Fitch Ratings has downgraded CapitalSource Inc.'s (CSE) long-term Issuer Default Rating (LT IDR) to 'BB-' and assigned a long-term IDR of 'BB' to CapitalSource Bank (CSB). The Rating Outlook has been revised from Negative to Stable. A complete list of ratings is provided below.
The downgrade of CSE reflects its transition to bank holding company (BHC) status, as defined by Fitch, and is consistent with Fitch's criteria and methodology for rating bank holding companies. As a BHC, CSE's obligation to support its bank subsidiary takes priority relative to its own recourse debt obligations which amounted to approximately $0.9 billion at Dec. 31, 2010. The downgrade also reflects CSE's, inconsistent operating performance, elevated nonperforming asset levels and the challenges inherent in liquidating a stressed portfolio. CSE's strong liquidity provides support at the new, lower IDR and, should debt at the holding company diminish significantly, Fitch would revisit the relative notching.
The assignment of a 'BB' long-term IDR to CapitalSource Bank reflects the bank's solid current liquidity and capitalization, offset by execution risks associated with the company's plan to convert CSB to a commercial bank charter, lack of operating history and unseasoned performance of bank loan originations, a heavy reliance on spread income, poor but improving credit quality of legacy loan exposures, and a rate-sensitive deposit base. Additionally, the bank's competitive positioning longer-term remains uncertain, given its limited market participation in recent years.
Fitch has also adjusted its notching of CSE's debt instruments relative to its IDR. Based on the payment priority rights imbedded within CSE's remaining debt obligations, senior secured creditors remain in a more favorable position than subordinated creditors in the event of default. Accordingly, Fitch has assigned the senior secured debt rating one notch above the IDR, reflecting enhanced recovery prospects in the event of liquidation. The subordinated convertible is notched one level below the IDR reflecting its junior priority. However, the notching on the subordinated debt has been narrowed as senior debtholders have allowed CSE absent a default, to use available cash to purchase the subordinated convertible debt prior to maturity of the senior secured debt. The convertible debt is redeemable in July 2011 and July 2012 and the senior secured debt matures in 2014. At year-end 2010, senior secured obligations amounted to $286 million and subordinated debt amounted to $530 million versus $585 million of cash and liquid securities at CSE.
Fitch recognizes that transition of the company's funding platform has progressed substantially, as $4 billion of the $6.3 billion of parent company debt outstanding at fiscal year end (FYE) 2008 has been repaid from loan portfolio proceeds. Parent company liquidity primarily consists of cash generated from repayment of the legacy loan portfolio, and, relative to expected near-term funding requirements is considered solid.
Fitch also believes CSB's overall capital base is solid compared to similarly rated peers. However, given the credit quality concerns surrounding the legacy portfolio, a capital base of this size is considered appropriate to support current bank ratings. FDIC requirements include maintaining a minimum total risk-based capital ratio of 15%, minimum Tier-1 risk-based capital ratio of 6%, and a minimum Tier-1 leverage ratio of 5%. At Dec. 31, 2010, CSB's ratios exceeded these requirements and equaled 18.13%, 16.68% and 13.15%, respectively. CSB's tangible stockholder's equity to tangible assets ratio equaled 12.61% and exceeded the minimum 10% required under an approval order with the CA Dept. of Financial Institutions.
Deterioration in the legacy loan portfolio asset quality metrics over the last two years peaked during the first half of 2010. Trends and metrics began to show gradual improvement throughout 2010 and have steadily declined over the last few quarters. Overall delinquencies (30+ days) gradually declined during 2010 and have decreased by $766 million since Dec. 31, 2009 to $696 million at Dec. 31, 2010. Non-accruing loans peaked at $1.14 billion in first quarter 2010 (1Q'10) and have fallen to $699 million at Dec. 31, 2010. Impaired loans have fallen to $931 million since peaking at $1.5 billion at June 30, 2010. Trailing 12-month charge-offs peaked at $659 million at Dec. 31, 2009 and steadily declined during 2010 to $426 million at Dec. 31, 2010.
Over the past three years, the company's consolidated financial performance has reflected deteriorating asset quality metrics and included increases in non-performing loans, loss provisioning and recognition of substantially higher loan losses. As a result, reported pre-tax losses on continuing operations equaled $(161) million, $(775) million and $(459) million for FYE 2010, 2009 and 2008, respectively. However, given the recent improving credit performance metrics, the company markedly reduced loss provisioning over the last three quarters of 2010. As result of lower loss provisioning and higher loan origination volume within CSB, pre-tax income on a quarterly basis has steadily improved from ($198 million) in 1Q'10 to $42 million in 4Q'10. Fitch notes that reversal of current credit performance trends would likely result in higher loss provisioning and offset any operating momentum generated by loan growth within the bank.
The revision of the Outlook to Stable from Negative reflects recent stabilization in credit trends, solid bank capitalization, improved liquidity, and progress made in liquidating the legacy loan book.
However, an inability to compete effectively and grow origination volumes, deterioration in asset quality, continued operating losses, a reduction in liquidity relative to outstanding debt, and/or reduced capitalization could yield negative rating action.
Conversely, while Fitch believes positive rating momentum is limited over the intermediate term, further liquidation of legacy loan exposure within established loss reserves, repayment of remaining CSE debt, clarity regarding the outcome of the company's plan to convert CSB to a commercial bank from an industrial loan bank, stronger asset quality, improved operating consistency, the development of a 'sticky' deposit base over market cycles, and the retention of solid capitalization, could provide positive rating momentum.
Fitch has taken the following rating actions:
CapitalSource Inc.
--LT IDR rating downgraded to 'BB- from 'BB';
--Senior secured rating affirmed at 'BB';
--Senior subordinate rating upgraded to 'B+' from 'B'.
The Rating Outlook is Stable.
Fitch has assigned the following ratings:
CapitalSource Bank
--LT IDR rating 'BB';
--LT deposits 'BB+';
--ST IDR 'B';
--ST deposits 'B'
--Individual 'C/D';
--Support '5;
--Support Floor 'NF'.
The Rating Outlook is Stable.
For additional credit commentary and analysis on the financial institutions sector, see Fitch's recent Global Financial Institutions Snapshot available through the link below). The report compiles Fitch's views, analysis and tools for the sector in an easily navigable format.
Additional information is available at www.fitchratings.com. The ratings above have been initiated by Fitch as a service to investors. The issuer did not participate in the rating process other than through the medium of its public disclosure.
Applicable Criteria and Related Research:
--'Global Financial Institutions Rating Criteria' (Aug. 16, 2010);
--Bank Holding Companies Criteria (Dec. 30, 2009)
--'Short-Term Ratings Criteria for Corporate Finance' Nov. 2, 2010
--'Finance and Leasing Companies Criteria', Dec. 13, 2010.
Applicable Criteria and Related Research:
Finance and Leasing Companies Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=587245
Global Financial Institutions Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=547685
Short-Term Ratings Criteria for Corporate Finance
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=568726
Bank Holding Companies
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=493324
2008 Financial Institutions Rating Recap: A Quick Look Back For a Better Look Forward
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=419466
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