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

CapitalSource Inc.

Delaware		35-2206895
(State of Incorporation)		(I.R.S. Employer Identification No.)

4445 Willard Avenue, 12th Floor
Chevy Chase, MD 20815
(Address of Principal Executive Offices, Including Zip Code)

(800) 370-9431
(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. þ Yes o No

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

þ Large accelerated filer       o Accelerated filer       o Non-accelerated filer

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

     As of August 1, 2006, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 175,632,496.

 

 

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005			2
Consolidated Statements of Income (unaudited) for the three and six months ended June 30, 2006 and 2005			3
Consolidated Statement of Shareholders’ Equity (unaudited) for the six months ended June 30, 2006			4
Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2006 and 2005			5
Notes to the Unaudited Consolidated Financial Statements			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			29
Item 3. Quantitative and Qualitative Disclosures about Market Risk			51
Item 4. Controls and Procedures			51
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			52
Item 1A. Risk Factors			52
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			52
Item 3. Defaults Upon Senior Securities			52
Item 4. Submission of Matters to a Vote of Security Holders			52
Item 5. Other Information			53
Item 6. Exhibits			53
Signatures			54
Index to Exhibits			55

CapitalSource Inc.

Consolidated Balance Sheets

		June 30,				December 31,
		2006				2005
		(Unaudited)
		($ in thousands)
ASSETS
Cash and cash equivalents		$	302,055			$	323,896
Restricted cash			224,388				284,785
Mortgage-related receivables, net			2,412,279				39,438
Mortgage-backed securities pledged, trading			3,093,675				323,370
Receivables under reverse-repurchase agreements			95,632				33,243
Loans held-for-sale			42,221				59,589
Loans:
Loans			7,033,118				5,894,911
Less deferred loan fees and discounts			(127,584	)			(120,407	)
Less allowance for loan losses			(100,775	)			(87,370	)
Loans, net			6,804,759				5,687,134
Property and equipment, net			249,851				11,502
Investments			161,550				126,393
Deferred financing fees, net			49,805				42,006
Other assets			133,640				55,712
Total assets		$	13,569,855			$	6,987,068
LIABILITIES, NONCONTROLLING INTERESTS AND SHAREHOLDERS’ EQUITY
Liabilities:
Repurchase agreements		$	3,146,750			$	358,423
Unsecured credit facilities			460,000				—
Secured credit facilities			2,903,978				2,450,452
Term debt			4,131,981				1,779,748
Convertible debt			555,000				555,000
Subordinated debt			283,504				231,959
Stock dividend payable			—				280,720
Cash dividend payable			—				70,202
Other liabilities			79,689				60,626
Total liabilities			11,560,902				5,787,130
Noncontrolling interests			56,341				—
Shareholders’ equity:
Preferred stock (50,000,000 shares authorized; no shares outstanding)			—				—
Common stock ($0.01 par value, 500,000,000 shares authorized; 175,840,043 and 141,705,766 shares issued; 174,540,043 and 140,405,766 shares outstanding, respectively)			1,745				1,404
Additional paid-in capital			1,950,721				1,248,745
Retained earnings			26,406				46,783
Deferred compensation			—				(65,729	)
Accumulated other comprehensive income (loss), net			3,666				(1,339	)
Treasury stock, at cost			(29,926	)			(29,926	)
Total shareholders’ equity			1,952,612				1,199,938
Total liabilities, noncontrolling interests and shareholders’ equity		$	13,569,855			$	6,987,068

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Income

		Three Months Ended June 30,								Six Months Ended June 30,
		2006				2005				2006				2005
		(Unaudited)
		($ in thousands, except per share data)
Net investment income:
Interest income		$	256,037			$	119,267			$	451,535			$	227,841
Fee income			36,603				38,469				78,145				64,952
Total interest and fee income			292,640				157,736				529,680				292,793
Operating lease income			6,694				—				11,319				—
Total investment income			299,334				157,736				540,999				292,793
Interest expense			153,918				42,797				251,700				77,383
Net investment income			145,416				114,939				289,299				215,410
Provision for loan losses			11,471				5,047				26,184				14,949
Net investment income after provision for loan losses			133,945				109,892				263,115				200,461
Operating expenses:
Compensation and benefits			34,130				30,588				67,450				51,954
Other administrative expenses			19,561				10,521				36,860				19,775
Total operating expenses			53,691				41,109				104,310				71,729
Other income (expense):
Diligence deposits forfeited			1,103				329				3,370				1,477
(Loss) gain on investments, net			(1,489	)			3,164				(1,740	)			5,292
Gain (loss) on derivatives			6,124				(80	)			6,650				(7	)
Gain (loss) on residential mortgage investment portfolio			4,035				—				(2,071	)			—
Other income, net of expenses			1,523				2,321				5,431				3,282
Total other income			11,296				5,734				11,640				10,044
Noncontrolling interests expense			1,230				—				2,091				—
Net income before income taxes and cumulative effect of accounting change			90,320				74,517				168,354				138,776
Income taxes			17,531				29,062				30,641				54,123
Net income before cumulative effect of accounting change			72,789				45,455				137,713				84,653
Cumulative effect of accounting change, net of taxes			—				—				370				—
Net income		$	72,789			$	45,455			$	138,083			$	84,653
Net income per share:
Basic		$	0.43			$	0.39			$	0.87			$	0.73
Diluted		$	0.43			$	0.39			$	0.85			$	0.72
Average shares outstanding:
Basic			168,866,621				116,669,187				159,309,225				116,539,867
Diluted			170,569,836				117,906,997				162,515,548				117,991,390
Dividends declared per share		$	0.49			$	—			$	0.98			$	—

See accompanying notes.

