708	)
Non-cash loss (gain) on foreclosed assets, other property and equipment disposals		—			11,638			(344	)		6,471			—			17,765
Unrealized loss (gain) on derivatives and foreign currencies, net		—			1,650			(4,946	)		5,426			—			2,130
(Increase) decrease in interest receivable		—			(3,255	)		(5,688	)		28,219			—			19,276
Decrease in loans held for sale, net		—			173,160			11,353			16,437			—			200,950
Decrease (increase) in intercompany receivable		—			9			67,976			(619,138	)		551,153			—
(Increase) decrease in other assets		(3,735	)		32,909			45,771			15,685			(18,601	)		72,029
Decrease in other liabilities		(1,571	)		(54,357	)		(3,386	)		(30,586	)		13,334			(76,566	)
Net transfers with subsidiaries		(139,081	)		(241,270	)		202,825			(45,584	)		223,110			—
Cash (used in) provided by operating activities		(88,971	)		11,763			405,259			(547,131	)		546,897			327,817
Investing activities:
Decrease in restricted cash		—			2,907			20,456			3,967			—			27,330
Decrease (increase) in loans, net		—			25,878			(96,003	)		435,131			(460	)		364,546
Reduction of marketable securities, available for sale, net		—			75,790			—			19,000			—			94,790
Reduction of marketable securities, held to maturity, net		—			54,689			—			—			—			54,689
Reduction (acquisition) of other investments, net		—			26,269			(71	)		(2,515	)		—			23,683
Acquisition of property and equipment, net		—			(6,476	)		(618	)		—			—			(7,094	)
Cash provided by (used in) investing activities		—			179,057			(76,236	)		455,583			(460	)		557,944
Financing activities:
Deposits accepted, net of repayments		—			164,517			—			—			—			164,517
(Decrease) increase in intercompany payable		—			(46,850	)		619,138			(25,851	)		(546,437	)		—
Repayments on credit facilities, net		—			(66,890	)		—			(1,902	)		—			(68,792	)
Repayments and extinguishment of debt		—			(282,985	)		—			—			—			(282,985	)
Borrowings under (repayments of) other borrowings		—			68,000			(42	)		—			—			67,958
Proceeds from exercise of options		804			—			—			—			—			804
Payment of dividends		(6,447	)		—			—			—			—			(6,447	)
Cash (used in) provided by financing activities		(5,643	)		(164,208	)		619,096			(27,753	)		(546,437	)		(124,945	)
(Decrease) increase in cash and cash equivalents		(94,614	)		26,612			948,119			(119,301	)		—			760,816
Cash and cash equivalents as of beginning of period		94,614			353,666			252,012			120,158			—			820,450
Cash and cash equivalents as of end of period	$	—		$	380,278		$	1,200,131		$	857		$	—		$	1,581,266


33

Note 7. Deposits

As of June 30, 2012 and December 31, 2011, CapitalSource Bank had $5.4 billion and $5.1 billion, respectively, in deposits insured up to the maximum limit by the Federal Deposit Insurance Corporation (“FDIC”). As of June 30, 2012 and December 31, 2011, CapitalSource Bank had $480.6 million and $383.9 million, respectively, of certificates of deposit in the amount of $250,000 or more and $2.3 billion and $2.0 billion, respectively, of certificates of deposit in the amount of $100,000 or more.

As of June 30, 2012 and December 31, 2011, the weighted-average interest rates were 0.56% and 0.75% for savings and money market deposit accounts, respectively, and 1.04% and 1.14% for certificates of deposit, respectively. The weighted-average interest rates for all deposits as of June 30, 2012 and December 31, 2011 were 0.94% and 1.06%, respectively.

As of June 30, 2012 and December 31, 2011, interest-bearing deposits at CapitalSource Bank were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Interest-bearing deposits:
Money market	$	273,244	$	260,032
Savings		790,351		836,521
Certificates of deposit		4,318,417		4,028,442
Total interest-bearing deposits	$	5,382,012	$	5,124,995

As of June 30, 2012, certificates of deposit detailed by maturity were as follows ($ in thousands):


Maturing by:
June 30, 2013	$	3,512,803
June 30, 2014		683,770
June 30, 2015		58,336
June 30, 2016		40,962
June 30, 2017		22,546
Total	$	4,318,417

For the three and six months ended June 30, 2012 and 2011, interest expense on deposits was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Savings and money market	$	1,542		$	2,095		$	3,427		$	4,039
Certificates of deposit		11,151			11,364			22,611			22,859
Fees for early withdrawal		(53	)		(61	)		(107	)		(117	)
Total interest expense on deposits	$	12,640		$	13,398		$	25,931		$	26,781

Note 8. Variable

Interest Entities

Troubled Debt Restructurings

Certain of our loan modifications qualify as events that require reconsideration of our borrowers as variable interest entities. Through reconsideration, we determined that certain of our borrowers involved in TDRs did not hold sufficient equity at risk to finance their activities without subordinated financial support. As a result, we concluded that these borrowers were VIEs.

We also determined that we should not consolidate these borrowers because we do not have a controlling financial interest. The equity investors of these borrowers have the power to direct the activities that will have the most significant impact on the economics of these borrowers. These equity investors’ interests also provide them with rights to receive benefits in the borrowers that could potentially be significant. As a result, we have determined that the equity investors continue to have a controlling financial interest in the borrowers subsequent to the restructuring.


34

Our interests in borrowers qualifying as VIEs were $182.5 million and $207.3 million as of June 30, 2012 and December 31, 2011, respectively, and are included in loans held for investment. For certain of these borrowers, we may have obligations to fund additional amounts through either unfunded commitments or letters of credit issued to or on behalf of these borrowers. Consequently, our maximum exposure to loss as a result of our involvement with these entities was $264.5 million and $288.9 million as of June 30, 2012 and December 31, 2011, respectively.

Term Debt Securitizations

In conjunction with our commercial term debt securitizations, we established and contributed loans to separate single purpose entities (collectively, referred to as the “Issuers”). The Issuers are structured to be legally isolated, bankruptcy remote entities. The Issuers issued notes and certificates that are collateralized by their underlying assets, which primarily comprise loans contributed to the securitizations. We service the underlying loans contributed to the Issuers and earn periodic servicing fees paid from the cash flows of the underlying loans. The Issuers have all of the legal obligations to repay the outstanding notes and certificates and we have no legal obligation to contribute additional assets to the Issuers. As of June 30, 2012 and December 31, 2011, the total outstanding balances of these commercial term debt securitizations were $437.0 million and $534.9 million, respectively. These amounts include $222.9 million and $225.5 million of notes and certificates that we held as of June 30, 2012 and December 31, 2011, respectively.

We have determined that the Issuers are variable interest entities, subject to applicable consolidation guidance and have concluded that the entities were designed to pass along risks related to the credit performance of the underlying loan portfolio. Except as set forth below, as a result of our power to direct the activities that most significantly impact the credit performance of the underlying loan portfolio and our economic interests in the Issuers, we have concluded that we are the primary beneficiary of each of the Issuers. Consequently, except as set forth below, we report the assets and liabilities of the Issuers in our consolidated financial statements, including the underlying loans and the issued notes and certificates held by third parties. As of June 30, 2012 and December 31, 2011, the carrying amounts of the consolidated liabilities related to the Issuers were $214.3 million and $309.7 million, respectively. These amounts include term debt and represent obligations for which there is only legal recourse to the Issuers. As of June 30, 2012 and December 31, 2011, the carrying amounts of the consolidated assets related to the Issuers were $426.7 million and $511.4 million, respectively. These amounts include loans held for investment, net and relate to assets that can only be used to settle obligations of the Issuers.

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

As of June 30, 2012 and December 31, 2011, the fair value of our remaining interests in the 2006-A Trust that we had repurchased in the market subsequent to the initial securitization and held as of June 30, 2012 and December 31, 2011 was $19.9 million and $17.8 million, respectively, and was classified as investment securities, available-for-sale. We have no additional funding commitments or other obligations related to these interests. Except for a guarantee provided to a swap counterparty of the 2006-A Trust, we have not provided any additional financial support to the 2006-A Trust since the deconsolidation. This swap exposure had a fair value to the counterparty of $14.5 million and $15.1 million as of June 30, 2012 and December 31, 2011. The interests in the Trust and the swap guarantee comprise our maximum exposure to loss related to the 2006-A Trust. During the three and six months ended June 30, 2012, we recorded gross unrealized losses of $0.2 million and unrealized gains of $1.0 million, respectively, included as a component of other comprehensive income, on the securities that we still hold in the 2006-A Trust as of June 30, 2012.

Note 9. Borrowings

For additional information on our borrowings, see Note 11, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2011, included in our Form 10-K.

As of June 30, 2012 and December 31, 2011, the composition of our outstanding borrowings was as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Term debt, net⁽¹⁾	$	214,059	$	309,394
Other borrowings:
Convertible debt, net⁽²⁾		23,223		28,903
Subordinated debt		409,383		436,196
FHLB SF borrowings		597,000		550,000
Total other borrowings		1,029,606		1,015,099
Total borrowings	$	1,243,665	$	1,324,493

⁽¹⁾	Amounts presented are net of debt discounts of $40 thousand and $0.1 million as of June 30, 2012 and December 31, 2011, respectively.

⁽²⁾	Amounts presented are net of debt discounts of $5 thousand and $0.1 million as of June 30, 2012 and December 31, 2011, respectively.


35

Convertible Debt

We have issued five series of convertible debentures as part of our financing activities. Our 1.25% Senior Convertible Debentures due 2034 (originally issued in March 2004) and our 1.625% Senior Subordinated Convertible Debentures due 2034 (originally issued in April 2007) were repurchased in full during 2009. Our 3.5% Senior Convertible Debentures due 2034 (originally issued in July 2004) and our 4.0% Senior Subordinated Convertible Debentures due 2034 (originally issued in April 2007) were repurchased in full during 2011. As a result, our 7.25% Senior Subordinated Convertible Debentures due 2037 (“7.25% Convertible Debentures”) comprised our only outstanding convertible debt as of June 30, 2012 and December 31, 2011.

During the three and six months ended June 30, 2012, we repurchased $1.8 million and $5.8 million, respectively, of the outstanding principal of the 7.25% Convertible Debentures for $1.8 million and $5.9 million, respectively, and recorded related pre-tax losses of $18 thousand and $0.1 million, respectively, on the extinguishment of debt.

In July 2012, we repurchased the remaining outstanding 7.25% Convertible Debentures totaling $23.2 million and recognized no gain or loss on the extinguishment of debt.

As of June 30, 2012 and December 31, 2011, the carrying amounts of our convertible debt were as follows:


	June 30, 2012			December 31, 2011
	($ in thousands)
Convertible debt principal	$	23,228		$	28,978
Less: debt discount		(5	)		(75	)
Net carrying value	$	23,223		$	28,903

As of June 30, 2012, the conversion price of the 7.25% Convertible Debentures was $27.09 and the number of shares used to determine the aggregate consideration that would be delivered upon conversion was 857,297 shares.

For the three and six months ended June 30, 2012 and 2011, the interest expense recognized on our Convertible Debentures and the effective interest rates on the liability components were as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Interest expense recognized on:
Contractual interest coupon	$	444		$	4,884		$	934		$	12,261
Amortization of deferred financing fees		2			203			6			503
Amortization of debt discount		29			1,764			61			4,368
Total interest expense recognized	$	475		$	6,851		$	1,001		$	17,132
Effective interest rate on the liability component:
3.5% Senior Convertible Debentures due 2034		—			7.16	%		—			7.16	%
4.0% Senior Subordinated Convertible Debentures due 2034		—			7.85	%		—			7.85	%
7.25% Senior Subordinated Convertible Debentures due 2037		7.79	%		7.79	%		7.79	%		7.79	%

The unamortized discount on our 7.25% Convertible Debentures was amortized through the first put date of July 15, 2012.


36

Subordinated Debt

We have issued subordinated debt to statutory trusts (“TP Trusts”) that are formed for the purpose of issuing preferred securities to outside investors, which we refer to as Trust Preferred Securities (“TPS”). We generally retained 100% of the common securities issued by the TP Trusts, representing 3% of their total capitalization. The terms of the subordinated debt issued to the TP Trusts and the TPS issued by the TP Trusts are substantially identical.

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

In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and cancelled during the three months ended June 30, 2012, and we recognized a related pre-tax gain of $8.2 million on the extinguishment of debt.

The carrying value of our subordinated debt was $409.4 million and $436.2 million as of June 30, 2012 and December 31, 2011, respectively.

FHLB SF Borrowings and FRB Credit Program

CapitalSource Bank is a member of the FHLB SF. As of June 30, 2012 and December 31, 2011, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:


	June 30, 2012			December 31, 2011
	($ in thousands)
Borrowing capacity	$	895,023		$	838,531
Less: outstanding principal		(597,000	)		(550,000	)
Less: outstanding letters of credit		(300	)		(600	)
Unused borrowing capacity	$	297,723		$	287,931

CapitalSource Bank is an approved depository institution under the primary credit program of the FRB SF’s discount window and is eligible to borrow from the FRB for short periods, generally overnight. As of June 30, 2012 and December 31, 2011, collateral with amortized costs of $86.3 million and $93.9 million, respectively, and fair values of $88.0 million and $94.3 million, respectively, had been pledged under this program. As of June 30, 2012 and December 31, 2011, there were no borrowings outstanding.

Note 10. Shareholders’

Equity

Common Stock Shares Outstanding

Common stock share activity for the six months ended June 30, 2012 was as follows:


Outstanding as of December 31, 2011	256,112,205
Repurchase of common stock	(31,008,500	)
Exercise of options	21,595
Restricted stock and other stock activities	(125,594	)
Outstanding as of June 30, 2012	224,999,706


37

Accumulated other comprehensive income, net

Accumulated other comprehensive income, net, as of June 30, 2012 and December 31, 2011 was as follows:


	June 30, 2012
	Unrealized Gain on Investment Securities, Available-for-Sale, net of tax		Unrealized Gain on Foreign Currency Translation, net of tax			Accumulated Other Comprehensive Income, Net
	($ in thousands)
Beginning balance	$	19,055	$	351		$	19,406
Other comprehensive income (loss)		487		(351	)		136
Ending balance	$	19,542	$	—		$	19,542


	December 31, 2011
	Unrealized Gain on Investment Securities, Available-for-Sale, net of tax		Unrealized Gain on Foreign Currency Translation, net of tax			Accumulated Other Comprehensive Income, Net
	($ in thousands)
Beginning balance	$	5,763	$	4,178		$	9,941
Other comprehensive income (loss)		13,292		(3,827	)		9,465
Ending balance	$	19,055	$	351		$	19,406

Note 11. Income

Taxes

We provide for income taxes as a “C” corporation on income earned from operations. For the tax years ended 2010 and 2009, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We have reconsolidated our subsidiaries in 2011 for federal tax purposes. We are subject to federal, foreign, state and local taxation in various jurisdictions.

In 2009, we established a valuation allowance against a substantial portion of our net deferred tax assets where we determined that there was significant negative evidence with respect to our ability to realize such assets. Negative evidence we considered in making this determination included the history of operating losses and uncertainty regarding the realization of a portion of the deferred tax assets at future points in time. As of March 31, 2012 and December 31, 2011, the valuation allowance was $513.5 million and $515.2 million, respectively.

During three months ended June 30, 2012, we reversed $347.4 million, or 68%, of the valuation allowance that existed as of March 31, 2012. Each of the deferred tax assets was evaluated based on their associated character and jurisdiction. The decision to reverse a large portion of the valuation allowance was based on our evaluation of significant improvements in consolidated earnings and loan credit quality. A valuation allowance of $166.1 million remains in effect as of June 30, 2012 with respect to deferred tax assets where we believe sufficient evidence does not exist at this time to support a reduction in the allowance. It is more likely than not that the remaining deferred tax assets subject to a valuation allowance will not be realized.

Consolidated income tax (benefit) expense for the three months ended June 30, 2012 and 2011 was $(340.0) million and $17.2 million, respectively. The tax benefit for the three months ended June 30, 2012 was caused primarily the reversal of a large portion of the valuation allowance against our deferred tax assets. The expense for the three months ended June 30, 2011 was primarily by the result of the change in the net deferred tax assets of CapitalSource Bank. Consolidated income tax (benefit) expense for the six months ended June 30, 2012 and 2011 was $(314.3) million and $28.4 million, respectively. The tax benefit for the six months ended June 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets. The tax expense recorded for the six months ended June 30, 2011 was incurred primarily as a result of our plan to reconsolidate our corporate entities for federal tax purposes in 2011.


38

The effective income tax rate on our consolidated net income (loss) from continuing operations was (715.3)% and (320.1)% for the three and six months ended June 30, 2012, respectively, and 51.0% and 59.0% for the three and six months ended June 30, 2011, respectively.

We file income tax returns with the United States and various state, local and foreign jurisdictions and generally remain subject to examinations by these tax jurisdictions for tax years 2006 through 2010. We are currently under examination by the Internal Revenue Service for the tax years 2006 through 2008, and by certain state jurisdictions for the tax years 2006 through 2009.

Note 12. Net

Income Per Share

The computations of basic and diluted net income per share for the three and six months ended June 30, 2012 and 2011, respectively, were as follows:


	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
	($ in thousands, except per share data)
Net income	$	387,549	$	16,594	$	412,487	$	19,753
Average shares — basic		226,532,286		320,426,484		233,805,456		320,311,588
Effect of dilutive securities:
Option shares		2,262,534		2,003,029		2,308,968		2,261,172
Stock units and unvested restricted stock		4,302,919		4,658,204		4,233,713		4,452,828
Average shares — diluted		233,097,739		327,087,717		240,348,137		327,025,588
Basic net income per share	$	1.71	$	0.05	$	1.76	$	0.06
Diluted net income per share	$	1.66	$	0.05	$	1.72	$	0.06

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


	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Stock units		273		1,943		776		972
Stock options		1,416,856		2,338,277		1,252,991		2,079,437
Shares issuable upon conversion of convertible debt		857,297		13,507,407		857,297		13,498,059
Unvested restricted stock		60,617		297,850		97,243		274,604

Note 13. Bank

Regulatory Capital

CapitalSource Bank is subject to various regulatory capital requirements established by federal and state regulatory agencies. Failure to meet minimum capital requirements can result in regulatory agencies initiating certain mandatory and possibly additional discretionary actions that, if undertaken, could have a direct material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, CapitalSource Bank must meet specific capital guidelines that involve quantitative measures of its assets and liabilities as calculated under regulatory accounting practices. CapitalSource Bank’s capital amounts and other requirements are also subject to qualitative judgments by its regulators about risk weightings and other factors. See Item 1, Business — Supervision and Regulation, in our Form 10-K and Supervision and Regulation within Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-Q for a further description of CapitalSource Bank’s regulatory requirements.


