Fitch Upgrades CapitalSource Inc., Affirms CapitalSource Bank; Outlook Remains Stable

NEW YORK--(BUSINESS WIRE)--

Fitch Ratings has upgraded CapitalSource Inc.'s (CSE) long-term Issuer Default Rating (IDR) and senior subordinated debt rating to 'BB' and 'BB-', respectively, and affirmed the long-term IDR of its wholly-owned bank subsidiary, CapitalSource Bank (CSB) at 'BB'. The Rating Outlook remains Stable. A complete list of ratings is provided below.

Fitch's rating action reflects improving asset quality trends in CSE's legacy loan portfolio, resulting in a reduction in loss provisioning and subsequent improvement in operating performance. Fitch believes CSE's liquidity profile has strengthened over the last year due to substantial repayment of parent company debt. Given existing cash balances relative to near-term funding requirements, Fitch views CSE's liquidity to be more than sufficient.

Fitch has equalized the IDR of CSE to that of its bank subsidiary to reflect the significant progress CSE has made since last year to reduce debt at the parent company. Through cash proceeds received from the liquidation of CSE's legacy loan portfolio, the company repaid nearly 62% of its outstanding debt in 2011. Total debt at CSE and its nonbank subsidiaries declined to $774 million as of year-end 2011 compared to $959 billion at year-end 2010. An additional $29 million of debt will mature in 2012 from the balance remaining on its 7.25% convertible senior subordinated debt, which CSE can redeem at par beginning July 2012. As a result of the significant deleveraging, Fitch has also upgraded the credit ratings of CSE's senior subordinate debt, reflecting the above-average recovery prospects in the event of liquidation.

The affirmation of CSB's IDR at 'BB' reflects the bank's solid liquidity and capitalization profile relative to its peers, offset by unseasoned performance of new bank originations, reliance on spread income, poor but improving asset quality of legacy loan exposures, and a rate-sensitive deposit base. Fitch believes CSB's planned bank charter conversion is reasonable, but there remain potential regulatory and execution risks. Absent approval by the regulators, Fitch notes CSB's funding platform will likely remain narrow and rate-sensitive due to the nature of CSB's funding base, which is primarily comprised of short-term, retail certificates of deposit.

Overall asset quality continued to improve in 2011 as compared to 2010. Asset quality metrics bottomed during the first half of 2010, attributed to the underperformance of CSE's legacy loan portfolio. Total delinquencies (30+ days) continued to improve through 2011, decreasing to $109 million at year-end 2011 compared to $349 million at year-end 2010. Non-accruing and impaired loans also showed improvement, totaling $281 million and $425 million, respectively, in 2011 compared to $699 million and $931 million, respectively, in 2010. On a trailing 12-month basis, charge-offs declined to $268 million at year-end 2011 compared to $426 million one year prior.

Overall loss reserves as a percentage of the loan portfolio totaled 2.67% at Dec. 31, 2011, which is significantly lower than 5.17% at Dec. 31, 2010, reflecting improved asset quality performance. Given the positive trends, the company continued to release loss reserves through 2011. Assuming current credit quality trends continue to improve, Fitch believes CSE has adequately reserved for potential future losses. However, Fitch notes that weakness or deterioration beyond current expectations, particularly in the remaining legacy loan exposure, may continue to have an adverse effect on CSE's financial performance and possibly generate negative ratings momentum.

As mentioned, CSE's consolidated financial performance improved in 2011 benefitting from improved asset quality metrics and a significant decline in loss provisioning as compared to the prior three years. CSE reported pre-tax operating losses on continuing operations of $15 million in 2011 compared to losses of $161 million and $775 million for the years ended 2010 and 2009, respectively. On a standalone basis, CSB's financial performance and profitability over the last two years have been similarly affected by the poor performance trends of the bank's portion of the legacy loan portfolio, but to a much lesser degree relative to its parent. CSE reported pre-tax operating profit of $171 million at year-end 2011 compared to $65 million in 2010, which was primarily attributed to increased net interest income generated from significant loan growth. Fitch expects near-term profitability to be constrained by tail risk associated with the performance of the remaining legacy loan book and nonperforming assets. However, Fitch believes CSE will return to profitability as the company works through its problem loans and lending volume increases at CSB.

