For This REIT, Bank Status Is Worth the Tax

CapitalSource Inc. enjoys a tax advantage as a real estate investment trust, but it is willing to give that up to accelerate loan growth, lower its funding costs, and gain access to a larger infusion of government capital.

The Chevy Chase, Md., commercial finance company entered the banking business when it established an industrial loan company in July, and it has been so pleased with the results that it wants to shed its REIT status and convert to a bank holding company.

CapitalSource is already flush with capital, but as a bank holding company it would have a platform to gather even more deposits, which it would use to lend more to middle-market businesses, said Tad Lowrey, the president and chief executive of CapitalSource Bank in Pasadena, Calif.

The conversion would also put the $19 billion-asset CapitalSource in better position to buy more banks.

CapitalSource Bank was formed when the parent company bought $5.6 billion of deposits, 22 branches, and some assets from Fremont Investment and Loan, an industrial loan company owned by Fremont General Corp. in Brea, Calif.

Now Mr. Lowrey said CapitalSource is on the lookout for other "opportunistic" deals. "We have lots of liquidity and lots of capital, and we plan to be more aggressive in 2009," he said.

CapitalSource has already won approval from California regulators and the Federal Deposit Insurance Corp. to convert its industrial loan company charter to a commercial bank charter, but before it can do so it must get approval from the Federal Reserve Board to become a bank holding company. Mr. Lowrey said it expects the holding company application, filed in early November, to be approved any day.

CapitalSource is not alone among specialty finance companies seeking bank holding company charters. As funding from the capital markets has evaporated, several of them — along with some investment banks and insurers — have applied to become bank holding companies so they can offer retail deposits.

But CapitalSource was angling for deposit-based funding long before the capital markets seized up. In May 2007 it agreed to acquire TierOne Corp., a Lincoln, Neb., thrift company, but the deal collapsed after the credit crisis worsened. Last spring it dropped its bid to charter a Utah industrial loan company, citing unfavorable regulatory conditions.

Events started to break CapitalSource's way shortly after that when it agreed to acquire pieces of the troubled Fremont.

Growth in loan originations had been slowing for several quarters, but since forming the bank, CapitalSource has originated or received commitments for a total of $700 million of new commercial loans, primarily in the health-care sector. Of the roughly $276 million it originated in the third quarter, 45% were funded by bank deposits.

In a November conference call with analysts, John Delaney, the chairman and CEO of CapitalSource Inc., said that for lenders with "real liquidity," conditions for making new loans to middle-market customers are extraordinary.

"As one of my colleagues said recently, it is almost like selling oxygen on the moon," Mr. Delaney said. "No competition and you can name your price."

Without the deposit-based funding, CapitalSource likely would have pulled the reins tighter, said Robert Napoli, an analyst at Piper Jaffray & Co. in Chicago.

"I doubt that they would be growing loans right now if they didn't have the bank," Mr. Napoli said. "They would be shrinking their balance sheet."

Most of the company's new loans are being made through CapitalSource Bank, which at Sept. 30 had a total risk-based capital-to-assets ratio above 16%.

Though liquidity is not a concern at the moment, CapitalSource has applied to participate in the Treasury Department's Capital Purchase Program. Its $6.1 billion-asset bank unit is eligible to receive a maximum of $140 million, but Mr. Lowrey said the hope is that the parent will be approved as a holding company and thus be eligible for a larger infusion.

In the long term, the parent's conversion to a bank holding company and the bank's switch to a commercial charter would allow CapitalSource to offer more deposit products.

As banking assets grow, CapitalSource expects its funding costs to fall, Mr. Lowrey said. Those costs fell by 20 basis points in the third quarter, to 5.2%, but are still well above the average bank's cost of funds.

"We are a finance company that realized the value of bank deposits a while ago," Mr. Lowrey said. "We think it is a safer, more stable business model."

Though its efforts to find deposit-based funding predate the credit crunch, CapitalSource likely would have reassessed its business model in the current economy anyway, said David Chiaverini, an analyst with Bank of Montreal's BMO Capital Markets Corp.

"They were ahead of the curve in stabilizing their funding sources in anticipation of an environment like the one we have now," Mr. Chiaverini said. "If they didn't get it, they probably would be scrambling. Being dependent on others for funds is tough right now."

CapitalSource earned $74.9 million in the first nine months of 2008, down nearly 61% from the previous year. It attributed the drop to a more than 2,300% increase in its loan-loss provision — to $147.6 million at Sept. 30 — and a $73.3 million loss on its residential mortgage investment portfolio.

CapitalSource intends to sell its mortgage investment portfolio as part of its transition from a REIT to a bank holding company.

Mr. Lowrey said that if the holding company application is approved, CapitalSource will try to increase assets to around $25 billion within three to five years.

Though CapitalSource is eager to build the banking side of the business, Mr. Lowrey said the banking unit has no real intention of becoming a traditional in-market lender. Rather, it is relying on the parent company to bring it loan candidates from across the country, with the bank having the final say on whether to accept or reject the loan.

Mr. Chiaverini said CapitalSource is unlikely to do any "large-scale acquisitions" soon. It will probably seek deals similar to the Fremont one, in which it buys only the segments it wants, he said.

Mr. Lowrey would not disclose if the company is in negotiations with any institutions, but he said it is interested in "strategic acquisitions" that would help broaden its offering of services to business customers. Fed approval on its holding company application would allow it to offer checking accounts, lockboxes, and cash management, among other things, but Mr. Lowrey said it could ramp up in those areas faster by acquiring a bank.

"Having the authority to do something and the ability to do something are two different things," he said.

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