39

Under prompt corrective action regulations, a “well-capitalized” bank must have a total risk-based capital ratio of 10%, a Tier 1 risk-based capital ratio of 6%, and a Tier 1 leverage ratio of 5%. Under its approval order from the FDIC, CapitalSource Bank must be “well-capitalized” and at all times have a minimum total risk-based capital ratio of 15%, a minimum Tier-1 risk-based capital ratio of 6% and a minimum Tier 1 leverage ratio of 5%. CapitalSource Bank’s ratios and the minimum requirements as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012										December 31, 2011
	Actual					Minimum Required					Actual					Minimum Required
	Amount		Ratio			Amount		Ratio			Amount		Ratio			Amount		Ratio
	($ in thousands)
Tier-1 Leverage	$	860,529		12.69	%	$	339,070		5.00	%	$	877,746		13.61	%	$	322,559		5.00	%
Tier-1 Risk-Based Capital		860,529		14.94			345,512		6.00			877,746		16.17			325,714		6.00
Total Risk-Based Capital		932,916		16.20			863,781		15.00			945,978		17.43			814,284		15.00

Note 14. Commitments

and Contingencies

We provide standby letters of credit in conjunction with several of our lending arrangements and property lease obligations. As of June 30, 2012 and December 31, 2011, we had issued $52.3 million and $79.4 million, respectively, in stand-by letters of credit which expire at various dates over the next 8.5 years. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be required to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. These arrangements had carrying amounts totaling $1.1 million and $1.7 million, as reported in other liabilities as of June 30, 2012 and December 31, 2011, respectively.

As of June 30, 2012 and December 31, 2011, we had unfunded commitments to extend credit to our clients of $1.2 billion and $1.4 billion, respectively, including unfunded commitments to extend credit by CapitalSource Bank of $983.1 million and $944.7 million, respectively, and by the Parent Company of $186.3 million and $408.0 million, respectively. Additional information on these contingencies is included in Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2011, included in our Form 10-K.

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

Note 15. Derivative

Instruments

We are exposed to certain risks related to our ongoing business operations. The primary risks managed through the use of derivative instruments are interest rate risk and foreign exchange risk. We do not enter into derivative instruments for speculative purposes. As of June 30, 2012, none of our derivatives were designated as hedging instruments pursuant to GAAP.

We may enter into various derivative instruments to manage our exposure to interest rate risk. The objective would be to reduce the volatility of our earnings that may otherwise result due to changes in interest rates.

We have entered into basis swaps to eliminate risk between our LIBOR-based term debt securitizations and the prime-based loans pledged as collateral for that debt. These basis swaps modify our exposure to interest rate risk by converting our prime rate loans to a one-month LIBOR rate. The objective of this swap activity is to protect us from risk that interest collected under the prime rate loans will not be sufficient to service the interest due under the one-month LIBOR-based term debt.

We have entered into forward exchange contracts to hedge foreign currency denominated loans we originate against foreign currency fluctuations. The objective is to manage the uncertainty of future foreign exchange rate fluctuations. These forward exchange contracts provide for a fixed exchange rate which has the effect of reducing or eliminating changes to anticipated cash flows to be received from foreign currency-denominated loan transactions as the result of changes to exchange rates.

Derivative instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk exposure consists primarily of the termination value of agreements where we are in a favorable position. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from certain


40

counterparties and monitor all exposure and collateral requirements daily. We continually monitor the fair value of collateral received from counterparties and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. As of June 30, 2012, we also posted collateral of $10.0 million related to counterparty requirements for foreign exchange contracts at CapitalSource Bank. Our agreements generally include master netting agreements whereby we are entitled to settle our individual derivative positions with the same counterparty on a net basis upon the occurrence of certain events. As of June 30, 2012, our derivative counterparty exposure was as follows ($ in thousands):


Gross derivative counterparty exposure	$	230
Master netting agreements		(219	)
Net derivative counterparty exposure	$	11

We report our derivatives in our consolidated balance sheets at fair value on a gross basis irrespective of our master netting arrangements. We held no collateral against our derivative instruments that were in an asset position as of June 30, 2012. For derivatives that were in a liability position, we had posted collateral of $1.5 million as of June 30, 2012.

There were no interest rate swaps terminated during the three months ended June 30, 2012. During the six months ended June 30, 2012, we terminated interest rate swaps of $53.2 million which were in an asset position and $87.1 million which were in a liability position as of the respective termination dates. As a result of these terminations, we received $8.3 million, net of collateral held and posted.

As of June 30, 2012, the notional amounts and fair values of our various derivative instruments as well as their locations in our consolidated balance sheets were as follows:


	June 30, 2012						December 31, 2011
			Fair Value						Fair Value
	Notional Amount		Other Assets		Other Liabilities		Notional Amount		Other Assets		Other Liabilities
	($ in thousands)
Interest rate contracts	$	10,944	$	—	$	22	$	1,128,647	$	58,935	$	93,110
Foreign exchange contracts		31,486		230		219		25,946		167		183
Total	$	42,430	$	230	$	241	$	1,154,593	$	59,102	$	93,293

The gains and losses on our derivative instruments recognized during the three and six months ended June 30, 2012 and 2011 as well as the locations of such gains and losses in our consolidated statements of operations were as follows:


		Three Months Ended June 30,					Six Months Ended June 30,
	Location	2012		2011			2012			2011
		($ in thousands)
Interest rate contracts	Gain (loss) on derivatives, net	$	5	$	186		$	341		$	(616	)
Foreign exchange contracts	Gain (loss) on derivatives, net		427		(457	)		(12	)		(1,533	)
Total		$	432	$	(271	)	$	329		$	(2,149	)

Note 16. Fair

Value Measurements

We use fair value measurements to record fair value adjustments to certain of our assets and liabilities and to determine fair value disclosures. Investment securities, available-for-sale, warrants and derivatives are recorded at fair value on a recurring basis. In addition, we may be required, in specific circumstances, to measure certain of our assets at fair value on a nonrecurring basis, including investment securities, held-to-maturity, loans held for sale, loans held for investment, REO and certain other investments.


41

Fair Value Determination

Fair value is based on quoted market prices or by using market based inputs where available. Given the nature of some of our assets and liabilities, clearly determinable market based valuation inputs are often not available; therefore, these assets and liabilities are valued using internal estimates. As subjectivity exists with respect to many of our valuation estimates used, the fair values we have disclosed may not equal prices that we may ultimately realize if the assets are sold or the liabilities settled with third parties.

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

Assets and Liabilities

Cash

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

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consist of U.S. Treasury bills, Agency discount notes, Agency callable notes, Agency debt, Agency MBS, Non-agency MBS, asset-backed securities, a municipal bond and a collateralized loan obligation that are carried at fair value on a recurring basis and classified as available-for-sale securities. Fair value adjustments on these investments are generally recorded through other comprehensive income. However, if impairment on an investment, available-for-sale is deemed to be other-than-temporary, all or a portion of the fair value adjustment may be reported in earnings. The securities are valued using quoted prices from external market participants, including pricing services. If quoted prices are not available, the fair value is determined using quoted prices of securities with similar characteristics or independent pricing models, which utilize observable market data such as benchmark yields, reported trades and issuer spreads. These securities are primarily classified within Level 2 of the fair value hierarchy.

Investment securities, available-for-sale, also consist of a corporate debt security. At December 31, 2011, we valued our corporate debt security using unobservable inputs that were significant to the fair value measurement. As a result, we classified the fair measurement within level 3 of the fair value hierarchy. In March

2012, we received market information surrounding the fair value of the security. As a result, we transferred the asset from Level 3 to Level 2 of the fair value hierarchy. Our policy is to record such transfers as of the last day of the reporting period.

Investment securities, available-for-sale, also consist of equity securities which are valued using the stock price of the underlying company in which we hold our investment. Our equity securities are classified in Level 1 or 2 depending on the level of activity within the market.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity consists of commercial mortgage-backed-securities. These securities are generally recorded at amortized cost, but are recorded at fair value on a non-recurring basis to the extent we record an OTTI on the securities. Fair value measurements are determined using quoted prices from external market participants, including pricing services. If quoted prices are not available, the fair value is determined using quoted prices of securities with similar characteristics or independent pricing models, which utilize observable market data such as benchmark yields, reported trades and issuer spreads.

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value, with fair value adjustments recorded on a nonrecurring basis. The fair value is determined using actual market transactions when available. In situations when market transactions are not available, we use the income approach through internally developed valuation models to estimate the fair value. This requires the use of significant judgment surrounding discount rates and the timing and amounts of future cash flows. Key inputs to these valuations also include costs of completion and unit settlement prices for the underlying collateral of the loans. Fair values determined through actual market transactions are classified within Level 2 of the fair value hierarchy, while fair values determined through internally developed valuation models are classified within Level 3 of the fair value hierarchy.

Loans Held for Investment

Loans held for investment are recorded at outstanding principal, net of any deferred fees and unamortized purchase discounts or premiums and net of an allowance for loan and lease losses. We may record fair value adjustments on a nonrecurring basis when we have determined that it is necessary to record a specific reserve against a loan and we measure such specific reserve using the fair value of the loan’s collateral. To determine the fair value of the collateral, we may employ different approaches depending on the type of collateral.


42

In cases where our collateral is a fixed or other tangible asset, our determination of the appropriate method to use to measure fair value depends on several factors including the type of collateral that we are evaluating, the age of the most recent appraisal performed on the collateral, and the time required to obtain an updated appraisal. Typically, we obtain an updated third-party appraisal from an external valuation specialist or use prior or pending transactions to estimate fair value. We may or may not adjust these amounts based on our own internally developed judgments and estimates. These adjustments typically include discounts for lack of marketability and foreign property discounts. We may also utilize industry valuation benchmarks such as revenue multiples for operating commercial properties. Significant decreases to any of these inputs would result in decreases in the fair value measurements. For certain loans collateralized by residential real estate, we utilize discounted cash flow techniques to determine the fair value of the underlying collateral. Significant unobservable inputs used in these fair value measurements include recovery rates and marketability discounts. Significant decreases in recovery rates or significant increases in marketability discounts would result in significant decreases in the fair value measurements.

An impaired loan is considered collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.

For impaired collateral dependent commercial real estate loans, we typically obtain an updated appraisal as of the date the loan is deemed impaired to measure the amount of impairment. In situations where we are unable to obtain a timely updated appraisal, we perform internal valuations which utilize assumptions and calculations similar to those customarily utilized by third party appraisers and consider relevant property specific facts and circumstances. In certain instances, our internal assessment of value may be based on adjustments to outdated appraisals by analyzing the changes in local market conditions and asset performance since the appraisals were performed. The outdated appraisal values may be discounted by percentages that are determined by analyzing changes in local market conditions since the dates of the appraisals as well as by consulting databases, comparable market sale prices, brokers’ opinions of value and other relevant data. We do not make adjustments that increase the values indicated by outdated appraisals by using higher recent sale comparisons.

Impaired collateral dependent commercial real estate loans for which ultimate collection depends solely on the sale of the collateral are charged off to the estimated fair value of the collateral less estimated costs to sell. For certain of these loans, we charged off to an amount different than the value indicated by the most recent appraisal. This was primarily the result of both factors

causing the appraisal to be outdated as outlined above and other factors surrounding the loans not considered by appraisals, such as pending loan sales and other transaction specific factors. As of June 30, 2012 and December 31, 2011, we charged off an additional $60.5 million, net, and $88.0 million, net, respectively, in loan balances compared with amounts that would have been charged off based on the appraised values of the collateral.

Our policy on updating appraisals related to these originated impaired collateral dependent commercial real estate loans generally is to obtain current appraisals subsequent to the impairment date if there are significant changes to the underlying assumptions from the most recent appraisal. Some factors that could cause significant changes include the passage of more than twelve months since the time of the last appraisal; the volatility of the local market; the availability of financing; the inventory of competing properties; new improvements to, or lack of maintenance of, the subject property or competing surrounding properties; a change in zoning; environmental contamination; or failure of the project to meet material assumptions of the original appraisal. This policy for updating appraisals does not vary by commercial real estate loan type.

We continue to monitor collateral values on partially charged off impaired collateral dependent commercial real estate loans and may record additional charge offs upon receiving updated appraisals. We do not return such partially charged off loans to performing status, except in limited circumstances when such loans have been formally restructured and have met key performance criteria including compliance with restructured payment terms. We do not return such partially charged off loans to performing status based solely on the results of appraisals.

In cases where our collateral is not a fixed or tangible asset, we typically use industry valuation benchmarks such as EBITDA multiples to determine the value of the asset or the underlying enterprise. Decreases in these benchmarks would result in significant decreases in the fair value measurements.

When fair value adjustments are recorded on loans held for investment, we typically classify them in Level 3 of the fair value hierarchy.

We determine the fair value estimates of loans held for investment for fair value disclosures primarily using external valuation specialists. These valuation specialists group loans based on risk rating and collateral type, and the fair value is estimated utilizing discounted cash flow techniques. The valuations take into account current market rates of return, contractual interest rates, maturities and assumptions regarding expected future cash flows. Within each respective loan grouping, current market rates of return are determined based on quoted prices for similar instruments that are actively traded, adjusted as necessary to reflect the illiquidity of the instrument. This approach requires the


43

use of significant judgment surrounding current market rates of return, liquidity adjustments and the timing and amounts of future cash flows.

Other Investments

Other investments accounted for under the cost or equity methods of accounting are carried at fair value on a nonrecurring basis to the extent that they are determined to be other-than-temporarily impaired during the period. As there is rarely an observable price or market for such investments, we determine fair value using internally developed models. Our models utilize industry valuation benchmarks, such as multiples of net revenue or EBITDA, to determine a value for the underlying enterprise. Significant decreases to these valuation benchmarks would result in significant decreases in the fair value measurements. We reduce this value by the value of debt outstanding to arrive at an estimated equity value of the enterprise. When an external event such as a purchase transaction, public offering or subsequent equity sale occurs, the pricing indicated by the external event will be used to corroborate our private equity valuation. Fair value measurements related to these investments are typically classified within Level 3 of the fair value hierarchy.

Warrants

Warrants are carried at fair value on a recurring basis. The fair value is derived through an option pricing model which utilizes the expected term and volatility of the underlying shares to determine the fair value of the warrant. Decreases in these inputs would result in significant decreases in the fair value measurements. Given the lack of trading activity surrounding the underlying shares, we classify the fair value warrant in Level 3 of the fair value hierarchy.

FHLB SF Stock

Our investment in FHLB SF stock is recorded at historical cost. FHLB SF stock does not have a readily determinable fair value, but may be sold back to the FHLB SF at its par value with stated notice. The investment in FHLB SF stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB SF and its overall financial condition. No impairment losses on our investment in FHLB SF stock have been recorded through June 30, 2012.

Derivative Assets and Liabilities

Derivatives are carried at fair value on a recurring basis and primarily relate to interest rate swaps, caps, floors, basis swaps and forward exchange contracts which we enter into to manage interest rate risk and foreign exchange risk. Our derivatives are principally traded in

over-the-counter markets where quoted market prices are not readily available. Instead, the fair value of derivatives is measured using market observable inputs such as interest rate yield curves, volatilities and basis spreads. We also consider counterparty credit risk in valuing our derivatives. We typically classify our derivatives in Level 2 of the fair value hierarchy.

Real Estate Owned

REO is initially recorded at its estimated fair value less costs to sell at the time of foreclosure if the related REO is classified as held for sale. REO held for sale is carried at the lower of its carrying amount or fair value subsequent to the date of foreclosure, with fair value adjustments recorded on a nonrecurring basis. REO held for use is recorded at its carrying amount, net of accumulated depreciation, with fair value adjustments recorded on a nonrecurring basis if the carrying amount of the real estate is not recoverable and exceeds its fair value. When available, the fair value of REO is determined using actual market transactions. When market transactions are not available, the fair value of REO is typically determined based upon recent appraisals by third parties. We may or may not adjust these third party appraisal values based on our own internally developed judgments and estimates. These adjustments typically include discounts for lack of marketability and foreign property discounts. Significant increases to these inputs would result in significant decreases in the fair value measurements. To the extent that market transactions or third party appraisals are not available, we use the income approach through internally developed valuation models to estimate the fair value. This requires the use of significant judgment surrounding discount rates and the timing and amounts of future cash flows. Fair values determined through actual market transactions are classified within Level 2 of the fair value hierarchy while fair values determined through third party appraisals and through internally developed valuation models are classified within Level 3 of the fair value hierarchy.

Other Foreclosed Assets

When we foreclose on a borrower whose underlying collateral consists of loans, we record the acquired loans at the estimated fair value at the time of foreclosure. Valuation of that collateral, which often is a pool of many small balance loans, is typically performed utilizing internally developed estimates. These estimates rely upon recovery rates, prepayment rates and market discount rates. Significant decreases in recovery rates or prepayment rates and significant increases in market discount rates in isolation would result in significant decreases in the fair value measurements. Generally, a change in the assumption used for the recovery rate is accompanied by a similar change in the prepayment rate assumption. Fair value measurements for these loans are classified in Level 3 of the fair value hierarchy.


44

Deposits

Deposits are carried at historical cost. The carrying amounts of deposits for savings and money market accounts and brokered certificates of deposit are deemed to approximate fair value as they either have no stated maturities or short-term maturities. Certificates of deposit are grouped by maturity date, and the fair value is estimated utilizing discounted cash flow techniques. The interest rates applied are rates currently being offered for similar certificates of deposit within the respective maturity groupings.

Credit Facilities

The fair value of credit facilities is estimated based on current market interest rates for similar debt instruments adjusted for the remaining time to maturity.

Term Debt

Term debt comprises our term debt securitizations. For disclosure purposes, the fair values of our term debt securitizations are determined based on actual prices from recent third party purchases of our debt when available and based on indicative price quotes received from various market participants when recent transactions have not occurred.

Other Borrowings

Our other borrowings comprise convertible debt and subordinated debt. For disclosure purposes, the fair value of our convertible debt is determined from quoted market prices in active markets or, when the market is not active, from quoted market prices for debt with similar maturities. The fair value of our subordinated debt is determined based on recent third party purchases of our debt when available and based on indicative price quotes received from market participants when recent transactions have not occurred.

Off-Balance Sheet Financial Instruments

Loan Commitments and Letters of Credit

Loan commitments and letters of credit generate ongoing fees at our current pricing levels, which are recognized over the term of the commitment period. For disclosure purposes, the fair value is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current creditworthiness of the counterparties and current market conditions. In addition, for loan commitments, the market rates of return utilized in the valuation of the loans held for investment as described above are applied to this analysis to reflect current market conditions.


45

Assets and Liabilities Carried at Fair Value on a Recurring Basis

Assets and liabilities have been grouped in their entirety within the fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of June 30, 2012 were as follows:


	Fair Value Measurement as of June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)
Assets
Investment securities, available-for-sale:
Agency securities	$	1,043,646	$	—	$	1,043,646	$	—
Assets-backed securities		12,453		—		12,453		—
Collateralized loan obligation		19,864		—		—		19,864
Municipal bond		2,129		—		—		2,129
Non-agency MBS		50,785		—		50,785		—
U.S. Treasury and agency securities		19,165		—		19,165		—
Total investment securities, available-for-sale		1,148,042		—		1,126,049		21,993
Other assets held at fair value:
Derivative assets		230		—		230		—
Total assets	$	1,148,272	$	—	$	1,126,279	$	21,993
Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	22	$	—	$	22	$	—


46

Assets and liabilities carried at fair value on a recurring basis on the balance sheet as of December 31, 2011 were as follows:


	Fair Value Measurement as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)
Assets
Investment securities, available-for-sale:
Agency securities	$	1,056,828	$	—	$	1,056,828	$	—
Asset-backed securities		15,607		—		15,607		—
Collateralized loan obligation		17,763		—		—		17,763
Corporate debt		700		—		—		700
Equity security		393		393		—		—
Municipal bond		3,235				—		3,235
Non-agency MBS		66,930		—		66,930		—
U.S. Treasury and agency securities		26,546		—		26,546		—
Total investment securities, available-for-sale		1,188,002		393		1,165,911		21,698
Investments carried at fair value:
Warrants		193		—		—		193
Other assets held at fair value:
Derivative assets		59,102		—		59,102		—
Total assets	$	1,247,297	$	393	$	1,225,013	$	21,891
Liabilities
Other liabilities held at fair value:
Derivative liabilities	$	93,293	$	—	$	93,293	$	—

A summary of the changes in the fair values of assets and liabilities carried at fair value for the three months ended June 30, 2012 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Collateralized Loan Obligation			Municipal Bond			Total			Warrants			Total Assets
	($ in thousands)
Balance as of April 1, 2012	$	19,486		$	2,633		$	22,119		$	188		$	22,307
Realized and unrealized gains (losses):
Included in income		814			(1,106	)		(292	)		10			(282	)
Included in other comprehensive income, net		(211	)		602			391			—			391
Total realized and unrealized gains (losses)		603			(504	)		99			10			109
Sales and settlements
Sales		—			—			—			(198	)		(198	)
Settlements		(225	)		—			(225	)		—			(225	)
Total sales and settlements		(225	)		—			(225	)		(198	)		(423	)
Balance as of June 30, 2012	$	19,864		$	2,129		$	21,993		$	—		$	21,993
Unrealized gains (losses) as of June 30, 2012	$	814		$	(1,106	)	$	(292	)	$	—		$	(292	)


47

A summary of the changes in the fair values of assets and liabilities carried at fair value for the three months ended June 30, 2011 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Corporate Debt		Collateralized Loan Obligation		Municipal Bond		Total		Warrants			Total Assets
	($ in thousands)
Balance as of April 1, 2011	$	—	$	17,931	$	3,235	$	21,166	$	218		$	21,384
Realized and unrealized gains (losses):
Included in income		—		690		—		690		(8	)		682
Included in other comprehensive income, net		—		1,825		—		1,825		—			1,825
Total realized and unrealized gains (losses)		—		2,515		—		2,515		(8	)		2,507
Acquisitions:
Acquisitions		717		—		—		717		—			717
Balance as of June 30, 2011	$	717	$	20,446	$	3,235	$	24,398	$	210		$	24,608
Unrealized gains (losses) as of June 30, 2011	$	—	$	690	$	—	$	690	$	(8	)	$	682

Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the three months ended June 30, 2012 and 2011, reported in interest income and gain on investments, net were as follows:


	Interest Income				(Loss) Gain on Investments, Net
	Three Months Ended June 30,
	2012		2011		2012			2011
	($ in thousands)
Total gains (losses) included in earnings for the period	$	814	$	690	$	(1,111	)	$	(8	)
Unrealized gains (losses) relating to assets still held at reporting date		814		690		(1,111	)		(8	)

A summary of the changes in the fair values of assets and liabilities carried at fair value for the six months ended June 30, 2012 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Corporate Debt			Collateralized Loan Obligation			Municipal Bond			Total			Warrants			Total Assets
		($ in thousands)
Balance as of January 1, 2012	$	700		$	17,763		$	3,235		$	21,698		$	193		$	21,891
Realized and unrealized gains (losses):
Included in income		11			1,617			(1,106	)		522			5			527
Included in other comprehensive income, net		(45	)		1,016			—			971			—			971
Total realized and unrealized gains (losses)		(34	)		2,633			(1,106	)		1,493			5			1,498
Transfers out of Level 3		(666	)		—						(666	)		—			(666	)
Sales and settlements
Sales		—			—			—			—			(198	)		(198	)
Settlements		—			(532	)		—			(532	)		—			(532	)
Total settlements and sales		—			(532	)		—			(532	)		(198	)		(730	)
Balance as of June 30, 2012	$	—		$	19,864		$	2,129		$	21,993		$	—		$	21,993
Unrealized gains (losses) as of June 30, 2012	$	—		$	1,617		$	(1,106	)	$	511		$	(5	)	$	506


48

A summary of the changes in the fair values of assets and liabilities carried at fair value for the six months ended June 30, 2011 that have been classified in Level 3 of the fair value hierarchy was as follows:


	Investment Securities, Available-for-Sale
	Corporate Debt			Collateralized Loan Obligation			Municipal Bond			Total			Warrants			Total Assets
	($ in thousands)
Balance as of January 1, 2011	$	15		$	12,249		$	—		$	12,264		$	222		$	12,486
Realized and unrealized gains (losses):
Included in income		—			17,036			(1,496	)		15,540			1			15,541
Included in other comprehensive income, net		(15	)		10,161			—			10,146			—			10,146
Total realized and unrealized gains (losses)		(15	)		27,197			(1,496	)		25,686			1			25,687
Acquisitions and sales:
Acquisitions		717			—			4,731			5,448			—			5,448
Sales		—			(19,000	)		—			(19,000	)		(13	)		(19,013	)
Total acquisitions and sales		717			(19,000	)		4,731			(13,552	)		(13	)		(13,565	)
Balance as of June 30, 2011	$	717		$	20,446		$	3,235		$	24,398		$	210		$	24,608
Unrealized gains (losses) as of June 30, 2011	$	—		$	2,352		$	(1,496	)	$	856		$	(13	)	$	843

Realized and unrealized gains and losses on assets and liabilities classified in Level 3 of the fair value hierarchy included in income for the six months ended June 30, 2012 and 2011, reported in interest income and gain on investments, net were as follows:


	Interest Income				(Loss) Gain on Investments, Net
	Six Months Ended June 30,
	2012		2011		2012			2011
	($ in thousands)
Total gains (losses) included in earnings for the period	$	1,628	$	3,056	$	(1,111	)	$	11,803
Unrealized gains (losses) relating to assets still held at reporting date		1,617		1,657		(1,111	)		(1,496	)


49

Assets Carried at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis. As described above, these adjustments to fair value usually result from the application of lower of cost or fair value accounting or write downs of individual assets. The table below provides the fair values of those assets for which nonrecurring fair value adjustments were recorded during the three and six months ended June 30, 2012, classified by their position in the fair value hierarchy. The table also provides the gains (losses) related to those assets recorded during the three and six months ended June 30, 2012.


	Fair Value Measurement as of June 30, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Net Losses for the Three Months Ended June 30, 2012			Total Net (Losses) Gains for the Six Months Ended June 30, 2012
	($ in thousands)
Assets
Loans held for investment⁽¹⁾	$	61,449	$	—	$	12,510	$	48,939	$	(24,032	)	$	(29,652	)
Investments carried at cost		866		—		—		866		(2,095	)		(4,700	)
REO⁽²⁾		11,111		—		5,489		5,622		(2,225	)		(1,460	)
Loans acquired through foreclosure, net		2,250		—		—		2,250		73			(9	)
Total assets	$	75,676	$	—	$	17,999	$	57,677	$	(28,279	)	$	(35,821	)

⁽¹⁾	Represents impaired loans held for investment measured at fair value of the collateral less transaction costs of $3.9 million.

⁽²⁾	Represents REO measured at fair value of the collateral less transaction costs of $1.0 million.

The table below provides the fair values of those assets for which nonrecurring fair value adjustments were recorded during the three and six months ended June 30, 2011, classified by their position in the fair value hierarchy. The table also provides the gains (losses) related to those assets recorded during the three and six months ended June 30, 2011.


	Fair Value Measurement as of June 30, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Net Losses for the Three Months Ended June 30, 2011			Total Net Losses for the Six Months Ended June 30, 2011
	($ in thousands)
Assets
Loans held for investment⁽¹⁾	$	181,657	$	—	$	—	$	181,657	$	(46,221	)	$	(96,572	)
Investments carried at cost		1,586		—		—		1,586		(182	)		(355	)
REO⁽²⁾		36,932		—		—		36,932		(11,080	)		(13,116	)
Loans acquired through foreclosure, net		23,392		—		—		23,392		398			(7,405	)
Total assets	$	243,567	$	—	$	—	$	243,567	$	(57,085	)	$	(117,448	)

⁽¹⁾	Represents impaired loans held for investment measured at fair value of the collateral less transaction costs of $16.6 million.

⁽²⁾	Represents REO measured at fair value of the collateral less transaction costs of $1.7 million.


50

Significant Unobservable Inputs and Valuation Techniques of Level 3 Fair Value Measurements

For our fair value measurements classified in Level 3 of the fair value hierarchy as of June 30, 2012, a summary of the significant unobservable inputs and valuation techniques is as follows:


	Fair Value Measurement as of June 30, 2012		Valuation Techniques	Unobservable Input	Range (Weighted Average)
	($ in thousands)
Assets
Loans held for investment
Services	$	26,577	Market Comparables	EBITDA Multiple Marketablility Discount Illiquidity Discount	3x - 8.3x (7.6x) 20% - 50% (37.4%) 30%

Commercial Real Estate		19,311	Market Comparables	Revenue Multiple Marketability Discount Foreign Discount	8x 15% - 85% (66.6%) 40%

Residential Real Estate		3,051	Discounted Cash Flows	Recovery Rate	18.3% - 33.3% (19.2%)
Total loans held for investment		48,939

Investments carried at cost		866	Market Comparables	Net Revenue Multiple EBITDA Multiple Illiquidity Discount	11.0x 7.4x - 13.8x (12.9x) 25%

REO		5,622	Third Party Appraisals	Marketability Discount Foreign Discount	19.8% - 56.1% (53.2%) 40.00%

Loans acquired through foreclosure, net		2,250	Discounted Cash Flows	Recovery Rate Prepayment Rate Discount Rate	60.00% 5.00% 15.00%
Total assets	$	57,677

The table above excludes collateralized loan obligation and municipal bond categorized within Level 3 of the fair value hierarchy because the fair value of these assets is measured using third-party pricing information without adjustments.

Fair Value of Financial Instruments

GAAP requires the disclosure of the estimated fair value of financial instruments which are not recorded at fair value. The table below provides fair value estimates for our financial instruments as of June 30, 2012 and December 31, 2011, excluding financial assets and liabilities for which carrying value is a reasonable estimate of fair value and those which are recorded at fair value on a recurring basis.


	June 30, 2012				December 31, 2011
	Carrying Value		Fair Value⁽¹⁾		Carrying Value		Fair Value
	($ in thousands)
Assets:
Loans held for sale⁽⁴⁾	$	31,519	$	32,000	$	193,021	$	197,103
Loans held for investment, net⁽⁴⁾		5,843,617		5,802,246		5,536,516		5,410,511
Investments carried at cost⁽³⁾		31,361		65,379		36,252		64,076
Investment securities, held-to-maturity⁽²⁾		108,520		111,234		111,706		112,972
Liabilities:
Deposits⁽²⁾		5,382,012		5,392,283		5,124,995		5,135,843
Term debt⁽³⁾		214,059		171,264		309,394		252,739
Convertible debt, net⁽²⁾		23,223		23,228		28,903		29,739
Subordinated debt⁽²⁾		409,383		272,239		436,196		252,994
Loan commitments and letters of credit⁽³⁾		—		22,414		—		20,636

⁽¹⁾	There is no financial instrument in this table that is classified in Level 1 of the fair value hierarchy.

⁽²⁾	The fair value has been classified in Level 2 of the fair value hierarchy.


51

⁽³⁾	The fair value has been classified in Level 3 of the fair value hierarchy.

⁽⁴⁾	The fair value has been classified in Levels 2 and 3 of the fair value hierarchy.

Note 17. Segment

Data

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


	Three Months Ended June 30, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	96,112	$	22,978		$	(1,108	)	$	117,982
Interest expense		15,394		4,770			—			20,164
Provision (benefit) for loan and lease losses		12,569		(2,033	)		—			10,536
Non-interest income		13,198		1,594			(6,342	)		8,450
Non-interest expense		43,179		11,629			(6,608	)		48,200
Net income before income taxes		38,168		10,206			(842	)		47,532
Income tax expense (benefit)		15,106		(355,123	)		—			(340,017	)
Net income	$	23,062	$	365,329		$	(842	)	$	387,549
Total assets as of June 30, 2012	$	7,059,460	$	1,516,600		$	(6,401	)	$	8,569,659
Total assets as of December 31, 2011		6,793,496		1,534,698			(28,126	)		8,300,068

The financial results of our operating segments for the three months ended June 30, 2011 were as follows:


	Three Months Ended June 30, 2011
	CapitalSource Bank			Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	90,490		$	40,701		$	(3,766	)	$	127,425
Interest expense		15,612			30,195			—			45,807
(Benefit) provision for loan and lease losses		(1,331	)		2,854			—			1,523
Non-interest income		7,508			27,450			(18,681	)		16,277
Non-interest expense		37,102			44,375			(18,948	)		62,529
Net income (loss) before income taxes		46,615			(9,273	)		(3,499	)		33,843
Income tax expense (benefit)		18,840			(1,591	)		—			17,249
Net income (loss)	$	27,775		$	(7,682	)	$	(3,499	)	$	16,594


52

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


	Six Months Ended June 30, 2012
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	194,732	$	45,680		$	(2,353	)	$	238,059
Interest expense		31,453		9,569			—			41,022
Provision for loan and lease losses		14,472		7,136			—			21,608
Non-interest income		28,667		5,085			(13,752	)		20,000
Non-interest expense		84,343		27,189			(14,282	)		97,250
Net income before income taxes		93,131		6,871			(1,823	)		98,179
Income tax expense (benefit)		38,265		(352,573	)		—			(314,308	)
Net income	$	54,866	$	359,444		$	(1,823	)	$	412,487

The financial results of our operating segments for the six months ended June 30, 2011 were as follows:


	Six Months Ended June 30, 2011
	CapitalSource Bank		Other Commercial Finance			Intercompany Eliminations			Consolidated Total
	($ in thousands)
Total interest income	$	182,294	$	88,315		$	(1,032	)	$	269,577
Interest expense		30,822		61,737			—			92,559
Provision for loan and lease losses		9,911		36,421			—			46,332
Non-interest income		13,340		65,158			(36,009	)		42,489
Non-interest expense		72,910		91,055			(38,954	)		125,011
Net income (loss) before income taxes		81,991		(35,740	)		1,913			48,164
Income tax expense		21,935		6,476			—			28,411
Net income (loss)	$	60,056	$	(42,216	)	$	1,913		$	19,753

The accounting policies of each of the individual operating segments are the same as those described in Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2011, included in our Form 10-K.

Intercompany Eliminations

The intercompany eliminations consist of eliminations for intercompany activity among the segments. Such activities primarily include services provided by the Parent Company to CapitalSource Bank and by CapitalSource Bank to the Parent Company, loan sales between the Parent Company and CapitalSource Bank, and daily loan collections received at CapitalSource Bank for Parent Company loans and daily loan disbursements paid at the Parent Company for CapitalSource Bank loans.


53

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q, including the footnotes to our unaudited consolidated financial statements included herein, contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including certain plans, expectations, strategies, goals, and projections and including statements about our expectations regarding Parent Company liquidity, CapitalSource Bank liquidity, Parent Company asset run off, return of capital to shareholders, prepayment of trust preferred securities, intentions to expand the CapitalSource Bank’s lending business, expectation about additional deferred tax asset valuation allowance reversal, accelerated disposition of Parent Company assets, calling of Parent Company securitized debt, Parent Company capital contributions to CapitalSource Bank, and realizing the allowed portion of the deferred tax asset, all which are subject to numerous assumptions, risks, and uncertainties. All statements contained in this Form 10-Q that are not clearly historical in nature are forward-looking, and the words ‘anticipate,’ ‘assume,’ ‘intend,’ ‘believe,’ ‘expect,’ ‘estimate,’ ‘forecast,’ ‘plan,’ ‘position,’ ‘project,’ ‘will,’ ‘should,’ ‘would,’ ‘seek,’ ‘continue,’ ‘outlook,’ ‘look forward,’ and similar expressions are generally intended to identify forward-looking statements. All forward-looking statements (including statements regarding preliminary and future financial and operating results and future transactions and their results) involve risks, uncertainties and contingencies, many of which are beyond our control, which may cause actual results, performance, or achievements to differ materially from anticipated results, performance or achievements. Actual results could differ materially from those contained or implied by such statements for a variety of factors, including without limitation: continued or worsening disruptions in credit and other markets; borrowers’ lack of financial strength to repay loans; the Parent Company’s decision to make new loans or extend existing loans; the success and timing of other business strategies and asset sales; declines in asset values; lower than expected Parent Company’s recurring tax basis income; lower than expected taxable income at CapitalSource Bank for which CapitalSource Bank has to reimburse the Parent Company for income tax expenses in accordance with the tax sharing agreement; the need to retain capital for strategic or regulatory reasons including the implementation of Basel III standards; lower than anticipated liquidity; inability to attract qualified professionals; drawdown of Parent Company unfunded commitments substantially in excess of historical drawings;

changes in economic or market conditions or investment or lending opportunities; continued or worsening credit losses, charge offs, reserves and delinquencies; competitive and other market pressures on product pricing and services; reduced demand for our services; our inability to grow deposits and access wholesale funding sources; regulatory safety and soundness considerations; changes in tax laws or regulations affecting our business; changes in tax characteristics of income generated; loan repayments higher than expected; excess Parent Company liquidity; our inability to generate sufficient earnings; tax planning or disallowance of tax benefits by tax authorities; and other factors described in CapitalSource’s 2011 Annual Report on Form 10-K and documents subsequently filed by CapitalSource with the Securities and Exchange Commission. All forward-looking statements included in this Form 10-Q are based on information available at the time of the release.

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

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

Overview

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its subsidiaries. References to CapitalSource Bank or the Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank.

For the three and six months ended June 30, 2012 and 2011, we operated as two reportable segments: CapitalSource Bank and Other Commercial Finance. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our legacy loan portfolio and investment activities in the Parent Company. For additional information, see Note 17, Segment Data.

Through our CapitalSource Bank segment activities, we provide financial products primarily to small and middle market businesses throughout the United States and also offer depository products and services in southern and central California, which are insured by the Federal Deposit Insurance Corporation (“FDIC”) to the maximum amounts permitted by regulation. As of June 30, 2012, CapitalSource Bank had an outstanding loan principal balance of $5.3 billion and deposits of $5.4 billion.


54

Through our Other Commercial Finance segment activities, the Parent Company satisfies existing loan commitments made prior to CapitalSource Bank’s formation and receives payments on its existing loan portfolio. As of June 30, 2012, the Parent Company had an outstanding loan principal balance of $801.1 million.

Current Developments

As part of the transformation to a more traditional bank structure, we have been liquidating Parent Company assets, reducing Parent Company debt, using excess capital to repurchase stock, simplifying our consolidated operations and focusing our strategic growth initiatives entirely on CapitalSource Bank.

In addition to growing assets and increasing profitability at CapitalSource Bank, our current strategy is to run off our remaining Parent Company assets over time. We intend to regularly assess alternatives for implementing our strategy and may consider accelerated disposition of Parent Company assets, prepayments of Trust Preferred Securities, calling the securitized debt and alternative uses of Parent Company capital, including contributions to CapitalSource Bank, if attractive opportunities become available.

During the year ended December 31, 2011, we repurchased our outstanding 3.5% and 4.0% Convertible Debentures for an aggregate repurchase price of $280.5 million, made open market purchases of $221.0 million of the outstanding principal balance of $250.0 million of our 7.25% Convertible Debentures and redeemed $300.0 million of our 12.75% Senior Secured Notes. As a result of these activities, we reduced the Parent Company’s outstanding recourse indebtedness by $781.5 million, or 63%, resulting in Parent Company outstanding recourse indebtedness of $465.1 million as of December 31, 2011. In March 2012, we purchased an aggregate of $26.1 million of preferred securities from our TP Trusts 2005-1 and 2006-4 at a discount from liquidation value. As a result of this purchase, the related subordinated debt of $26.1 million was exchanged and cancelled during the second quarter. We recorded a related pre-tax gain of $8.2 million on the extinguishment of debt. During the six months ended June 30, 2012, we repurchased $5.8 million of our 7.25% Convertible Debentures, and in July 2012, we repurchased the remaining outstanding 7.25% Convertible Debentures totaling $23.2 million and recognized no gain or loss on the extinguishment of debt. The outstanding balances of the non-recourse securitization debt and Trust Preferred Securities were $214.1 million and $409.4 million, respectively, as of June 30, 2012.

As the Parent Company assets are repaid, the Company intends to return excess capital to shareholders via a combination of share repurchases, recurring dividends and/or special dividends. As part of our strategy, we repurchased 1.4 million shares of our common

stock during 2010, 70.2 million shares in 2011 and 31.0 million shares during the six months ended June 30, 2012. Since this strategy was put into place in December 2010, we have repurchased 102.6 million shares, or 31.8% of the shares outstanding at December 2010. Subject to the share price of our common stock, Parent Company liquidity, credit and capital metrics, and ongoing evaluation for alternative uses of our excess capital, we intend to continue to return excess Parent Company capital to shareholders during the remainder of 2012.

Our broader business strategy focuses on developing and growing our banking operations. As of June 30, 2012, CapitalSource Bank had $7.1 billion of assets. We offer a broad range of specialized senior secured, commercial loan products to small and middle-market businesses, and we offer our loan products on a nationwide basis, despite the regional nature of our deposit base. With a low cost deposit gathering platform based in southern and central California, we believe our business model is well positioned to deliver a broad range of customized financial solutions to borrowers.

Since June 30, 2011, CapitalSource Bank’s loan balance has grown by 25% and the Parent Company’s loan balance has decreased by 43%. Since the formation of the Bank, we have launched or acquired five lending platforms — equipment finance, small business, professional practice, multifamily lending and premium finance lending. It is our intent to continue to seek lending platforms and experienced individuals who will further augment our specialized businesses.

Operating Results for the Three and Six Months Ended June 30, 2012

As further described below, the most significant factors influencing our consolidated results of operations for the three and six months ended June 30, 2012, compared to the three and six months ended June 30, 2011 were:

Decreased deferred tax asset valuation allowance;

Increased net interest margin;

Decreased interest-earning assets and interest-bearing liabilities;

Decreased gains on our investments;

Decreased expense of real estate owned and other foreclosed assets, net;

Increased gain on extinguishment of debt; and

Decreased operating expenses.


55

Our consolidated operating results for the three and six months ended June 30, 2012 compared to the three and six months ended June 30, 2011, were as follows:


	Three Months Ended June 30,								Six Months Ended June 30,
	2012			2011		% Change			2012			2011		% Change
	($ in thousands)
Interest income	$	117,982		$	127,425		(7	)%	$	238,059		$	269,577		(12	)%
Interest expense		20,164			45,807		56			41,022			92,559		56
Provision for loan and lease losses		10,536			1,523		(592	)		21,608			46,332		53
Non-interest income		8,450			16,277		(48	)		20,000			42,489		(53	)
Non-interest expense		48,200			62,529		23			97,250			125,011		22
Income tax (benefit) expense		(340,017	)		17,249		2,071			(314,308	)		28,411		1,206
Net income		387,549			16,594		2,235			412,487			19,753		1,988

Our consolidated yields on interest-earning assets and the costs of interest-bearing liabilities for the six months ended June 30, 2012 and 2011 were as follows:


	Six Months Ended June 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Total interest-earning assets⁽¹⁾	$	7,564,978	$	238,059		6.33	%	$	8,407,875	$	269,577		6.47	%
Total interest-bearing liabilities⁽²⁾		6,584,273		41,022		1.25			6,936,171		92,559		2.69
Net interest spread			$	197,037		5.08	%			$	177,018		3.78	%
Net interest margin						5.24	%						4.25	%

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

⁽²⁾	Interest-bearing liabilities include deposits, repurchase agreements, credit facilities, term debt, convertible debt and subordinated debt.

Income Taxes

We provide for income taxes as a “C” corporation on income earned from operations. For the tax years ended 2010 and 2009, our subsidiaries were not able to participate in the filing of a consolidated federal tax return. We have consolidated our subsidiaries in 2011 for federal tax purposes. We are subject to federal, foreign, state and local taxation in various jurisdictions.

We account for income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates for the periods in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the change.

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


56

During three months ended June 30, 2012, we reversed $347.4 million, or 68%, of the valuation allowance that existed at March 31, 2012. Each of the deferred tax assets was evaluated based on their associated character and jurisdiction. The decision to reverse a large portion of the valuation allowance was based on our evaluation of significant improvements in consolidated earnings and loan credit quality. A valuation allowance of $166.1 million remains in effect as of June 30, 2012 with respect to deferred tax assets where we believe sufficient evidence does not exist at this time to support a reduction in the allowance. It is more likely than not that the remaining deferred tax assets subject to a valuation allowance will not be realized.

Consolidated income tax (benefit) expense for the three months ended June 30, 2012 and 2011 was $(340.0) million and $17.2 million, respectively. The tax benefit for the three months ended June 30, 2012 was caused primarily the reversal of a large portion of the valuation allowance against our deferred tax assets. The expense for the three months ended June 30, 2011 was primarily the result of the change in the net deferred tax assets of CapitalSource Bank. Consolidated income tax (benefit) expense for the six months ended June 30, 2012 and 2011 was $(314.3) million and $28.4 million, respectively. The tax benefit for the six months ended June 30, 2012 was caused primarily by the reversal of a large portion of the valuation allowance against our deferred tax assets. The tax expense recorded for the six months ended June 30, 2011 was incurred primarily as a result of our plan to reconsolidate our corporate entities for federal tax purposes in 2011.

Comparison of the Three and Six Months Ended June 30, 2012 and 2011

CapitalSource Bank Segment

Our CapitalSource Bank segment operating results for the three and six months ended June 30, 2012, compared to the three and six months ended June 30, 2011, were as follows:


	Three Months Ended June 30,								Six Months Ended June 30,
	2012		2011			% Change			2012		2011		% Change
	($ in thousands)
Interest income	$	96,112	$	90,490			6	%	$	194,732	$	182,294		7	%
Interest expense		15,394		15,612			1			31,453		30,822		(2	)
Provision (benefit) for loan and lease losses		12,569		(1,331	)		(1,044	)		14,472		9,911		(46	)
Non-interest income		13,198		7,508			76			28,667		13,340		115
Non-interest expense		43,179		37,102			(16	)		84,343		72,910		(16	)
Income tax expense		15,106		18,840			20			38,265		21,935		(74	)
Net income		23,062		27,775			(17	)		54,866		60,056		(9	)


57

Interest Income

Three months ended June 30, 2012 and 2011

Total interest income increased to $96.1 million for the three months ended June 30, 2012 from $90.5 million for the three months ended June 30, 2011, with an average yield on interest-earning assets of 5.89% for the three months ended June 30, 2012 compared to 6.13% for the three months ended June 30, 2011. Total interest income increased due a $9.2 million increase in loan interest income, offset by a $3.6 million decrease in investment interest income. During the three months ended June 30, 2012 and 2011, interest income on loans was $87.7 million and $78.5 million, respectively, yielding 7.09% and 7.98% on average loan balances of $5.0 billion and $3.9 billion, respectively. Loan interest income increased by $14.4 million from interest generated on held-for-investment loans and $1.3 million from direct financing lease interest and fees. Increases were offset by a $6.5 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on held-for-investment loans. During the three months ended June 30, 2012 and 2011, $3.1 million and $4.4 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the yield on loans by 0.25% and 0.45%, respectively. During the three months ended June 30, 2012, no interest was collected on loans previously on non-accrual status. During the three months ended June 30, 2011, $0.1 million of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the three months ended June 30, 2012 and 2011, interest income from our investments, including available-for-sale and held-to-maturity securities, was $8.0 million and $11.6 million, respectively, yielding 2.61% and 2.99% on an average balance of $1.2 billion and $1.6 billion, respectively. Interest income on investments decreased $3.6 million primarily due to a $2.3 million decrease in income from the available-for-sale portfolio. The available-for-sale portfolio is mostly comprised of agency mortgage-backed securities, which have been experiencing an acceleration of premium amortizations due to updated prepayment assumptions. During the three months ended June 30, 2012, we purchased $119.8 million of investment securities, available-for-sale, while $90.1 million and $3.0 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively. For the three months ended June 30, 2011, we purchased $221.8 million of investment securities, available-for-sale while $136.6 million and $44.4 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the three months ended June 30, 2012 and 2011, interest income on cash and cash equivalents was $0.4 million and $0.4

million, respectively, yielding 0.46% and 0.38% on average balances of $318.4 million and $406.7 million, respectively.

Six months ended June 30, 2012 and 2011

Total interest income increased to $194.7 million for the six months ended June 30, 2012 from $182.3 million for the six months ended June 30, 2011, with an average yield on interest-earning assets of 6.01% for the six months ended June 30, 2012 compared to 6.31% for the six months ended June 30, 2011. Total interest income increased due to a $21.2 million increase in loan interest income, offset by an $8.8 million decrease in investment interest income. During the six months ended June 30, 2012 and 2011, interest income on loans was $176.5 million and $155.3 million, respectively, yielding 7.17% and 8.10% on average loan balances of $4.9 billion and $3.9 billion, respectively. Loan interest income increased by $28.2 million from interest generated on held-for-investment loans and $3.3 million from direct financing lease interest and fees. Increases were offset by a $10.3 million decrease in deferred loan fee income arising from the accelerated amortization of loan fee premiums and discounts due to earlier pay downs on held-for-investment loans. During the six months ended June 30, 2012 and 2011, $5.2 million and $9.5 million, respectively, of interest income was not recognized for loans on non-accrual status, which negatively impacted the yield on loans by 0.21% and 0.49%, respectively. During the six months ended June 30, 2012 and 2011, $0.8 million and $0.1 million, respectively, of interest was collected on loans previously on non-accrual status and recognized in interest income.

During the six months ended June 30, 2012 and 2011, interest income from our investments, including available-for-sale and held-to-maturity securities, was $17.5 million and $26.3 million, respectively, yielding 2.84% and 3.37% on an average balance of $1.2 billion and $1.6 billion, respectively. Interest income on investments decreased $8.8 million due to a $2.9 million decrease in income from the available-for-sale portfolio and a $5.9 million decrease in held-to-maturity securities. The agency mortgage-backed securities within the available-for-sale portfolio experienced decelerated premium amortizations in the first quarter offset by accelerated amortization arising from updated prepayment assumptions. The held-to-maturity portfolio primarily includes commercial mortgage-backed securities which experienced a decrease due to fluctuations in interest rates and prepayment assumptions. The Bank has the intent and ability to hold held-to-maturity debt securities to maturity, and these securities are not significant to the Bank’s liquidity needs. During the six months ended June 30, 2012, we purchased $149.4 million of investment securities, available-for-sale, while $179.9 million and $4.0 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity,


58

respectively. For the six months ended June 30, 2011, we purchased $448.1 million of investment securities, available-for-sale while $472.7 million and $54.7 million of principal repayments were received from our investment securities, available-for-sale and held-to-maturity, respectively.

During the six months ended June 30, 2012 and 2011, interest income on cash and cash equivalents was $0.6 million and $0.6 million, respectively, yielding 0.30% and 0.26% on average balances of $275.3 million and $361.1 million, respectively.

Interest Expense

Three months ended June 30, 2012 and 2011

Total interest expense decreased to $15.4 million for the three months ended June 30, 2012 from $15.6 million for the three months ended June 30, 2011. The decrease was due to a decline in the average cost of interest-bearing liabilities which was 1.05% and 1.21% during the three months ended June 30, 2012 and 2011, respectively, offset by an increase in the average balance of interest-bearing liabilities which was $5.9 billion and $5.2 billion during the three months ended June 30, 2012 and 2011, respectively. Our interest expense on deposits for the three months ended June 30, 2012 and 2011 was $12.6 million and $13.4 million, respectively, with an average cost of deposits of 0.95 % and 1.13%, respectively, on average balances of $5.3 billion and $4.7 billion, respectively. During the three months ended June 30, 2012, $0.9 billion of our time deposits matured with a weighted average interest rate of 0.96% and $1.1 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.83%. During the three months ended June 30, 2011, $1.0 billion of our time deposits matured with a weighted average interest rate of 1.05% and $1.0 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.96%. Additionally, during the three months ended June 30, 2012, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, decreased from 0.61% at the beginning of the quarter to 0.56% at the end of the quarter.

During the three months ended June 30, 2012, our interest expense on borrowings, consisting of FHLB SF borrowings, was $2.8 million with an average cost of 1.89% on an average balance of $585.8 million. There were $40.0 million in advances with a weighted-average-rate of 0.97% and $30.0 million in maturities with a weighted-average-rate of 1.14%. Weighted-average-rates for FHLB SF borrowings maturing within one year, two to five years, and greater than five years were 1.83%, 1.76%, and 2.28%, respectively. In addition, the overall FHLB SF borrowings balance had a weighted-average-life of 3.58 years as compared to 4.37

years for new advances during the quarter. During the three months ended June 30, 2011, our interest expense on FHLB SF borrowings was $2.2 million with an average cost of 2.08% on an average balance of $426.5 million. During the three months ended June 30, 2011, there were $120.0 million of advances taken and $40.0 million of maturities.

Six months ended June 30, 2012 and 2011

Total interest expense increased to $31.5 million for the six months ended June 30, 2012 from $30.8 million for the six months ended June 30, 2011. The increase was due to an increase in the average balance of interest-bearing liabilities which was $5.9 billion and $5.1 billion during the six months ended June 30, 2012 and 2011, respectively, offset by decline in the average cost of interest-bearing liabilities which was 1.08% and 1.22% during the six months ended June 30, 2012 and 2011, respectively. Our interest expense on deposits for the six months ended June 30, 2012 and 2011 was $25.9 million and $26.8 million, respectively, with an average cost of deposits of 0.99 % and 1.15%, respectively, on average balances of $5.3 billion and $4.7 billion, respectively. During the six months ended June 30, 2012, $2.1 billion of our time deposits matured with a weighted average interest rate of 1.03% and $2.5 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.87%. During the six months ended June 30, 2011, $2.0 billion of our time deposits matured with a weighted average interest rate of 1.07% and $2.2 billion of new and renewed time deposits were issued at a weighted average interest rate of 0.96%. Additionally, during the six months ended June 30, 2012, our weighted average interest rate of our liquid account deposits, which include savings and money market accounts, decreased from 0.75% at the beginning of the year to 0.56% at the end of the quarter.

During the six months ended June 30, 2012, our interest expense on borrowings, consisting of FHLB SF borrowings, was $5.5 million with an average cost of 1.93 % on an average balance of $27.8 million. There were $85.0 million in advances with a weighted-average-rate of 1.04% and $38.0 million of maturities with a weighted-average-rate of 1.93%. The overall FHLB borrowings balance has a weighted-average-life of 3.58 years as compared to 4.52 years for new advances made during the year to date. During the six months ended June 30, 2012, there were $85.0 million in advances taken and $38.0 million of maturities. During the six months ended June 30, 2011, our interest expense on FHLB SF borrowings was $4.0 million with an average cost of 2.04% on an average balance of $400.0 million. During the six months ended June 30, 2011, there were $303.0 million of advances taken and $235.0 million of maturities.


59

Net Interest Margin

Three months ended June 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the three months ended June 30, 2012 and 2011 were as follows:


	Three Months Ended June 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Total interest-earning assets⁽¹⁾	$	6,558,331	$	96,112		5.89	%	$	5,925,269	$	90,490		6.13	%
Total interest-bearing liabilities⁽²⁾		5,919,981		15,394		1.05			5,164,717		15,612		1.21
Net interest spread			$	80,718		4.84	%			$	74,878		4.92	%
Net interest margin						4.95	%						5.07	%

Six months ended June 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the six months ended June 30, 2012 and 2011 were as follows:


	Six Months Ended June 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Total interest-earning assets⁽¹⁾	$	6,519,945	$	194,732		6.01	%	$	5,824,845	$	182,294		6.31	%
Total interest-bearing liabilities⁽²⁾		5,862,645		31,453		1.08			5,106,199		30,822		1.22
Net interest spread			$	163,279		4.93	%			$	151,472		5.09	%
Net interest margin						5.04	%						5.24	%

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

⁽²⁾	Interest-bearing liabilities include deposits and borrowings.

Provision for Loan and Lease Losses

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


60

Non-Interest Income

Non-interest income includes loan and deposit fees, servicing and shared services income, leased equipment income, gains (losses) on the sale of loans, gains (losses) on the sale of debt and equity investments, dividends, unrealized appreciation (depreciation) on certain investments, other-than-temporary impairment on investment securities, available for sale, gains (losses) on derivatives and foreign currency swaps, unrealized appreciation (depreciation) of our equity interests in certain non-consolidated entities and other miscellaneous fees and expenses.

CapitalSource Bank acts as servicer and agent for loans and other assets, which are owned by the Parent Company and partially owned by third parties, for which it receives fees based on the level of servicing effort for the loans and other assets. Loans serviced by CapitalSource Bank for the benefit of others were $1.7 billion and $3.1 billion as of June 30, 2012 and December 31, 2011, respectively, of which $0.8 billion and $2.5 billion, respectively, were owned by the Parent Company. CapitalSource Bank also provides tax, credit, treasury and other similar services to the Parent Company for which it receives fees.

Three months ended June 30, 2012 and 2011

Non-interest income increased to $13.2 million for the three months ended June 30, 2012 from $7.5 million for the three months ended June 30, 2011 primarily due to a $3.2 million increase in leased equipment income, a $2.5 million increase in revenue for shared services to parent, a $1.3 million increase in loan fees, a $0.2 million increase in gains on derivatives and a net $1.0 million increase due to miscellaneous income, which were offset by a $1.7 million decrease in intercompany loan servicing income and a $0.8 million decrease attributed to foreign currency translation losses on international loans.

Six months ended June 30, 2012 and 2011

Non-interest income increased to $28.7 million for the six months ended June 30, 2012 from $13.3 million for the six months ended June 30, 2011 primarily due to a $6.4 million increase in leased equipment income, a $4.8 million increase in revenue for shared services to parent, a $2.5 million increase in loan fees, a $0.7 million increase in gains on derivatives and a net $4.8 million increase due to miscellaneous income, which were offset by a $1.9 million decrease on gains related to sale of assets, a $1.1 million decrease in intercompany loan servicing income and a $0.8 million decrease attributed to foreign currency translation losses on international loans.

Non-Interest Expense

Non-interest expense includes compensation and benefits, professional fees, FDIC fees and assessments, loan sourcing and due diligence fees, expense of real estate owned and other foreclosed assets, net, travel expenses, occupancy expenses, insurance, depreciation and amortization, marketing and other general and administrative expense, and other expenses incurred in the normal course of business operations.

Prior to 2012, CapitalSource Bank relied on the Parent Company to refer loans and to provide loan origination due diligence services. For these services CapitalSource Bank paid the Parent Company fees based upon the commitment amount of each new loan funded by CapitalSource Bank during the period. CapitalSource Bank also paid the Parent Company to perform certain underwriting and other services. These fees were eliminated in consolidation. Effective January 1, 2012, the Parent Company no longer performed these services and CapitalSource Bank directly assumed the expenses for these services. The expenses are included in other non-interest expense and were $2.3 million and $13.3 million for the three months ended June 30, 2012 and 2011, respectively.

CapitalSource Bank subleases from the Parent Company office space in several locations and also leases space to the Parent Company in other facilities in which CapitalSource Bank is the primary lessee.

Three months ended June 30, 2012 and 2011

Non-interest expense increased to $43.2 million for the three months ended June 30, 2012 from $37.1 million for three months ended June 30, 2011. The increase was primarily due to compensation related to the transfer of Parent Company employees into CapitalSource Bank on January 1, 2012 and salary expense increases, partially offset by the elimination of loan referral fees paid to the Parent Company and lower REO expense.

Six months ended June 30, 2012 and 2011

Non-interest expense increased to $84.3 million for the six months ended June 30, 2012 from $72.9 million for six months ended June 30, 2011. The increase was primarily due to compensation related to the transfer of Parent Company employees into CapitalSource Bank on January 1, 2012, partially offset by the elimination of loan referral fees paid to the parent and lower REO expense.


61

Other Commercial Finance Segment

Our Other Commercial Finance segment operating results for the three and six months ended June 30, 2012, compared to the three and six months ended June 30, 2011, were as follows:


	Three Months Ended June 30,									Six Months Ended June 30,
	2012			2011			% Change			2012			2011			% Change
	($ in thousands)
Interest income	$	22,978		$	40,701			(44	)%	$	45,680		$	88,315			(48	)%
Interest expense		4,770			30,195			84			9,569			61,737			85
(Benefit) provision for loan and lease losses		(2,033	)		2,854			171			7,136			36,421			80
Non-interest income		1,594			27,450			(94	)		5,085			65,158			(92	)
Non-interest expense		11,629			44,375			74			27,189			91,055			70
Income tax (benefit) expense		(355,123	)		(1,591	)		22,221			(352,573	)		6,476			5,544
Net income (loss)		365,329			(7,682	)		4,856			359,444			(42,216	)		951

Interest Income

Three months ended June 30, 2012 and 2011

Interest income decreased to $23.0 million for the three months ended June 30, 2012 from $40.7 million for the three months ended June 30, 2011, primarily due to a decrease in average total interest-earning assets. During the three months ended June 30, 2012, our average balance of interest-earning assets decreased by $1.6 billion, or 61.25%, compared to the three months ended June 30, 2011, due to the runoff of Parent Company loans. During the three months ended June 30, 2012, yield on average interest-earning assets increased to 9.09% from 6.30% for the three months ended June 30, 2011. During the three months ended June 30, 2012, our lending spread to average one-month LIBOR was 9.67% compared to 9.71% for the three months ended June 30, 2011. Fluctuations in yields are driven by a number of factors, including changes in short-term interest rates such as changes in the prime rate or one-month LIBOR, the coupon on loans that pay down or pay off, non-accrual loans and modifications of interest rates on existing loans.

Six months ended June 30, 2012 and 2011

Interest income decreased to $45.7 million for the six months ended June 30, 2012 from $88.3 million for the six months ended June 30, 2011, primarily due to a decrease in average total interest-earning assets. During the six months ended June 30, 2012, our average balance of interest-earning assets decreased by $1.5 billion, or 59.57%, compared to the three months ended June 30, 2011, due to the runoff of Parent Company loans. During the six months ended June 30, 2012, yield on average interest-earning assets decreased to 4.38% from 6.91% for the six months ended June 30, 2011. Fluctuations in yields are driven by a number of factors, including changes in short-term interest rates such as changes in the prime rate or one-month LIBOR, the coupon on loans that pay down or pay off, non-accrual loans and modifications of interest rates on existing loans.

Interest Expense

Three months ended June 30, 2012 and 2011

Interest expense decreased to $4.8 million for the three months ended June 30, 2012 from $30.2 million for the three months ended June 30, 2011 primarily due to a decrease in average interest-bearing liabilities of $1.8 billion as of June 30, 2011 to $0.7 billion as of June 30, 2012, a 60.72% decrease, from the reduction of the outstanding balances on our credit facilities and other term debt. Our cost of borrowings decreased to 2.79% for the three months ended June 30, 2012 from 6.89% for the three months ended June 30, 2011, as a result of the reduction and termination of certain of our credit facilities and decreases in our remaining securitization balances, all of which generally had higher borrowing costs than the remainder of our borrowings.

Six months ended June 30, 2012 and 2011

Interest expense decreased to $9.6 million for the six months ended June 30, 2012 from $61.7 million for the six months ended June 30, 2011 primarily due to a decrease in average interest-bearing liabilities of $1.8 billion as of June 30, 2011 to $0.7 billion as of June 30, 2012, a


62

60.57% decrease, from the reduction of the outstanding balances on our credit facilities and other term debt. Our cost of borrowings decreased to 1.34% for the six months ended June 30, 2012 from 6.80% for the six months ended June 30, 2011, as a result of the reduction and termination of certain of our credit facilities and decreases in our remaining securitization balances, all of which generally had higher borrowing costs than the remainder of our borrowings.

Net Interest Margin

Three months ended June 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the three months ended June 30, 2012 and 2011 were as follows:


	Three Months Ended June 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Total interest-earning assets⁽¹⁾	$	1,004,777	$	22,702		9.09	%	$	2,592,896	$	40,701		6.30	%
Total interest-bearing liabilities⁽²⁾		690,928		4,799		2.79			1,758,963		30,195		6.89
Net interest spread			$	17,903		6.30	%			$	10,506		-0.59	%
Net interest margin						7.17	%						1.64	%

Six months ended June 30, 2012 and 2011

The yields of income earning assets and the costs of interest-bearing liabilities in this segment for the six months ended and 2011 were as follows:


	Six Months Ended June 30,
	2012							2011
	Weighted Average Balance		Net Interest Income		Average Yield/Cost			Weighted Average Balance		Net Interest Income		Average Yield/Cost
	($ in thousands)
Total interest-earning assets⁽¹⁾	$	1,042,642	$	22,702		4.38	%	$	2,579,155	$	88,315		6.91	%
Total interest-bearing liabilities⁽²⁾		721,629		4,799		1.34			1,829,972		61,737		6.80
Net interest spread			$	17,903		3.04	%			$	26,578		0.11	%
Net interest margin						3.45	%						2.08	%

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

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

Provision for Loan and Lease Losses

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


63

Non-Interest Income

Three months ended June 30, 2012 and 2011

Non-interest income decreased to $1.6 million for the three months ended June 30, 2012 from $27.5 million for the three months ended June 30, 2011, primarily due to the termination of loan referral services provided by CapitalSource Bank in 2012.

Six months ended June 30, 2012 and 2011

Non-interest income decreased to $5.1 million for the six months ended June 30, 2012 from $65.2 million for the six months ended June 30, 2011, primarily due to the termination of loan referral services provided by CapitalSource Bank in 2012.

Non-Interest expense

Three months ended June 30, 2012 and 2011

Non-interest expense decreased to $11.6 million for the three months ended June 30, 2012 from $44.4 million for the three months ended June 30, 2011 due to the transfer of Parent Company employees to CapitalSource Bank on January 1, 2012, decreases in professional fees and gains on the extinguishment of debt. In addition, non-interest expense increased by $2.3 million due to the lease abandonment and sublease of the operating lease for a portion of the Chevy Chase, Maryland facility effective June 1, 2012.

Six months ended June 30, 2012 and 2011

Non-interest expense decreased to $27.2 million for the six months ended June 30, 2012 from $91.1 million for the six months ended June 30, 2011 primarily due to the transfer of Parent Company employees to CapitalSource Bank on January 1, 2012.

Financial Condition

CapitalSource Bank Segment

As of June 30, 2012 and December 31, 2011, the CapitalSource Bank segment included:


	June 30, 2012		December 31, 2011
	($ in thousands)
Assets:
Cash and cash equivalents⁽¹⁾	$	275,456	$	317,455
Investment securities, available-for-sale		1,126,049		1,159,119
Investment securities, held-to-maturity		108,520		111,706
Loans⁽²⁾		5,268,483		4,917,335
Other investments		23,239		23,774
FHLB SF stock		28,059		27,792
Total	$	6,829,806	$	6,557,181
Liabilities:
Deposits	$	5,382,012	$	5,124,995
FHLB SF borrowings		597,000		550,000
Total	$	5,979,012	$	5,674,995

⁽¹⁾	As of June 30, 2012 and December 31, 2011, the amounts include restricted cash of $50.1 million and $0.8 million, respectively.

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

Cash and Cash Equivalents

Cash and cash equivalents consist of amounts due from banks, U.S. Treasury securities, short-term investments and commercial paper with an initial maturity of three months or less. For additional information, see Note 3, Cash and Cash Equivalents and Restricted Cash, in our accompanying consolidated financial statements for the three and six months ended June 30, 2012.


64

Investment Securities, Available-for-Sale

Investment securities, available-for-sale, consists of Agency discount notes, Agency callable notes, Agency debt, Agency MBS, Non-agency MBS, corporate debt securities and U.S. Treasury and agency securities. CapitalSource Bank pledged a significant portion of its investment securities, available-for-sale, to the FHLB SF and the FRB as a source of borrowing capacity as of June 30, 2012. For additional information, see Note 5, Investments, in our accompanying consolidated financial statements for the three and six months ended June 30, 2012.

Investment Securities, Held-to-Maturity

Investment securities, held-to-maturity, consists of AAA-rated commercial mortgage-backed securities. For additional information on our investment securities, held-to-maturity, see Note 5, Investments, in our accompanying consolidated financial statements for the three and six months ended June 30, 2012.

Loan Portfolio Composition

The CapitalSource Bank loan balances reflected in the portfolio statistics below include loans held for sale of $31.5 million and $129.9 million as of June 30, 2012 and December 31, 2011, respectively.

As of June 30, 2012 and December 31, 2011, the composition of the CapitalSource Bank loan portfolio by loan type was as follows:


	June 30, 2012				December 31, 2011
	($ in thousands)
Commercial	$	2,827,950	53	%	$	2,682,407	54	%
Real estate		2,417,113	46			2,223,603	45
Real estate — construction		23,420	1			11,325	1
Total⁽¹⁾	$	5,268,483	100	%	$	4,917,335	100	%

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of June 30, 2012, the scheduled maturities of the CapitalSource Bank loan portfolio by loan type were as follows:


	Due in One Year Or Less		Due in One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	274,727	$	2,076,453	$	476,770	$	2,827,950
Real estate		96,936		1,185,670		1,134,507		2,417,113
Real estate — construction		422		—		22,998		23,420
Total loans⁽¹⁾	$	372,085	$	3,262,123	$	1,634,275	$	5,268,483

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of June 30, 2012, approximately 58% of the CapitalSource Bank accruing adjustable rate portfolio was subject to an interest rate floor. Due to low market interest rates as of June 30, 2012, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 95% as of June 30, 2012. To the extent the underlying indices subsequently increase, CapitalSource Bank’s interest yield on this portfolio will not rise as quickly due to the effect of the interest rate floors.


65

As of June 30, 2012, the composition of CapitalSource Bank loan balances by adjustable rate index and by loan type was as follows:


	Loan Type
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	1,078,896	$	923,473	$	—	$	2,002,369		38	%
2-Month LIBOR		62,815		1,271		—		64,086		1
3-Month LIBOR		613,498		121,584		—		735,082		14
6-Month LIBOR		115,257		72,545		—		187,802		4
9-Month EURIBOR		—		2,485		—		2,485		—
Prime		386,571		152,233		21,570		560,374		11
Other		25,195		50,705		—		75,900		1
Total adjustable rate loans		2,282,232		1,324,296		21,570		3,628,098		69
Fixed rate loans		467,553		1,068,988		1,850		1,538,391		29
Loans on non-accrual status		78,163		23,827		—		101,990		2
Total loans⁽¹⁾	$	2,827,948	$	2,417,111	$	23,420	$	5,268,479		100	%

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

FHLB SF Stock

Investments in FHLB SF stock are recorded at historical cost. FHLB SF stock does not have a readily determinable fair value, but can generally be sold back to the FHLB SF at par value upon stated notice. The investment in FHLB SF stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB and its overall financial condition. No impairment losses have been recorded through June 30, 2012.

Deposits

As of June 30, 2012 and December 31, 2011, a summary of CapitalSource Bank’s deposits by product type and the maturities of the certificates of deposit were as follows:


	June 30, 2012					December 31, 2011
	Balance		Weighted Average Rate			Balance		Weighted Average Rate
	($ in thousands)
Interest-bearing deposits:
Money market	$	273,244		0.54	%	$	260,032		0.73	%
Savings		790,351		0.57			836,521		0.76
Certificates of deposit		4,318,417		1.04			4,028,442		1.14
Total interest-bearing deposits	$	5,382,012		0.94	%	$	5,124,995		1.06	%


66


	June 30, 2012
	Balance		Weighted Average Rate
	($ in thousands)
Remaining maturity of certificates of deposit:
0 to 3 months	$	1,103,233		0.96	%
4 to 6 months		1,777,866		0.99
7 to 9 months		442,449		0.93
10 to 12 months		189,255		1.12
Greater than 12 months		805,614		1.29
Total certificates of deposit	$	4,318,417		1.04	%

FHLB SF Borrowings

FHLB SF borrowings increased to $597.0 million as of June 30, 2012 from $550.0 million as of December 31, 2011. These borrowings were used primarily for interest rate risk management and short-term funding purposes. The weighted-average remaining maturities of the borrowings were approximately 3.6 years and 3.7 years as of June 30, 2012 and December 31, 2011, respectively.

As of June 30, 2012, the remaining maturity and the weighted average interest rate of FHLB SF borrowings were as follows:


	Balance		Weighted Average Rate
	($ in thousands)
Less than 1 year	$	38,000		1.83	%
After 1 year through 2 years		55,000		2.02
After 2 years through 3 years		102,500		1.54
After 3 years through 4 years		189,000		2.13
After 4 years through 5 years		130,000		1.27
After 5 years		82,500		2.28
Total	$	597,000		1.83	%

Other Commercial Finance Segment

As of June 30, 2012 and December 31, 2011, the Other Commercial Finance segment included:


	June 30, 2012		December 31, 2011
	($ in thousands)
Assets:
Investment securities, available-for-sale	$	21,993	$	28,883
Loans⁽¹⁾		801,127		1,034,676
Other investments⁽²⁾		49,430		57,472
Deferred income taxes, net⁽³⁾		379,259		32,858
Total	$	1,251,809	$	1,153,889

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

⁽²⁾	Includes investments carried at cost, investments carried at fair value and investments accounted for under the equity method.

⁽³⁾	Includes short-term and long-term deferred income tax assets, net of related valuation allowance.

Investment Securities, Available-for-Sale

Investment securities, available-for-sale consist of municipal bonds and our interests in the 2006-A Trust of $19.9 million.


67

Other Investments

The Parent Company has made investments in some of our borrowers in connection with the loans provided to them. These investments usually include equity interests such as common stock, preferred stock, limited liability company interests, limited partnership interests and warrants.

Loan Portfolio Composition

The Other Commercial Finance loan balances reflected in the portfolio statistics below include loans held for sale of $63.1 million as of December 31, 2011. There were no loans held for sale reflected in the portfolio statistics below as of June 30, 2012.

As of June 30, 2012 and December 31, 2011, the composition of the Other Commercial Finance loan portfolio by loan type was as follows:


	June 30, 2012				December 31, 2011
	($ in thousands)
Commercial	$	727,483	91	%	$	862,183	83	%
Real estate		59,496	7			117,533	12
Real estate — construction		14,148	2			54,960	5
Total⁽¹⁾	$	801,127	100	%	$	1,034,676	100	%

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of June 30, 2012, the scheduled maturities of the Other Commercial Finance loan portfolio by loan type were as follows:


	Due in One Year or Less		Due in One to Five Years		Due After Five Years		Total
	($ in thousands)
Commercial	$	193,962	$	533,521	$	—	$	727,483
Real estate		21,640		37,462		394		59,496
Real estate — construction		14,148		—		—		14,148
Total⁽¹⁾	$	229,750	$	570,983	$	394	$	801,127

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

As of June 30, 2012, approximately 76% of the Other Commercial Finance accruing adjustable rate loan portfolio was subject to an interest rate floor. Due to low market interest rates as of June 30, 2012, substantially all loans with interest rate floors were bearing interest at such floors. The weighted average spread between the floor rate and the fully indexed rate on the loans was 89% as of June 30, 2012. To the extent the underlying indices subsequently increase, the interest yield on these adjustable rate loans will not rise as quickly due to the effect of the interest rate floors.


68

As of June 30, 2012, the composition of Other Commercial Finance loan balances by adjustable rate index and by loan type was as follows:


	Loan Type
	Commercial		Real Estate		Real Estate - Construction		Total		Percentage
	($ in thousands)
1-Month LIBOR	$	259,680	$	—	$	—	$	259,680		32	%
3-Month LIBOR		132,227		—		—		132,227		17
Prime		251,603		—		—		251,603		31
Total adjustable rate loans		643,510		—		—		643,510		80
Fixed rate loans		18,771		37,736		—		56,507		7
Loans on non-accrual status		65,202		21,761		14,148		101,111		13
Total loans⁽¹⁾	$	727,483	$	59,497	$	14,148	$	801,128		100	%

⁽¹⁾	Excludes the impact of deferred loan fees and discounts and the allowance for loan and lease losses. Includes lower of cost or fair value adjustments on loans held for sale.

Credit Quality and Allowance for Loan and Lease Losses

Consolidated

The outstanding unpaid principal balances of non-performing loans in our consolidated loan portfolio as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	143,365	$	151,609
Real estate		45,587		104,438
Real estate — construction		14,148		24,628
Total loans on non-accrual	$	203,100	$	280,675
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		5,603
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	5,603
Total non-performing loans
Commercial	$	143,365	$	151,609
Real estate		45,587		110,041
Real estate — construction		14,148		24,628
Total non-performing loans	$	203,100	$	286,278

The decrease in the non-performing loan balance from December 31, 2011 to June 30, 2012 is primarily due to payoffs, charge offs, sales and foreclosures on those loans.

Potential problem loans are loans that are not considered non-performing loans, as disclosed in the table above, or loans that have been restructured in a TDR, but loans where management is aware of information regarding potential credit problems of a borrower that leads to serious doubts as to the ability of such borrower to comply with the loan repayment terms. Such defaults could eventually result in the loans being reclassified as non-performing loans. As of June 30, 2012 and December 31, 2011, we had $1.1 million and $4.8 million, respectively, in potential problem loans related to four and 11 loans, respectively, for which we have determined that it is probable that we will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement, but we have concluded that repayment in full of the loans is fully supported by existing collateral or an enterprise valuation of the borrower in accordance with our most recent valuation analysis.


69

Of our non-accrual loans, $0.5 million were 30-89 days delinquent and $63.1 million were over 90 days delinquent as of June 30, 2012, and $4.3 million were 30-89 days delinquent and $90.2 million were over 90 days delinquent as of December 31, 2011. Accruing loans 30-89 days delinquent were $0.2 million and $8.4 million as of June 30, 2012 and December 31, 2011, respectively.

Most of our $37.6 million of real estate construction loans as of June 30, 2012 include an interest reserve that is established upon origination of the loan. We recognize interest income from the reserve during the construction period as long as the interest is deemed collectible. As part of our ongoing credit review process, we monitor the construction of the underlying real estate to determine whether the project is progressing as originally planned. If we determine that adverse changes have occurred such that full payment of principal and interest is no longer expected, we will place the loan on non-accrual status and establish a specific reserve or charge off a portion of the principal balance, as appropriate.

We maintain a comprehensive credit policy manual that is supplemented by specific loan product underwriting guidelines. Among other things, the credit policy manual sets forth requirements that meet the regulations enforced by both the FDIC and the California Department of Financial Institutions (“DFI”). Several examples of such requirements are the loan-to-value limitations for real estate secured loans, various real estate appraisal and other third-party reports standards, and collateral insurance requirements.

Our underwriting guidelines outline specific underwriting standards and minimum specific risk acceptance criteria for each lending product offered, including the use of interest reserves. For additional information, see Credit Risk Management within this section.

We maintain servicing procedures for real estate construction loans, and the objective of the procedures is to maintain the proper relationship between the loan amount funded and the value of the collateral securing the loan. The principal servicing tasks include, but are not limited to:

Monitoring construction of the project to evaluate the work in place, quality of construction (compliance with plans and specifications) and adequacy of the budget to complete the project. We generally use a third party consultant for this evaluation, but also maintain frequent contact with the borrower to obtain updates on the project.

Monitoring, where applicable, the leasing or unit sales activity compared to market leasing or market unit sales and compared to the underwritten leasing or unit sales actively.

Monitoring compliance with the terms and conditions of the loan agreement, which contains important construction and leasing provisions.

Reviewing and approving advance requests per the loan agreement which establishes the frequency, conditions and process for making advances. Typically, each loan advance is conditioned upon funding only for work in place, certification by the construction consultant, and sufficient funds remaining in the loan budget to complete the project.

In considering the performing status of a real estate construction loan, the current payment of interest, whether in cash or through an interest reserve, is only one of the factors used in our analysis. Our impairment analysis generally considers the loan’s maturity, the likelihood of a restructuring of the loan and if that restructuring constitutes a troubled debt restructuring, whether the borrower is current on interest and principal payments, the condition of underlying assets and the ability of the borrower to refinance the loan at market terms. Although an interest reserve may mitigate a delinquency that could cause impairment, other issues with the loan or borrower (like the project’s progress compared to underwriting and the market in which the project is located) may lead to an impairment determination. Impairment is then measured based on a fair market or discounted cash flow value to assess the current value of the loan relative to the principal balance. If the valuation analysis indicates that repayment in full is doubtful, the loan will be placed on non-accrual status and designated as non-performing.

Interest income recognized on the real estate construction loan portfolio was $0.2 million and $0.4 million for the three and six months ended June 30, 2012, and $0.9 million and $2.7 million for the three and six months ended June 30, 2011, respectively. Cumulative capitalized interest on the real estate construction loan portfolio was $12.5 million and $11.6 million as of June 30, 2012 and December 31, 2011, respectively. As of June 30, 2012 and December 31, 2011, $14.1 million, or 37.7%, and $55.0 million, or 82.9%, respectively, of the total real estate construction loan portfolio was non-performing.

As of June 30, 2012, three of the 23 loans that comprise our real estate construction portfolio have been extended, renewed or restructured since origination. These modifications have occurred for various reasons including, but not limited to, changes in business plans and/or work-out efforts that were best achieved via a restructuring.

Additionally, our risk assessment policies and procedures require that the assignment of a risk rating consider whether the capitalization of interest may be masking other performance related issues. We consider the status of the construction project


70

securing our loan, including its leasing or sales activity (where applicable), relative to our expectations for the status of the project during our initial underwriting. The adequacy of the interest reserve generally is evaluated each time a risk rating conclusion is required or rendered with particular attention paid to the underlying value of the collateral and its ongoing support of the transaction. Obtaining updated third-party valuations is considered when significant negative variances to expected performance exist. Generally, our policy on updating appraisals is to obtain current appraisals subsequent to the impairment date if there are significant changes to the underlying assumptions from the most recent appraisal. Some factors that could cause significant changes include the passage of more than twelve months since the time of the last appraisal; the volatility of the local market; the availability of financing; the number of competing properties; new improvements to or lack of maintenance of the subject property or competing surrounding properties; a change in zoning; environmental contamination; or failure of the project to meet material assumptions of the original appraisal. We generally consider appraisals to be current if they are dated within the past twelve months. However, we may obtain an updated appraisal on a more frequent basis if in our determination there are significant changes to the underlying assumptions from the most recent appraisal. As of June 30, 2012, $82.3 million of our collateral dependent loans had an appraisal older than twelve months. The fair value of the collateral for these loans was determined through inputs outside of appraisals, including actual and comparable sales transactions, broker price opinions and other relevant data.

The activity in the allowance for loan and lease losses for the three and six months ended June 30, 2012 and 2011 was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	151,902		$	283,274		$	153,631		$	329,122
Charge offs:
Commercial		(18,362	)		(36,167	)		(28,941	)		(116,897	)
Real estate		(6,462	)		(33,917	)		(7,716	)		(37,760	)
Real estate — construction		(8,670	)		(13,384	)		(9,285	)		(25,273	)
Total charge offs		(33,494	)		(83,468	)		(45,942	)		(179,930	)
Recoveries:
Commercial		4,170			2,353			5,048			3,458
Real estate		245			22			273			11,413
Real estate — construction		—			188			—			1,105
Total recoveries		4,415			2,563			5,321			15,976
Net charge offs		(29,079	)		(80,905	)		(40,621	)		(163,954	)
Charge offs upon transfer to held for sale		—			(4,754	)		(1,259	)		(12,362	)
Provision for loan and lease losses:
General		(8,979	)		(40,809	)		(14,624	)		(68,875	)
Specific		19,515			42,332			36,232			115,207
Total provision for loan and lease losses		10,536			1,523			21,608			46,332
Balance as of end of period	$	133,359		$	199,138		$	133,359		$	199,138
Allowance for loan and lease losses ratio		2.23	%		3.55	%		2.23	%		3.55	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		0.71	%		0.11	%		1.45	%		1.67	%
Net charge offs as a percentage of average loans outstanding (annualized)		1.95	%		6.12	%		2.80	%		6.00	%

Our allowance for loan and lease losses decreased by $20.2 million to $133.4 million as of June 30, 2012 from $153.6 million as of December 31, 2011. This decrease was attributable to a $14.6 million decrease in general reserves and a $5.6 million decrease in specific reserves on impaired loans as further described below.


71

The decrease in the general reserves was driven by loans from older origination vintages that had higher historical loss factors paying off or paying down. This decrease was due to additions to the general reserve from new loan originations that were comprised of loan types with lower historical loss factors. As of June 30, 2012, the unpaid principal balance of non-impaired loans had increased to $5.7 billion and the general reserves allocated to that portfolio had decreased to $112.6 million, representing an effective reserve percentage of 2.0%. As of December 31, 2011, the unpaid principal balance of non-impaired loans was $5.3 billion and the general reserves allocated to that portfolio were $127.2 million, representing an effective reserve percentage of 2.4%. The lower effective reserve percentage was attributable to the loan composition of the portfolio as of June 30, 2012 having more favorable credit loss characteristics based on historical experience than the loan portfolio as of December 31, 2011.

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

shortfall exists, a specific reserve is established. The specific reserves in place at each period end are directly related to the population of impaired loans in place at each period end.

The decrease in specific reserves from December 31, 2011 to June 30, 2012 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $6.6 million, ii) reversals of specific reserves for loans impaired as of December 31, 2011 net of related reversals or charge offs of $7.0 million, and iii) new specific reserves net of related charge offs for loans new to impairment status during the six months ended June 30, 2012 of $8.0 million. The specific reserves in place at June 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

As of June 30, 2012, the unpaid principal balance of impaired loans was $366.2 million with a specific allowance attributable to that portfolio of $20.8 million. Additionally, as of June 30, 2012, $172.4 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of June 30, 2012 of $193.2 million represented an expected total loss of 33.0% of the legal balance of $586.0 million (the June 30, 2012 balance plus amounts previously charged off). As of December 31, 2011, the unpaid principal balance of impaired loans was $425.3 million with a specific allowance attributable to that portfolio of $26.4 million. Additionally, as of December 31, 2011, $191.3 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of December 31, 2011 of $217.7 million represented an expected total loss of 33.3% of the legal balance of $654.6 million (the December 31, 2011 balance plus amounts previously charged off).


72

CapitalSource Bank Segment

The outstanding unpaid principal balances of non-performing loans in the CapitalSource Bank loan portfolio as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	78,163	$	51,799
Real estate		23,827		69,460
Real estate — construction		—		—
Total loans on non-accrual	$	101,990	$	121,259
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		—
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	—
Total non-performing loans
Commercial	$	78,163	$	51,799
Real estate		23,827		69,460
Real estate — construction		—		—
Total non-performing loans	$	101,990	$	121,259

We had four potential problem loans with an unpaid principal balance of $1.1 million as of June 30, 2012, and eleven potential problem loans with an unpaid principal balance of $4.8 million as of December 31, 2011.

Of our non-accrual loans, $59 thousand and $1.9 million were 30-89 days delinquent, and $21.4 million and $17.7 million were over 90 days delinquent as of June 30, 2012 and December 31, 2011, respectively. Accruing loans 30-89 days delinquent were $0.2 million and $8.0 million as of June 30, 2012 and December 31, 2011, respectively.


73

The activity in the allowance for loan and lease losses for the three and six months ended June 30, 2012 and 2011 was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	96,616		$	132,970		$	94,650		$	124,878
Charge offs:
Commercial		(1,821	)		(1,127	)		(2,099	)		(1,177	)
Real estate		(6,114	)		(22,193	)		(6,217	)		(25,920	)
Real estate — construction		—			—			—			(11,530	)
Total charge offs		(7,935	)		(23,320	)		(8,316	)		(38,627	)
Recoveries:
Commercial		337			85			767			85
Real estate		197			—			211			11,369
Real estate — construction		—			188			—			1,019
Total recoveries		534			273			978			12,473
Net charge offs		(7,401	)		(23,047	)		(7,338	)		(26,154	)
Charge offs upon transfer to held for sale		—			—			—			(43	)
Provision for loan losses:
General		3,536			(22,903	)		3,325			(15,686	)
Specific		9,033			21,572			11,147			25,597
Total provision for loan losses		12,569			(1,331	)		14,472			9,911
Balance as of end of period	$	101,784		$	108,592		$	101,784		$	108,592
Allowance for loan and lease losses ratio		1.96	%		2.58	%		1.96	%		2.58	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		1.01	%		0.13	%		1.17	%		0.48	%
Net charge offs as a percentage of average loans outstanding (annualized)		0.60	%		2.31	%		0.59	%		1.34	%

Our allowance for loan and lease losses increased by $7.1 million to $101.8 million as of June 30, 2012 from $94.7 million as of December 31, 2011. This increase was attributable to a $3.3 million increase in general reserves and a $3.8 million increase in specific reserves .

The increases in the general reserves was driven by additions to the general reserve from new loan originations that were only partially offset by loans paying off or paying down. As of June 30, 2012, the unpaid principal balance of non-impaired loans had increased to $5.1 billion and the general reserves allocated to that portfolio were $87.9 million, representing an effective reserve percentage of 1.7%. As of December 31, 2011, the unpaid principal balance of non-impaired loans was $4.7 billion and the general reserves allocated to that portfolio were $84.6 million, representing an effective reserve percentage of 1.8%. The reduction in the effective reserve percentage was attributable to the loan composition of the portfolio as of June 30, 2012 having more favorable credit loss characteristics based on historical experience than the loan portfolio as of December 31, 2011.


74

The increase in specific reserves from December 31, 2011 to June 30, 2012 stems from the net effect of i) additional specific reserves for loans impaired as of December 31, 2011 net of related reversals or charge offs of $0.6 million, and ii) new specific reserves net of related charge offs for loans new to impairment status during the six months ended June 30, 2012 of $3.2 million. The specific reserves in place at June 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

As of June 30, 2012, the unpaid principal balance of impaired loans was $149.0 million with a specific allowance attributable to that portfolio of $13.9 million. Additionally, as of June 30, 2012, $37.9 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of June 30, 2012 of $51.8 million represented an expected total loss of 26.2% of the legal balance of $198.0 million (the June 30, 2012 balance plus amounts previously charged off). As of December 31, 2011, the unpaid principal balance of impaired loans was $124.1 million with a specific allowance attributable to that portfolio of $10.1 million. Additionally, as of December 31, 2011, $47.0 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of December 31, 2011 of $57.1 million represented an expected total loss of 31.8% of the legal balance of $179.1 million (the December 31, 2011 balance plus amounts previously charged off).