CapitalSource Inc.

Consolidated Statement of Shareholders’ Equity

																		Accumulated Other				Treasury				Total
		Common				Additional				Retained				Deferred				Comprehensive Income				Stock,				Shareholders’
		Stock				Paid-in Capital				Earnings				Compensation				(Loss), net				at cost				Equity
		(Unaudited)
		($ in thousands)
Total shareholders’ equity as of December 31, 2005		$	1,404			$	1,248,745			$	46,783			$	(65,729	)		$	(1,339	)		$	(29,926	)		$	1,199,938
Net income			—				—				138,083				—				—				—				138,083
Other comprehensive income:
Unrealized gains, net of tax			—				—				—				—				5,005				—				5,005
Total comprehensive income																											143,088
Cumulative effect of accounting change, net of taxes			—				(370	)			—				—				—				—				(370	)
Dividends paid			—				2,125				(158,412	)			—				—				—				(156,287	)
Issuance of common stock, net			327				749,506				—				—				—				—				749,833
Stock option expense			—				4,409				—				—				—				—				4,409
Exercise of options			4				3,323				—				—				—				—				3,327
Restricted stock activity			10				(59,273	)			(48	)			65,729				—				—				6,418
Tax benefit on exercise of options			—				2,244				—				—				—				—				2,244
Tax benefit on vesting of restricted stock grants			—				12				—				—				—				—				12
Total shareholders’ equity as of June 30, 2006		$	1,745			$	1,950,721			$	26,406			$	—			$	3,666			$	(29,926	)		$	1,952,612

See accompanying notes.

CapitalSource Inc.

Consolidated Statements of Cash Flows

		Six Months Ended June 30,
		2006				2005
		(Unaudited)
		($ in thousands)
Operating activities:
Net income		$	138,083			$	84,653
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option expense			4,409				180
Restricted stock expense			11,944				7,933
Loss on extinguishment of debt			2,582				—
Non-cash prepayment fee			(8,353	)			—
Cumulative effect of accounting change, net of taxes			(370	)			—
Amortization of deferred loan fees			(43,143	)			(36,595	)
Interest on paid-in-kind loans			(3,202	)			(5,202	)
Provision for loan losses			26,184				14,949
Amortization of deferred financing fees and discounts			17,763				11,459
Depreciation and amortization			5,719				1,314
Benefit for deferred income taxes			(5,684	)			(1,351	)
Non-cash loss (gain) on investments, net			5,106				(3,151	)
(Gain) loss on derivatives			(6,650	)			7
Unrealized loss on residential mortgage investment portfolio			16,513				—
Net increase in mortgage-backed securities pledged, trading			(7,112	)			—
Amortization of discount on residential mortgage investments			(7,798	)			—
Increase in loans held-for-sale, net			(24,843	)			(3,791	)
(Increase) decrease in other assets			(30,458	)			3,094
Increase (decrease) in other liabilities			3,547				(14,549	)
Cash provided by operating activities			94,237				58,950
Investing activities:
Decrease in restricted cash			60,397				8,073
Increase in mortgage-related receivables, net			(2,442,119	)			—
Increase in receivables under reverse-repurchase agreements, net			(62,389	)			—
Increase in loans, net			(1,168,978	)			(735,010	)
Acquisition of real estate, net of cash acquired			(37,199	)			—
Acquisition of investments, net			(14,612	)			(5,110	)
Acquisition of property and equipment, net			(1,487	)			(2,669	)
Cash used in investing activities			(3,666,387	)			(734,716	)
Financing activities:
Payment of deferred financing fees			(25,562	)			(12,451	)
Borrowings under repurchase agreements, net			31,323				—
Borrowings on unsecured credit facilities, net			460,000				—
Borrowings on secured credit facilities, net			495,705				351,663
Borrowings of term debt			3,165,124				1,153,160
Repayments of term debt			(845,333	)			(867,235	)
Borrowings of subordinated debt			50,000				—
Proceeds from issuance of common stock, net of offering costs			440,097				582
Proceeds from exercise of options			3,327				534
Tax benefits on share-based payments			2,256				—
Payment of dividends			(226,628	)			—
Cash provided by financing activities			3,550,309				626,253
Decrease in cash and cash equivalents			(21,841	)			(49,513	)
Cash and cash equivalents as of beginning of period			323,896				206,077
Cash and cash equivalents as of end of period		$	302,055			$	156,564
Noncash transactions from investing and financing activities:
Issuance of common stock		$	309,736			$	—

See accompanying notes.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization

     CapitalSource Inc. (“CapitalSource”), a Delaware corporation, is a specialized finance company operating as a real estate investment trust (“REIT”) and providing a broad array of financial products to small and medium-sized businesses. We primarily provide and invest in the following products:

	•		First Mortgage Loans — Commercial loans that are secured by first mortgages on the property of the client;
	•		Senior Secured Asset-Based Loans — Commercial loans that are underwritten based on our assessment of the client’s eligible collateral, including accounts receivable, real estate related receivables and/or inventory;
	•		Senior Secured Cash Flow Loans — Commercial loans that are underwritten based on our assessment of a client’s ability to generate cash flows sufficient to repay the loan and maintain or increase its enterprise value during the term of the loan, thereby facilitating repayment of the principal at maturity;
	•		Term B, Second Lien and Mezzanine Loans — Commercial loans, including subordinated mortgage loans, that come after a client’s senior loans in right of payment or upon liquidation;
	•		Direct Real Estate Investments — Commercial investments in land, buildings and other assets, including those that are purchased from and triple-net leased back to the current operators through sale-leaseback transactions;
	•		Private Equity Co-Investments — Opportunistic equity investments, typically in conjunction with commercial lending relationships and on the same terms as other equity investors; and
	•		Residential Mortgage Investments — Investments in residential mortgage loans, residential mortgage-backed securities and residential asset-backed securities that constitute qualifying REIT assets.