Fitch believes CSB's capital base is solid and of good quality, as compared to similarly rated peers. However, given asset quality concerns with respect to CSE's legacy loan portfolio, Fitch believes a capital base of CSE's current size is appropriate to support CSB's current ratings. In connection with the FDIC's consent order, CSB must maintain a minimum total risk-based capital ratio of at least 15%, a minimum Tier-1 risk-based capital ratio of at least 6% and a minimum Tier-1 leverage ratio of at least 5%. At Dec. 31, 2011, CSB's ratios exceeded these requirements, at 17.43%, 16.17% and 13.61%, respectively.

The Rating Outlook remains Stable in connection with Fitch's rating actions, reflecting improving credit trends, adequate bank capitalization, improved liquidity and progress liquidating the legacy loan portfolio.

Fitch believes positive rating momentum with respect to CSE is limited over the near- to medium-term due to potential execution risks associated with the company's planned charter conversion and subsequent limited funding profile as an industrial bank. Although CSB benefits from its current asset-light strategy and 'sticky' deposit base, Fitch believes CSB will gain additional funding flexibility from longer-term deposits post-charter conversion. In addition, consistency in earnings at CSE on a consolidated basis and solid asset quality trends in the overall portfolio will also be viewed positively by Fitch.

Conversely, negative rating actions could result from additional deterioration in asset quality beyond existing reserve and capitalization levels, particularly stemming from the remaining legacy loan portfolio. In addition, Fitch would view negatively continued operating losses, a reduction in liquidity relative to outstanding debt, or reduced capitalization levels. A decline in CSB's competitive position or an inability to grow origination volumes could also yield negative rating actions.

CapitalSource Inc. CSE, through its subsidiary CapitalSource Bank (CSB), is a commercial lender providing financial products to small and middle market businesses nationwide and provides depository products and services through its 21-branch network in southern and central California. The company maintains its corporate headquarters in Los Angeles, California with key offices nationwide dedicated to its loan origination efforts. As of Dec. 31, 2011, CSE had total consolidated assets of $8.3 billion, including loans of $5.7 billion and deposits of $5.1 billion.

Fitch has upgraded the following ratings with a Stable Outlook:

CapitalSource Inc.

-- Long-term IDR to 'BB' from 'BB-';

-- Senior subordinate to 'BB-' from 'B+'.

Fitch has affirmed the following ratings with a Stable Outlook:

CapitalSource Bank

-- Long-term IDR at 'BB';

-- Short-term IDR at 'B';

-- Viability Rating at 'bb';

-- Support at '5';

-- Support Floor at 'NF'

-- Short-term deposits at 'B'

-- Long-term deposits at 'BB+'.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

Applicable Criteria and Related Research:

--'Global Financial Institutions Rating Criteria' (Aug. 16, 2011);

--'Bank Holding Companies' (Aug. 16, 2011);

--'Viability Ratings: An Introductory Primer' (July 20, 2011);

--'Finance and Leasing Companies Criteria' (Dec. 12, 2011);

--'U.S. Banking Quarterly Review: 4Q11 (Now For the Cost Cutting)' (Feb. 28, 2012);

--'2012 Outlook: U.S. Finance and Leasing Companies' (Dec. 19, 2011).

Applicable Criteria and Related Research:

Global Financial Institutions Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=649171

Bank Holding Companies

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648612

Viability Ratings: An Introductory Primer

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=645609

Finance and Leasing Companies Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=659834

U.S. Banking Quarterly Review: 4Q11 (Now For the Cost Cutting)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=671289

2012 Outlook: U.S. Finance and Leasing Companies

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=659850

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE.