Fitch Ratings said it has upgraded CapitalSource’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. Fitch said the rating outlook remains stable.

Fitch said its 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.

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.

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