     Our wholly owned significant subsidiaries and their purposes as of June 30, 2006 were as follows:

Entity		Purpose
CapitalSource TRS Inc.		Subsidiary that owns interest in CapitalSource Finance LLC that made a taxable REIT subsidiary election effective January 1, 2006.
CapitalSource Finance LLC		Primary operating subsidiary of CapitalSource TRS Inc. that conducts commercial lending and investment business of CapitalSource and manages our REIT operations.
CSE Mortgage LLC		Subsidiary that holds qualifying REIT assets of CapitalSource.
CapitalSource Finance II Inc.		Subsidiary of CapitalSource Finance LLC that holds certain limited liability companies established in accordance with credit facilities and term debt securitizations.

Note 2. Summary of Significant Accounting Policies

Unaudited 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. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP 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 unaudited consolidated financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005 as filed with the Securities and Exchange Commission on March 8, 2006.

     The accompanying financial statements reflect our consolidated accounts, including all of our subsidiaries and the related consolidated results of operations with all intercompany balances and transactions eliminated in consolidation.

     Certain amounts in prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.

     Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements as of December  31, 2005 included in our Annual Report on Form 10-K. The following accounting policies have become significant accounting policies during the six months ended June 30, 2006.

Segment Reporting

     Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information, requires that a public business enterprise report financial and descriptive information about its reportable operating segments including a measure of segment profit or loss, certain specific revenue and expense items and segment assets. In connection with our REIT election and our related purchases of residential mortgage investments, we began operating as two reportable segments on January 1, 2006: 1) Commercial Lending & Investment and 2) Residential Mortgage Investment. Our Commercial Lending & Investment segment includes our commercial lending and investment business and our Residential Mortgage Investment segment includes all of our activities related to our residential mortgage investments. Prior to 2006, we operated as a single business segment as substantially all of our activity was related to our commercial lending and investment business, and disclosures required by this statement were not applicable.

Mortgage-Related Receivables and Related Owner Trust Securitizations

     We purchased beneficial interests in special purpose entities (“SPEs”) that acquired and securitized pools of residential mortgage loans. In accordance with the provisions of FASB Interpretation No. 46 (Revised 2003), Consolidation of Variable Interest Entities — An Interpretation of ARB No. 51, we determined that we were the primary beneficiary of the these SPEs and, therefore, consolidated the assets and liabilities of such entities for financial statement purposes. We determined that the SPEs’ interest in the underlying mortgage loans constituted, for accounting purposes, receivables secured by underlying mortgage loans. As a result, through consolidation, we recorded mortgage-related receivables, as well as the principal amount of related debt obligations incurred by SPEs to fund the origination of such receivables, on our accompanying consolidated balance sheet as of June 30, 2006. Such mortgage-related receivables maintain all of the economic attributes of the underlying mortgage loans legally held in trust by such SPEs and, as a result of our interest in such SPEs, we maintain all of the economic benefits and related risks of ownership of underlying mortgage loans.

     Our investments in mortgage-related receivables are recorded at amortized cost. Purchase premiums and discounts that relate to such receivables are amortized into interest income over the estimated lives of such assets in accordance with the interest method of SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (“SFAS No. 91”). We also apply the interest method of SFAS No. 91 for purposes of amortizing into interest expense recognized discounts and other deferred items relating to the consolidated debt obligations of the SPEs.

Note 3. Recently Issued Accounting Guidance

     In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation requires recognition of the impact of a tax position if that position is more likely than not of being sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In addition, FIN 48 provides measurement guidance whereby a tax position that meets the more-likely-than-not recognition threshold is calculated to determine the amount of benefit to recognize in the financial statements. FIN 48 is effective beginning the first fiscal year beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We plan to adopt FIN 48 on January 1, 2007. We have not completed our assessment of the impact of adoption on our consolidated financial statements, but do not expect it to be significant based on our current business plan.

Note 4. Mortgage-Related Receivables

     As of June 30, 2006, we had $2.4 billion in mortgage-related receivables that, as further discussed above in Note 2 , Summary of Significant Accounting Policies, are secured by prime residential mortgage loans. As of June 30, 2006, the weighted average interest rate on such receivables was 5.38%, and the weighted average contractual maturity was 29.2 years. As of June 30, 2006, the carrying amount of our residential mortgage-related receivables, including accrued interest and the unamortized balance of purchase discounts, was $2.4 billion.

     We did not record any additional provision for loan losses related to our mortgage-related receivables during the three months ended June 30, 2006. For the six months ended June 30, 2006, our provision for loan losses was $0.3 million and the allowance for loan losses was $0.3 million as of June 30, 2006. The allowance for loan losses is recorded in the accompanying consolidated balance sheet as a reduction to the carrying value of mortgage-related receivables.

Note 5. Residential Mortgage-Backed Securities and Certain Derivative Instruments

     As of June 30, 2006 and December 31, 2005, we owned $3.1 billion and $2.3 billion, respectively, in residential mortgage-backed securities (“RMBS”). As of June 30, 2006 and December 31, 2005, all of our RMBS were pledged as collateral for repurchase agreements that were used to finance the purchase of such investments. Our investments in RMBS include mortgage-backed securities that are rated AAA by Standard & Poor’s or Moody’s Investors Service, as well as mortgage-backed securities whose payments of principal and interest are guaranteed by the Federal National Mortgage Association (“Fannie Mae”) or Freddie Mac. As of June 30, 2006 and December 31, 2005, our portfolio comprised 1-year adjustable-rate RMBS and 3-year, 5-year and 7-year hybrid adjustable-rate RMBS issued by Fannie Mae or Freddie Mac. The weighted average net coupon of RMBS in our portfolio was 4.64% and 4.59% as of June 30, 2006 and December 31, 2005, respectively.

     As of December 31, 2005, $2.0 billion of our purchases of RMBS were financed through repurchase agreements that were executed with the seller of such investments. We accounted for the various contractual elements of these transactions on a net basis such that forward commitments to purchase RMBS were recorded on our consolidated balance sheet as derivative instruments, as well as a margin-related cash deposit that was made in connection with the related repurchase agreements. These derivative instruments were adjusted to fair value through income in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

     In March 2006, we exercised our contractual right to substitute RMBS that were assigned as collateral to such repurchase agreements. As a result, as of June 30, 2006, we recorded RMBS on our accompanying consolidated balance sheet that we accounted for as debt securities classified as trading pursuant to the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS No. 115”). Additionally, in recording such investments, we also recorded liabilities

to counterparties of corresponding repurchase agreements that were executed to finance the purchase of such investments. For further discussion of our accounting for such transactions, see Note 2, Summary of Significant Accounting Policies, in our audited consolidated financial statements for the year ended December 31, 2005 included in our Annual Report on Form 10-K.

     As of June 30, 2006, the fair value of RMBS in our portfolio was $3.1 billion. For the three and six months ended June 30, 2006, we recognized $18.0 million and $38.6 million, respectively, of unrealized losses related to these investments in income as a component of gain (loss) on residential mortgage investment portfolio in the accompanying consolidated statements of income. During the six months ended June 30, 2006, and prior to executing the aforementioned right of collateral substitution, we recognized a net unrealized loss of $10.8 million in gain (loss) on residential mortgage investment portfolio related to period changes in the fair value of our forward commitments to purchase RMBS. As of December 31, 2005, RMBS with a fair value of $323.4 million were classified as trading securities on our accompanying consolidated balance sheet.

     We use various derivative instruments to economically hedge the market risk associated with the RMBS in our portfolio. We account for such derivative instruments pursuant to the provisions of SFAS No. 133 and, as such, adjust such instruments to fair value through income as a component of gain (loss) on residential mortgage investment portfolio in the accompanying consolidated statements of income. We recognized gains of $22.0 million and $47.3 million during the three and six months ended June 30, 2006, respectively, related to such derivative instruments. These amounts include interest-related accruals that we recognize in connection with the periodic settlement of such instruments.

Note 6. Commercial Loans and Credit Quality

     As of June 30, 2006 and December 31, 2005, our total commercial loan portfolio had an outstanding balance of $7.2 billion and $6.0 billion, respectively. Included in these amounts are commercial loans held-for-sale with outstanding balances of $42.2 million and $59.6 million as of June 30, 2006 and December 31, 2005, respectively, and receivables under reverse-repurchase agreements with outstanding balances of $95.6 million and $33.2 million as of June 30, 2006 and December 31, 2005, respectively. Our commercial loans held-for-sale were recorded at the lower of cost or market value on the accompanying consolidated balance sheets. None of these commercial loans had a market value below cost as of June 30, 2006 or December 31, 2005. During the three months ended June 30, 2006, we derecognized $188.1 million of loans that are resident in a special purpose entity that was previously consolidated for financial statement purposes as of December 31, 2005.

Credit Quality

     As of June 30, 2006 and December 31, 2005, the principal balances of loans 60 or more days contractually delinquent, non-accrual loans and impaired loans in our commercial lending portfolio were as follows:

		June 30,				December 31,
Commercial Loan Asset Classification		2006				2005
		($ in thousands)
Loans 60 or more days contractually delinquent		$	94,073			$	41,785
Non-accrual loans(1)			143,788				137,446
Impaired loans(2)			235,552				199,257
Less: loans in multiple categories			(193,243	)			(175,070	)
Total		$	280,170			$	203,418
Total as a percentage of total loans			3.91%				3.40%

     As defined by SFAS No. 114, Accounting by Creditors for Impairment of a Loan (“SFAS No. 114”), 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, including principal and scheduled interest payments. Pursuant to SFAS No. 114, impaired loans include loans for which we expect to have a credit loss and other loans that meet the definition of an impaired loan, but

for which we do not currently expect to have a credit loss. As of June 30, 2006 and December 31, 2005, we had $101.9 million and $98.2 million of impaired commercial loans, respectively, with allocated reserves of $37.6 million and $33.1 million, respectively. As of June 30, 2006 and December 31, 2005, we had $133.6 million and $101.0 million, respectively, of impaired commercial loans for which we did not record any allocated reserves as we believe it is probable that we will collect all principal and interest amounts due.

     The average balance of impaired commercial loans during the three and six months ended June 30, 2006 was $212.8 million and $212.6 million, respectively, and was $157.0 million and $121.8 million, respectively, during the three and six months ended June 30, 2005. The total amount of interest income that was recognized on impaired commercial loans during the three and six months ended June 30, 2006 was $2.5 million and $4.8 million, respectively, and was $2.1 million and $6.1 million, respectively, during the three and six months ended June 30, 2005. The amount of cash basis interest income that was recognized on impaired commercial loans during the three and six months ended June 30, 2006 was $2.6 million and $3.9 million, respectively, and was $2.2 million and $5.3 million, respectively, during the three and six months ended June 30, 2005. If the non-accrual commercial loans had performed in accordance with their original terms, interest income would have been higher than reported by $5.3 million and $10.3 million for the three and six months ended June 30, 2006, respectively, and $2.8 million and $4.0 million, respectively, for the three and six months ended June 30, 2005.

     During the three and six months ended June 30, 2006, we classified commercial loans with an aggregate carrying value of $29.7 million and $102.7 million, respectively, as of June 30, 2006 as troubled debt restructurings as defined by SFAS No. 15, Accounting for Debtors and Creditors for Troubled Debt Restructurings. As of June 30, 2006, commercial loans with an aggregate carrying value of $121.9 million were classified as troubled debt restructurings. These loans were also classified as impaired loans since, under SFAS No. 114, loans classified as troubled debt restructurings are also classified as impaired loans generally for a period of one year following the restructuring. The allocated reserve for commercial loans classified as troubled debt restructurings was $17.1 million as of June 30, 2006. For the year ended December 31, 2005, commercial loans with an aggregate carrying value of $73.7 million as of December 31, 2005 were classified as troubled debt restructurings. The allocated reserve for commercial loans classified as troubled debt restructurings was $13.6 million as of December 31, 2005.

     Activity in the allowance for loan losses related to our Commercial Lending & Investment segment for the six months ended June 30, 2006 and 2005 was as follows:

		Six Months Ended
		June 30,
		2006				2005
		($ in thousands)
Balance as of beginning of period		$	87,370			$	35,208
Provision for loan losses			25,883				14,949
Charge offs, net			(12,478	)			(5,608	)
Balance as of end of period		$	100,775			$	44,549

Note 7. Investments

     Investments as of June 30, 2006 and December 31, 2005 were as follows:

		June 30,				December 31,
		2006				2005
		($ in thousands)
Investments carried at cost		$	64,107			$	51,907
Investments carried at fair value:
Investments available-for-sale			56,912				50,461
Warrants			7,847				10,259
Investments accounted for under the equity method			32,684				13,766
Total		$	161,550			$	126,393

     We account for the warrants noted in the preceding table as derivative instruments pursuant to the provisions of SFAS No. 133. As a result, we adjust such instruments to fair value through income as a component of loss (gain) on investments, net in the accompanying consolidated statements of income. During the three and six months ended June 30, 2006, we recognized $2.0 million and $2.3 million, respectively, of unrealized losses in income. During the three and six months ended June 30, 2005, we recognized $0.6 million and $3.9 million, respectively, of unrealized gains in income.

     During the three months ended June 30, 2006, we purchased $36.9 million of residential asset-backed securities that are collateralized by subprime residential mortgage loans. We account for these investments as debt securities that are classified as available-for-sale investments in accordance with SFAS No. 115. As a result, we record these investments at fair value with all

temporary changes in fair value recorded in shareholders’ equity as a component of accumulated other comprehensive income (loss), net. These investments are included in investments on our accompanying consolidated balance sheet as of June 30, 2006.

     For the three and six months ended June 30, 2006, we sold investments for $4.5 million and $41.9 million, respectively, recognizing net pretax gains of $1.7 million and $2.0 million, respectively. For the three and six months ended June 30, 2005, we sold investments for $4.1 million and $5.0 million, respectively, recognizing gross pretax gains of $2.8 million and $3.4 million, respectively.

Note 8. Borrowings

     For a detailed discussion of our borrowings, see Note 9, Borrowings, in our audited consolidated financial statements for the year ended December 31, 2005 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 8, 2006 and see Note 9, Borrowings, in our unaudited consolidated financial statements for the three months ended March 31, 2006 included in our Quarterly Report on Form 10-Q, as filed with the Securities and Exchange Commission on May 10, 2006. The following changes to our borrowings occurred during the three months ended June 30, 2006:

Repurchase Agreements

     During the three months ended June 30, 2006, we entered into a master repurchase agreement with one additional financial institution to finance purchases of residential mortgage investments. The terms of this repurchase agreement are similar to those of our seven existing repurchase agreements. The amount financed under this repurchase agreement will bear interest at a per annum rate that is less than, and that adjusts based upon, short-term LIBOR indices. As of June 30, 2006 and December 31, 2005, the aggregate amount outstanding under our repurchase agreements used to finance purchases of residential mortgage investments was $3.0 billion and $2.2 billion, respectively. As of June 30, 2006 and December 31, 2005, repurchase agreements that we executed had a weighted average borrowing rate of 5.27% and 4.36%, respectively, and a weighted average remaining maturity of 1.2 months and 2.9 months, respectively. RMBS with a fair value of $3.1 billion, including accrued interest, asset-backed securities with a fair value of $37.4 million, including accrued interest, and cash deposits of $6.5 million made to cover margin calls collateralized these repurchase agreements as of June 30, 2006. RMBS with a fair value of $2.3 billion, including accrued interest, and cash deposits of $1.8 million made to cover margin calls collateralized these repurchase agreements as of December 31, 2005.

     Financing purchases of mortgage-backed securities through repurchase agreements exposes us to the risk that margin calls will be made if interest rates change or the value of the assets decline and that we will not be able to meet those margin calls. To meet margin calls, we may be required to sell our RMBS which could result in losses and adversely affect our ability to meet the applicable REIT asset and income requirements.

Credit Facilities

     As of June 30, 2006, we had eight credit facilities, seven of which were secured and one of which was unsecured, with 18 financial institutions which we use to fund our commercial loans and for general corporate purposes. During the three months ended June 30, 2006, we decreased our committed credit facility capacity to $4.8 billion. As of June 30, 2006, two of our credit facilities, with a total capacity of $1.3 billion, are scheduled to mature within one year, both of which are subject to annual renewal. Our other six credit facilities, with a total capacity of $3.5 billion, have scheduled maturity dates between one and three years, of which $2.6 billion is subject to annual renewal.

     In April 2006, we decreased the maximum facility amount of our $1.6 billion credit facility with Citigroup Global Markets Inc. to $600.0 million. We used the proceeds from our April 2006 term debt securitization, discussed below, and from other financing sources to repay $762.0 million under this facility. In addition, on June 30, 2006, we amended the maximum advance rate under this credit facility to 85%.

     On April 28, 2006, we amended our $1.0 billion credit facility with Wachovia Capital Markets LLC to increase the number of lenders participating in the facility, increase the maximum amount of the facility to $1.2 billion and extend the maturity date to April 28, 2009 from April 28, 2006.

     On June 30, 2006, we amended our unsecured syndicated revolving credit facility to, among other things, increase the maximum facility amount to $640.0 million from $545.0 million. This amendment added four new financial institutions to the syndicate, increasing the total number of lenders within the facility to 16.

     On June 30, 2006, we entered into a $500.0 million secured, revolving credit facility with Citigroup Global Markets Realty Corp. We used the proceeds from the facility primarily to finance the origination of commercial real estate and real estate-related loan assets. The credit facility is secured by commercial real estate and real estate-related loan assets and has a scheduled maturity date of June 27, 2009. Interest on borrowings under the credit facility will be charged at the applicable commercial paper rate or the Alternate Rate, as defined in the related Sale and Servicing Agreement. On July 28, 2006, we amended this credit facility to increase the maximum facility amount to $900.0 million through the addition of a new lender.

Term Debt

     On April 11, 2006, we completed a $782.3 million term debt securitization. Consistent with all of our prior term debt securitizations, we recorded this transaction as an on-balance sheet financing in accordance with SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In conjunction with this transaction, we established a single-purpose, bankruptcy-remote subsidiary, CapitalSource Commercial Loan Trust 2006-1. The transaction covers the sale of $715.8 million of floating-rate asset-backed notes, which are backed by a $782.3 million diversified pool of commercial loans from our commercial lending portfolio. Subject to the satisfaction of certain conditions, we remain servicer of the loans. The offered notes represent 91.5% of the collateral pool, and we retained an 8.5% interest in the collateral pool. The Class A, B, C and D notes carry an interest rate of 30-day LIBOR plus 0.12%, 0.25%, 0.55% and 1.30%, respectively, and are expected to mature at various dates through December 2010. We used the proceeds to repay outstanding indebtedness under one of our secured credit facilities.

Note 9. Guarantor Information

     The following represents the unaudited supplemental consolidating condensed financial statements of CapitalSource Inc., which was the issuer of the convertible debt issued in March 2004 and July 2004, and CapitalSource Finance LLC (“CapitalSource Finance”), which was a guarantor of the convertible debentures, and our subsidiaries that are not guarantors of the convertible debentures as of June 30, 2006 and December 31, 2005 and for the three and six months ended June 30, 2006 and 2005. CapitalSource Finance, a wholly owned indirect subsidiary of CapitalSource Inc., has guaranteed the debentures, fully and unconditionally, on a senior basis. Through October 12, 2005, CSE Holdings LLC, formerly CapitalSource Holdings Inc. (“CSE Holdings”), was also a guarantor of the convertible debentures. On October 12, 2005, CSE Holdings merged with and into CapitalSource Inc., with CapitalSource Inc. as the surviving entity. The following condensed consolidating financial statements include the activity of CSE Holdings for the three and six months ended June 30, 2005. Separate consolidated financial statements of each guarantor are not presented, as we have determined that they would not be material to investors.

Consolidating Balance Sheet
June 30, 2006

						CapitalSource Finance LLC
						Combined Non-				Combined				Other Non-
						Guarantor				Guarantor				Guarantor								Consolidated
		CapitalSource Inc.				Subsidiaries				Subsidiaries				Subsidiaries				Eliminations				CapitalSource Inc.
		(Unaudited)
		($ in thousands)
Assets
Cash and cash equivalents		$	1,806			$	148,752			$	73,772			$	77,725			$	—			$	302,055
Restricted cash			—				131,190				74,800				18,398				—				224,388
Mortgage-related receivables, net			—				—				—				2,412,279				—				2,412,279
Mortgage-backed securities pledged, trading			—				—				—				3,093,675				—				3,093,675
Receivables under reverse-repurchase agreements			—				95,632				—				—				—				95,632
Loans held-for-sale			—				26,223				15,998				—				—				42,221
Loans:
Loans			—				3,785,020				623,320				2,633,572				(8,794	)			7,033,118
Less deferred loan fees and discounts			—				(41,198	)			(45,378	)			(41,008	)			—				(127,584	)
Less allowance for loan losses			—				—				(83,278	)			(17,497	)			—				(100,775	)
Loans, net			—				3,743,822				494,664				2,575,067				(8,794	)			6,804,759
Property and equipment, net			—				27				11,516				238,308				—				249,851
Investment in subsidiaries			2,914,688				—				772,494				1,094,451				(4,781,633	)			—
Intercompany due from/(due to)			52,367				—				(142,366	)			89,999				—				—
Intercompany note receivable			—				2,909				12,403				—				(15,312	)			—
Investments			—				46,301				77,899				37,350				—				161,550
Deferred financing fees, net			12,592				19,149				8,592				9,472				—				49,805
Other assets			6				776				22,633				118,243				(8,018	)			133,640
Total assets		$	2,981,459			$	4,214,781			$	1,422,405			$	9,764,967			$	(4,813,757	)		$	13,569,855
Liabilities, noncontrolling interests and shareholders’ equity
Liabilities:
Repurchase agreements		$	—			$	112,651			$	—			$	3,034,099			$	—			$	3,146,750
Unsecured credit facilities			460,000				—				—				—				—				460,000
Secured credit facilities			—				1,585,978				—				1,318,000				—				2,903,978
Term debt			—				1,708,095				6,714				2,417,172				—				4,131,981
Convertible debt			555,000				—				—				—				—				555,000
Subordinated debt			—				—				283,504				—				—				283,504
Other liabilities			13,847				20,255				37,736				24,663				(16,812	)			79,689
Intercompany note payable			—				15,312				—				—				(15,312	)			—
Total liabilities			1,028,847				3,442,291				327,954				6,793,934				(32,124	)			11,560,902
Noncontrolling interests			—				—				—				56,345				(4	)			56,341
Shareholders’ equity:
Preferred stock			—				—				—				—				—				—
Common stock			1,745				—				—				—				—				1,745
Additional paid-in capital			1,950,721				246,182				310,460				2,754,886				(3,311,528	)			1,950,721
Retained earnings			26,406				526,286				780,229				155,833				(1,462,348	)			26,406
Accumulated other comprehensive income, net			3,666				22				3,762				3,969				(7,753	)			3,666
Treasury stock, at cost			(29,926	)			—				—				—				—				(29,926	)
Total shareholders’ equity			1,952,612				772,490				1,094,451				2,914,688				(4,781,629	)			1,952,612
Total liabilities, noncontrolling interests and shareholders’ equity		$	2,981,459			$	4,214,781			$	1,422,405			$	9,764,967			$	(4,813,757	)		$	13,569,855

Consolidating Balance Sheet

December 31, 2005

						CapitalSource Finance LLC
						Combined Non-				Combined				Other Non-
						Guarantor				Guarantor				Guarantor								Consolidated
		CapitalSource Inc.				Subsidiaries				Subsidiaries				Subsidiaries				Eliminations				CapitalSource Inc.
		($ in thousands)
Assets
Cash and cash equivalents		$	2,038			$	145,065			$	156,571			$	20,222			$	—			$	323,896
Restricted cash			—				125,832				153,299				5,654				—				284,785
Mortgage-related receivables, net			—				—				—				39,438				—				39,438
Mortgage-backed securities pledged, trading			—				—				—				323,370				—				323,370
Receivables under reverse-repurchase agreements			—				33,243				—				—				—				33,243
Loans held-for-sale			—				17,378				42,211				—				—				59,589
Loans:
Loans			—				4,087,078				374,833				1,440,828				(7,828	)			5,894,911
Less deferred loan fees and discounts			—				(971	)			(100,123	)			(19,313	)			—				(120,407	)
Less allowance for loan losses			—				—				(78,003	)			(9,367	)			—				(87,370	)
Loans, net			—				4,086,107				196,707				1,412,148				(7,828	)			5,687,134
Property and equipment, net			—				—				11,502				—				—				11,502
Investment in subsidiaries			2,063,092				—				655,627				—				(2,718,719	)			—
Intercompany note receivable			—				7,803				35,288				—				(43,091	)			—
Investments			33,494				21,210				71,689				—				—				126,393
Deferred financing fees, net			11,114				22,868				7,944				80				—				42,006
Other assets			20,110				1,018				19,839				14,745				—				55,712
Total assets		$	2,129,848			$	4,460,524			$	1,350,677			$	1,815,657			$	(2,769,638	)		$	6,987,068
Liabilities and shareholders’ equity
Liabilities:
Repurchase agreements		$	—			$	47,157			$	—			$	311,266			$	—			$	358,423
Secured credit facilities			—				1,938,273				42,179				470,000				—				2,450,452
Term debt			—				1,774,475				5,273				—				—				1,779,748
Convertible debt			555,000				—				—				—				—				555,000
Subordinated debt			—				—				231,959				—				—				231,959
Stock dividend payable			280,720				—				—				—				—				280,720
Cash dividend payable			70,202				—				—				—				—				70,202
Other liabilities			3,661				22,228				41,112				1,453				(7,828	)			60,626
Intercompany note payable			20,327				22,764				—				—				(43,091	)			—
Total liabilities			929,910				3,804,897				320,523				782,719				(50,919	)			5,787,130
Shareholders’ equity:
Preferred stock			—				—				—				—				—				—
Common stock			1,404				—				—				—				—				1,404
Additional paid-in capital			1,248,745				278,656				362,137				1,025,690				(1,666,483	)			1,248,745
Retained earnings			46,783				377,492				668,762				7,248				(1,053,502	)			46,783
Deferred compensation			(65,729	)			—				—				—				—				(65,729	)
Accumulated other comprehensive loss, net			(1,339	)			(521	)			(745	)			—				1,266				(1,339	)
Treasury stock, at cost			(29,926	)			—				—				—				—				(29,926	)
Total shareholders’ equity			1,199,938				655,627				1,030,154				1,032,938				(2,718,719	)			1,199,938
Total liabilities and shareholders’ equity		$	2,129,848			$	4,460,524			$	1,350,677			$	1,815,657			$	(2,769,638	)		$	6,987,068

Consolidating Statement of Income

Three Months Ended June 30, 2006

						CapitalSource Finance LLC
						Combined Non-				Combined				Other Non-
						Guarantor				Guarantor				Guarantor								Consolidated
		CapitalSource Inc.				Subsidiaries				Subsidiaries				Subsidiaries				Eliminations				CapitalSource Inc.
		(Unaudited)
		($ in thousands)
Net investment income:
Interest income		$	—			$	116,621			$	15,604			$	124,299			$	(487	)		$	256,037
Fee income			—				47,791				(22,505	)			11,317				—				36,603
Total interest and fee income			—				164,412				(6,901	)			135,616				(487	)			292,640
Operating lease income			—				—				—				6,694				—				6,694
Total investment income			—				164,412				(6,901	)			142,310				(487	)			299,334
Interest expense			7,647				52,041				7,006				87,711				(487	)			153,918
Net investment (loss) income			(7,647	)			112,371				(13,907	)			54,599				—				145,416
Provision for loan losses			—				—				7,432				4,039				—				11,471
Net investment (loss) income after provision for loan losses			(7,647	)			112,371				(21,339	)			50,560				—				133,945
Operating expenses:
Compensation and benefits			—				1,375				32,755				—				—				34,130
Other administrative expenses			3,745				689				14,736				3,978				(3,587	)			19,561
Total operating expenses			3,745				2,064				47,491				3,978				(3,587	)			53,691
Other income (expense):
Diligence deposits forfeited			—				—				1,103				—				—				1,103
Loss on investments, net			—				—				(1,489	)			—				—				(1,489	)
Gain on derivatives			—				624				1,123				4,377				—				6,124
Gain on residential mortgage investment portfolio			—				—				—				4,035				—				4,035
Other income, net of expenses			76				89				4,945				—				(3,587	)			1,523
Earnings in subsidiaries			84,105				—				105,319				47,872				(237,296	)			—
Intercompany			—				(5,701	)			5,701				—				—				—
Total other income (expense)			84,181				(4,988	)			116,702				56,284				(240,883	)			11,296
Noncontrolling interests expense			—				—				—				1,230				—				1,230
Net income before income taxes and cumulative effect of accounting change			72,789				105,319				47,872				101,636				(237,296	)			90,320
Income taxes			—				—				—				17,531				—				17,531
Net income before cumulative effect of accounting change			72,789				105,319				47,872				84,105				(237,296	)			72,789
Cumulative effect of accounting change, net of taxes			—				—				—				—				—				—
Net income		$	72,789			$	105,319			$	47,872			$	84,105			$	(237,296	)		$	72,789

Consolidating Statement of Income

Six Months Ended June 30, 2006

						CapitalSource Finance LLC
						Combined Non-				Combined				Other Non-
						Guarantor				Guarantor				Guarantor								Consolidated
		CapitalSource Inc.				Subsidiaries				Subsidiaries				Subsidiaries				Eliminations				CapitalSource Inc.
		(Unaudited)
		($ in thousands)
Net investment income:
Interest income		$	549			$	231,809			$	31,923			$	189,115			$	(1,861	)		$	451,535
Fee income			—				76,731				(24,016	)			25,430				—				78,145
Total interest and fee income			549				308,540				7,907				214,545				(1,861	)			529,680
Operating lease income			—				—				—				11,319				—				11,319
Total investment income			549				308,540				7,907				225,864				(1,861	)			540,999
Interest expense			12,953				105,456				12,533				122,619				(1,861	)			251,700
Net investment (loss) income			(12,404	)			203,084				(4,626	)			103,245				—				289,299
Provision for loan losses			—				—				17,753				8,431				—				26,184
Net investment (loss) income after provision for loan losses			(12,404	)			203,084				(22,379	)			94,814				—				263,115
Operating expenses:
Compensation and benefits			—				2,306				65,144				—				—				67,450
Other administrative expenses			7,339				1,237				28,350				7,053				(7,119	)			36,860
Total operating expenses			7,339				3,543				93,494				7,053				(7,119	)			104,310
Other income (expense):
Diligence deposits forfeited			—				—				3,370				—				—				3,370
Loss on investments, net			—				—				(1,740	)			—				—				(1,740	)
Gain on derivatives			—				1,035				1,238				4,377				—				6,650
Loss on residential mortgage investment portfolio			—				—				—				(2,071	)			—				(2,071	)
Other income, net of expenses			76				318				14,738				(2,582	)			(7,119	)			5,431
Earnings in subsidiaries			157,750				—				187,564				102,997				(448,311	)			—
Intercompany			—				(13,330	)			13,330												—
Total other income (expense)			157,826				(11,977	)			218,500				102,721				(455,430	)			11,640
Noncontrolling interests expense			—				—				—				2,091				—				2,091
Net income before income taxes and cumulative effect of accounting change			138,083				187,564				102,627				188,391				(448,311	)			168,354
Income taxes			—				—				—				30,641				—				30,641
Net income before cumulative effect of accounting change			138,083				187,564				102,627				157,750				(448,311	)			137,713
Cumulative effect of accounting change, net of taxes			—				—				370				—				—				370
Net income		$	138,083			$	187,564			$	102,997			$	157,750			$	(448,311	)		$	138,083