CapSource Taps New Source of Funding: You and Me

If borrowing in the capital markets stink, and right now it does, there’s always another way to get money: buy a retail bank full of money from folks like you and me.

That’s what mid-market LBO lender CapitalSource did today, agreeing to acquire the 22 retail branches of troubled California bank Fremont General Corp. To get at $5.6 billion in deposits, CapitalSource will pay a maximum of $198 million—$58 million plus 2 percent of deposits. The company also agreed to lend Fremont $200 million. The deal is scheduled to close by July 31.

If the transaction clears regulatory scrutiny, CapSource will be able to tap a pool of capital that’s far less expensive than what’s available from Wall Street. The company estimates the cost of Fremont’s deposits to be 3.75 percent for the nine months ending Sept. 30; CapSource’s cost of funding its commercial finance business, which many consists of originating senior secured loans, was 6.27 percent for the same period. If anything, the difference between those two rates has widened since last year, according to CapSource’s chief financial officer.

John Delaney, CapSource’s CEO, said the deal would enhance the company’s liquidity in a “game-changing manner.” He added, speaking in a conference call with analysts: “It will be a better source of funding over time.”

Like a lot of finance companies, mid-market LBO lender CapSource’s cost of doing business has gotten a lot more expensive in the last nine months. The company’s model rests essentially on borrowing money in the capital markets then using that money to issue new loans at higher interest rates. Finance companies have faced liquidity shortages as the cost of borrowing has increased, denting their ability to originate new loans.

CIT Group, for instance, had to tap more than $7 billion in emergency funding last month because its liquidity had evaporated. It’s still looking for an investor to inject more money into the company, although rumors of its eventual sale to a competitor such as GE Inc. persist.

CapSource, based in Chevey Chase, Md., wasn’t in the same perilous situation as CIT, but the basic math of its operations is the same. The increasing cost of funds threatened to dampen its ability to make new loans, an unfortunate circumstance since well-capitalized lenders are thriving in a market ripe with high credit spreads and favorable terms and covenants.

Consequently, the company sought to diversify its funding base. In that vein, CapSource last year made a bid for Nebraska-based TierOne bank, but the deal fell apart last month.

It turns out the Fremont transaction is better, anyway. Fremont is in a world of hurt right now: It’s been battered by the subprime mortgage explosion (it was the nation’s fifth largest subprime lender), and regulators forced the bank to unload its branches by the end of May. As a result, CapSource got to buy a depressed, must-sell asset in the valuable market of Southern California, which isn’t quite Lincoln, Neb.

CapSource plans to rebrand the bank following the deal’s closure.