CapitalSource Part Four: The Commercial Portfolio
Over the past several days, I’ve looked at CapitalSource Bank, CapitalSource’s Health Care Real Estate Portfolio, and CapitalSource’s equity in securitization residuals. The equity in each component of these businesses is $916 million, $650 million, and $910 million respectively. All of this for a company with a market capitalization of less than $500 million.
From a liability perspective, only the securitization residuals have required any capital. Despite the $4.6 billion in loan assets being match funded by approximately $3.6 billion in loans within six separate special purpose entities, CapitalSource has in the past purchased $162 million in problem loans from these trusts to preserve the credit quality of these issues. So the question remains, why is CapitalSource priced at such a small fraction of their book value?
Parent Commercial Loan Portfolio
In their annual report, CapitalSource notes that they have a commercial loan portfolio that totals $9.5 billion. However, this includes commercial loans in both CapitalSource Bank and the securitization trusts that technically do not result in liabilities to CapitalSource. In their year-end earnings call, CapitalSource notes that $2.2 billion of this total are loans held at CapitalSource Bank, and $4.6 billion are loans held in securitizations, leaving about $2.6 billion held at the parent level. The conference call notes $2.3 billion.
Liabilities at the parent company level have to be calculated as well. The conference call transcript has the best summary of this information. The majority of the almost $7 billion in total debt outstanding is matched to various asset pools and is not recourse to CapitalSource. The syndicated credit facility totaling $972 million is the one exception. The syndicated facility is secured by $1.6 billion in loans.
The web of credit facilities and matched collateral is difficult to map out. In my opinion, this coupled with the covenant modifications on their syndicated facility provide the bulk of the reason behind the low price to book ratio. CapitalSource has $473 million in structured facilities secured by $950 million in commecial loans. These facilities are as follows:
| Facility | Capacity | Balance | Maturity |
|---|---|---|---|
| CS III | $100MM | $74MM | 4/29/09 |
| CS Europe | $175MM | $166MM | 9/23/09 |
| CS VII | $285MM | $177MM | 3/31/10 |
| CSE QRS I | $250MM | $16MM | 4/24/10 |
| CS VIII | $40MM | $40MM | 7/19/10 |
There have been no announcements regarding the combining or refinance of these facilities, though they are not recourse to CapitalSource. Still, they are secured by $950 million in loans and CapitalSource remains at the mercy of their lenders to renew or extend these facilities. It would be nice to see an announcement soon regarding the credit facility maturing at the end of April.
The reliance on these facilities is a risk for CapitalSource. In addition to these facilities, CapitalSource has a syndicated credit facility totaling $995 million that is recourse to CapitalSource. This facility matures March 13, 2010 and has step-down provisions to $900MM by June 30, 2009 and $700MM by December 31, 2009. In December 2008, this syndicated facility had to be amended to provide more flexibility for charge-offs. As part of this amendment, the facility was collateralized, and the rate was increased. Then in the first quarter of this year, the syndicated (recourse) facility was again amended to avoid a default under the interest average covenant due to loss provisions.
These credit facilities all appear to be well-secured based on collateral margins, but they are secured by commercial loans. CapitalSource has traditionally tended to be further out on the risk spectrum to gain higher yields to offset their funding costs. Now, when CapitalSource needs loan repayment most to meet their own obligations, credit quality in their portfolio is the most strained.
CapitalSource Bank helped to offset some of the funding cost issues, but they still remain at the parent level. Now de-leveraging is very important to remove the risks of these facilities at a time when lending is constrained. CapitalSource must look to their more stable business units to help in the deleveraging process. CapitalSource Bank will likely retain all their earnings over the next 2-3 years. So liquidity will have to come from the real estate portfolio, securitization residuals, and the parent loan portfolio.
In their conference call, management noted that they had $265 million in liquidity at year-end, though this includes both cash and amounts available under their lines. Investors were told that CapitalSource has sufficient liquidity to meet their obligations, though management’s assumptions were not shared. Cash flow is difficult to break-out, especially considering the Bank will retain their earnings. In the fourth quarter, CapitalSource reported $145MM in net investment income before provisions for losses. Assuming one-third of this comes from CapitalSource Bank leaves about $100 million in quarterly cash flow to pay down their lines. Assuming the lines maturing 4/30/09 and 9/23/09 are renewed or extended, it looks like management’s assessment of liquidity is correct. Through 2009, $400 million in net investment income will allow CapitalSource to step down to their $700 million line balance by year-end.
Other Considerations
Liquidity is the primary focus for the company, or it should be. The syndicated facility has step down provisions requiring significant paydowns over the next year. So it was only somewhat surprising to see CapitalSource issue stock at $3.15 per share to raise about $61 million in liquidity. This, however, was followed by the board authorizing a $25 million buyback.
To construct the four components of CapitalSource was no easy task. The annual report for the company is 195 pages long, and appears to obfuscate rather than explain with any reasonable clarity. The commercial loan portfolio is often discussed as a whole rather than being divided between a bank, securitized pools, and collateral for various credit facilities. Hopefully management at CapitalSource can better clarify the holdings of the company and where the risks lie in the future.
Investors have certainly been waiting for positive news regarding the refinance or consolidation of CapitalSource’s structured facilities, but instead received word that their CFO, Thomas Fink, recently resigned. He is now being replaced by Donald Cole. There is certainly a lot of turmoil at this company, and this announcement does not exactly inspire confidence.
Conclusion
There is certainly a lot of potential upside to CapitalSource. The company has shareholder equity of $2.5 billion and a market cap under $500 million. There is a good deal of stability at CapitalSource Bank, a stable source of cash flow in their Health Care Net Lease Portfolio, and at least limits on liability in their securitization residuals.
All of this value is clouded by the debt and liquidity issues at the parent company level. The company has managed the transition in their business model fairly well by capturing deposits at CapitalSource Bank, but work still remains. More clarity and less drama are needed for shareholders at this point.
Based on these issues, I will likely proceed with caution regarding a CapitalSource investment. Debt at the parent company appears to be under control, though I’d like to see further deleveraging, fewer losses, and debt easily within covenants before making any significant purchases of their shares. That said, management has not inspired a long-term commitment based on their candor and recent turmoil within managment.
Disclosure: I currently hold shares of CapitalSource