We believe the origination strategy and underwriting practices in place support a loan portfolio with normal, acceptable degrees of credit risk. We acknowledge, however, that some of our lending products have greater credit risk than others. The categories with more credit risk than others are those that have comprised a greater degree of our historical charge offs. For the years ended December 31, 2011 and 2010, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception comprised 71% and 93%, respectively, of those years’ charge offs. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to July 2008 have a higher degree of credit risk than other lending products in our portfolio. As of June 30, 2012 and December 31, 2011, commercial real estate loans, excluding healthcare real estate loans, originated prior to July 2008 totaled $110.5 million and $202.6 million, respectively, or 2.1% and 4.1% of total loans, respectively.

During the three and six months ended June 30, 2012, loans with an aggregate carrying value of $15.4 million and $64.9 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and six months ended June 30,

2011, loans with an aggregate carrying value of $11.4 million and $107.6 million, respectively, as of their respective restructuring dates, were involved in TDRs. Loans involved in these TDRs are assessed as impaired, generally for a period of at least one year following the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. There were no specific reserves allocated to loans that were involved in TDRs as of June 30, 2012. The specific reserves allocated to loans that were involved in TDRs were $1.6 million as of December 31, 2011.

During 2010, CapitalSource Bank restructured, in TDRs, three commercial real estate loans into new loans using an “A note / B note” structure in which the B note component has been fully charged off. The contractual principal balances of these three loans prior to the restructurings totaled $91.6 million. In connection with the restructurings, $8.8 million of debt was forgiven and charged off, and $4.9 million was collected as principal payments, leaving $59.9 million of A notes and $18.2 million of B notes. In March 2011, one of these A / B note arrangements with an aggregate carrying value of $21.1 million as of December 31, 2010 was repaid in full, including the previously charged off $9.6 million B note. In January 2012, one of the remaining two A/B note arrangements with an aggregate carrying value of $12.0 million as of December 31, 2011 was repaid in full. The $2.3 million B note of this arrangement was forgiven as part of the TDR restructure. As of June 30, 2012, the aggregate carrying value of the remaining one A note was $22.8 million, and as of December 31, 2011, the aggregate carrying value of the remaining two A notes was $35.7 million. The remaining one B note had no aggregate carrying value as of June 30, 2012 and the remaining two B notes had no aggregate carrying value as of December 31, 2011. As of June 30, 2012, the one remaining A note that was a TDR with an aggregate carrying value of $22.8 million was no longer considered as impaired as it performed in accordance with market-based restructured terms for twelve consecutive months.

The workout strategy discussed above results in the A note equaling a balance the borrower can service and is underwritten to a loan to value ratio based on the current collateral valuation. The A note may be assigned an internal risk rating of pass based on the revised terms and management’s assessment of the borrower’s ability and intent to repay. The A note is structured at a market interest rate, and the A note debt service is typically covered by the in-place property operations allowing it to be placed on accrual status. The reduced loan amount induces the borrower to continue to support the loan and maintain the collateral despite the observed reduction in the collateral value. The B note usually bears no interest or an interest rate significantly below the market rate. The A note contains amortization provisions, and the B note requires amortization only after the full repayment of the A note.


75

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

All loans that have undergone this A note / B note restructuring are considered TDRs. The A notes are deemed impaired and remain so classified for at least one year from the date of the restructuring. After one year, the A notes are evaluated quarterly to determine if the loan performance has complied with the terms of the TDR such that the impairment classification may be removed.

In January 2012, Capital Source Bank restructured, as a TDR, a commercial real estate loan into new loans using an A note / B note / C note structure similar to the A note / B note structure stated above. The contractual principal balance of the loan prior to the restructure totaled $61.0 million, of which $11.2 million was previously charged off during the year ended December 31, 2011. The January 2012 restructure resulted in a $47.4 million A note, a $2.4 million B note and a $11.2 million C note, in which the C note represents the amount of the loan previously charged off. During January 2012, the B note was repaid in full. As of June 30, 2012, the carrying value of the A note was $30.6 million and the C note had no carrying value.

Other Commercial Finance Segment

The outstanding unpaid principal balances of non-performing loans in Other Commercial Finance loan portfolio as of June 30, 2012 and December 31, 2011 were as follows:


	June 30, 2012		December 31, 2011
	($ in thousands)
Non-accrual loans
Commercial	$	65,202	$	99,810
Real estate		21,760		34,978
Real estate — construction		14,148		24,628
Total loans on non-accrual	$	101,110	$	159,416
Accruing loans contractually past-due 90 days or more
Commercial	$	—	$	—
Real estate		—		5,603
Real estate — construction		—		—
Total accruing loans contractually past-due 90 days or more	$	—	$	5,603
Total non-performing loans
Commercial	$	65,202	$	99,810
Real estate		21,760		40,581
Real estate — construction		14,148		24,628
Total non-performing loans	$	101,110	$	165,019

We had no potential problem loans as of June 30, 2012 and December 31, 2011.

Of our non-accrual loans, $0.5 million and $2.4 million were 30-89 days delinquent, and $41.7 million and $72.5 million were over 90 days delinquent as of June 30, 2012 and December 31, 2011, respectively. There were no accruing loans 30-89 days delinquent as of June 30, 2012. Accruing loans 30-89 days delinquent were $0.4 million as of December 31, 2011.


76

The activity in the allowance for loan and lease losses for the three and six months ended June 30, 2012 and 2011 was as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	($ in thousands)
Balance as of beginning of period	$	55,286		$	150,304		$	58,981		$	204,244
Charge offs:
Commercial		(16,541	)		(35,040	)		(26,842	)		(115,720	)
Real estate		(348	)		(11,724	)		(1,499	)		(11,840	)
Real estate — construction		(8,670	)		(13,384	)		(9,285	)		(13,743	)
Total charge offs		(25,559	)		(60,148	)		(37,626	)		(141,303	)
Recoveries:
Commercial		3,833			2,268			4,281			3,373
Real estate		48			22			62			44
Real estate — construction		—			—			—			86
Total recoveries		3,881			2,290			4,343			3,503
Net charge offs		(21,678	)		(57,858	)		(33,283	)		(137,800	)
Charge offs upon transfer to held for sale		—			(4,754	)		(1,259	)		(12,319	)
Provision for loan and lease losses:
General		(12,515	)		(17,906	)		(17,949	)		(53,189	)
Specific		10,482			20,760			25,085			89,610
Total provision for loan and lease losses		(2,033	)		2,854			7,136			36,421
Balance as of end of period	$	31,575		$	90,546		$	31,575		$	90,546
Allowance for loan and lease losses ratio		3.99	%		6.46	%		3.99	%		6.46	%
Provision for loan and lease losses as a percentage of average loans outstanding (annualized)		-0.80	%		0.82	%		2.81	%		5.25	%
Net charge offs as a percentage of average loans outstanding (annualized)		8.55	%		15.63	%		13.62	%		15.24	%

Our allowance for loan and lease losses decreased by $27.4 million to $31.6 million as of June 30, 2012 from $59.0 million as of December 31, 2011. This decrease was attributable to a $17.9 million decrease in general reserves and a $9.5 million decrease in specific reserves on impaired loans as further described below.

The decrease in general reserves was a result of loan payoffs, sales and foreclosures. Our loans in categories with the greatest historical loss experience continue to pay off or be otherwise resolved. As of June 30, 2012, the unpaid principal balance of non-impaired loans had decreased to $584.0 million and the general reserves allocated to that portfolio were $24.6 million, representing an effective reserve percentage of 4.2%. As of December 31, 2011, the unpaid principal balance of non-impaired loans was $670.4 million and the general reserves allocated to that portfolio were $42.6 million, representing an effective reserve percentage of 6.4%.


77

The decrease in specific reserves from December 31, 2011 to June 30, 2012 stems from the net effect of i) loan resolutions of impaired loans with existing specific reserves of $6.6 million, ii) new specific reserves net of related charge offs for loans new to impairment status during the six months ended June 30, 2012 of $4.7 million and iii) reversals of reserves of $7.6 million on existing impaired. The specific reserves in place at June 30, 2012 and at December 31, 2011 reduce the carrying values of our impaired loans to the amounts we expect to collect.

As of June 30, 2012, the unpaid principal balance of impaired loans was $217.1 million with a specific allowance attributable to that portfolio of $6.9 million. Additionally, as of June 30, 2012, $134.5 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of June 30, 2012 of $141.4 million represented an expected total loss of 36.4% of the legal balance of $388.0 million (the June 30, 2012 balance plus amounts previously charged off). As of December 31, 2011, the unpaid principal balance of impaired loans was $301.2 million with a specific allowance attributable to that portfolio of $16.4 million. Additionally, as of December 31, 2011, $144.3 million of the original legal balance of that portfolio had been previously charged off as collection was deemed remote for portions of these loans. The total cumulative charge offs and specific reserves as of December 31, 2011 of $160.7 million represented an expected total loss of 33.8% of the legal balance of $475.5 million (the December 31, 2011 balance plus amounts previously charged off).

In the Other Commercial Finance portfolio, the areas with more credit risk than others are those that have comprised a greater degree of our historical charge offs. For the years ended December 31, 2011 and 2010, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception comprised 22% and 48%, respectively, of those years’ charge offs. As such, we believe commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception have a higher degree of credit risk than other lending products in our portfolio. As of June 30, 2012 and December 31, 2011, commercial real estate loans, excluding healthcare real estate loans, originated prior to the Bank’s July 2008 inception totaled $56.9 million and $101.1 million, respectively, or 7.1% and 9.8% of total loans, respectively. Additionally, cash flow based commercial loans originated prior to the Bank’s July 2008 inception are considered to be higher risk based on historical charge offs. For the years ended December 31, 2011 and 2010, cash flow based commercial loans originated prior to the Bank’s July 2008 inception comprised 55% and 40%, respectively, of those years’ charge offs. As of June 30, 2012 and

December 31, 2011, cash flow based commercial loans originated prior to the Bank’s July 2008 inception totaled $450.3 million and $588.7 million, respectively, or 56.2% and 56.9% of total loans, respectively.

During the three and six months ended June 30, 2012, loans with an aggregate carrying value of $5.3 million and $26.8 million, respectively, as of their respective restructuring dates, were involved in TDRs. During the three and six months ended June 30, 2011, loans with an aggregate carrying value of $57.3 million and $115.9 million, respectively, as of their respective restructuring dates, were involved in TDRs. Additionally, loans involved in these TDRs are assessed as impaired, generally for a period of at least one year following the restructuring, assuming the loan performs under the restructured terms and the restructured terms were at market. The specific reserves allocated to loans that were involved in TDRs were $2.1 million and $5.8 million as of June 30, 2012 and December 31, 2011, respectively.

Liquidity and Capital Resources

We separately manage the liquidity of CapitalSource Bank and the Parent Company as required by regulation. Our liquidity management is based on our assumptions related to expected cash inflows and outflows, including operating cash contingency balances that we believe are reasonable. These include our assumption that substantially all newly originated loans will be funded by CapitalSource Bank.

As of June 30, 2012, we had $1.2 billion of unfunded commitments to extend credit to our clients, of which $983.1 million were commitments of CapitalSource Bank and $186.3 million were commitments of the Parent Company. Due to their nature, we cannot know with certainty the aggregate amounts we will be required to fund under these unfunded commitments. In many cases, our obligation to fund unfunded commitments is subject to our clients’ ability to provide collateral to secure the requested additional fundings, the collateral’s satisfaction of eligibility requirements, our clients’ ability to meet specified preconditions to borrowing, including compliance with the loan agreements, and/or our discretion pursuant to the terms of the loan agreements. In other cases, however, there are no such prerequisites or discretion to future fundings by us, and our clients may draw on these unfunded commitments at any time. We forecast adequate liquidity to fund the expected borrower draws under these commitments.

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


78

CapitalSource Bank Liquidity

CapitalSource Bank’s primary sources of liquidity include deposits, payments of principal and interest on loans and securities, cash equivalents and borrowings from the FHLB SF. Secondary sources of liquidity may also include capital contributions and borrowings from the Parent Company, borrowings from banks or the FRB, loan sales and the issuance of debt securities. We intend to maintain sufficient liquidity at CapitalSource Bank to meet depositor demands and fund loan commitments and operations as well as to maintain liquidity ratios required by our regulators.

CapitalSource Bank’s primary uses of liquidity include funding new and existing loans, purchasing investment securities, funding net deposit outflows, paying operating expenses, paying income taxes pursuant to our intercompany tax allocation arrangement and paying dividends. CapitalSource Bank operates in accordance with the remaining conditions imposed and contractual agreements entered in connection with regulatory approvals obtained upon its formation, including requirements that CapitalSource Bank maintain a total risk-based capital ratio of not less than 15% and capital levels required for a bank to be considered “well- capitalized” under relevant banking regulations. In addition, we have a policy to maintain 7.5% of CapitalSource Bank’s assets in unencumbered cash, cash equivalents and investment securities, available-for-sale. In accordance with regulatory guidance, we have identified, modeled and planned for the liquidity impact of various hypothetical events and scenarios that would cause a large outflow of deposits, a reduction in borrowing capacity, and a material increase in loan funding obligations. We anticipate that CapitalSource Bank would be able to maintain sufficient liquidity and ratios in excess of its required minimum ratios in these events and scenarios. CapitalSource Bank has a contingency funding plan which contains the steps the Company would take to mitigate a liquidity crisis.

CapitalSource Bank’s primary source of liquidity is deposits, most of which are in the form of certificates of deposit. As of June 30, 2012, deposits at CapitalSource Bank were $5.4 billion. We utilize various product, pricing and promotional strategies in our deposit business, so that we are able to obtain and maintain sufficient deposits to meet our liquidity needs. For additional information, see Note 9, Deposits, in our audited consolidated financial statements for the year ended December 31, 2011, in our Form 10-K.

CapitalSource Bank supplements its liquidity with borrowings from the FHLB SF. As of June 30, 2012, CapitalSource Bank had financing availability with the FHLB SF equal to 35% of CapitalSource Bank’s total assets. The maximum financing available under this formula was $2.5 billion and $2.3 billion as of June 30, 2012 and December 31, 2011, respectively. The financing is subject to various terms and conditions including pledging acceptable collateral, satisfaction of the FHLB SF stock ownership requirement and certain limits regarding the maximum term of

debt. As of June 30, 2012, securities collateral with an estimated fair value of $377.2 million and loans with an unpaid principal balance of $661.8 million were pledged to the FHLB SF. Securities and loans pledged to the FHLB SF are subject to an advance rate in determining borrowing capacity.

As of June 30, 2012 and December 31, 2011, CapitalSource Bank had borrowing capacity with the FHLB SF based on pledged collateral as follows:


	June 30, 2012			December 31, 2011
	($ in thousands)
Borrowing capacity	$	895,023		$	838,531
Less: outstanding principal		(597,000	)		(550,000	)
Less: outstanding letters of credit		(300	)		(600	)
Unused borrowing capacity	$	297,723		$	287,931

CapitalSource Bank participates in the primary credit program of the FRB of San Francisco’s discount window under which approved depository institutions are eligible to borrow from the FRB for periods of up to 90 days. As of June 30, 2012, collateral with an estimated fair value of $88.0 million had been pledged under this program, and there were no borrowings outstanding under this program.

CapitalSource Bank also maintains a portfolio of available-for-sale investment securities. As of June 30, 2012, CapitalSource Bank had $217.4 million of unrestricted cash and cash equivalents and $741.9 million of unrestricted investment securities, available-for-sale. The available-for-sale investment portfolio comprises primarily highly liquid securities that can be sold and converted to cash if additional liquidity needs arise.

Parent Company Liquidity

The Parent Company’s primary sources of liquidity include cash and cash equivalents, income tax payments from CapitalSource Bank pursuant to our intercompany tax allocation arrangement, payments of principal and interest on loans, asset sales and, if permitted by banking regulations and guidelines, dividends from CapitalSource Bank. The Parent Company also has access to secondary sources of liquidity including bank borrowings and the issuance of debt and equity securities.

The Parent Company’s primary uses of liquidity include interest and principal payments on our existing debt, tax payments, share repurchases pursuant to our Stock Repurchase Program, debt repurchases, any dividends that we may pay and the funding of unfunded commitments. In July 2012, we repurchased the remaining outstanding 7.25% Convertible Debentures totaling $23.2 million and recognized no gain or loss on the extinguishment of debt.


79

Pursuant to agreements with our regulators, to the extent CapitalSource Bank independently is unable to do so, the Parent Company must maintain CapitalSource Bank’s total risk-based capital ratio at not less than 15% and must maintain the capital levels of CapitalSource Bank at all times to meet the levels required for a bank to be considered “well-capitalized” under the relevant banking regulations. Additionally, pursuant to requirements of our regulators, the Parent Company has provided a $150.0 million unsecured revolving credit facility to CapitalSource Bank that CapitalSource Bank may draw on at any time it or the FDIC deems necessary. As of June 30, 2012, there were no amounts outstanding under this facility.

In December 2010, our Board of Directors authorized the repurchase of up to $150.0 million of our common stock over a period of up to two years, and through June 30, 2012, our Board of Directors authorized the repurchase of an additional $635.0 million of our common stock during such period (in aggregate, the “Stock Repurchase Program”). During the three months ended June 30, 2012, we repurchased 11.5 million shares of our common stock under the Stock Repurchase Program at an average price of $6.48 per share for a total purchase price of $74.6 million. During the six months ended June 30, 2012, we repurchased 30.5 million shares of our common stock under the Stock Repurchase Program at an average price of $6.68 per share for a total purchase price of $203.7 million. Any share repurchases made under the Stock Repurchase Program will be made through open market purchases or privately negotiated transactions. The amount and timing of any repurchases will depend on market conditions and other factors and repurchases may be suspended or discontinued at any time. All shares repurchased under the Stock Repurchase Program were retired upon settlement.

For additional information, see Note 12, Shareholders’ Equity, in our audited consolidated financial statements for the year ended December 31, 2011, in our Form 10-K.

Special Purpose Entities

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

We evaluate all SPEs with which we are affiliated to determine whether such entities must be consolidated for financial statement purposes. If we determine that such entities represent variable interest entities, we consolidate these entities if we also determine that we are the primary beneficiary of the entity. For special purpose entities for which we determine we are not the primary beneficiary, we account for our economic interests in

these entities in accordance with the nature of our investments. The assets and related liabilities of all special purpose entities that we use to issue our term debt are recognized in our accompanying audited consolidated balance sheets as of June 30, 2012 and December 31, 2011.

Commitments, Guarantees & Contingencies

As of June 30, 2012 and December 31, 2011, we had unfunded commitments to extend credit to our clients of $1.2 billion and $1.4 billion, respectively. Additional information on these contingencies is included in Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2011, included in our Form 10-K, and Liquidity and Capital Resources herein.

We have non-cancelable operating leases for office space and office equipment, which expire over the next twelve years and contain provisions for certain annual rental escalations. For additional information, see Note 19, Commitments and Contingencies, in our audited consolidated financial statements for the year ended December 31, 2011, in our Form 10-K.

We provide standby letters of credit in conjunction with several of our lending arrangements. As of June 30, 2012 and December 31, 2011, we had issued $52.3 million and $79.4 million, respectively, in letters of credit which expire at various dates over the next 8.5 years. If a borrower defaults on its commitment(s) subject to any letter of credit issued under these arrangements, we would be responsible to meet the borrower’s financial obligation and would seek repayment of that financial obligation from the borrower. These arrangements had carrying amounts totaling $1.1 million and $1.7 million as of June 30, 2012 and December 31, 2011, respectively, and are included in other liabilities. We also provide standby letters of credit under certain of our property leases.

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

During the years ended December 31, 2010 and 2009, we sold all of our remaining direct real estate investment properties. We are responsible for indemnifying the current owners for any remediation, including costs of removal and disposal of asbestos that existed prior to the sales, through the third anniversary date


80

of the sale. We will recognize any remediation costs if notified by the current owners of their intention to exercise their indemnification rights, however, no such notification has been received to date. As of June 30, 2012, sufficient information was not available to estimate our potential liability for conditional asset retirement obligations as the obligations to remove the asbestos from these properties continue to have indeterminable settlement dates.

Credit Risk Management

Credit risk within our loan portfolio is the risk of loss arising from adverse changes in a borrower’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. The degree of credit risk will vary based on many factors, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral. We manage credit risk of our derivatives and credit-related arrangements by limiting the total amount of arrangements outstanding with an individual counterparty, by obtaining collateral based on the nature of the lending arrangement and management’s assessment of the client, and by applying uniform credit standards maintained for all activities with credit risk.

Credit risk is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. Credit risk exists primarily in our loan, lease and derivative portfolios and the portion of our investment portfolio comprised of non-agency MBS, non-agency ABS and CMBS. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral. We manage credit risk of our derivatives and credit-related arrangements by limiting the total amount of arrangements outstanding with an individual counterparty, by obtaining collateral based on the nature of the lending arrangement and management’s assessment of the client, and by applying uniform credit standards maintained for all activities with credit risk.

As appropriate, various committees evaluate and approve credit standards and oversee the credit risk management function related to our loans and other investments. Its primary

responsibilities include ensuring the adequacy of our credit risk management infrastructure, overseeing credit risk management strategies and methodologies, monitoring economic and market conditions having an impact on our credit-related activities and evaluating and monitoring overall credit risk and monitoring our client’s financial condition and performance.

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

Our underwriting guidelines outline specific underwriting standards and minimum specific risk acceptance criteria for each lending product offered. Loan types defined within these guidelines are broadly categorized as asset-based loans, cash flow loans and real estate loans (commercial real estate and real estate construction loans), and each of these broad categories has specific subsections that define in detail the following:

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

Collateral descriptions and appropriate valuation methods;

Underwriting considerations which include minimum diligence and verification requirements; and

Specific risk acceptance criteria which enumerate for each loan type the minimum acceptable credit performance standards. Examples of these criteria include maximum loan-to-value amounts for real estate loans, maximum advance rate amounts for asset-based loans and minimum historical and projected debt service coverage amounts for all loans.

We measure and document each loan’s compliance with our specific risk acceptance criteria at underwriting. If at underwriting, there is an exception to these criteria, an explanation of the factors that mitigate this additional risk is considered before an approval is granted. Upon the amendment of any loan agreement, we also measure a loan’s compliance with our specific risk acceptance criteria. A record of which loans have exceptions to our specific risk acceptance criteria at underwriting is maintained.

We continuously monitor a client’s ability to perform under its obligations. Additionally, we manage the size and risk profile of our loan portfolio by syndicating loan exposure to other lenders and selling loans.


81

Under our credit risk management process, each loan is assigned an internal risk rating that is based on defined credit review standards. While rating criteria vary by product, each loan rating focuses on: the borrower’s financial performance and financial standing, the borrower’s ability to repay the loan, and the adequacy of the collateral securing the loan. Subsequent to loan origination, risk ratings are monitored and reassessed on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the client’s financial condition, cash flow or financial position. We use risk rating aggregations to measure credit risk within the loan portfolio. In addition to risk ratings, we consider the market trend of collateral values and loan concentrations by borrower industries and real estate property types (where applicable).

Concentrations of Credit Risk

In our normal course of business, we engage in lending activities with clients primarily throughout the United States. As of June 30, 2012, the largest borrower industry concentrations in our outstanding loan balance were real estate, rental and leasing; health care and social assistance; and timeshare which represented approximately 20.4%, 19.4% and 9.8% of the outstanding loan portfolio, respectively.

Apart from the borrower industry concentrations, loans secured by real estate represented approximately 41% of our outstanding loan portfolio as of June 30, 2012. Within this area, the largest property type concentration was the multifamily category, comprising approximately 31% and the largest geographical concentration was in California, comprising approximately 24% of this loan portfolio.

Selected information pertaining to our largest credit relationships as of June 30, 2012 was as follows:


Loan Balance		% of Total Portfolio			Loan Type	Industry	Amount of Loan(s) at Origination		Loan Commitment		Performing		Specific Reserves		Underlying Collateral⁽¹⁾	Date of Last Collateral Appraisal	Amount of Last Appraisal
($ in thousands)
	$192,016		3.2	%	Commercial	Timeshare	$	173,663	$	215,240		Yes	$	—	Timeshare receivables	N/A		N/A	⁽²⁾

	94,403		1.6		Real Estate	Resort Vacation Club		93,972		103,524		Yes		—	Portfolio of vacation properties	Various ranging from November 2008 to May 2011		523,404	⁽³⁾

	91,283		1.5		Real Estate	Health Care and Social Assitance		400,000		91,283		Yes		—	Nursing care facilities	May 2010		458,500	⁽⁴⁾
	$377,702		6.3	%			$	667,635	$	410,047			$	—

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

⁽²⁾

The collateral that secures our loan balance of $192.0 million as of June 30, 2012 primarily consists of timeshare receivables and timeshare real estate that had a total value of $632.1 million as of June 30, 2012. Total senior debt, including our loan balance, secured by the collateral was $255.6 million as of June 30, 2012.

⁽³⁾	Total senior debt, including our loan balance, was $247.2 million as of June 30, 2012.

⁽⁴⁾	Total senior debt, including our loan balance, was $360.6 million as of June 30, 2012.

Non-performing loans include all loans on non-accrual status and accruing loans which are contractually past due 90 days or more as to principal or interest payments. There were 111 credit relationships in the non-performing portfolio as of June 30, 2012, and our largest non-performing credit relationship totaled $33.2 million and comprised 16% of our total non-performing loans.

Derivative Counterparty Credit Risk

Derivative financial instruments expose us to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where we are in a favorable position. Credit risk related to derivative financial instruments is considered and provided for separately from the allowance for loan and lease losses. We manage the credit risk associated with various derivative agreements through counterparty credit review and monitoring procedures. We obtain collateral from all


82

counterparties based on terms stipulated in the collateral support annex. We also monitor all exposure and collateral requirements daily on a per counterparty basis. We continually monitor the fair value of collateral received from counterparties and may request additional collateral from counterparties or return collateral pledged as deemed appropriate. Our agreements generally include master netting agreements whereby the counterparties are entitled to settle their derivative positions “net.” As of June 30, 2012 and December 31, 2011, the gross positive fair value of our derivative financial instruments was $0.2 million and $59.1 million, respectively. Our master netting agreements reduced the exposure to this gross positive fair value by $0.2 million and $40.3 million as of June 30, 2012 and December 31, 2011, respectively. We held $18.8 million of collateral against derivative financial instruments as of December 31, 2011. We held no collateral as of June 30, 2012.

Market Risk Management

Market risk is the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions such as interest rate fluctuations. This risk is inherent in the financial instruments associated with our operations and/or activities, including loans, securities, short-term borrowings, long-term debt, trading account assets and liabilities and derivatives.

The primary market risk to which we are exposed is interest rate risk, which is inherent in the financial instruments associated with our operations, primarily including our loans and borrowings. Our traditional loan products are non-trading positions and are reported at amortized cost. Additionally, debt obligations that we incur to fund our business operations are recorded at historical cost. While GAAP requires a historical cost view of such assets and liabilities, these positions are still subject to changes in economic value based on varying market conditions.

Interest Rate Risk Management

Interest rate risk refers to the timing and volume differences in the re-pricing of our rate-sensitive assets and liabilities, changes in the general level of market interest rates and changes in the shape and level of various indices, including LIBOR-based indices and the prime rate. We attempt to mitigate exposure to the earnings impact of the interest rate changes by conducting the majority of our loan and deposit activity using interest rate structures that resets on a periodic basis. The majority of our loan portfolio bears interest at a spread to the LIBOR rate or a prime-based rate with most of the remainder bearing interest at a fixed rate. The majority of the deposit portfolio is comprised of certificates of deposits that generally have an initial term between 3 and 18 months. Our investment and borrowings portfolios are used to offset a portion of the remaining re-pricing risk that exists between our loans and deposits.

The estimated changes in net interest income for a twelve-month period based on changes in the interest rates applied to the combined portfolios of our segments as of June 30, 2012, were as follows ($ in thousands):


Rate Change (Basis Points)
+ 200	$	16,621
+ 100		1,167
- 100		4,227
- 200		4,123

For the purpose of the above analysis, CapitalSource Bank loans, investment securities, borrowings, and deposits are assumed to be replaced as they run off. The new loans, investment securities, borrowings and deposits are assumed to have interest rates that reflect our forecast of prevailing market terms. We also assumed that LIBOR and prime rates do not fall below 0% for loans and borrowings. Parent Company loans, investment securities and borrowings are assumed to convert to cash as they run off.


83

As of June 30, 2012, approximately 60% of the aggregate outstanding principal amount of our loans had interest rate floors and were accruing interest. Of the loans with interest rate floors and accruing interest, approximately 94% had contractual rates below the interest rate floor and the floor was providing a benefit to us. The loans with contractual interest rate floors as of June 30, 2012 were as follows:


	Amount Outstanding		Percentage of Total Portfolio
	($ in thousands)
Loans with contractual interest rates:
Below the interest rate floor	$	3,414,439		56	%
Exceeding the interest rate floor		98,105		2
At the interest rate floor		125,233		2
Loans with interest rate floors on non-accrual		84,028		1
Loans with no interest rate floor		2,347,805		39
Total	$	6,069,610		100	%

We enter into basis swap agreements to hedge basis risk between our LIBOR-based term debt and the prime-based loans pledged as collateral for that debt. These basis swaps modify our exposure to interest rate risk by synthetically converting prime rate loans to one-month LIBOR. Our basis swap agreements partially protect us from the risk that interest collected under prime rate loans will not be sufficient to service the interest due under the one-month LIBOR-based term debt.

We have also entered into relatively short-dated forward exchange agreements to minimize exposure to foreign currency risk arising from foreign currency denominated loans.

Critical Accounting Policies

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

There have been no significant changes during the three months ended June 30, 2012 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Estimates within Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Form 10-K for the year ended December 31, 2011.

Supervision and Regulation

This is an update to certain sections from our discussion of Supervision and Regulation in our Form 10-K. For further information and discussion of supervision and regulation matters, see Item I. Business — Supervision and Regulation, in our Form 10-K for the year ended December 31, 2011. Together with the discussion of supervision and regulation matters in our Form 10-K for the year ended December 31, 2011, the following describes some of the more significant laws, regulations, and policies that affect our operations, but is not intended to be a complete listing of all laws that apply to us. From time to time, federal, state and foreign legislation is enacted and regulations are adopted which may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. We cannot predict whether or when potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations.


84

Our bank operations are subject to regulation by federal and state regulatory agencies. This regulation is intended primarily for the protection of depositors and the deposit insurance fund, and secondarily for the stability of the U.S. banking system. It is not intended for the benefit of stockholders of financial institutions. CapitalSource Bank is a California industrial bank and is subject to supervision and regular examination by the FDIC and the DFI. CapitalSource Bank’s deposits are insured by the FDIC up to the maximum amounts permitted by law.

Although the Parent Company is not directly regulated or supervised by the DFI, the FDIC, the FRB or any other federal or state bank regulatory authority either as a bank holding company or otherwise, the FDIC has authority pursuant to a contractual supervisory agreement with the Parent Company (the “Parent Company Agreement”) to examine the Parent Company, the relationship and transactions between it and CapitalSource Bank and the effect of such relationships and transactions on CapitalSource Bank. The Parent Company also is subject to regulation by other applicable federal and state agencies, such as the Securities and Exchange Commission. We are required to file periodic reports with these regulators and provide any additional information that they may require.

The international Basel Committee on Banking Supervision published the final text of Basel III on December 16, 2010 with revisions to update capital rules on June 1, 2011. The Basel III requirements will be implemented starting January 1, 2013 and its adoption will be phased-in over an extended period of time from 2013 through 2019. From January 1, 2013 onwards, banks will have to meet the following minimum capital requirements expressed in risk-weighted assets: 3.5% share capital, 4.5% Tier-1 capital and 8% total capital. During the transition period, these ratios will gradually be stepped up to 4.5% share capital, 6% Tier-1 capital and 8% total capital. The total capital ratio will be built-up with increases along gradual lines from 0.625% at January 1, 2016 to 2.5% at January 1, 2019. As a result, banks will ultimately have to hold 10.5% of their total capital expressed in risk-weighted assets as of January 1, 2019.

In addition, the international Basel Committee on Banking Supervision will begin to introduce minimum standards over bank leverage, liquidity coverage and net stable funding ratios after specified monitoring and observation periods. The Basel Committee on Banking Supervision will introduce the leverage ratio after an initial phase-in period starting January 1, 2013 with complete migration in effect by January 1, 2018. The liquidity coverage ratio and net stable funding ratio minimum standards will be in effect by January 1, 2015 and January 1, 2018, respectively.

We will continue to monitor developments relating to Basel III adoption in the U.S. and its potential impact on our operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain financial market risks, which are discussed in detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Market Risk Management section of this Form 10-Q and our Form 10-K. In addition, for additional information on our derivatives, see Note 15, Derivative Instruments, in our consolidated financial statements for the three and six months ended June 30, 2012, and Note 22, Credit Risk, in our audited consolidated financial statements for the year ended December 31, 2011 included in our Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2012. There have been no changes in our internal control over financial reporting during the three and six months ended June 30, 2012, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


85

Part II. Other Information

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

A summary of our repurchases of shares of our common stock for the three months ended June 30, 2012 was as follows:


	Total Number of Shares Purchased⁽¹⁾		Average Price Paid		Total Number of Shares Purchased as Part of Publicly Announced Plan or Programs⁽²⁾		Maximum Number of Shares (or Approximate Dollar Value) that May Yet be Purchased Under the Plans⁽²⁾
April 1 – April 30, 2012		5,023,000	$	6.55		5,023,000		—
May 1 – May 31, 2012		57,519		6.68		—
June 1 – June 30, 2012		6,504,902		6.42		6,484,600		—
Total		11,585,421	$	6.48		11,507,600	$	131,201,738

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

⁽²⁾

In December 2010, our Board of Directors authorized the repurchase of up to $150.0 million of our common stock over a period of up to two years. Subsequently, our Board of Directors authorized the repurchase of an additional $635.0 million of our common stock during such period (in the aggregate, the “Stock Repurchase Program”). In June we repurchased 6,984,600 shares of our common stock under the Stock Repurchase Program at an average price of $6.43 per share for a total purchase price of $44.9 million. Of these purchases, purchases of 500,000 shares at an average price of $6.53 per share were settled in July 2012 which, for accounting purposes, were recorded in June 2012. Any share repurchases made under the Stock Repurchase Program will be made through open market purchases or privately negotiated transactions. The amount and timing of any repurchases will depend on market conditions and other factors and repurchases may be suspended or discontinued at any time. All shares repurchased under the Stock Repurchase Program were retired upon settlement.

Item 5. Other Information

On July 30, 2012, CapitalSource Bank filed its Consolidated Reports of Condition and Income for A Bank With Domestic Offices Only — FFIEC 041, for the quarter ended June 30, 2012 (the “Call Report”) with the Federal Deposit Insurance Corporation (“FDIC”).

Our Chairman, John K. Delaney, has founded Alliance Partners, an asset management and services firm which manages BancAlliance, a bank-controlled cooperative which helps member banks diversify loan portfolios, access a broader range of asset opportunities and manage their commercial real estate concentrations. The Company Board believes that it is in the best interest of the Company and our shareholders for Mr. Delaney to continue to serve on our Board of Directors, and has determined that the current activities of Alliance Partners and BancAlliance are not in competition with the Company or in conflict with Mr. Delaney’s responsibilities to the Company. The Company Board has approved Mr. Delaney’s serving as a director of Alliance Partners and BancAlliance and, on August 3, 2012, granted a Code of Conduct waiver to Mr. Delaney with respect to any of his current activities in connection with Alliance Partners, BancAlliance or their affiliates that are, or could be deemed to be, or result in an appearance of conflict with any provision of, or under, our Code of Conduct.

Item 6. Exhibits

(a)

Exhibits

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


86

Signatures

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


		CAPITALSOURCE INC.

Date: August 6, 2012		/s/ JAMES J. PIECZYNSKI
		James J. Pieczynski
		Director and Chief Executive Officer (Principal Executive Officer)

Date: August 6, 2012		/s/ JOHN A. BOGLER
		John A. Bogler
		Chief Financial Officer (Principal Financial Officer)

Date: August 6, 2012		/s/ MICHAEL A. SMITH
		Michael A. Smith
		Senior Vice President and Chief Accounting Officer (Principal Accounting Officer)


87

INDEX TO EXHIBITS


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

†	Filed herewith.

*	Management contract or compensatory plan or arrangement.


88